The economics of discount pricing

Sam Walton, the pioneer of the modern day superstore, brought discount shopping into the mainstream. Starting with his chain of Ben Franklin stores, which he grew to be incredibly profitable and operated with razor precision, Walton created his large super-centers all across America. Today, Walmart does over $400B+ in annual revenue and has a market cap of over $200B.

Sam Walton realized a simple truth: you can use the power of volume to increase your profits.

A classic discount pricing offer [Source]

Let’s see how the math works out. Imagine you make a box of tissues for $0.60. You could potentially price that box of tissues at $2 and make a $1.40 profit on each box of tissues you sell.

However, you could also could run a promotion where you advertise “buy 2, get one free!”, in which case, you could price 3 boxes of tissues at $4. Here, the math says, while you sell 3 for $4 and your cost of making the goods is $1.80 ($0.60/box), you actually end up with a slightly higher profit - $2.20, instead of $1.40.

Turns out consumers are really bad at understanding discount prices. Stores can essentially force the consumer to buy a cheaper looking option, often getting them to buy volume they don’t need.

For instance, researchers at the University of Minnesota's Carlson School of Management looked at consumers' attitudes to discounting. Shoppers, they found, prefer getting something extra for free to getting something cheaper. Consumers fail to understand that a 33% discount in price is essentially equivalent to a 50% increase in quantity. They usually assume the latter is the better value [Source].

In another experiment, researchers sold 73% more hand lotion when it was offered in a bonus pack than when it carried an equivalent discount. Hacks using discount pricing as promotions got so popular that the UK tried to ban them in supermarkets [Source].

So next time you hear a buy one get one free offer, feel free to do the math, because somebody is definitely about to make a profit!