Book excerpt

Priceless

The Myth of Fair Value (and How to Take Advantage of It)

William Poundstone

Farrar, Straus and Giroux

One

The $2.9 Million Cup of Coffee

In 1994 an Albuquerque jury awarded Stella Liebeck $2.9 million in damages after she spilled a piping-hot cup of McDonald’s coffee on herself. This resulted in third-degree burns and precious little sympathy from the American public. Late-night comics and drive-time DJs turned Liebeck into a punch line. Talk radio pundits saw the lawsuit as Exhibit A to What’s Wrong with Our Legal System. A Seinfeld episode had Kramer suing over spilled coffee, and a website inaugurated the "Stella Awards"—booby prizes for the wackiest perversions of the justice system.

Liebeck’s injuries were no joke. Her grandson had driven her to the McDonald’s drive-through window. They bought the coffee, then pulled over and stopped the car so that Mrs. Liebeck could add cream and sugar. She steadied the cup between her legs as she pried off the lid. That’s when it spilled. Liebeck racked up $11,000 in medical bills for skin grafts on her groin, buttocks, and thighs. The tricky question was, how do you put a price on Liebeck’s suffering and McDonald’s culpability?

Liebeck initially asked the fast-food chain for $20,000. McDonald’s dismissed that figure and countered with a buzz-off offer of $800.

Liebeck’s attorney, New Orleans–born S. Reed Morgan, had ridden in this rodeo before. In 1986 he sued McDonald’s on behalf of a Houston woman who also had third-degree burns from a coffee spill. In his most mesmerizing Deep South baritone, Morgan advanced the legally ingenious theory that McDonald’s coffee was "defective" because it was too hot. McDonald’s quality control people said the coffee should be served at 180 to 190 degrees Fahrenheit, and this was shown to be hotter than some other chains’ coffee. The Houston case was settled for $27,500.

Morgan monitored subsequent coffee lawsuits closely. He knew that in 1990 a California woman had suffered third-degree burns from McDonald’s coffee and settled, with no great fanfare, for $230,000. There was one big difference. In the California case, it was a McDonald’s employee who had spilled coffee on the woman.

Since Liebeck had spilled the coffee on herself, logic would say that her case was worth a lot less than $230,000. Morgan ignored that precedent and used a controversial psychological technique on the jury. I will describe that in a moment. For the time being, I will represent it with a row of dollar signs:

$ $ $ $ $ $ $ $ $ $ $ $

The technique worked. As if hypnotized, the jury awarded Liebeck just under $2.9 million. That was $160,000 in compensatory damages plus $2.7 million in punitive damages. It took the jury four hours to decide. Reportedly, some jurors wanted to award as much as $9.6 million, and the others had to talk them down.

Judge Robert Scott apparently thought the jury award was as outlandish as almost everyone else in America did. He slashed the punitive damages to $480,000.

Even with the reduced award, an appeal from McDonald’s was inevitable. The eighty-one-year-old Liebeck wasn’t getting any younger. She soon settled with McDonald’s for an undisclosed amount said to be less than $600,000. She must have recognized that she had hit a home run and wasn’t likely to repeat it.

Skippy peanut butter recently redesigned its plastic jar. "The jar used to have a smooth bottom," explained Frank Luby, a price consultant with Simon-Kucher & Partners in Cambridge, Massachusetts. "It now has an indentation, which takes a couple of ounces of peanut butter out of the product." The old jar contained 18 ounces; the new one has 16.3. The reason, of course, is so that Skippy can charge the same price.

That dimple at the bottom of the peanut butter jar has much to do with a new theory of pricing, one known in the psychology literature as coherent arbitrariness. This says that consumers really don’t know what anything should cost. They walk the supermarket aisles in a half-conscious daze, judging prices from cues, helpful and otherwise. Coherent arbitrariness is above all a theory of relativity. Buyers are mainly sensitive to relative differences, not absolute prices. The new Skippy jar essentially amounts to a 10 percent increase in the price of peanut butter. Had they just raised the price 10 percent (to $3.39, say), shoppers would have noticed and some would have switched brands. According to the theory, the same shopper would be perfectly happy to pay $3.39 for Skippy, just as long as she doesn’t know there’s been an increase.

Luby holds a physics degree from the University of Chicago. In his job as price consultant, he more often thinks like a magician. Like a skillful conjurer, he is asked to manage what buyers notice and remember. Skippy peanut butter’s customers often have small children and purchase it so regularly that they remember the last price they paid. For such products, consultants recommend creative ways of "invisibly" shrinking packages. In summer 2008 Kellogg’s phased in thinner boxes of Cocoa Krispies, Froot Loops, Corn Pops, Apple Jacks, and Honey Smacks cereals. No one noticed. Shoppers just see the box’s width and height on the shelf; by the time they reach for the box, the decision has been made and they’re thinking of something else.

Dial and Zest recently changed the sculptural contours of their bars, shaving half an ounce off the weight. The boxes stayed about the same. Quilted Northern made its Ultra Plush toilet paper half an inch narrower. The makers of Puffs tissues shrank the length of their product from 8.6 to 8.4 inches. As the Puffs box remained the same (9.5 inches wide), there is presently over an inch of air hidden inside. You can’t see it because the opening is in the middle. In any case, a shopper wouldn’t notice the shrinkage unless she archived old Puffs tissues and measured them.

This ruse can go on only so long. Cereal boxes would collapse to cardboard envelopes; jars would become plastic voids. Eventually there arrives a point at which the manufacturer must make a bold move everyone will notice. It introduces a new, economy-size package. In size, shape, or other design features, the new package (and its price) is difficult to compare to the old. The consumer is flummoxed, unable to tell whether the new package is a good deal or not. So she tosses it into the cart. The cycle of shrinking packages repeats, ad infinitum.

If you find this a silly charade, you’re not alone. Just about everyone does, when they think about it. Many grumble they’d rather pay an inflation-adjusted price for the quantities they’ve known. Others swear they look at the market’s comparison labels, giving price per ounce, and wouldn’t be fooled. One of the things that price consultants have learned is that what consumers say and what they do are not the same thing. For the most part, memories of prices are short, and memories of boxes and packages shorter.

It wasn’t so long ago that companies priced their products with no strategy beyond the demand curves of Economics 101. In the past generation, firms such as Boston Consulting, Roland Berger, Revionics, and Atenga have prospered by advising businesses on the surprisingly complex psychology of price. No firm has spearheaded the professionalization of pricing more than Simon-Kucher & Partners (SKP). German business professor Hermann Simon and two of his doctoral students founded the firm in Bonn in 1985. SKP is now nearing five hundred employees stationed all over the globe, with U.S. offices in Cambridge, New York, and San Francisco. With sixty Ph.D.s on staff, quite a few in physics, SKP has a reputation as the rocket scientists of pricing. The firm exudes a Star Trek cosmopolitanism. Employees from India, Korea, Germany, Switzerland, and Spain mingle in the Cambridge office, and it’s the practice to rotate promising consultants among nations. Each year SKP assembles its far-flung employees for a party at a castle on the Rhine.

The influence of SKP on the prices we pay for just about everything is as little recognized as it is staggering. Rules that apply to other types of consultancies don’t apply to pricing. An ad agency would not have Coca-Cola and Pepsi as clients—but SKP does. In many industries, SKP advises half a dozen of the leading firms. Its current roster of clients includes Procter & Gamble, Nestlé, Microsoft, Intel, Texas Instruments, T-Mobile, Vodaphone, Nokia, Sony Ericsson, Honeywell, Thyssen-Krupp, Warner Music, Bertelsmann, Merck, Bayer, Johnson & Johnson, UBS, Barclays, HSBC, Goldman Sachs, Dow Jones, Hilton, British Airways, Lufthansa, Emirates Airlines, BMW, Mercedes, Volkswagen, Toyota, General Motors, Volvo, Caterpillar, Adidas, and the Toronto Blue Jays. The same psychological tricks apply whether you’re setting a price for text messages or toilet paper or airline tickets. To SKP’s consultants, prices are the most pervasive of hidden persuaders.

Though a price is just a number, it can evoke a complex set of emotions—something now visible in brain scans. Depending on the context, the same price may be perceived as a bargain or a rip-off; or it may not matter at all. A few of the tricks are timeless, like shrinking packages and prices ending in the magic number 9. But price consultancy is more than the latest chapter in flat-world hucksterism. It draws on some of the most important and innovative recent work in psychology. In the mundane act of naming a price, we translate the desires of our hearts into the public language of numbers. That turns out to be a surprisingly tricky process.

Excerpted from Priceless by William Poundstone.
Copyright 2010 by William Poundstone.
Published in 2010 by Hill and Wang.
All rights reserved. This work is protected under copyright laws and reproduction is strictly prohibited. Permission to reproduce the material in any manner or medium must be secured from the Publisher.

William Poundstone is the author of two previous Hill and Wang books: Fortune’s Formula and Gaming the Vote.