The Economics of Marketing

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I came across this hilarious explanation of economics today and thought I’d share it with you today (sorry for the poor video quality but it’s not my video). If you enjoy this treatment of economics, you’ll understand why the economics of marketing doesn’t necessarily fit what most economists believe as fact.

A professor once explained marketing to me as having 2 parents — economics and psychology. Much of what I focus on in Hausman Marketing Letter is the psychology side of marketing. In fact, much of what you hear from marketers and social media types focuses on only the psychology side. But, there is a place for economics in marketing and there are markets where the economics side of marketing is dominant — just not the ones you think.

The economics of marketing

If economics is the harsh father of marketing — containing all the sternness, rationality, and sobriety — it’s not an easy relationship, which probably explains why marketers tend to focus on the psychology side of marketing, the nurturing mother side of marketing. Yet, we can’t totally ignore economics in marketing. For instance, the principle of supply and demand does help explain some aspects of pricing. In the 1970s, OPEC (the oil-producing nations of the Middle East and Nigeria) sent their sons to America and other developed countries to learn economics from our top university professors. These sons came back bringing the supply/ demand function with them. Their fathers began restricting the amount of oil they pumped to the world and prices took off like a rocket ship, causing massive gas shortages, and destabilizing world economies. I’d just bought my first car as the crisis hit and gas went from a few cents (I remember gas at $.25 a gallon) to dollars (in this image, it’s $3.66). I also remember getting stuck with my parents for a particularly long period because I didn’t have enough gas to get to my apartment (you could only buy gas on odd or even days depending on your license plate).

economics of marketing
Image courtesy of Buzzfeed

In this case, the laws of supply and demand played out exactly as the economists predicted. Part of the reason economics worked is that you can’t just create gas from thin air. You either have it underground or you don’t. So, you don’t have to worry about a competitor cutting you out of your profits by building a new product and making it readily available. Plus, gas is gas. If we can’t find Mobile, we’re happy to put Exxon in the tank. That’s exactly why economics doesn’t work in some situations.

It’s the exceptions to the rules of supply and demand that economists don’t recognize. First, if you have a product, you have competition with new competitors entering the market all the time. If you restrict supply to drive up prices, someone will hop into the void and increase supply. Now, you’re sitting with a pile of stuff you must discount to get off your books. That’s the rationale behind Porter’s 5 Forces Model (shown below). Someone is always out there ready to eat your lunch.

porter's five forces
Image courtesy of Oxford

Plus, most products exist in markets where consumers prefer certain brands. This is the essence of marketing. Apple is a good example of an exception to the rule based on brand preference. Apple products, from their MacBook computers to their iPhones, command a price premium over the competition without restricting supply because consumers are willing to stand in line to purchase the new iPhone even when there are a bunch of Android phones ready to buy without a line.

Hence, while marketing and economics are uneasy collaborators, there’s an economics of marketing that does hold water. Below are some points of agreement between the two.

Points of agreement between marketing and economics

1. People face trade-offs

Despite the humorous approach to economics in the video, choice is an important element of consumer behavior. No matter how much money you have, you can’t possibly buy everything you want. That means you need to make trade-offs. So, maybe you forgo the Mercedes you want for a Chevy so you can afford to pay your rent. Marketing focuses a lot on product choice, especially when it comes to buying one brand versus another.

Economists view the money spent on marketing to influence consumer choice as a waste that simply increases the price of products. In fact, without the opportunity to attract customers to your product, you wouldn’t waste effort and money to build a competing product and the resulting monopoly would mean higher prices.

But, it gets worse when you must make trade-offs between different products. For instance, what if the consumer must make a choice between paying for medicine and food (at a minimum wage of $7.25 too many families face this dire choice)?

customer decision-making
Image courtesy of WebBooks.com

So, how does this relate to marketing? It means that brands don’t just compete with each other, they compete with other choices a consumer might make. So, choice is not just between the Snickers and M&M’s illustrated in the video, we make choices between Snickers and a hamburger. But, we also make choices between Snickers and shoes.

Practical implications – the practical implication is that you need to convince consumers not only that your brand is the best candy bar for the money, but that a candy bar fills some innate need worth spending their money on. Just using a catchy slogan and celebrity to convince consumers they should buy a Snickers isn’t enough.

2. The cost of something is what you’re willing to give up to get it

True.  And, not everyone is willing to give up the same amount to get something. This supports price skimming – where you charge consumers willing to pay more a lot for something and consumers willing to pay less for something less. For instance, the new iPhone is over $1000 while you can get the last model for much less. Price skimming only works in some situations, however. The guy flying to Phoenix for work doesn’t care how much the ticket costs because he needs to go to keep his job or make money. The gal traveling to visit her family cares a lot about the price and may postpone her trip, travel overnight, or make other changes to her schedule to get a better price. The marketing trick is to make sure you can sell to the business traveler at a higher price, which is where the Saturday night stay emerged as a trend.

Practical implications – if you have something not easily copied, you can sell it for a lot initially and slowly lower the price over time. Sales start with people willing to pay more and, once they’ve all bought, you lower prices to convince other folks to buy your product. You can also use this in international trade — by selling at a higher price to affluent countries and lower prices to less affluent countries, such as happens in the pharmaceutical industry.

3. People respond to incentives

If you give consumers coupons, for instance, consumers are more likely to buy. The funny thing is that coupons work even when folks don’t use them so you make more money when offering a coupon than a sale price. Rebates work even better as fewer people are willing to go through the hassle of doing what’s necessary to collect the rebate. Another reason for coupons is that many manufacturers sell through retailers. If they discount the price retailers pay, the retailer won’t discount at the consumer level until she sold all the higher priced merchandise she has in stock or maybe keep the difference for extra profits. Coupons offer more control and instantly impact sales.

But, all incentives don’t have to be financial. You can offer any incentive, such as a donation to a worthy cause. Purina did this a few years ago by donating pet food to shelters when consumers bought their food. As consumers are increasingly influenced by corporate values, this makes a lot of sense.

corporate social responsibility
Image courtesy of Customer Insight Group

Practical Implications – this explains why coupons and rebates work or why consumers will wait in long lines for discounts.

4. Trade can may everybody better off

In early civilizations, consumers created what they consumed. In modern society, we’re specialized, which reduces costs and leads to more choice. We create things we’re good at and buy other things we need from people who are good at making those things. This is efficient. If you’re good at something, you do it better than someone else and often do it faster and cheaper. If you do a lot of something, you can do it cheaper, as well. Think about the farmer who spends a bunch of money to buy a harvester for his 25 acres versus ConAgra which uses the harvester on its 1000 acres.

Practical Implications – people make trade-offs with labor, too. So, rather than creating your own advertising, you might hire an advertising agency. The same is true for doing your social media marketing. Companies also may need help creating their long-term strategy from a company experienced with strategy. As you can see below, between the costs of digital marketing tools and the opportunity costs of doing bad marketing, hiring an agency makes a lot of sense.

in-house versus agency costs
Image courtesy of Alfredo Media

Points of disagreement between economics and marketing.

Maybe more important than the points of agreement are the points of disagreement. And, while the marketing notion of the previous elements of economics are somewhat different, there’s some level of agreement. However, there are some serious areas of disagreement between economics and marketing.

1. People are rational

This is the hallmark of economics yet there’s lots of evidence that people aren’t rational. Look at people who spend their rent money going on vacation or people who buy a luxury car then live in a dangerous part of town. People are emotional and often buy based on how they feel. Even corporations, which we see as more rational than the average consumer still make decisions that are head-scratchers. That’s because corporations are made up of people who make decisions that help them.

Besides, it takes a lot of brain power to make rational decisions, especially when the decision is complex such as buying a home. It’s hard to compare the various features of the different options and you can’t compare based on price alone since the offerings are so different. We call this information processing overload and consumers tend to avoid it.

Practical implications – emotional appeals work better than rational appeals, at least in a marketing context. Look at the success of the e-Trade baby — a totally emotional appeal for even a major financial commitment. Don’t forget emotions in retail settings — people will buy more if they’re happy. So, creating a setting that makes people happy will result in more sales.

2. Markets are efficient

This assumes people have “perfect knowledge” which almost never exists. It’s also a long-term focus. In the long run, maybe bad products fail to sell and their firms go out of business. But, in the short run, lots of bad products exist and consumers lose money buying them. Consider the iPod versus the technologically superior Zune (a Microsoft product). While both are obsolete now, the iPod crushed the Zune due to better marketing, especially among the younger target market for audio products. The literature is replete with examples where a bad product beat out a good one due to better marketing. For instance, Betamax was beaten out by the inferior VHS because the large number of competitors in making VHS equipment translated into more people purchasing VHS machines, more video stores buying VHS videos to meet the demand of VHS owners, and ultimately crushed Betamax.

Conclusion

The economics of marketing is complex and based on the nature of the market, including competitors, consumers, and trends that often don’t follow logic or reason. But, that doesn’t mean the economics of marketing is immaterial in your business strategy. It just means you must think long and hard to determine how consumers make choice when it comes to your market and what forces are likely to act on that marketing in the near future. It also means you must constantly scan the environment to ensure your strategic plan is up to date.

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