Monday, March 26, 2012

Pricing pain at the petrol pump: Why $1.60 hurts

Petrol prices are on the rise and so too hysteria about what this means to Aussie households.  So why does petrol fuel such intense consumer reaction? Let's see whether Behavioural Economics can provide an answer.

Price sensitivity but demand inelasticity

In Melbourne, petrol moved from around $1.40 to $1.60 overnight last week which is a 14% increase. Some media outlets are joyfully speculating that we'll be paying $1.65 over the Easter break, stirring outrage amongst their readership. The price hike means that a car with a 60 litre tank will be paying around $12 more for one fill.  Ouch.

According to ANOP research cited in the 2007 Australian Competition and Consumer Commission (ACCC)'s review of petrol pricing, 70% of consumers are price sensitive when it comes to petrol.  The 30% who are insensitive are largely those with company vehicles, meaning the rest of us are paying attention to whether petrol is higher or lower than it was yesterday.  

Our sensitivity comes despite petrol being a largely inelastic purchase; we have to buy when the tank is empty regardless of price.  It is this sense of powerlessness that I believe drives our desire to try to 'beat the system" by trying to anticipate price rises, and slavishly handing over our 4 cents off a litre shopper dockets.

Petrol is like the stock market; we think it's about knowing when to buy 
In some ways, buying petrol is like the stock market.  There is unforeseen variation brought about by mysterious offshore forces, and inevitable speculation about the right time to buy. And just like those in the stock market, we all have theories on when the price will move (school holidays, long weekends, Thursdays etc) because we can't help but look for patterns in things. And yet, as Nassim Taleb writes in his book The Black Swan, we fool ourselves into thinking we know more than we do.  There really is no pattern to petrol pricing, and even if for a time Tuesdays seem to be cheaper, the following week that may change.

Here's are some of the behavioural forces at play with petrol pricing.

Consumers generally cope best with undesirable change like price rises when it is done quickly, we can adapt and life can move on. The challenge with petrol pricing is that it seems to change day to day, keeping us guessing.  But here's the peculiar thing; we are so used to price fluctuation that we have adapted to not adapting.  Just like the price of fruit and vegetables, consumers expect there to be change in petrol. 

But, it seems consumers adapt to petrol price variation within a certain tolerance range. Changes a few cents up or down seem fine, and incremental price changes are tolerated, but leaping $0.20 is beyond the usual cycle. 

An anchor is the information on which a consumer relies to establish a sense of value for a product or service.  In the case of petrol, the huge price signs are blatant anchors, and drivers scan these as they assess whether they should stop to buy. In Melbourne we had been anchored around the $1.40/litre mark for a few weeks.  When $1.60 suddenly appeared, it interfered with our sense of value and created newsworthy confusion about why it had changed so significantly.

The interesting thing of course is that $1.60 is the new anchor, so if petrol drops back to $1.40 or even $1.50 it will seem like a better deal.   Remember it was only 2005 that we punched through the $1/litre psychological and price barrier, and from there on we have been continually re-anchored to higher price points. If you were visiting from New Zealand, by the way, $1.60 would seem like a bargain because they are paying nearer to $2/litre.

Loss aversion
Consumers hate the possibility that we will drive past the bowser only to see the price jump up when we need to fill the tank.  If only we'd stopped in the morning!  The sense of having 'lost' the lower price torments us because it reflects a poorly made decision. In the case of normal price variations, this may mean the difference of only a couple of dollars on a tank, so intellectually we should not be concerned.  But emotionally, we feel like we've lost.

Loss aversion is why price guarantees are such a popular behavioural device; they make us feel comfortable about committing to the purchase without fear of finding the product cheaper elsewhere. Loss aversion is also behind the success of fuel discount vouchers.  It is too painful to give up the fuel discount so we instead drive with purpose to particular outlets to save around $2.  

Lessons for businesses

Petrol pricing reminds us that pricing is as emotional as it is intellectual. As fuel discount dockets have shown, consumers will change their behaviour to save a couple of dollars.  Whilst this may not make rational economic sense, Behavioural Economics shows that we are all subject to forces that influence us to act in irrational ways.  For your business it means you must consider how your price is anchored, how you will help your customers adapt to a price rise and methods of supporting your customers to overcome their aversion to loss.  You have the power to positively control the response to your pricing with help from Behavioural Economics. Happy driving.

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1 comment:

  1. Bri,

    It has been proven that there is a short and a long run price elasticity when it comes to petrol. In the short run, consumers are inelastic (as you point out). but in the long run, they can move closer to work, buy a more fuel efficient car, or switch to a car share scheme like

    Where petrol pricing differs from the stock market is that it is a tangible good, and despite the fact that there is petrol "in the pipeline, tanks, etc", the price rises tend to apply immediately, despite the fact that the petrol in pipeline, tanks, etc. has been purchased at a cheaper price.

    Go figure?