The Psychology of Price

by Leigh Caldwell

  The Psychology of Price

  The Psychology of Price

  How to use price to increase demand, profit and customer satisfaction

  Leigh Caldwell

  The Psychology of Price

  Leigh Caidwell

  This 1st edition is published in 2012 by Crimson Publishing

  Crimson Publishing, Westminster House, Kew Road, Richmond, Surrey TW9 2ND

  © Crimson Publishing Ltd, 2012

  Epub edition 2012 ISBN: 978 1 78059 200 8

  The author has asserted their moral rights to be identified as the the author of this work in accordance with the Copyrights, Designs and Patents Act 1988.

  British Library cataloguing in Publication data

  A catalogue record for this book is available from the British Library

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  Contents

  Acknowledgements

  Introduction

  The seven principles of pricing

  Chapter 1 Pricing as positioning

  Chapter 2 Cost-based calculations

  In focus: Famous prices in history

  Chapter 3 Reading the customer’s mind

  Case study: Cereals at Tesco

  Case study: Jewellery maker

  Chapter 4 Segmentation

  In focus: Does 99p pricing work?

  Chapter 5 New launches, belief and fairness

  Case study: A specialist consultancy and its reseller

  Chapter 6 Memory and expectations, trials and reframing your prices

  In focus: Should you increase your prices in line with inflation?

  Chapter 7 Anchoring

  Case study: Business consultancy

  Chapter 8 Competition

  In focus: Pricing publicity

  Chapter 9 Decoys

  Case study: Decoys on services

  Case study: Self-decoying

  Chapter 10 Paying tomorrow for what you get today

  In focus: Negotiating

  Chapter 11 The tea party

  Chapter 12 Bundling

  In focus: Name your own price

  Chapter 13 Free offers

  Chapter 14 Upselling

  In focus: Occasional versus frequent purchases

  Chapter 15 Absorption and value pricing

  Case study: Software company

  Case study: Marketing consultant

  Chapter 16 Other people’s money

  In focus: Should you publish your prices?

  Chapter 17 Managing the pricing environment

  Chapter 18 The psychology of giving

  In focus: How many pricing models are there?

  Chapter 19 The ethics and law of pricing

  Epilogue

  Bibliography and further reading

  Appendix A. A pricing diagnostic

  30 questions to ask to find out if your pricing is optimal

  A quick-reference method for pricing a new product

  Appendix B. A theory of psychology and cognition: the background to this book

  Acknowledgements

  As a teenager, I had a bet with my brother that I’d write a book and have it published by the time I reached the age of … well, let’s just say I missed the deadline. But thanks, Owen, for helping provide the initial, indirect stimulus for this work.

  The rest of my family have also provided love and support over the years and I’d never have been in the position to write this without the framework and happiness that they provided. My deep gratitude to all of you.

  The idea to write this particular book arose from many conversations, long walks and glasses of wine over the years with Annette, who has inspired many ideas and achievements by me and other people. More encouragement and thoughts came from Ebru and from Emma, whose introduction to Ali Yates at Crimson initiated the final part of the process.

  The content of the book is informed by many years of doing business, and everyone I’ve worked with has taught me something. So if we’ve worked together over the years then you have influenced this book. Special thanks to Bastiaan, Daniel, David, Nabil, Philip, Rajiv and Safina for many conversations and collaborations that helped shape my understanding of this field. Helder Miguel also helped nudge me onto this path.

  During the writing process both my productivity and sustenance were aided by the hospitality of Shani Hiraoka in Honolulu and everyone at Pret A Manger in Stamford Street.

  More direct input came from Sally Holloway via Tim Harford, from the folks at the Society of Authors, from my editor Ian Wallis and from those who kindly read early drafts. Thaddaeus Frogley went well beyond the call of duty, giving extensive and detailed comments on the entire manuscript, as did Kay Caldwell, Alice Moseley, Phil Lord and Martin Caldwell. My good friends John, Paul and George led by example, giving me their books to review before I wrote mine; any authors named Ringo are invited to email me to complete the set.

  Introduction

  About half of the contents of this book were originally offered as a training manual for partners and directors of major companies, alongside an expert consulting and research service, at £155 – a bargain considering it could increase your income by hundreds of thousands of pounds each year.

  We slashed the price to just £33.50 as a promotional offer, and had a surge of interest from smaller companies.

  And now it’s been published in paperback so we can get the message out to as many people as possible. The new low price: an irresistible £14.99.

  See what I did there? In theory, the previous price of this book should be irrelevant to today’s reader. In reality, it’s not. The psychological power of naming a higher price implicitly makes people believe that a product has a higher value.

  For years, setting prices in the businesses I was involved in, I wondered about the psychology of my customers. Like most new business owners I started out by setting a price based on my costs plus a margin. Sometimes the clients would negotiate and sometimes we’d have to match the price of a competitor. The whole time, though, I was convinced that I must be missing something that was going on inside the heads of my customers. If selling a DVD at £9.99 really works better than selling it at £10, surely there must be something I could use in my pricing strategy too.

  In 2002 Daniel Kahneman won the Nobel Prize for Economics. This was when the science of behavioural economics, which combines the practice of economics with the experimental discoveries of psychology, started to become more widely known. As I started learning about it, I soon found that this new research had the answers I’d been looking for. It reveals how consumers perceive different price points, whether it is better to negotiate down from a high starting price, whether people will pay more for a monthly contract, and how to persuade clients to pay for the value they are getting. Eventually I set up a business which specialises in providing pricing advice – the advice that is encapsulated in this book.

  Behavioural economics research has revealed a rich set of discoveries relating to how people buy products and services, and how much they are willing to pay. From this research, we and other pricing specialists have designed at least 20 different new pricing approaches, including insights into setting basic positioning, segmentation
and pricing strategy, how to present prices in retail or business-to-business environments, and how to use pricing to ensure loyalty without giving up profit margins.

  It turns out that psychology is one of the main influences on successful pricing. For some products and services, like those of a London-based software company we worked with, the right psychological approach can increase revenues by more than 200%. The difference isn’t always that great: we worked with a magazine publisher in a declining market and the improvement was more like 10%. In every case, understanding consumer psychology gives you the ability to improve your pricing power and increase your profits. Indeed, a business must get its approach to pricing right in order to survive and grow; it is a fundamental matter of strategy, not an optional extra.

  This is the first book to tell you, step by step, how to use the psychology of price in your business; no matter what you sell, whether a product or a service, to consumers, to other businesses, or to government. It starts with the first steps in using price to position your product or service, then explains how to price differently for different segments of your market, followed by a series of pricing techniques that help you work with, rather than against, the way your customers’ minds work.

  Along the way you’ll read the story of a unique business: the Chocolate Teapot Company. This is a company which used pricing strategies to create a whole new product category, achieve a premium position for it in several markets, and make big profits by understanding the psychology of its customers. It’s also a fictional company, so don’t expect to see chocolate teapots on the shelves of your local supermarket any time soon – but everything that happens in this book is based on real examples from other businesses.

  Each chapter is divided into three sections.

  The first part of each chapter tells the story of the Chocolate Teapot Company, showing a new example of how its founders used pricing techniques to launch a product, increase profits, widen its customer base or defend against competitors. The second part explains the particular pricing approach in more detail, discusses the psychological reasons behind it, and provides other case studies of businesses which have used this approach. The third part is a ‘How to apply it’ toolkit, giving a step-by-step methodology for applying this technique in your business.

  At the end of the book is a list of sources where you can find out more about the research and theories that this book is based on, including references to books and articles where you can learn more.

  You can read through the book from start to finish. Or you may prefer to focus just on the story, the discussions or the toolkit: each part can stand alone, though if you read them together each one will help to illuminate the others.

  Every business is different, and you will find that some of the techniques and chapters are more relevant to your company than others. In any case, they will all give you some insight into how people think, and how that translates into what they buy.

  You can also find the supporting materials and electronic versions of most parts of the toolkit on the book’s website, www.psyprice.com.

  Please do visit the site, talk to other readers and send me your thoughts. I’d particularly enjoy seeing examples of clever pricing approaches you’ve used in your own business. The best examples will be promoted on the site and, with your permission, may be used as case studies in future editions of this book.

  The seven principles of pricing

  1. Pricing should be based on the value to the customer, not the cost to you.

  2. Prices should be tangible, so your customers can see what they get for what they pay.

  3. Prices should be comparable – on terms that you control.

  4. If you want to change your prices, you must reframe the service or product.

  5. Price differentiation is the key enabler of profit.

  6. Pricing communication shapes the client’s perception of value.

  7. You must be prepared to lose some sales in order to increase profits.

  Chapter 1

  Pricing as positioning

  I burst out laughing when she told me the name of the product.

  “Chocolate teapots? You’re joking, right?”

  Maggie smiled. “Not at all. But I’m glad you reacted that way. I think we’re going to get a lot of attention with this.”

  She opened a cardboard packet and carefully removed an object about the size of a grapefruit. It did, indeed, appear to be shaped like a teapot – and made of a substance which looked just like milk chocolate.

  A kettle was just coming to the boil. She opened the lid of the teapot, placed some leaves inside and, to my puzzlement, poured the boiling water straight in. Somehow it wasn’t melting.

  She handed the teapot to me and I realised that the object itself was made of a thin shell of clear plastic. The brown, in fact, was fading as the chocolate layer inside started to melt.

  “You can pour now or wait longer if you’d like it a bit sweeter. Try it,” she said, handing me a cup.

  I poured out a small amount. It tasted remarkable. The softly aromatic tea flavour was balanced by a light note of sweetness, creaminess and bitter cocoa. I sipped it for a few moments then tried pouring out a little more. This time it was stronger, with the tea and chocolate competing for dominance – maybe a little too sweet and intense for my taste. By now the chocolate had all dissolved. After a minute more, I poured out the last of it and the tea had strengthened, dominating the flavours now with just a relatively soft note of cream and sweetness balancing it.

  “What a strange experience,” I said. “Might take some getting used to, but I think you’ve invented something … quite good.”

  Maggie smiled. “Nobody really knows what to make of it at first. But mostly people like it – if they take sugar in their tea. I’m developing a bitter version for those who don’t.”

  Maggie, whom I’d known since first seeing her pricing methods used in a shop a few years ago had invited me to visit her new company and write something about it. I wasn’t sure yet what the story was going to be, though it was immediately obvious that the product was original enough to be worth writing up. When I first met her, she was working in photography so I wondered if her product might be something related to mobile phones or technology. I had not expected a cup of tea.

  “Anyway,” she went on, “the flavour isn’t what I want to show you. The really interesting part is this.”

  She opened a door and invited me through to a new room laid out a bit like a shop, with a series of different display shelves.

  “Before I show this to you,” she asked me, “how much do you think you would pay for one of those teapots?”

  I thought about it. “It’s very hard to say. I’ve never really seen anything like it before. How much does it cost to make?”

  “Well, there’s an interesting question,” she said. “But I’m not going to answer it. Have a look at this.”

  She pointed me towards the first set of shelves. It was laid out like a supermarket aisle, with jars of instant coffee, bags of filter coffee, boxes of 80 and 160 teabags, and, next to them, the chocolate teapots. I looked more closely, to see the prices.

  100g Nescafé Instant

  £2.49

  100g Gold Blend

  £3.39

  80 Tetley teabags

  £1.79

  250g Lavazza coffee

  £3.29

  Pack of six chocolate teapots

  £2.79

  Pack of 12 chocolate teapots

  £4.95

  “I’m not sure I’d buy them very often at that price,” I said. “I only get six cups for the same price as a whole jar of coffee. It doesn’t seem like good value. Are people willing to pay that much for it?”

  “Well done – you’ve spotted the flaw in the positioning here,” she replied. “So let me show you this instead.”

  The next set of shelves looked more like the display in an Italian café. Cups of various sizes were laid out with price
tags beside them:

  Cappuccino – small

  £1.89

  Cappuccino – medium

  £2.29

  Cappuccino – large

  £2.59

  Americano – small

  £1.69

  Americano – medium

  £2.05

  Americano – large

  £2.35

  Espresso

  £1.29

  Double espresso

  £1.79

  Vanilla frappuccino

  £3.49

  Chocolate teapot

  £2.89

  “OK, I can see how people would buy that,” I said. “It’s pretty much in the same range as everything else. I can imagine buying it at that price.”

  “Well, let’s look at one more before you decide.”

  The final shelving unit was actually a small open-fronted refrigerator. In it was a range of dairy and juice products.

  Organic yoghurt – single

  £1.09

  Organic yoghurt x 4

  £2.89

  Fresh fruit smoothie – 250ml

  £1.99

  Fresh fruit smoothie – 1l

  £3.69

  Energy drink – single

  £1.15

  Energy drink x 4

  £3.95

  Chocolate teapot – single

  £1.59

  Chocolate teapot x 4

  £4.45

  I thought about it for a while. “I guess if I were in the habit of buying these kind of things the chocolate teapot would seem like reasonable value. How often do people buy a four-pack of Red Bull, though?”

  Maggie opened up a notebook. “There are about two million cans of Red Bull sold every week in UK supermarkets, a million smoothies and – even more tempting – a hundred million pots of yoghurt. So it’s not a bad market to get into.”