The Power of Ratchet Effect Businesses: Combining Pricing Power and Customer Habits

A Profitable Way of Investing?

Hi Guys, Hidden Market Gems here 👋

Something I love, maybe more than investing (I said maybe), something that passionate me a lot, is psychology and neuroscience. Why? I don’t really know! I came in this field by chance and I couldn’t help myself but to learn more and more on my free time.

• Mere Exposure Effect ?

• Hick-Hyman Law ?

• Dunning-Kruger Effect ?

• Neuroplasticity ?

• Working Memory ?

• Zeigarnik Effect ?

I could talk about it all day. All day. 24/7. So today I decided to do an article that sync those two passion!

The Power of Ratchet Effect Businesses: Combining Pricing Power and Customer Habits

The concept of the "ratchet effect" in business represents one of the most powerful competitive advantages available to modern corporations. At its core, this effect combines two formidable business attributes: pricing power and customer habit formation. For investors seeking resilient, high-performing stocks with sustainable competitive advantages, understanding this powerful combination can provide a significant edge in portfolio construction and long-term wealth creation.

The Ratchet Effect: A Powerful Business Mechanism

The ratchet effect derives its name from a mechanical device that allows movement in only one direction. In business contexts, it refers to a process that, once initiated, becomes exceedingly difficult to reverse. This one-way progression creates a self-reinforcing cycle that leads to sustainable competitive advantages, particularly when it combines pricing power with deeply ingrained customer habits.

The ratchet effect manifests in numerous business decisions, from capital investments and pricing strategies to performance expectations. For instance, once a company has invested in advanced machinery or specialized talent, scaling back becomes challenging due to sunk costs and competitive pressures. Similarly, once prices increase or performance standards are established, reverting to previous levels often proves difficult or undesirable.

Understanding Pricing Power: The First Component

Pricing power—the ability to raise prices without losing customers to competitors—represents a fundamental strength that Warren Buffett has called "the single most important decision in evaluating a business". Companies with robust pricing power can increase prices to boost profits, combat rising costs, or invest in innovation without fear of significant customer defection.

Several factors contribute to pricing power:

Sources of Pricing Power

• Brand Strength: Companies like Apple and Coca-Cola leverage powerful brand identities that create emotional connections with customers, enabling premium pricing.

• Product Differentiation: Unique product features, intellectual property, or innovative solutions that competitors cannot easily replicate support pricing flexibility.

• Market Position: Dominant market share or operating in industries with high barriers to entry allows companies to maintain pricing advantages.

• Customer Criticality: Products or services that are essential to customer operations or daily lives face less price sensitivity.

Financial Impact of Pricing Power

The financial implications of pricing power are substantial. Research indicates that a mere 1% increase in price can result in an 11.3% rise in profits, compared to a 5.5% increase from a 1% cost reduction. This leverage effect makes pricing power a potent profit driver and explains why these companies often maintain higher, more stable profit margins even during economic downturns.

Companies with pricing power also demonstrate greater resilience to inflation, as they can pass increased costs to customers without significant volume loss. This ability to preserve margins during inflationary periods provides significant protection for long-term investors.

The Power of Customer Habits: The Second Component

Customer habits—the automatic behaviors consumers develop over time—represent the second crucial element of the ratchet effect. Once formed, habits create powerful customer loyalty that extends beyond rational decision-making. Here’s the psychological part!

The Formation of Customer Habits

Habit formation involves a psychological process where repetitive behaviors become automatic responses to specific triggers. Charles Duhigg's "habit loop" framework identifies three key elements:

1. Cue: The trigger that initiates a behavior

2. Routine: The behavior itself

3. Reward: The reinforcement that encourages repetition

Companies that successfully embed their products into this loop create powerful customer retention mechanisms that resist competitive threats. And that my friend, is powerful, that’s an idea you want to keep in mind. Because when you think about it, habits can be seen as a moat:

Customer Habits as Business Moats