ECON 325 – Pricing Theory and Strategies
Outline Three: Behavioral Economics and the Psychology of Pricing
Misbehaving: The Making of Behavioral Economics by Richard H. Thaler; Phishing for Phools: The Economics of Manipulation and Deception by George A. Akerlof and Robert J. Shiller; What Behavioral Economics Can Teach Us About Pricing by Steven Forth; The Theory of the Leisure Class by Thorstein Veblen, Pricing Experiments You Might Not Know, But Can Learn From by Peep Laja.
Economic Thought Background:
Mainstream economics is famous for the “economic man” model.
Rationality as defined as:
Interpretation is that buyers always act rationally – they “maximize utility” subject to a budget constraint. All options are known and given, all prices are known and given.
In step psychologists Daniel Kahneman and Amos Tversky (paper published in 1979 on “prospect theory”). Many believe this was the beginning of Behavioral Economics.
Kahneman won the 2002 Nobel Prize in economics for "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty." Since then it has been a popular area of study in economics.
Punching holes in the mainstream theory of the economic man became popular among those in other fields – marketing is no exception.
The idea is that people don’t really act rationally – meaning they don’t always make decisions that are in their best interest.
1. Because their information is not perfect (sometimes called “bounded rationality” (H. Simon). This seems obvious. Non mainstream economists have been emphasizing this way before Behavioral Economics became popular.
But: is acting without perfect information acting irrationally?
2. Because people make choices that don’t appear to be in their interest or that don’t always “maximize monetary returns” for example.
But when subjective theory of value is considered – again, can we say people are acting in an irrational way? From whose point of view?
In any case, price does play a big role in behavioral economics – so let’s focus on that area.
Here is a quotation from Florian Bauer, consultant in “Behavioral Pricing”:
“Classical [mainstream economic] pricing research and methods are built on the assumption that people decide rationally. It is simply impossible within this approach to leverage the margin potentials given by the predictably irrational behavior real people show. Behavioral Pricing builds on a totally different set of insights. For example, Behavioral Pricing has empirically proven that the notion of people having a predefined “willingness to pay” is wrong. Rather than having a willingness to pay, people tend to develop a price acceptance throughout their decision making process. This in turn implies that companies pricing strategies should not only react to a predefined and quantified willingness to pay but should focus on actively enlarging price acceptance.”
But he distinguishes Behavioral Pricing and what he calls “price acceptance” from Value Based Pricing:
“Price acceptance is not driven by value as is assumed in value-based pricing. This would imply that people only pay for the product features . . . . In fact, people pay for much more than product features. Context and decision dynamics very much define price acceptance”
So basically, what behavioral pricing is adding to the picture is the idea that psychological factors that play into people’s decisions are also important as to whether or not they “accept” a price and buy a good or service. This is what he means by “context and decision dynamics.”
Betty accepts a price and buys something because she is with her friends that day and want to impress them.
A man buys a more expensive engagement ring than he otherwise would in order to appear to “fit in” with his soon-to-be in-laws.
But also -- examples about how a seller can change the consumer's buying environment (through a pricing strategy) such that they are more likely to buy!
So we will see what this means in the following examples that might be called:
Pricing Strategies and Psychology:
1. The Prestige Effect of Price
American Institutionalist economist Thorsten Veblen in The Theory of the Leisure Class (1898) maybe can be called the first behavioral pricing theorist! He talked about how people will buy expensive items because by doing so they signal to others how rich and important they are. He called this the “snob” effect (or "conspicuous consumption". This explained why people who had money spent it on nice, expensive things – not so much to have those nice things – but to show other people that they could afford them.
This signal to others gave them some kind of psychological utility that supposedly is considered to be “irrational” (not by Veblen) – but behavioral economists, for example.
The Pricing Strategy: The pricing strategy idea here is that the price itself becomes an indication for the quality and exclusivity of luxury products.
This is actually explained by some as an upward sloping demand curve. When the price increases, people buy more. Is it really an upward sloping demand curve?
Examples: Notice how the price increases went along with changing the way consumers viewed the brand name of the product -
Delvaux, a Belgian manufacturer of exclusive handbags, raised prices quite a lot in conjunction with a repositioning of the brand. Sales rose sharply, as consumers started to view the product as a viable alternative Louis Vuitton handbags. From their website:
Le brillant patent leather handbag DELVAUX
Sales of the famous whiskey brand Chivas Regal were in the doldrums in the 1970s. In order to reposition the brand, the company developed a label with a more high-end look and raised the price by 20%. The whiskey itself remained exactly the same. With the price increase, sales rose significantly.
This is from their website:
This blended whisky was originally created in 1953 to pay tribute to Her Majesty Queen Elizabeth II, and only 2,500 cases were produced. Its name refers both to a 21-gun salute, which is a symbol of respect, and to the fact that each of the whiskies in the blend is at least 21 years old. It scored a Double Gold medal at the 2013 San Francisco World Spirits Competition.
Of course – for premium and luxury goods like these, a company needs to know whether such prestige effects exist ! Will the goods give the consumers that added psychological utility they are looking for?
Obviously some uncertainty about this will exist – so the best practice would be to gradually raise prices toward the higher range. AND – it is also a good idea – as in the cases of Delvaux and Chivas Regal – to combine the higher price with an enhanced design or a packaging upgrade.
2. Price as an Indicator of Quality
This is similar to the prestige phenomenon. Consumers use the price as an indicator of the product’s quality.
A low price can cause consumers to forgo a purchase, because the price raises concerns about the quality. “You get what you pay for!”
If there are enough customers using this “rule of thumb” – increasing a price can lead to more sales.
So when do consumers assess a product primarily or solely based on its price?
a. Uncertainty about the products quality and price is the only information available:
The product is new to them or the consumer rarely buys it.
Several researchers have concluded that when brand name, store reputation, or product information is available, consumers appear to rely on them rather than on price. So price appears to be used as an indicator of quality only when other indicators are absent or ambiguous.
b. When the absolute price of the product is not very high:
On higher priced items, consumers are more likely to do more research about the good and are less likely to be as uncertain about the quality.
c. When there is little transparency on prices for alternatives:
Again – more uncertainty about what the price “should be” in the consumer’s mind.
d. Consumers think there are large differences in quality between brands:
e. When consumers are under time pressure:
Why do consumers use price as an indicator of quality? What are some “psychological” explanations?
If the consumer has had a good experience with a high priced item before. However, the more experience the consumer obtains about a particular good, the less they need to rely on price as an indicator. Or they had a bad experience with a low priced item.
b. Ease of comparison:
This is especially true when the price is fixed and nonnegotiable. In places where prices are negotiable, consumers are less likely to judge quality by price.
c. A “cost-plus” mentality:
d. Consumers think there are large differences in quality between brands:
e. There is generally a range of acceptable prices – if a price is too low, the consumer thinks it must have very poor quality; on the other hand, if the price is too high – the consumer might think he is being taken to the cleaners. Consumers might go to the high end of the range thinking quality is generally high for all products in that range.
There are a lot of empirical examples of customer’s judging quality by price. From nasal spray, panty hose, ink, electrical goods, etc. Also in the service sector – restaurants and hotels.
Adding to the psychology of price and quality: The Placebo Effect of Price
Sometimes judging quality by price goes beyond just perceiving better quality at a higher price. There have been studies that show this relationship can create a placebo effect:
Usually used in medicine. A patient thinks he or she is getting better because they are taking a pill – the pill is sugar or something.
In one experiment: study participants received a pain reliever at different prices. One group saw a tag with a high price, and the other group saw a low price. Without exception, the participants in the high-price group claimed that the pain reliever was very effective. In the low-price group, half of the participants made that claim. In both cases, however, the pain reliever was actually a vitamin C placebo, which has no objective ability to relieve pain. The only difference between the two groups was the price they saw.
So – maybe price differences really can make consumers think differently about the same product!!
Strategy Note: Price as a Defused Weapon
If prestige, quality, or placebo effects are present in a market, this has a major impact on both what price is charged and how and what a price communicates to customers.
These effects defuse price as a competitive weapon. Why?
If a seller wants to increase her market share through aggressive pricing (lowering the price) – she will probably fail.
This does make it more difficult for a new product to break into the market. But not impossible. In fact the price can be the way to do it (along with maybe some fancy packaging).
What should a company do if it can’t use price as a competitive weapon? The best method may be to position the product in a price range which corresponds to its true quality and accept lower sales initially. This will require patients (and maybe deep pockets) until customers actually learn and appreciate the product’s quality.
Example: Audi had this problem in the 1980s – it took 20 years to get the brand to the price and prestige position it “deserved.”
Another new Source: The Psychology of Price by Leigh Caldwell.
3. Price Anchor Effects (Price Anchoring) or sometimes called the “First Impressions” Effect
What if consumers know nothing about the quality of a product. The buyer has neither knowledge or means to make a qualified assessment of a product’s quality, nor the information about the price range for this product category?
a. Do thorough research of course! Look online, read Consumer Reports, ask your friends, etc.
This might make sense for a major purchase – such as a house or car. But it is time consuming and costly. An economist would say that people will search up to the point where the marginal cost of the search is just equal to the marginal benefit.
But what if a consumer’s marginal opportunity cost is very high – or the marginal benefits of the search just aren’t worth the cost because the good has a lower value?
b. In this case consumers look for reference points or “anchors.” And this gives a supplier an opportunity to “shape” the consumer’s perception of what his product is worth.
Anchoring: If you show someone a high price first, their expectations about the value of a product will be shifted upwards. When they then see the lower price which they will actually be charged, this will increase the attractiveness of your product or service.
The psychological idea is that people will compare the price of your product to the range of prices for comparable options. So if your price is $200 and the comparative range is $100 - $1,000, your product will look like a good value. If the comparative range is $30 - $200, you will look expensive!
The old story about Sid and Harry – brothers who operated a clothing store in New York in the 1930’s:
There have been a lot of experiments to show that anchoring does seem to work – mostly be academics but also by sellers!
Example: When customers walk into a store the display they see first has products (let’s say candles) that have a range of prices that are relatively high. Further back in the store they see candles that have lower price ranges. Having been exposed to the higher priced candles – they are more likely to buy the higher priced candles from the lower range candles. The high priced candles “anchored” a price in their minds about candles. So they didn’t want to go too low and get low quality.
Example: Behavioral economist Dan Ariely did an experiment with his MIT undergraduates. He (and his colleagues) auctioned off some “tricky-to-value” items – wireless keyboards, luxury chocolates and obscure French wines.
The trick was this: before the auction, they asked each person to write down the last two digits of their social security number and ask themselves, “Would I pay this number of dollars for the item?”
So someone with a social security number 5500-84-8398 was looking at a price of $98.00. But if the social security number ended in 9415 – then the person was looking at a price of $15.00.
These had nothing to do with the prices offered in the auctions. But guess what – those with high digits ended up bidding about 50% more than those with low digits.
Basically what is happening is that an “anchor” price is somehow shown to the consumer – and the consumer tends to then base his or her pricing decision against the anchor.
Downside of Anchoring
Anchoring can have a powerful effect on the sales of the product you are focusing on, but it can have an effect on consumers’ assumptions about your overall price levels. If you have high-priced anchor products it will be difficult to convincingly present an image as a discount or good-value supplier. But if you are smaller and offer high-value, high-margin goods – it can work pretty well.
The Pricing Strategy – How to Apply Anchoring:
There are a lot of ways to use anchoring in a business. Here is a process from The Psychology of Price by Leigh Caldwell:
a. Collect data. Know as much as possible about the range of prices that you and your competitors charge for a given product. If you have a unique product for which no benchmark exists – lucky you. But for most businesses, there are competitors or at least some kind of comparable product out there already. Compile a list of all of these products and their prices.
b. b. Order these by price level – this way you can see the range of prices charged for similar products.
c. c. Then consider the path a consumer takes before choosing to buy your product. Do they see a range of items in your store? Or on your website? Or do they find different options by searching the Web? Is your product sitting in a store alongside other similar products?
d. d. Find where in that path you can add a new product at a high price. See if you can place the high priced product such that the customers see if first before seeing your “standard” products.
e. e. Choose your anchor price to be substantially higher than your standard price.
f. f. If possible, try to measure the consumer behavior with or without the anchor.
So to sum up: Anchor pricing takes advantage of the human tendency to rely too heavily on the first piece of information received and make later judgements in relation to it (definition from Beyond Cost Plus).
Famous example: Steve Jobs introducing the original iPad. Remember at this time tablets were new to the market – so Apple was basically creating a new market.
Here’s what Jobs did: for several minutes a price of $999 is up on the screen behind him - establishing that as the anchor price, while he talks about the product and how they decided to price it.
Then, at the end, when the actual price of $499 comes down from above and crushes the $999 – the audience was aghast!! This new product, which they were just told was worth $999, is actually being sold for half of that. Pretty darn clever!
Would the reaction- and the sales they made - have been the same if the $999 anchor had been left out, and they had gone straight to the $499 price? Probably not. Nobody knew what that new kind of device would cost. $499 seemed like an incredible deal primarily because the anchor had just been established at $999.
4. 4. Decoy Pricing
This is related to anchoring – in fact it seems very similar if price is being used as a decoy. But typically with anchoring – the higher price is the anchor. With decoy pricing – there typically are three prices – the middle ground price being the one that the seller wants the buyer to choose.
So what is it? Decoy prices are used to cause a shift in preference between other available prices. The goal of the decoy is to make one price (presumably the price more profitable for the seller) more attractive to the consumer.
Here’s a famous example by behavioral economist Dan Ariely (Predictably Irrational is his book).
Another example: Travel packages
Consumers were originally offered a trip to Paris (option A) or a trip to Rome (option B). A lot of people had a hard time choosing.
So they were then offered three choices: a trip to Paris with free breakfast (option A), a trip to Paris without free breakfast (option A-), and a trip to Rome with free breakfast (option B).
Guess what: an overwhelming majority chose option A.
Why does it work?
a. One psychological explanation is that it is easier to compare the two options to Paris because they are basically similar – but very difficult to compare Paris and Rome.
So when a slightly worse option is added that is similar to A (call it A-), then it is easier to see that A is better than A-, and people choose it.
The chapter your read from The Psychology of Price also mentioned the following reasons:
b. b. People don’t like extreme options – they like compromise and balance – “because it feels like we are less likely to make a mistake.”
c. c. Diminishing marginal utility:
He is obviously using a different definition here. Even in mainstream economics this theory is explained by a consumer consuming the exact same good – one after the other. Not different goods. So be careful!!
In the wine example, the author says the taste difference between the best and second-best wine is smaller than the difference between the second and third.
But the price difference is just as great, or in his example greater.
I really don’t think this is a good reason as to why a decoy might work. What do you think?
Two Ways to Use A Decoy
a. Asymmetric dominance approach.
Basically – this is when product features or additional services are compared.
You vs. a competitor:
Your competitor’s product
You invent a decoy that is definitely less attractive than your product – but similar to it.
Consumers compare your product and the decoy and choose your product.
Be careful: consumers might choose your decoy – so be ready if the decoy really doesn’t exist for sale.
b. Price-level Decoys.
Simpler. If you offer three similar products at different prices – finished (although you need to look at the range between prices).
If you offer two products – add a third and price it very high.
If you offer one product – add two new ones and price both of them higher than your first product.
DO ICE FIVE
5. Price Thresholds and Odd Prices
Go to pretty much any store (or shop online) and you see a lot of prices ending with 9. Does it really work?
Of course people understand that $29 and $30 are basically the same price – don’t they?
Well, there are many studies that suggest it does work – that is, more people will buy the product at $29 than at $30.
For example: in an experiment done by University of Chicago and MIT, a mail order catalog was printed in 3 different versions. One women’s clothing item tested was sold for $39. In different versions of the catalog, the company offered the same item for $34 and $44. Each catalog was sent to an identically sized sample.
There were more sales at the price of $39 than at either of the other prices, including the cheaper $34. The price of $39 had both greater sales volume and greater profit per sale.
The explanation of why numbers ending with 9 work better has been much debated over the years. Here’s how Hermann Simon sees it:
Price Threshold: “a price point which triggers a pronounced change in sales whenever it is crossed.”
In economic terms, a reservation price is the highest price a consumer will pay for something. So a price threshold would be similar. If a price goes above a reservation price for a lot of consumers, sales will drop off considerably.
The problem though is determining where that is!!
The idea of a “kink in a demand curve”:
Arguments for “odd prices”:
a. Customers perceive the digits in a price with decreasing intensity as they read from left to right.
b. Customers tend to associate prices ending in 9 with promotions or special offers.
So cut price from $1.00 to 99 cents – sales increase a lot. Is the increase due to the drop in price or the 9 effect?
If a store uses the odd pricing strategy – they should set their “price as close to the threshold as possible.” Again though – where is that?
One way of looking at how much a price change affects sales is by looking at the price elasticity of demand:
The study in your reading found that when a price changed from a price ending in 99 to 49 was more elastic than a price change ending in 75 to 50.
Even so – “convincing scientific evidence for a general price –threshold effect is still lacking.”
Studies have had mixed results.
Even so – it is widely used. If a store uses 9’s – there are problems:
b. If the price is not changed, change the package size instead:
c. Missed opportunities (what if the price threshold doesn’t really exist):
d. Raising a price from 99 cents to $1.00 could actually lead to a double in profits – or at least a big increase even if there is drop in demand:
Is there another strategy that can outsell 9?
Some studies have found that sale price markers (with the old or anchor price mentioned) were more effective than mere prices ending with the number nine.
For example: In the following split test, the left one won:
Then the split tested the winner above with a similar tag, but which had $39 instead of $40:
This had even a stronger change in sales.
Believe it or not – the font size also seems to also matter.
One study found that when the font size between the sale price and the original price were different – they were more effective – “increased purchase likelihood.” They concluded that, “our findings suggest that consumers are not consciously aware of the role of magnitude representations in influencing price perceptions.
Coulter, Keith S. and Robin A. Coulter (2005), “Size Does Matter: The Effects of Magnitude Representation Congruency on Price Perceptions and Purchase Likelihood,” Journal of Consumer Psychology .
Price comparison Examples.
6. Prospect Theory (Kahneman and Tversky)
Positive and negative utility may be asymmetrical.
See figure 3.3 in your reading.
The Theory: “for any absolute gain or loss of identical size, the negative utility from the loss is greater than the corresponding positive utility from the gain. In other words, the pain we feel from a loss is greater than the happiness we feel from a gain, even if the magnitude of the loss and gain themselves is equal.”
Prospect Theory and Pricing:
Paying a price: negative utility (a loss)
The product or service: positive utility (a gain)
Therefore (what does prospect theory supposedly explain? Some of things don’t really relate to pricing):
a. Endowment Effect: “The negative utility of giving up something we already own is significantly greater than the positive utility we get from a good that we first need to buy.”
The mug example in your reading – p. 41.
Do you see an issue with this example?
b. Negative utility from paying by credit card is less than the positive utility from getting the same amount of cash.
So does this mean that a price can be higher for a charged purchase than a cash purchase?
c. c. Sunk costs:
The sunk cost (negative utility) is “higher” if the person pays for a ticket than if they receive it for “free” but is unable to use the ticket.
d. Reminder Effect of Cash:
It is harder for people to part with cash than to pay via credit card, the negative utility is greater with cash.
e. e. Cash Back Pricing Schemes:
Idea is that the negative utility from paying the price is less than the utility from both the good received plus the cash back – inducing people to buy.
f. Moon Prices: List prices that no one ever pays.
1. Price discrimination:
2. The discount provides more utility for the consumer:
g. Price Structures and Price Metric: How will the consumers pay the price?
Prospect theory says that a lump sum is better – why? (How often do customers “feel” the pain?)
However, why did Simon say that fitness studios are a “contradiction to prospect theory?”
DO ICE SIX