The Psychology of Price

by Leigh Caldwell

  For many companies, examining their cost base is as far as they get towards determining a pricing strategy. It is an important step, but it is only a small part of the picture. The cost of providing your product or service tells you the lowest price you can charge, but it does not tell you the right price.

  One reason for this is that the right price depends on the volume you sell. Your variable costs – the direct material costs of manufacturing each item or delivering each service – are incurred for each unit you sell. Your fixed costs are incurred when you start up or invest in expansion, and then each month while you operate. These fixed costs must be apportioned across all the units you sell to find the breakeven price – but you do not know in advance how many sales you will achieve. And the sales you can achieve are in turn influenced by the price point you set.

  This makes the minimum price nearly impossible to calculate exactly. The calculation ends up being circular, and you can only work it out if you have an unachievable level of detail on customer buying behaviour.

  However, you can at least work out some options. Here’s an example for the Chocolate Teapot Company.

  Base costs

  If they sell … 10 units/year

  100,000 units/year

  3m units/year*

  Base (variable) cost per unit

  19p

  19p

  19p

  19p

  Startup costs (over 3 years)

  £330,000

  Startup cost apportioned per year

  £110,000

  Startup cost per teapot

  £11,000

  £1.10

  3.7p

  Annual costs – marketing plus overheads

  £250,000

  Overheads per teapot

  £25,000

  £2.50

  8.3p

  Minimum selling price per unit

  £36,000.19

  £3.79

  31p

  * In fact, if they sell as many as three million units, the company will probably have to invest in more equipment, and overheads will go up to support the extra sales and distribution. The fixed costs will therefore increase, but as they buy in bulk and get better prices on the ingredients, variable costs will go down. The minimum selling price will probably go down a little overall.

  You can see how much the minimum selling price varies depending on the volume you sell. This makes it very important to get some idea of the volume you can expect, so that you know what kinds of positioning are compatible with your costs.

  In this example, CTC knows that they cannot pursue a high-volume positioning strategy that puts them in competition with teabags and instant coffee. If they had not been confident of selling at least a million units, it would have been impossible to sell into the supermarket channel at all – they would have had to restrict themselves to cafés only.

  This information gives you some important input into your strategy and a check on your cost structure, but it is only the very beginning of your pricing journey. Do not be tempted to take your costs and simply add on a percentage for profit. You will be leaving money on the table but, more importantly, you will be sending the wrong signals to your customers.

  If all you value about your product is the ingredients that go into it, you will signal to your customers that there is little reason to buy from you, except to save themselves the trouble of putting the ingredients together on their own. To give your customers something to believe in, a reason to buy from you as well as a reason to pay attention to the experience of consuming your product or service – and to make a profit that is worth the time and passion you put into your business – you must find a way to charge a price based on the value you give to your customer, and not the cost you incur in doing it.

  How to apply it

  To work out your minimum selling price, fill out the following tables:

  Direct cost per unit

  Direct labour cost 1

  Direct labour cost 2

  Direct labour cost 3

  Material cost 1

  Material cost 2

  Material cost 3

  Material cost 4

  Material cost 5

  TOTAL (a)

  Fixed costs

  Startup capital – one-off costs (b)

  Management salaries

  Marketing salaries

  Operational salaries

  Marketing costs

  Office/premises rental

  Other overheads

  Other

  TOTAL (c)

  Base costs

  If you sell …

  ____

  units/year

  ____

  units/year

  ____

  units/year

  Per unit

  (a)

  Startup costs (over ____ years)

  (b)

  Startup cost per year

  Annual costs – marketing plus overheads

  (c)

  Minimum selling price per unit

  Chapter summary

  • Your costs should not be the main basis of your price, but they do provide a baseline for the minimum you can afford to charge.

  • Understanding the difference between fixed and variable costs is critical to knowing how to maximise the profits from a product.

  • All prices must cover variable costs, but some pricing strategies are specifically designed to help cover your fixed costs.

  In focus

  Famous prices in history

  In the history books, a price may seem like just another number. In fact, there were many negotiations in past centuries in which the price was critical, not just to the deal itself, but also in how it was seen by posterity.

  • What is now the state of Alaska was sold by Russia to America in 1867 for two cents per acre, or a total of $7.2m. Russia wanted to get rid of it as it feared it might lose the land anyway in future wars; the purchase was mostly seen as positive by Americans, except for those who realised that the cost of maintaining and policing the land might far exceed the purchase price. As things transpired, the oil and minerals under the land are incredibly valuable, and their exploitation is now a politically controversial topic in the USA. What’s more, without Alaska we would never have had Sarah Palin.

  • The Louisiana Purchase was even more significant. Nearly a quarter of the current land in the USA, covering 15 states, was purchased from France for $15m in 1803. The history of this purchase and its consequences had immense significance for the future of the USA – and France treated its sale as a political gain – helping establish the USA as a naval power that would potentially rival Britain.

  • London Bridge was sold as a tourist attraction to a US property developer for £1.6m in 1968. Despite popular myth, it is apparently not true that the buyer thought he was getting Tower Bridge. It is hard to evaluate whether this price was a good deal for the buyer – it turned out he had to build his own bridge anyway and could use only the marble stone facing from the original – but no doubt it helped to establish the reputation of his tourist resort in Arizona. London County Council had decided to demolish the bridge anyway, so whatever price they managed to get for it was better than nothing.

  • In an early value-based pricing deal, Christopher Columbus agreed with Queen Isabella of Spain that he (and his funders) would receive 10% of all revenues from whatever new lands he discovered in his explorations. Perhaps unsurprisingly, the Queen reneged on this part of their deal.

  • The price of oil may be the most important single price in history. It has been a driver of much of political and economic history from the 1970s onwards. The oil supply crises of the 1970s pushed the price of oil to a record high, which led directly to military conflicts in the Middle East, helped Keynesian fiscal policy to fall out of favour, and contributed to the political history of the 1980s and 1990s in the USA and Europe. The rise of oil prices in 2007 and 2008 to a new record of $145 per barrel probably contributed to the financial crisis and
recession that started in the latter year. Though many people think that conspiracies between suppliers help to push prices up, it seems unlikely that the oil market, which is worth $3 trillion a year, could possibly be manipulated in this way. This may be the least psychologically driven price there is, although the psychology of how consumers and politicians respond to it could be the subject of a whole new book.

  • The price of gold used to be of huge political significance, but it is now much less important. Gold (and silver) was used to set the effective value of most currencies until the 1930s, and in some countries up to the 1970s. The gold standard meant that the price of gold – legally defined as $20.67 per ounce in the USA until the 1930s – limited the number of dollars or pounds that a government could issue. Most economists believe that the gold standard, and the resulting lack of flexibility in monetary policy, helped cause the Great Depression. When the USA revalued gold to $35 per ounce in 1934, and the UK left the gold standard altogether, both economies started to recover.

  • More generally, governments have often tried to fix the price of goods, usually by forbidding suppliers from raising prices beyond a certain level. Typically this is done because demand exceeds supply at the current price, and rather than allowing prices to rise, the policy instead causes supply shortages which can only be solved by queues or rationing. This typically affects basic commodities such as bread and petrol, though some governments in the 1960s and 1970s tried to freeze prices and wages across their whole economy to control inflation.

  • The price of the Imperial Palace in Tokyo and the three square miles around it was once famously estimated at more than the value of all the land in California. Of course, it was never sold at this price; it is reasonable to think that if this much land had come onto the market in Tokyo, land prices would have fallen substantially.

  • Manhattan, on the other hand, really was sold. Dutch colonists bought it for 60 guilders in 1626 from Native Americans who lived next door in Brooklyn. Exchange rates were not really established at that time, but the value has been estimated at about $1,000. If invested for the 386 years since, at 4% interest, that money would now be worth $3.75bn – quite cheap, though considering the land was undeveloped at the time, maybe not a complete rip-off of the locals. If they could have got 6% interest, their $1,000 would have turned into nearly $6 trillion – at which price the seller definitely got the best end of the deal.

  • Maybe the most famous sale in history is the 30 pieces of silver that the Bible says was paid by the priests to Judas to betray Jesus. Historically this may be related to the standard price paid for a slave – some prices in ancient times were much more stable than they are today, as inflation did not really exist. A myriad of prices are defined in various cultures as amounts to be paid for certain things: a day of labour, the punishment for putting out someone’s eye, and many more. Anthropologist David Graeber suggests that these legally defined prices are the reason why debts and money were originally invented, and that trade and other uses of money only emerged afterwards.

  Chapter 3

  Reading the customer’s mind

  Price discrimination and letting people tell you what they want

  One windy Saturday morning in May 2009 I arrived to see Maggie lining up a number of teapots on a long dining table. She’d invited me along to see some of the first customer tests of the new products. The key question today was: how much should she charge for a chocolate teapot?

  The traditional approach to this question is to work out a “demand curve”. It’s obvious that people will buy more if the product is cheaper, and less if it is more expensive. But if you make it too cheap, the lost profit margins may outweigh the additional volume. And if it’s too expensive, you might sell none at all, or too few to be worthwhile. Somewhere along the price range there is an optimal, most profitable price. And to find out what that is, you either need to do lots of customer surveys, or try it out in the shops, and see how much people are willing to spend.

  The diagrams on the next page show what a traditional demand curve looks like, with various different price points.

  The standard economic reasoning goes like this: no matter what price you are charging now, if you increase the price you’ll sell less, and if you cut the price you’ll sell more. At some point when you cut the price too much, you won’t win enough new sales to make up for it, and the total revenue will fall (which you see at the £2 price level in diagram 1 on the next page). Similarly, if you increase the price too much, you will lose more customers than are justified by the extra revenue (£5 in this example). But at some point in the middle, there’s an optimal price where you earn the maximum revenue – the point where the rectangle under the curve has the largest area (as shown in diagram 2). (In fact you want to maximise profit instead of revenue, but the argument works the same way.)

  Diagram 1

  Quantity sold

  Diagram 2

  Quantity sold

  I asked Maggie if she already had some idea what the demand curve for chocolate teapots might be like, and she laughed.

  “Demand curves? Demand curves are useless. Let me show you why.”

  The first four customers had come in and started to look at the teapots on display. They each picked out a teapot and wrote down how much they’d be willing to pay for it. One of Maggie’s researchers collected up the slips of paper and handed them over to her. She showed them to me:

  • £1.15

  • £2.10

  • 99p

  • 40p

  “Right,” said Maggie, “so how much should we charge per teapot if we want to make the most profit from these four customers? Ignore the manufacturing costs for now – you can assume it only costs a few pennies to make.”

  I tried to figure it out. “Well, probably not 40p. You would sell one to all four customers but you’d only get £1.60 in total. And if you charge £2.10 you’d get more than that from the second customer alone.”

  “Good. So what if we pick a price in between?”

  “Well, if we go for £1.15 we will sell one to each of the first two customers, for £2.30. And if we go for 99p we’ll make £2.97. So that seems to be the best option.”

  “OK, well done. That is the right answer according to the demand curve. And it’s completely wrong according to me. Here’s why.”

  Maggie called over the third customer, who’d written down 99p. His name tag said “John”.

  “Hey, John. So you’re willing to pay 99p for a teapot.” John nodded. “Thanks, that’s good to know. Unfortunately we’ve been looking at the figures and we are not sure we can make it profitable at that price. Do you think you’d be able to stretch to £1.10?”

  John thought about it a bit. “Yeah, probably. It’s only 10p more; I suppose that doesn’t make much difference. I’m pretty curious to try it out and see what it tastes like.”

  Maggie thanked him, and John continued. “Are you really going to make these things? It seems a ridiculous idea.”

  Maggie laughed. “Well, let’s see if we can make this work. I think you’ll like it once you give it a try.”

  John went back to the table and Maggie turned to me. “So, there’s your first problem with the demand curve: customers don’t tell you the truth. They tell you a lower figure than they are really willing to pay, because they want to get you to set a lower price. They think if they give you a low answer, they’ll be able to buy it cheaper when you launch. In fact, they probably don’t even know what they’re really willing to pay: it’s influenced by how much you ask for the product, what else is sitting around them in the shop, what mood they’re in – lots of things that they can’t control and aren’t even aware of a lot of the time. And if we can figure out that John will really pay £1.10, we can set the price accordingly and make £3.30 total revenue, 10% more than we thought originally.”

  “But isn’t that always a problem with measuring people in a lab?” I asked. “Presumably if you go out and get real sales da
ta by testing the product in a shop, you can get the truth?”

  “Well, you can get closer to it. But every shop is different, and the truth when you test a new product is different from the truth after it’s been launched, advertised, people get to know it and the novelty effect wears off. So you have to make some kind of compromise between what people tell you, what you can infer from the products they buy in shops today, and your vision for what you have invented. In any case, that’s not the biggest problem with the demand curve approach. Let me show you something else.”

  Maggie asked the second customer, who’d written down £2.10, to come over and talk to us. Her tag said “Elise”.

  “Hi, Elise. Thanks for coming in today. We’re looking at launching these new teapots in the next two months and so your input is really important to us. Now let me ask you a question. You’ve said you’d be willing to spend £2.10 on a teapot, and that’s roughly the price we are expecting to launch it at. But what if the usual price was £2.10 in the shop you normally visit, but on the way there you noticed teapots on sale at another shop for £1.10. Do you think you’d continue on to your usual shop?”