Customers are the reason businesses exist. The fundamental purpose of a business is to serve its customers, but how do these customer relationships change when the world economy is in turmoil? We cannot turn to experts at the moment, there aren’t any. Even the economists I work with at the Fed have no precedents to guide them. Nobody has a Ph.D in World Economic Shutdown. History, however, does provide answers to this question — two completely different answers, in fact, depending on the type of business you have.
Most businesses are commodities. This doesn’t mean that your brand has no value, or that there are not customers who prefer your type of accounting or beer. But most mature industries have dozens of similar firms with similar offerings. If your customer has a choice, the data tells us that generosity during crises only results in lost profits. I have internet service at home, for example, and I don’t expect my provider to give me a discount this month because I need them for everything from board meetings to babysitting. I know they would gouge me if they could, and they know I would switch if I could.
When you have loyal customers during normal times, you should go out of your way to help them during tough times.
But there are also companies that should do just the opposite. Occasionally companies build collections of interlocking inventions that solve a central problem — I call these “Innovation Stacks” — which create new markets and allow these firms to wield tremendous power. These companies have customers so loyal and a product so unique that they have wide discretion in pricing. In other words, these companies’ products deliver massive excess value compared to their price. Amazingly, the companies that maintain their market dominance, usually under the watchful eye of the founder, refuse to raise their prices despite their customers’ willingness to pay more.
To any MBA student, this probably seems insane. Basic pricing theory teaches us to price discriminate by charging what the market will bear. But it actually makes sense for businesses with Innovation Stacks to ignore basic pricing theory in order to preserve something more valuable: long-term customer trust. In other words, when you have loyal customers during normal times, you should go out of your way to help them during tough times.
Southwest Airlines LUV, +1.66% provides a great example of a company that has tried it both ways. In the early 1970s, Southwest built an Innovation Stack that allowed it to eventually become the biggest U.S. airline. During its first three decades, Southwest basically ignored their competitors’ prices and passed on to customers most of the savings the Innovation Stack created. Then, after founder Herb Kelleher retired in 2008, Southwest tried it the other way.
For the next five years, while other carriers increased their prices an average of 8% annually, Southwest’s prices climbed over 30%. After this increase, Southwest’s prices were 17% to 145% higher than its competitors. In 2018, Southwest, along with rival carriers American, Delta, and United, settled a price-fixing lawsuit by the U.S. Department of Justice.
Did Southwest’s changing its pricing change its competitive position in the industry? Let’s look at the results. Twenty-two low-cost airlines tried to compete with Southwest during Herb’s tenure, and every one failed except JetBlue JBLU, +2.86% . (JetBlue also embraced low price, won special landing rights in the nation’s busiest city, and had its own Innovation Stack.) Low price protected Southwest Airlines for four decades.
But since Southwest abandoned low price in 2008, five new airlines now compete with Southwest and are all succeeding. I’m sure many things at Southwest have changed since Kelleher retired, but the only one I’ve noticed as a customer is that Southwest no longer gives me a reliably low price. I remember the first time I found American Airlines had a lower price than Southwest. At first, I thought this was just another bug in American’s notoriously unstable reservations system, but soon the pattern was clear. Twenty years of my trusting Southwest — gone like the space in the overhead bin.
What happened to Southwest’s stock price? During Herb’s tenure, Southwest was one of the best performing stocks in the market. It temporarily performed even better once they decided to lead the industry in price increases. But now Southwest no longer owns the budget travel category, so now their skies are full of competitors.
In other words, the data gives us two answers. If yours is a commodity business without loyal customers, then charge whatever you can get away with. If this means gouging people for toilet paper and hand sanitizer, the market will not punish you. Rather, you are punished every day by a commoditized industry where your customers will abandon you for a competitor at any time.
On the other hand, if your business has an Innovation Stack that gives you a unique and trusted relationship with your customers, then you should do precisely the opposite. Square SQ, +6.57% , the company I cofounded with Jack Dorsey, just proactively refunded our software license fees to our customers at the time when our customers need these products the most. I look forward to that case study baffling MBA students for years to come.
When we finally emerge from under our face masks, the world will be changed in ways we cannot predict. The cruise ships of today may be tomorrow’s quarantine villas. Or maybe just the opposite: with a virus spreading everywhere only the cruise ships will be safe. Either way, I’m still not getting in the hot tub.
What we can know from history is that there are two diametrically opposed answers about how to approach customer loyalty. If our customers are opportunistic, then we businesspeople should be as well. Most businesses are probably in this category. On the other hand, companies with Innovation Stacks and loyal customers should do exactly the opposite. Customer trust is more precious than customer love, and now is the time when that trust is earned.
Jim McKelvey is co-founder of payments firm Square and author of The Innovation Stack: Building an Unbeatable Business One Crazy Idea at a Time. (Portfolio 2020)
Originally Published on MarketWatch
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