This Guest Blog Post was written by Hermann Simon and Chuck Gammal of Simon-Kucher & Partners.
Negative prices for oil have caused a sensation in the last few days. The price of a barrel of West Texas Intermediate (WTI), the benchmark for US oil, fell to -$37.63 USD per barrel earlier this week.
However, the concept of negative prices is by no means new. In several sectors of the economy, negative prices have existed for years, meaning that it is not the seller, but the buyer of a product who is paid.
The utility and banking industries are two examples where you see negative prices. The trigger for negative prices are imbalances between supply and demand and marginal costs of zero.
In normal transactions, the customer pays the seller a positive price and receives the product or service in return. The customer is willing to pay the positive price if the good purchased is of benefit to him.
From the seller's point of view, the short-term lower price limit is the marginal cost, which means that he or she only sells a product at a positive contribution margin. Under most circumstances, marginal costs are generally greater than zero, so that prices of zero are rare and those below zero practically never occur.
In the case of oil, this has now happened for the first time.
Negative Power Prices
At the European Power Exchange, the number of hours with negative electricity prices has increased from 15 hours in 2008 to 211 hours in 2019. Last year in the EU, the power producer paid the buyer a (negative) price per megawatt hour for almost ten days. Similarly in the US, the duration of negative prices reported by the California Independent System Operator (CAISO) jumped to almost 208 hours in 2017 as compared to less than 10 hours in 2013. The buyers received the electricity plus money.
How can these changes be explained?
Obviously, one condition is that even with a price of zero, the supply of electricity is greater than the demand. What remains is a supply overhang. Normally, electricity producers would stop production under these circumstances.
However, this is not possible with certain power generation methods, such as photovoltaics. Even traditional power plants have limited flexibility. The electricity produced must be purchased.
This purchase could only happen on certain days if the electricity producer paid the customer a negative price.
In order to be able to produce on days with positive prices and make a profit, the producers must subsidize the electricity on days with negative prices. With the negative oil prices we are currently observing, we encounter the same conditions.
It is more advantageous for the oil producer to pay the buyer a negative price than to interrupt production or to pay a higher price for additional storage capacity.
Negative Interest
Interest is nothing other than the price of money. Negative interest rates were first observed in Denmark in 2012. Today they have become a widespread and a much discussed topic. The President of the United States frequently has asked the Federal Reserve to drop interest rates below zero, although it has not happened yet in the US as it has in the EU. For a loan of 1000 Euros with Check24 one only had to pay back 972.49 Euros after twelve months. This corresponds to an interest of -2.7 percent.
The portal Smava lent 1000 Euros for three years and only demanded 923 Euros back. Economist Carl-Christian von Weizsäcker speaks of a "negative natural interest rate" as a phenomenon that is by no means temporary, but rather permanent. He sees the cause in a "structural surplus of the private will to save over the private will to invest.
For European banks it can be more profitable to lend the surplus money at an interest rate of -0.2 percent instead of depositing it at the central bank and having to pay negative interest of -0.5 percent.
And if depositors are willing to provide the bank with money at a negative interest rate, the bank can lend this money at a negative interest rate and still achieve a positive contribution margin.
Negative Prices Due To Transfer Effects
There are special situations in which negative prices may occur due to inter-period, cross-product or person-related factors. Free samples (e.g., consumer products), i.e. prices of zero, are widespread for new product launches.
Here the rule that the price should be above marginal costs is neglected during the product launch phase. This tactic makes sense if the price of zero stimulates sales in subsequent periods, i.e. the customers won with the free sample buy the product more often in the future.
However, the question arises why zero should be the lower price limit in this situation. If you think one step further, zero appears as an arbitrary lower price limit.
Perhaps the acceptance of a new, previously unknown product could be accelerated by paying a negative price to the first acquirers instead of "only" offering the product at a price of zero.
With marginal costs of zero this option becomes much more attractive than with the high positive marginal costs in the traditional economy. In fact, such negative prices can be observed.
Commerzbank has been crediting new customers with 50 euros for a long time, which means it pays a negative price. The same applies to the voucher in the same amount that METRO Cash & Carry gave to new customers.
In its initial phase, PayPal also used negative prices. Each new customer received 20 US dollars. In China, providers of bicycle sharing services such as Mobike paid their customers to use the bikes.
An analogous argument can be used for cross-product effects. If a product A promotes the sales of a profitable product B, it can make sense to offer product A at a negative price. This chain of effects can be relevant for freemium constellations.
In the usual freemium model, the basic version has a price of zero. Here again the question arises why the lower price limit should be zero?
If, as a result of the experience with the basic version, many users convert to the paid premium version, it may well make sense to pay first-time users of the basic version for a limited period of time, i.e. to set a negative price.
Many telecommunications companies offer customers who sign a service a smartphone for free or for a symbolic price of 1 Euro or Dollar.
Again, the question is whether new customers should get paid for accepting the smartphone. A medium-sized marketer of telecommunications services reported a success with a negative price for the smartphone. The negative price was paid in cash, which probably increased the effect.
The cash back offers that are widespread in the US fit into this context. With this method, you buy a car for $30,000 and then get $2,000 back in cash. This 2,000 dollars can be interpreted as a negative price. What sense does that make? Why not just pay $28,000?
Daniel Kahnemann's prospect theory has an answer. The payment of the 30,000 dollars creates a perceived loss, because this sum must be sacrificed. This loss benefit is offset by the benefit of getting the car.
There is also a third benefit component, namely the benefit of receiving 2,000 dollars in cash. Obviously, many car buyers feel a higher net benefit from this price structure than if they simply pay $28,000 for the car and do not receive a negative price in the form of the cash back.
Ultimately, the question is how marketing and promotional measures work compared to negative prices. Product launches are regularly supported with substantial budgets. The funds flow into instruments such as advertising, displays, promotions and discounts.
So far, negative prices are rather rare with new product launches. But a negative price can be more effective than advertising or similar measures without having to provide larger budgets. With marginal costs approaching zero, such conditions become more likely.
Some suppliers will go below the lower price limit of zero and offer their products at negative prices. Even today, prices below marginal costs are being used in promotions. It is likely that we see more negative prices in the future.
Conclusion
In theory, the short-term lower price limit is the marginal cost. If this is zero, then zero becomes the lower price limit. However, we are increasingly seeing negative prices.
Behind these prices are production and cost conditions that override the price floor of zero. This can be caused by oversupply, which has to be sold even though demand is insufficient when the price is zero.
This is currently the case with the oil price and has been, for years, with electricity prices.
In the digitalization age, it can be expected that negative prices will increasingly become more common as a promotional tool that will have a positive return on investment if structured and controlled appropriately.
About The Authors:
Hermann Simon
Hermann Simon is the founder and honorary chairman of Simon-Kucher & Partners, the world’s leading price consultancy. Ranked on the Thinkers50 list of the most influential international management thinkers, he is considered the world’s leading authority on pricing.
Simon has published over 35 books in 26 languages, including the worldwide bestsellers Hidden Champions, Confessions of the Pricing Man, Power Pricing, and Manage for Profit Not for Market Share. From 1995 to 2009 he was the CEO of Simon-Kucher & Partners. He has advised many of the world’s leading companies, and has served as a board member of foundations and corporations.
Before committing himself entirely to management consulting, Simon was a professor of business administration and marketing at the Universities of Mainz (1989-1995) and Bielefeld (1979-1989). His visiting professorships include Harvard Business School, Stanford, London Business School, INSEAD, Keio University in Tokyo, and the Massachusetts Institute of Technology.
He has served on the editorial boards of numerous business journals, including the International Journal of Research in Marketing, Management Science, Recherche et Applications en Marketing, Décisions Marketing, and European Management Journal. He was also president of the European Marketing Academy (EMAC).
Simon studied economics and business administration at the Universities of Cologne and Bonn, where he received degrees in economics and earned his Ph.D. in management science. He has received many international awards and three honorary doctorates. He is honorary professor at the University of International Business and Economics in Beijing and the Hermann Simon Business School in China has been named in his honor.
Chuck Gammal
Chuck Gammal supports healthcare companies across sub-sectors, including medical technology, healthcare services, and healthcare IT. He also advises pharmaceutical and biotechnology companies on new business models for digital technologies. Chuck brings to his clients deep business expertise in marketing, pricing, and sales.
To learn more about Simon-Kucher and Partners, click HERE.