The following article is my reaction to a blog from a friend, Steve Haggett at Iron Mountain.  He responded to an article from our Patrick McCullough about some of the pricing abuses in the pharmaceutical industry. 

First and foremost, I want to go on record that I do not condone the 5000% price increase on Daraprim (Shkreli) or any other irrational price increase that is just not a fair price. But I think we need to take this concept even further, to look at the long term impact pricing strategies can have.

The first example I was reminded of, pertains to a 50 year old concept from Barbara Jackson of Harvard University. She suggested that if you want to have loyal customers, you should build in switching costs to your solution. That's right... build in additional switching costs as a way of creating "loyal customers". Prof. Richard Harmer of Boston University went on to call this the Golden Cage of loyalty because, in essence, switching costs were being used as way to hold customers hostage.

One such example, American Hospital Supply (AMS), used this concept to lock in hospital contracts quite successfully in the 1980s. However, these hospitals were in no way loyal customers. As soon as their procurement people figured out how to nullify the switching costs, using tactics similar to those exposed in our book Negotiating with Backbone, AMS lost the business or had to accept dramatically lower prices (no Backbone!). My point is that its fine to build-in switching costs if that is a part of your pricing strategy, but don't misconstrue the tactic as creating loyal customers. Instead, try to understand the long-term implications of how your customers buy and what you can do to build loyalty, rather than take unfair advantage as Prof. Jackson said.

In a similar fashion, a new wave of pharmaceutical companies are employing a strategy of massive price hikes for drugs serving specific patient populations who have no choice but to take their medication to maintain their well-being. Now, a portion of these patient populations is often willing and able to pay for these medications, even at "exorbitant" prices. But what do you think is going to happen as soon as an alternative is available? 

Here are a few thing to consider: 

1. I do not believe there is anything illegal about what these companies are doing. (note, I am not a lawyer…always get a legal opinion if you aren't sure)
2. Ethics aside, executives at these pharmaceutical firms exacerbate the negative sentiment and public outcry when they brag about the success of their pricing strategy. This leads to increased scrutiny by watchdog and government agencies that often uncover other abuses.  (Note: This is what ultimately led to Martin Shkreli's downfall.)
3. The pharmaceutical industry is unique in that consumers often lack choice and insurers pass along price increases to consumers like you and I. The juxtaposition of captive consumers and disassociated payers creates tension and blurs the line between legal and ethical issues.

In a B2B environment, you've got to be more careful. You cannot just raise the price of your products, even if you benefit from the lack of a reasonable alternative.  Procurement people have a number of things they can do if they feel they are getting abused. At times, procurement could go as far as not purchasing your product or service even if it would benefit their company. Further, despite the time and effort required, we've seen competitive buyers begin to develop their own alternatives to high priced products if they feel they are being held hostage.

Here's the rule: If you recognize that you have considerable pricing power due to high value and not just limited choice, it is reasonable to raise prices, dramatically or otherwise. But do it humbly and justify the increase - eg. quantify the customer benefit created, explain the cost of development, etc. Also consider the role of trust and identify if it is an important factor in your customers decision process. If it is, you need to recognize that exploiting pricing power will likely undermine trust and your customer may seek an alternative partner despite the value you deliver.

Thanks to Steve for taking the time to respond to Patrick's article. This is an important issue that needs to be discussed and I'm glad to be part of that process.

Read Stephen Haggett's blog here...