The Psychology of Price

by Leigh Caldwell

  If you offer only two products, simply add a third, premium option which is priced well above the higher of the two existing choices. If your two options are priced at £800 and £1,300, take the difference (£500), add 20% to get £600, and add that to the higher price to work out the price of the new premium option, £1,900. It doesn’t matter too much how you design the premium product: it could be an extra high-quality version; it could include extra services or upgraded features. The one thing not recommended is to increase the quantity or volume of the product – this runs the risk of making the new product look like a cheap ‘family pack’ rather than a premium choice.

  Finally, if you currently offer just one product, you need to add two options. The two options should both be more expensive than the current one. The exact proportions depend on the competitive dynamics and how people value your services, but a good rule of thumb is 3:4:6. That is, if your service costs £6,000, add a third to get the price of the middle option – £8,000 – and another 50% to get the price of the top product – £12,000. Compare this with the price ratios recommended in Chapter 7 (‘Anchoring’), which cover a wider range. Decoys are more likely to be of use when customers have some expectation of the existing market price point for the product. The wider price ranges are effective when you are defining a new segment or new product type – you want to match the biggest possible range of different valuations that different customers might place on the product.

  Case study

  Self-decoying

  This magazine publisher has no direct competitors in its market, but has two of its own product options. It sells subscriptions to its weekly magazine in two different formats: a print subscription at £120/year and an online version at £75/year. It would much prefer people to opt for the printed version – there is more profit in it, and it gets much better advertising rates – but it still needs to offer the online version for those who are highly price-sensitive and to build its search-engine rankings.

  How can it influence people towards the print version? In this case the printed magazine is more tangible and easier to read, but the online version is cheaper and available more quickly. So its decoy would be a slightly worse version of the printed edition: for instance, a printed version delivered monthly in a presentation binder instead of weekly, and sold for £135. Most subscribers do not want to wait a month for their magazine, nor will they pay more just for a binder, so this option is strictly inferior to the print product. It will, however, work as a decoy. It is likely that around 10% more customers, when offered all three options, will buy the print edition rather than the online subscription.

  The cost of offering decoy products

  The question arises: should you actually manufacture the decoy product or is it just a fictional offering to distract customers? The risk you face is that someone actually orders it.

  In most service businesses, it will be easy to offer a variation on your main offering because you are carrying out each service on request; and in product businesses where there are older, inferior versions of products, you can use old stock as the decoy. In others (such as the magazine binder example above) you may be able to have the decoy product manufactured on demand in the rare cases when someone orders one. But in some businesses, it can be expensive to produce a new product, especially when you are not expecting to make enough sales of it to pay back the startup costs. If this is the case, you may find it better to modify one of the products you already have, perhaps by removing or disabling a feature. The idea of a decoy is that it should be sufficiently similar to your main product that it is easy both for consumers to compare and for you to produce without much extra cost.

  If you really can’t think of another way to offer a new variation on the product, just take the same product, give it a new name and offer it at a higher price. This will work perfectly as a decoy, as it is, in the economic jargon, strictly dominated by the real, slightly cheaper product.

  In any case, few consumers will order the decoy product. In theory, nobody should ever want it, so if someone mistakenly asks for one you may be able to get in touch with them and suggest they take the real, non-decoy version instead. You’ll be doing them a favour.

  Chapter summary

  • Customers instinctively want to make comparisons between products. This makes their buying decisions easier.

  • Therefore you want to give them options which are definitively worse than your main product.

  • If you can introduce these ‘decoys’ into the buying process, you will make your product look subconsciously better than it would without the decoys.

  • If it is hard for people to compare the features or quality attributes of two products because they are not numeric quantities, you can use the price of the product itself as a decoy.

  Chapter 10

  Paying tomorrow for what you get today

  I thought at first it was just selective attention. You know how once you’ve booked your holiday to Tunisia you suddenly see the adverts for it everywhere? Well, I saw a lot of chocolate teapots that April, but I figured my senses were just on high alert.

  I mentioned it to Maggie on my next visit, but she thought otherwise. “It’s not an illusion – it’s real. We’re selling about three times as many as last month – and I can show you why.”

  You can imagine my intrigue, but Maggie didn’t want to tell me right away. We got into her car and she drove me to the local supermarket.

  We headed for the coffee and tea aisle and there, as usual, was a shelf of chocolate teapots, with the usual range of different flavours and sizes, a few of which I hadn’t seen before. Hanging from the handle of each one was a promotional label: Drink today for free.

  Maggie was visibly excited by this. “This is one of our best ideas so far. We struck a deal with the mobile phone operators and now you can get your teapot on instant credit. Try it.”

  I took a teapot from the shelf and brought it to the supermarket counter. The cashier scanned the promotional label and asked whether I wanted to pay now or next month. Prompted by Maggie, I said next month would be better for me. She then asked me to fill in my mobile number on the label – typed it into her till – and moments later, I received a text containing the code 44939. She asked to see it, typed it into the till and I walked off with my teapot.

  “It’s even better if you go into Caffe Milano,” Maggie said. “You can text them before you get there and they’ll have the teapot ready-boiled for you to take away. The number of impulse purchases we’ve had has gone up by about eight times.”

  “So how is this different from just putting it on your credit card?” I asked.

  “This is a completely different psychological process. Human beings are trained to be sensitive to the pain of paying money out of our pocket. This means that even when a process involves only metaphorical money – like a credit card or a storecard – some of the pain effect still carries over. However, when the cost is instead absorbed into a place where you are relatively insensitive to small changes in value – your monthly phone bill – the pain goes away.”

  I thought about it. It certainly had felt – sort of – like getting a free teapot. Though I had the concern that I would be paying for it eventually, and I wasn’t sure how I would feel once the bill came through.

  Maggie continued. “It’s not just the pain issue. It takes away a barrier to purchase: having no cash in your pocket. How often have you checked your pockets before going into a café and then turned away – or bought something different from what you wanted – because you were short of change? It happens a lot, especially among younger people. Even those who do have enough cash on them are tempted to spend more – our proportion of premium teapots has gone up by about 10 percentage points among phone-pay users.”

  Opening up my teapot to drink it, I noticed another offer on the packet: Make sure you get your daily teapot every morning in time for breakfast. This one I hadn’t spotted before. The offer: for £1.92 a day, I could
have my teapot waiting for me at Caffe Milano each morning the minute I arrived; or for 99p a day the teapots would be delivered to my home ready for me to add hot water.

  “Do people actually sign up for this?” I asked Maggie.

  “About 8,000 so far,” she said. “It’s a simple subscription plan – we charge them on a monthly direct debit and they get the teapots delivered. They get a cheap deal, we get guaranteed custom, for a while at least. Everyone’s happy except the competition. Cosanostra Cafe is trying to say we’re competing unfairly with them and we should stop the scheme. But you know when someone’s complaining that much you must be doing something right.”

  “Are people really so keen to buy things on credit? Even after the recession? I thought everyone was paying off their debts, not taking on new ones.”

  “They are: at least, they’re paying off what they think of as debts – bank loans and credit cards. Fortunately for us, these are not really debts in a substantive sense – the payment is always taken within 60 days – and the customer doesn’t seem to think of them that way.”

  “And you aren’t worried that you’re encouraging people to spend what they can’t afford?” I asked.

  “Well, we hardly get any non-payment of the bills – maybe about 2%, which is easy to absorb in our profit margins given the extra volume it generates. And I think people have to decide for themselves what they can afford. Our product isn’t addictive, so we have to assume the customer is capable of making a correct decision. They can always stop buying it if they want to, but so far only one in 10 has cancelled their subscription.”

  Back in the office, I looked up the research behind this idea.

  Both concepts, it turns out, are a variation on hyperbolic discounting. This phenomenon, discovered by psychologists in the 1960s and examined in economics research in the 1980s, says that people put much less value on money in the future than in the present. Of course this is part of how we all manage our finances – £100 this month is worth about £105 this time next year, if interest rates are 5%. But when you bring the payment forward right into the present moment – as most retail purchases do – the effect is much stronger than that.

  Essentially there is a resistance to spending money – and a corresponding desire to gain money – in the present moment, which is much stronger than the normal interest rate effect.

  If Maggie offers me £100 next week, or £110 in two weeks, I will almost certainly prefer the £110 in two weeks. It’s 10% more and I only have to wait an extra week to get it – that’s quite logical. I quite rightly believe that 10% is a very generous interest rate for waiting a whole week.

  But if she offers me a choice between £100 right now and £110 in one week, my decision changes. Suddenly 10% doesn’t seem such a good compensation for waiting a week. The impulse of getting money now versus the uncertainty of what might happen between now and then makes me more likely to choose the £100 today.

  The exact amounts, the lengths of time and the interest rates all vary. But this technique works effectively across many different consumer products and industries. It’s all about deferring payment while offering the benefit of the product today.

  Furniture shops are famous for this. Not only do they win customers who would otherwise not buy at all with their interest-free credit deals, but they get people to spend a lot more than they otherwise would. There’s even some rational logic to this – I get the benefit of a sofa over its lifetime, so why not pay for it over at least part of that timescale? But the effect isn’t really about rationality. It’s about deferring the pain of payment. For £899 out of my pocket, I can probably live with the old sofa for a bit longer. But for £38 a month over three years – with the payments not even starting for two months – why not indulge in a bit of luxury now? After all, it’s been a hard week and I’d just love to sink into that new sofa with its fresh smell while I load up a DVD and a glass of wine.

  As Maggie showed, this can be applied to any industry, for example if you sell a service to small businesses. Many of them are always short of cash – and may indeed be into their overdraft. Offering payment terms or credit is a good way to get people to buy now despite their uncertainty about paying next month’s wages.

  If you sell to consumers, any way you can get them to commit to buying a high volume without having to pay for it up front is likely to increase volumes and reduce price sensitivity.

  Another effect contributes to this: the idea of psychological distance. Psychological distance applies to any object, or decision, or experience that you think of in a way displaced from your current experience. This distance could be in time, if you are thinking of something that will happen in the future. It could be in space, if you think of something that is happening far away. Or it could be conceptual distance – an experience that is more abstract or vague, less concrete. All of these kinds of distance make the idea of payment less tangible, while the benefits do not diminish correspondingly. The cost–benefit tradeoff is changed, and people become willing to pay a higher cost for the same benefit.

  There are risks to delayed payment, of course: some clients may fail to pay the bill, or at least part of it, and others may cancel their subscription soon after taking it out. Depending on the details of what you do, you may legally have to offer a cooling-off period of a week or two (allowing people to cancel the payment plan if they change their minds – though of course in this case they must also return the product). For certain things you might also need a consumer credit licence, though this would be unusual if you sell to businesses. Worth checking with a lawyer – and don’t let them make you pay up front!

  All these costs are probably worthwhile, though. Experiments and informal experience indicate that some consumers will pay up to 50% more for a product if they can pay for it later rather than handing over the cash now. That’s a huge extra margin you can access with a simple change of timing.

  How to apply it

  Consider the time period over which your customers will use your product.

  If you have a one-off purchase, if the consumer buys and uses your product immediately, then it is hard to use this technique. But if they are buying it to use in the future, or if they are going to make repeat purchases, or if they are buying something whose benefits they will experience over a long period, then you have a good opportunity to use this approach.

  Draw a chart like this, graphing benefit received from your product against time.

  Diagram 5

  Mark the horizontal axis according to an appropriate time period and highlight the key benefits or values of your product on the vertical axis. Many products will have an initial period of high value, followed by a gradual slow decline of value over time. Imagine when you first get a new car, or move into a house – you will have a surge of pleasure and novelty over the first weeks or months, and once you get used to it this will decline. After a while the value becomes fairly steady, though over a long period the value reduces as the car or house becomes older – the bumpers get scratched or the boiler starts to make funny noises when it starts up.

  Work out how you can link what the customer pays to the benefit they get. And once the value declines below a certain level, think about how you can offer them something new – a new car, an extension to the house, or a different flavour of tea – to restore that surge of initial value they once had, and get them to pay you again.

  Chapter summary

  • Customers experience the act of paying for something almost as if it is a physical pain.

  • The experience of pain in the present moment is far more sharp and intense than pain in the future, which is easier to rationalise or ignore.

  • Thus, anything which allows customers to pay in the future will make them more likely to buy now.

  • If it is too much trouble to set up your own deferred payment scheme, you should at least try to accept payment by credit card, which achieves the same goal but lets the credit card company worry about making su
re the customer pays up.

  In focus

  Negotiating

  Most of the advice and examples in the book are structured around the pricing of standard products or services – a teapot, a haircut or a piece of jewellery. But many businesses don’t sell standard products. If you work in a consultancy, or in most professional firms, or indeed in any kind of service, there’s a good chance that you prepare a custom proposal and quote for any client, and then negotiate from there to reach a final price.

  It turns out that you can use most of the same principles in this context. Positioning is still important – working out the values of the client and deciding how to pitch your service. You can do this even more accurately when you know the concerns and wishes of the specific client.

  Price differentiation and anchoring work too. A good way to do this is usually to offer the client several different services, starting with a very expensive option, and then gradually scaling down to a more limited version. A management consulting firm might start out by offering the client a project costing £1.5m plus 2% of client revenues over three years, and then offer a set of more cost-effective or lower-risk options at £300,000, £100,000 or £40,000. As long as the services are clearly distinguished from each other, this encourages the client to reveal how big a budget they are willing to spend by selecting the option that fits best. (If you can get them to tell you their budget in advance, that’s usually even better, but be aware this risks getting the client mentally anchored to a figure, where you might otherwise have a chance to influence them to go higher.)

  You can use hyperbolic discounting and decoys in the same way as with a standard product, as well as social effects by discussing what other clients are already paying. You can also research what the competition is likely to do and respond accordingly.