Economists do not buy luxury goods, behavioral economists do!

For economists, qualities of luxury goods are SIFs (supposedly irrational factors). Why would a “homo economicus” pay more for a product just because it makes one look good among peers, gives a feeling of achievement, or has been made by an overpaid craftsman in some small European country for hundreds of years? To economists, it just does not make sense. These factors do not add to the utility of the product. Economics is not a friend of luxury – luxury goods do not maximize consumers’ utility.
The success of luxury goods while utterly inexplicable by economics becomes crystal clear through behavioral economics. While economics suggests that a high price will decrease the consumer utility, behavioral economics suggests that a premium price may actually serve as a heuristic that signals quality and favors the purchase of the brand. Similarly, while an economist may tut-tut at the behavior of consumers queueing up for a “limited period offer”, the behavioral economist deftly explains this as a “scarcity heuristic” in action.

Behavioral economics in action in China

Behavioral economists have much to be proud of their insights in China – the market has gone just as they anticipated. A recent report from Bain & Co states that “China will become the world’s largest luxury goods market by 2025, with Chinese consumers set to account for nearly half of the global spending in the sector”. According to Bain & Co, while the global luxury goods sale is likely to fall by 23 percent in 2020, the Chinese luxury market has already recovered and likely to post a healthy growth this year. This is particularly so in the local sales in the mainland and on online channels, as the hungry consumers are restrained from traveling and splurging overseas.

In my book published last year, “Chinese Consumers – Exploring the World’s Largest Demographic” (https://www.amazon.com/Chinese-Consumers-Exploring-Largest-Demographic/dp/9811089914) I discussed a number of historical and cultural factors, which have been fueling the luxury goods market in China. The behavioral economics concepts have been even more alive in China than in other markets! However, continuing with the behavioral perspective, I feel that some of these factors are undergoing significant dilution, and the super surge that luxury goods were reveling in so far, may lose some of its momentum – unless a significant “re-framing” is implemented.

A need for re-framing

Undoubtedly, China will remain an important contributor to the global luxury market, and the situation with the pandemic has certainly contributed to its disproportionately magnified share of the global output. However, the Chinese consumers and the Chinese luxury market is evolving, and once the transient effects of the pandemic, such as relatively rapid Chinese economic recovery and travel restraints are removed, the upward trajectory is unlikely to be as steep as the recent bonanza suggests. The following factors suggest that the future may not be a mere reflection of the past.
1. While China continues to add to its consuming class, the newer consumers face fierce competition, have more modest opportunities, and are likely to enjoy lower incomes and income growth as the economy matures. This will have a somewhat restraining influence on the powerful system 1 driven heuristics which lead the consumers to luxury goods.
2. At the same time, younger consumers have greater demands and competition for their money. Having missed the “housing lottery” (today the housing prices are in an entirely different league as compared to what the previous cohorts experienced) housing appropriates a much larger proportion of their incomes, and leaves behind a much smaller surplus for luxury consumption
3. One of the key contributors to the luxury market in China was the fact that because of the discontinuity in consumption in China, there were few “anchors” to which the consumers could compare the prices and quality. Hence the luxury products had the advantage of setting their own anchor and the consumers had no comparison benchmarks. However, with the rapid development of local, mid-priced brands, comparative anchors are emerging in many categories. This will make consumers look relatively unfavorably at the high-priced luxury brands.
4. Behavioral science suggests that experiences are more satisfying than product purchases. As is happening globally, Chinese consumers also increasingly look for experiences rather than products. While the consumption of luxury experiences may continue to gallop at a brisk pace, it may come at some cost to the traditional luxury products.
5. In the initial stages of a market’s development, one key driver for the adoption of luxury products is the differential between consumers’ ability to pay and their confidence in their judgment and discernment. This diffidence translates into the consumers buying luxury brands, using price as a heuristic which serves as an indicator of quality and desirability. As consumer confidence continues to increase, the consumers are more likely to rely on their judgment than the heuristics.
6. “Noble edge effect” leads to the creation of positive valence for brands that espouse a purpose. While the Chinese consumers may be lagging on the global trends of sustainability and concern for the environment, the trend for conscientious and responsible consumption is only likely to increase further, which will also put a damper on the frothing sales of luxury.
While the explanations from behavioral economics about what has been driving the luxury market in China still hold strong, historical and cultural accelerators of the luxury market in China are likely to play a diminishing role in the coming years. Consumers are using newer heuristics which serve as choice factors. This implies that luxury may need to be re-framed in China. While the market will continue to grow modestly on the strength of economic growth and further corrections of imbalances (e.g., the tax differential) the brands that make a serious attempt to understand the changing consumer heuristics, are the ones who will be able to nudge the consumers to their brands.

Ashok Sethi
Ashok.sethi@behave-consulting.com