Tuesday, March 31, 2009

How Marketing Feeds the Boom-and-Bust Cycle

It wasn’t so hard to sell people a newspaper every day a generation ago when the price was between 10 and 25 cents. Now that the price is more like a dollar, it’s a tougher sell. Large numbers of people still buy the newspaper, but not as often — perhaps just once a month instead of every day.

And therein lies the failing of one of the most trite ideas in marketing, an idea so pervasive in current management thinking that it often goes without saying. It is, after all, a very simple idea. If business revenue depends on the number of customers, the frequency with which customers buy, and the price they pay, then the way to make a fortune in business ought to be to sell a big-ticket item to a large number of repeat customers.

It makes sense, right? Do everything you can to increase the number of customers, the price they pay, and the number of times they buy, and watch your revenue go up and up. But while this approach may work in the short run, it does not work in the long run. And when you look at what has happened to newspapers, you can see why.

The more your customers pay, the greater the incentive they have to find alternatives. Then, if your competitors don’t take your customers away, some customers will find a way to bypass your industry entirely.

With this dynamic, the most successful marketing strategies will tend to lead to a boom, as more customers buy more often at higher and higher prices, followed by a bust, as customers notice how much they’ve been spending and seek out alternatives.

Worse, the bust tends not to happen until customers get squeezed financially and are forced to cut back. We saw newspaper revenue hang on remarkably well, in spite of the industry’s obvious problems, until about two years ago. Then it declined rapidly, and the decline in newspapers is adding momentum to the recession.

The same thing is happening, of course, in automobiles. That industry did remarkably well over the past half century at increasing its customer base, frequency of purchases, and prices. Most impressive was the way it kept a large number of its customers on a three-year replacement cycle even as the improved reliability of the product made that unnecessary. When that pattern started to fall apart around 2005, the industry was in trouble. If customers move from a three-year cycle to a five-year cycle, that is a 40 percent decline in sales, which of course, is about what has happened so far. Auto dealers say a five-year cycle will be the new norm, with people replacing their five-year-old cars, but it could just as well be a 12-year cycle. It depends on what the customers decide. It is not up to the dealers, who cannot influence this pattern until the potential customers find time to visit the showroom.

Whenever you see an industry that is doing remarkably well at expanding its customer base, frequency, and price, it is fair to ask when the collapse will come. We have been asking this question about the cellular phone business for three years, and indeed, two former industry leaders, Motorola and Nokia, are being forced to cut back. But looking more broadly at the economy, what about:

  • Health care. Prices keep going up, and the industry is lobbying hard for universal coverage to expand its market reach, but are people actually getting healthier?
  • Banking. The latest refinance boom is just another reminder that this industry relies too heavily on loans to repeat customers, many of whom would really prefer not to be in debt at all.
  • Entertainment. Look at cable TV, movies, or concerts, and you can’t help but ask, “How can they keep raising their prices like that?”
  • Government and education. A sector can use its monopoly powers to postpone modernization only so long. The cracks are already starting to show.

It might seem strange to list the banks as potentially heading for a fall when many of them are in serious trouble already, but it would be foolish to dismiss the many consumers who swear they will never borrow money again as merely blowing off steam. And when the top financial experts talk about the collapse of the financial system, they are not talking about something that has already happened, but something that could happen in the next couple of years if things go badly.

Last weekend we heard this from renegade financier George Soros, who in an interview with The Times saw the G20 summit as the last chance to avoid a financial system meltdown.

The odds would favour that it fails because there are such differences of opinion. It’s difficult enough to get it right in your own country let alone with 20 governments coming together, but if it’s a failure I think then the global financial and trading system falls apart.

Soros’s prediction of a depression is probably a fair description of what will happen across the financial sector, and also in automobiles, home construction, and other areas of the economy that have perhaps been a little too successful in squeezing money out of their customers in recent years. As the recession leads people to examine and adjust their spending priorities, it will create permanent realignments in economic activity.