Sticky Prices

What are Sticky Prices?

Sticky prices are prices that don’t change frequently, despite changes in supply and demand, economic conditions, and costs. This means the price of a product or service stays relatively constant over a period of time, even if the market suggests a more optimal price.

Basic economics teaches that supply and demand drive prices. When demand is high and supply is low, prices increase, and vice versa. In reality, several factors cause prices to resist this simple theory.

• Costs of changing prices
• Limitations of certain pricing strategies
• Customer price sensitivity
• Long-term contracts
• Market power of producers

Price stickiness is akin to a business saying, “Our product costs $20, and we’re sticking to it no matter what!” The same way every product has a certain level of price elasticity, it has a certain level of stickiness.

Synonyms

• Price rigidity
• Price stickiness
• Nominal rigidity

Foundational Concepts in Price Stickiness

As a consumer, you might think prices are constantly changing. While this is true for some products, in the grand scheme of things, prices are generally sticky. It’s usually advantageous for a business to keep prices consistent because that allows them to forecast revenue, plan production and inventory needs, and maintain customer loyalty.

Sticky prices also have an impact on businesses and their decision-making processes. For example, a company may need to consider the cost of changing prices before adjusting the price of their products or services. This cost could include updating price tags, reprogramming systems, and reprinting marketing materials.

Generally, prices are downwardly rigid. It’s easier for prices to go up than to go down because businesses are often hesitant to lower prices (as it can signal a decrease in product value or quality) and consumers eventually adjust to paying a higher price. However, this causes problems during a recession when demand drops and businesses struggle to lower prices accordingly.

Examples of Price Stickiness

Coca-Cola

One classic example of price stickiness is the price of a bottle of Coca-Cola, which remained at five cents from its invention in 1886 until the late 1950s. This was despite significant economic changes and inflation occurring during that period, which would have typically led to price adjustments for most other products.

The Costco Hot Dog

Perhaps the funniest example of price stickiness, Costco co-founder Jim Senegal once threatened the company’s now-CEO, Craig Jelinek, with his life if he were to raise the price of their famous $1.50 hot dog and soda combo.

Despite rising costs and inflation, the price of this beloved meal has remained unchanged since 1985. And, in a 2022 earnings call, the company publicly announced its commitment to keeping it that way.

Gas Station Prices

While the prices at gas stations are known to fluctuate more often than in some other industries (and drivers would definitely agree!), the reality is they still tend to remain relatively constant. Even as the wholesale prices of oil and gasoline experience massive volatility, retail prices at the pump won’t adjust immediately or proportionally, which underscores resistance to price movement.

Grocery Store Items

In the grocery industry, prices generally stay the same regardless of changes in supply and demand. This is because grocery stores often sign long-term contracts with suppliers, locking in prices for extended periods of time.

Since shoppers’ expectations and willingness to pay also play a role in setting market prices, grocery store brands don’t have an incentive to pass savings onto the consumer, even if they’re able to operate at better margins.

Let’s take Chef Boyardee as an example: If the cost of tomatoes, a primary ingredient for Chef Boyardee products, were to drop significantly, it is unlikely the company would lower its prices accordingly. Instead, the company might maintain its retail prices and enjoy a higher profit margin, a decision that reflects price stickiness — consumers don’t see a price change despite a decrease in input costs.

Airline Tickets

The aviation industry is among the most heavily subsidized. If it weren’t, rural areas would have limited access to air travel at considerably higher prices.

In this case, governments step in to stabilize prices and ensure air travel remains affordable for the average person. As a result, ticket prices are relatively consistent over time, despite fluctuations in fuel costs and demand for particular flights or routes.

Subscription Services

Companies using the subscription business model (e.g., streaming platforms, SaaS vendors) have trouble changing their prices because their subscribers expect consistency. If prices do change, it affects the perceived value of their product, makes customers feel like they’re being taken advantage of, and ultimately leads to churn.

To avoid customers accusing them of bait-and-switch tactics, subscription-based companies either…

• offer grandfathering, which allows existing customers to continue paying their original price while new subscribers pay the higher fee
• increase prices for all customers with ample warning and mounds of justification
• set prices slightly higher and offer new customers discounts or free trials
• forgo a portion of their profit margin

…in order to maintain a customer-centric reputation and avoid losing market share.

Reasons for Sticky Prices

Menu Costs

Businesses incur expenses when they change their prices. Changes in pricing may require updating price tags, reprogramming systems, reprinting marketing materials and signs, notifying customers of the change, training staff, and potentially losing customers (especially if there’s a price increase).

This concept of price stickiness originates from restaurants spending money to print new menus. It would only make sense for a restaurant to update its prices if the additional earnings (accounting for sales volumes and margins) outweigh the menu costs. Otherwise, it’s wiser to keep prices steady.

Perceived Value

Sticky prices also have a psychological component. When consumers see a lower price for a product or service, they may assume it is of inferior quality compared to similar products at higher prices. As a result, lowering prices decreases sales if customers associate a lower price with decreased value.

Fear of Price Wars

In an oligopoly — where only a few firms dominate and influence prices — there’s a tendency for companies to maintain stable prices to avoid starting price wars or losing their share of the market. Barriers like high start-up costs or patents further reinforce this behavior by preventing new competitors from entering and stirring up price competition.

The kinked demand curve this creates is one of the best representations of price stickiness. It illustrates how firms use competitor-based pricing to maintain market equilibrium and avoid unpredictable outcomes from aggressive pricing strategies.

Sales and Customer Loyalty

Customers find it extremely confusing and frustrating to see prices constantly changing. This can lead to a decline in customer loyalty and increased sales resistance.

While economic factors like production costs and supply and demand might affect you and your business, those aren’t the numbers customers care about. They only care about what they’re paying for your product.

Part of your business strategy is navigating market conditions and becoming more efficient. That way, you maximize revenue by keeping prices stable without your profit margin taking a huge hit.

Long-Term Contracts

Long-term contracts are common in the B2B sector — manufacturing, logistics, wholesale, and channel sales — and span several years. Usually, the parent company dictates a fixed price for the entire duration, and the seller must absorb any extra costs that arise on their end.

There’s a clear reason for this: The vendor wants to ensure pricing consistency between its product and those of its reseller or retail partners.

Generally, it’s a good thing. It means your end goal isn’t to switch partners but instead to focus on quality, delivery times, and reliability in a long-term business relationship.

Economic Implications of Sticky Pricing

According to Keynesian economics, rigid prices and wages disrupt the market’s natural self-balancing process.

Here’s an in-depth look at what that means:

Production Levels

The economy is a machine. It’s ‘supposed’ to automatically adjust to keep everything running smoothly. When people suddenly want to buy more (an increase in aggregate demand), in a perfectly responsive market, prices would quickly rise. Businesses would then know to make more goods to meet this demand, which prevents shortages.

Keynesian theory points out that in real life, prices don’t always rise as quickly as they should. So, businesses might not realize they should be producing more. Shortages follow when fewer goods are available for the actual number of interested buyers.

On the flip side, when people want less (a decrease in demand), prices are supposed to fall. This would be a signal for businesses to roll back production. But again, if prices are sticky and stay higher than they should, businesses might keep churning out too much, leading to a pile-up of unsold goods.

This sluggish adjustment of prices and wages makes the economy’s imbalances worse, making it harder to recover from recessions. It’s like the machine’s gears are gummed up, so it can’t adjust quickly to changes, leading to either too much or too little production compared to what people actually want.

Market Inefficiency

In an efficient market, prices reflect the information available to market participants. Sticky prices directly result from the fact markets don’t function “efficiently” simply due to human error and lag time. When prices don’t reflect the true supply and demand balance, buyers and sellers can’t trust them as signals.

For example, when an item is priced too low, a buyer will assume it’s worth much less than it truly is and might even think something’s wrong with it. So, when prices stay sticky, it makes it harder for markets to clear efficiently (meaning buyers and sellers have a harder time agreeing on the right price).

Employment Fluctuations

When prices are sticky, changes in demand will affect production levels rather than prices. This means that when there’s a drop in demand, businesses may not immediately lower the price of their goods but instead reduce production and lay off workers.

Sticky wage theory explains why this raises unemployment rates during recessions. Employers won’t easily (or ethically) slash workers’ pay, so they’re more likely to just let people go. In the SaaS industry, this is particularly common — from January to November 2023, nearly 230,000 people were laid off in the United States tech industry alone.

Inflation 

From a macroeconomic perspective, price stickiness is one factor that impacts inflation. When prices remain sticky, it takes longer for markets to adjust to changes in supply and demand. This prolongs the inflationary period.

In some cases, this leads to inflationary spirals, where people expect prices to keep going up and adjust their behavior accordingly. Since prices are more resistant to downward shifts, this creates a never-ending cycle of price increases.

Business Cycles

Sticky prices also contribute to the business cycle, which refers to the natural pattern of periods of economic expansion and contraction.

When prices are sticky, it takes longer for markets to adjust to demand fluctuations. This means that demand-driven shocks (i.e., unexpected shifts in consumer behavior) can have a more profound impact on the economy, leading to more pronounced business cycles.

Challenges of Sticky Pricing in Maximizing SaaS Revenue

From a customer’s standpoint, predictability is one of the biggest advantages of SaaS pricing. For vendors, it creates huge challenges. SaaS pricing is among the most insensitive to economic activity.

Costs of Changing Prices

Software companies use a combination of flat-rate, tiered, and usage-based pricing. So, raising prices isn’t as simple as adding a few bucks to the sticker price. There are different factors to consider.

• Raising the flat rate is generally the most simple, but it doesn’t always account for higher server and maintenance costs that come as customers add more users.
• Changing pricing for one price tier might play out well if its features are clearly a lot more valuable. But, you have to choose your features carefully to ensure the additional features add to the product value.
• Increasing usage-based components will have the best impact on your bottom line, but it’ll disproportionately affect your most valuable customers.

A lot of SaaS companies grandfather in current customers (at least for a year). That way, they can avoid the friction of needing to raise prices for current customers while maximizing revenue for future ones.

Long-Term Contracts

System integrators, value-added resellers, and managed service providers have long-term contracts with their end customers, which creates another challenge for SaaS pricing.

These customers often get advantageous prices in exchange for committing to multi-year deals and bringing in substantial volume. So, these partners don’t want to change prices mid-contract either — it could cause them severe cash flow and reputation problems.

Although this creates stability, it also leads to price stickiness because it prevents quick price adjustments in response to market changes.

Decreased Customer Satisfaction

Customers subscribe to a SaaS product, meaning they signed up for consistency from one month to the next. Equally importantly, these subscribers are other businesses, meaning they’re probably experiencing the same turmoil as you.

Competitive Pressure

If you increase prices, there’s a chance they love your product and feel it’s justified. If alternatives exist for considerably cheaper, though, they’ll probably take your customers.

A simple way around this is to justify higher prices by building more value into your product. Especially as an early-stage company, product innovation (and very small, understandable price changes) will help you fight price stickiness if you have to.

Customer Churn

Customer acquisition costs are as much as 7x higher than retention costs. If churn is a serious risk that accompanies a price increase, it’s nearly impossible to justify the new pricing. In cases where most of your customer base won’t stick around, lower margins from sticky prices pale in comparison to the costs of landing new customers.

Maintaining Employee Wages

During economic downturns, businesses can’t lower wages because employees won’t be willing to work for a pay cut (especially at a time when they’re struggling to pay their own expenses).

When SaaS companies resort to layoffs instead, it might save them money in the short term. Long-term, it’s more likely to create inefficiencies by losing experienced workers and forcing them to spend more to hire and train new ones.

How Price Optimization Software Helps

Sometimes, sticky prices are beneficial. Still, you can use price optimization software to set a within your customers’ price sensitivity window that more accurately reflects current market conditions.

Through advanced algorithms and machine learning, it analyzes demand, competition, and customer behavior to determine a product or service’s optimal price.

Although some types of companies (like airlines) use real-time pricing (or another form of dynamic pricing), you can also use it to set the best price from the beginning. By doing so, you’re hedging against the risk of locking too many customers into a price that isn’t sustainable as your costs go up.

TL;DR: Price optimization software helps businesses update prices in near-real time, and you can use it to protect yourself from inevitable price stickiness (which you will inevitably have to deal with).

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