Pricing managers in bare-knuckles, low margin commodity businesses are no strangers to arbitrage effects. Procurement experts – drilled relentlessly to put pressure on sales teams – will not shy away from buying products from a competitor if a price gap becomes too large. They will even buy product from a company’s subsidiary in another country when the price difference offsets any additional costs, such as logistics.
One would think that the manufacturers of higher-priced, high-margin products – such as pharmaceuticals, software, and luxury goods – are sheltered from these same pressures, if not immune to them. Their salespeople and pricing & marketing departments seem to have more flexibility on pricing and more margin for error.
Yet these companies also face the same sorts of arbitrage challenges as commodities manufacturers do, when currency effects, tax regimes, or regulatory issues conspire to distort supply and demand across borders. In fact, luxury goods companies face challenges which are even more complex than deciding how much gray imports to tolerate. These challenges, in turn, require a special set of knowledge and skills.
The solutions to pricing luxury goods are found in economics, but the success lies in psychology. In addition to mathematical and marketing rigor, knowledge of consumer psychology and a familiarity with tastes across cultures help pricing managers make reliable, stable determinations of perceived value in vast global industries.
Chanel, famous for its fragrances and fashion accessories, recently faced what seemed like straightforward arbitrage. According to several media reports, the broad-based depreciation of the Euro had made the prices for Chanel handbags so affordable for Chinese consumers or local resellers that they could book a round-trip flight to Europe, stock up on accessories, and still achieve a better deal than buying the same handbag locally.
This phenomenon is known as a gray market. It can damage a company’s profitability by shifting a large share of sales to a market with lower margins. China is a vitally important market for luxury goods manufacturers, so a shift of volume away from the local Chinese market can indeed have a material effect. In an effort to shrink the gray market and throttle the thriving arbitrage market for its products, Chanel raised prices for its handbags in Europe and lowered them in China. In detail, the company decided to “harmonize” prices in Europe, the United States, and China, three of its core markets. Chanel raised the price for the 11.12 bag in Europe by 20% to €4,260 (roughly US$4,500) and the price in China by 22% to 30,000 yuan, or roughly US$4,800.
The move, which took effect in April, may indeed stop the arbitrage. This is the same kind of approach a commodities manufacturer would undertake. By moving prices to within a small range of each other – usually between 5% and 10% as a rule of thumb – a company can eliminate the purely economic incentives to engage in arbitrage. But the value equation and the tradeoffs for Chanel – or any other luxury goods company – are more subtle and complicated.
To understand these tradeoffs, let’s look at a couple of alternative solutions Chanel may have tried: the company could have raised prices even more in Europe (to close the gap to China), but keep them constant in China, and thus harmonize its prices at a higher level. Or it could have made smaller moves first – say by changing prices by 10% rather than 20% – and then observing how the price changes affect demand.
Luxury goods are items that customers want but don’t need. An illustration of this point is the Engel Curve, which plots the relationship between personal or household income and demand for goods. It implies that while commodities manufacturers may have objective, accepted criteria to explain any differences their products have to their competitors, the local perceived value of luxury goods is subject to many other forces.
Luxury goods makers need to balance image and desirability with affordability and their own strategic goals. By putting too much weight on temporary macroeconomic effects – such as currency fluctuations beyond their control – they risk distorting the perceived value in vastly different local markets (Europe vs. China vs. the United States). Harmonized prices requires that price differentiation should be minimal and implies that differences in perceived value are slight, despite local tastes, purchasing power, and the psychological effects of high prices.
Price changes must be made with caution, as companies risk losing customers in some markets while striving to gain customers in another. At the same time, the phrase “price cut” may make the goods more affordable but less desirable, a factor which luxury goods manufacturers always need to keep in mind. Keeping the price in China fixed, but raising the European price to offset some of the price difference, may have preserved the integrity of prices in China and still reduced the arbitrage effect.
Making Significant Price Changes
The significant price change in both markets – at least 20% in both cases – begs an important question: what happens if the Euro strengthens and exchange rates normalize in the next 6 to 12 months? Would a manufacturer such as Chanel be willing to make re-adjustments of similar magnitude, and thereby risk confusing or upsetting consumers even more?
That is the primary argument against making swift, large adjustments to prices, especially in response to a temporary macroeconomic effects rather than a more permanent competitive or quality-based argument. The large moves do improve the chances of resolving the arbitrage problem quickly in the short term. But a potential price “yo-yo” creates uncertainty which may have extreme unintended consequences, ranging from a run on supply to a paralysis of demand. Neither is in the interest of a company like Chanel, which has built up a brand name and reputation over a century.
The luxury goods companies show that making pricing decisions amid extreme currency fluctuations is about more than just narrowing the gap to reduce arbitrage effects. Their decisions require knowledge about value, benefits, and customer behavior which can prevent unintended consequences and keep the company on course towards its strategic objectives, including preserving the brand’s integrity.
Article written by Paul Hunt, President of Pricing Solutions. Pricing Solutions Ltd. is an international pricing consultancy dedicated to helping clients achieve world class pricing competency.