14 Principles For Pricing Everything

Apr 28 2014

“They know the price of everything and the value of nothing.”  - Oscar Wilde

Priceless is a great read for anyone who wants to explore the psychology behind pricing (and currently only one of two books that really addresses this topic - I’ll be reviewing the other soon). Although it lacks an overall storyline and structure, the book is easy to read (spread across 57 chapters) and full of anecdotes and case studies. It contains extensive discussions of some of the underlying theories which can help explain some of the strange and quirky ways in which humans deal with issues of money, most notably those of behavioural economics and its chief spokesperson Daniel Kahneman.

To summarise some of the book’s content, here are 14 considerations for pricing anything and everything.

1) We don’t really know the price of anything

In the first chapter of Priceless, William Poundstone argues that none of us really know the price of anything at all. We rely on cues in the environment, and are more sensitive to relative differences (see point 2) than to absolute values. And even if we remember what something cost last time we bought it, we don’t remember the details of the pack size and shape, so even when businesses shrink the size of packs or add a dimple in the bottom of the bottle or jar, as long as the price we remember is the same, we assume everything else is too.

2) The pricing universe is relative

Priceless talks a lot about psychophysics and much of the research that has been conducted into judgements of sensory stimuli, like weights, lights and sounds. Even back in the 1800s, psychophysicists had realised that people are very sensitive to differences between stimuli, but not sensitive at all to the absolute values of the stimuli. We know which of two suitcases is heavier, but not whether either suitcase will meet the airline’s weight limits. The same is true for prices, a finding that Dan Ariely & co-workers have called “coherent arbitrariness”, by which they meant that relative valuations of things are coherent and stable while evaluations of absolute dollar values are arbitrary.

3) We anchor and then adjust

The present debates about bonuses and salaries in some industries are all driven by the importance of anchoring and adjusting (upwards). By that I mean, anyone is happy as long as others in their “reference group” earn less or at most the same as they do. Research on compensation awards in court cases show that the final award is highly dependent on the “first demand” (i.e., the amount that is used as the anchor at the start of negotiations). When negotiating prices, always be the first mover!

4) Pricing follows power laws

Pricing isn’t perceived in a linear way, but rather follows power laws, like other sensory stimuli. Experiments in psychophysics often use magnitude estimation showing that for a weight to feel “twice” as heavy it only needs to have 1.6 times the mass of another weight. An electric shock is twice as strong when the electric current is only 1.2 times as much. And a watch needs to cost almost nine times as much as another to be twice as desirable.

5) Frame the price with a picture

Maurice Allais conducted interesting research into what people will pay for a bullet (read the book to find out more) showing a huge effect of certainty - there is a huge difference between something that is 100% sure and something that is 99% likely. This is why “free” is so powerful (see below) and why some of the experiments on loss aversion and betting show such strange results. The point is that the way choices are framed and the language used to describe those choices influence the perception of value hugely. In the words of Amos Tversky, “We choose between descriptions of objects, rather than between the objects themselves”.

6) First impressions last

Anchoring and priming are often used to describe the same effect, although they actually describe slightly different interpretations of a particular phenomenon. In anchoring, the argument is  that we all “anchor” to the first piece of information we are given, and then “adjust” to what we think is the nearest plausible answer (in the case of price, adjusting down or up until we find a value that is within the range of plausibility or. put another way, the most extreme value we can accept). Another interpretation is that priming is much more arbitrary, and due to the “suggestibility” of people. Whatever the reason, many experiments have shown that even completely random numbers influence how we perceive value.

7) We never like to lose

The most important theory in behavioural economics, and Kahneman and Tversky’s greatest contribution, is prospect theory. The theory describes how we all evaluate losses, gains and risks, harking back to psychophysics: “Our perceptual apparatus is attuned to the evaluation of changes rather than to the evaluation of absolute magnitude …. an object at a given temperature may be experienced as hot or cold to the touch depending on the temperature to which one had adapted“. The use of reference points (hence the power of anchoring) is much like adaptation which is seen in evaluation of sensory stimuli. Apart from relativism, prospect theory also includes the ideas of loss aversion and of the certainty effect (see above). Loss aversion simply means that you need to gain more than $20 to balance the feeling of losing $10 (i.e. losses and gains are not psychologically additive).

Avoid the extremes

The one behavioural economics principle understood by all luxury retailers is anchoring. Most stores will often have (one) obscenely priced item displayed mainly to manage the expectations of customers. While the item is for sale, no one expects it to be sold. All it does is help to provide contrast for everything else (cf Hublot’s Black Caviar Big Bang watch as $ 1 million). When we are uncertain, we avoid extreme items with either the highest or the lowest price, and contrast effects usually point us to a “middle way”, Why else do many fast food outlets structure choices in the way they do, and why do Starbucks never include the “Short” on their menu?

9) Contrasts help trading off

The trade off contrast shows that when one item is clearly inferior or superior to another, it helps us make a clear decision. The fact that one is so clearly better than another gives us a “simple” reason to choose the better item and carries much more weight than it should in many situations. For example, if two similar handbags are shown at different prices, then the cheaper one “must be” better than the more expensive one. It stands to reason if there is really very little difference apart from price, right?

10) Bundle price, not value

Restaurant menus are full of pricing tricks. One common technique is to “bracket” items - for example, offering an expensive item in two sizes, making the smaller one feel much more attractively priced (when the smaller item is what the restaurant really wanted to sell. priced at what they really wanted to charge). Similarly, bundling is a common practice of selling several items together, such as “combo meals” in fast food restaurants. When burger plist fries plus drink is only a few cents more than just burger and fries, why wouldn’t you buy the combo? In reality, the restaurant makes a higher overall profit on selling all three.  Similarly, we ar wall biased to love flat rates above paying for each item or usage, because it “bundles’ paying into one pain point instead of multiple hits.

11) Every cloud has a silver lining

We all love rebates and savings, and they have a disproportionate impact on our buying behaviour. That’s because when they are framed in the right way, the rebate (or bundled extra) makes us feel good while the price of the overall package makes us feel bad, but the two can cancel each other out, reducing the pain of paying. Consider buying a new printer at $175 or a new printer at $200 with a $25 cash back. While the difference between 175 and 200 is relatively small, the joy of the 25 cash back makes the second option much more palatable. That’s the silver lining!

12) I want to break free

The joy of “free” can be unbounded - it provides certainty (see earlier) and the positive feeling of getting something without the associated pain of paying. The unique psychology of this price point, means that we can never regret “buying” something free because there is no downside. This is where psychophysics and other laws break down, because at zero the usual laws just don’t apply (much like dividing by zero in mathematics).

13) Charm your customers

Charm prices are one of the first rules we all learn about the psychology of pricing. Despite the evidence (which is a little mixed, although adding more than 20% to sales when averaged across different studies) retailers insist on using numbers ending in “9″. Interestingly, in one study, clothes sold at $39 outsold those sold at $34 and $44 (in split test). The success of 99 cent (maybe 99 dollars these days) stores show that the strategy can work. One theory is that a price like 29.99 feels like “twenty something” while 30.00 (only cent different) feels like “thirty something”, and that this is purely an effect of mental rounding. Another theory states that the 9 or 99 figures convey an implicit discount, and it is certainly true that putting the word ‘sale’ next to a price automatically increases sales (another split test). Finally, using the word sale and using the original price for comparison (with as much physical distance as possible to imply cost difference) is the most effective way to label price.

14) Help minimise risk

I found one short chapter towards the end of Priceless particularly useful, arguing that the most effective strategy, encompassing many of the above ideas, was to always provide a description that minimises the risk for the buyer. For example, guarantee a fixed amount or fixed rate (if there is a risk of a more variable offer), guarantee fixed percentage raise (if there is a risk of inflation or deflation) and guarantee purchasing power (indexing to cost of living rises, rather than risking less certain changes). Of course, such strategies rely on loss aversion to make the strategy more attractive. Here’s a great example, if you have a $100 product, say that it’s usually $149 but you can discount it to $99. When the cost rises eating into your margin, tell customers that the price is still $149, but now you still discount $119 for good customers. Then later, when this is accepted, tell them that the price has increased to $179, but for the very best customers, you can keep the discounted price of $119. Then repeat the cycle as often as necessary.

Priceless is a great read for anyone looking for ideas and examples of creative and successful pricing strategies. While there are no universal solutions there are enough ideas, and plenty of theory to back them, to make anyone a great pricing strategist.

REFERENCE
Priceless: The Myth of Fair Value (and How to Take Advantage of It) by William Poundstone

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