The Psychology of Price

by Leigh Caldwell

  • Coe, John (2003): The Fundamentals of Business-to-Business Sales and Marketing. McGraw-Hill Professional.

  Chapter 17: Managing the pricing environment

  • Kopalle, Praveen K., Ambar G. Rao and João L. Assunção (1996): ‘Asymmetric reference price effects and dynamic pricing policies’. Marketing Science, Vol 15 no 1.

  • Shipley, David and Elizabeth Bourdon (1990): ‘Distributor pricing in very competitive markets’. Industrial Marketing Management, Vol 19 issue 3.

  Chapter 18: The psychology of giving

  This is another field with its own in-depth literature. If you are interested I suggest starting with the following collection of papers, from which you can start an exploration of the broader literature on the subject.

  • Oppenheimer, Daniel M. and Christopher Y. Olivola (eds.) (2010): The Science of Giving: Experimental Approaches to the Study of Charity. Psychology Press.

  Chapter 19: The ethics and law of pricing

  Pricing law varies according to the jurisdiction you are in. UK readers can find some useful information at Business link (www.gov.uk/uk-welcomes-business)

  As this book is aimed at the United Kingdom, I have not reviewed the legal situation in other countries – however for the US, you could start with the guide at National Institute of Standards and Technology (www.nist.gov)

  There is also some treatment of pricing law in:

  • Baker, Walter L., Michael V. Marn and Craig C. Zawada (2010): ‘Legal degrees of freedom’. The Price Advantage, chapter 9. John Wiley & Sons.

  The ethics of pricing have not been explored extensively but there is a growing literature on ethics in behavioural economics more generally, for example:

  • Bovens, Luc (2009): ‘The ethics of nudge’. Preference Change. Theory and Decision Library A, Vol 42 Springer.

  • Selinger, Evan and Kyle Whyte: ‘Is there a right way to nudge: the practice and ethics of choice architecture’. Sociology Compass, Vol 5 issue 10.

  However these mainly focus on the issues for public policymakers – the ethics of behavioural economics in business is yet to develop as a discipline.

  Appendix A

  A pricing diagnostic

  Now that you are familiar with the most powerful pricing techniques, you can run this quick diagnostic exercise on your own business. These questions will help you figure out how close your current pricing policy is to the optimal strategy.

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

  1. What alternative products or services do customers compare you with when they consider purchasing from you?

  2. How does your pricing compare with the competition?

  3. What are your gross margins on different products?

  4. If a customer is willing to pay more than you’re charging, what tactics do you have for capturing their extra budget?

  5. What attributes does a customer really want when they buy each of your products?

  6. How many options do you give a customer when they are looking at buying from you?

  7. What do you do for customers who want your product, can’t quite afford it now but will have more money next month or next quarter?

  8. What do you give away for free?

  9. What have you done to ‘blind’ your products – to make them hard to compare directly with competitive options?

  10. What decoys are available to customers to make your products more attractive?

  11. What experiments have you done to measure or test your market’s willingness to pay?

  12. Which customers have you chosen not to sell to?

  13. Do you offer both a product and service version of what you sell?

  14. Do you make the intangible tangible?

  15. When and how will you next reframe your offering to increase price?

  16. What more expensive purchases do you attach your products to, to reduce price resistance?

  17. How do you use anchoring to increase the perception of the value of your products?

  18. What bundles do you offer with your products, to make them harder to compare with alternatives?

  19. Who do you consider your closest competitors?

  20. What do you do to defend against their pricing strategies?

  21. Do you know what price, or what pricing model, your customers think is fair?

  22. What are you doing to shift their view of fairness, and demonstrate that you have the right to charge more?

  23. What is the total value of what you provide to clients?

  24. What do your clients think the total value is? How are you demonstrating to them that your true value is higher?

  25. How do you upsell clients once they have bought one product from you?

  26. Through which channels do you sell? What others could you sell through?

  27. What are the objectives of the other businesses (and people) in your channels?

  28. What constraints do they operate under?

  29. Do customers have the chance to buy from you with someone else’s money?

  30. How do you use pricing to create a regular purchase habit?

  A quick-reference method for pricing a new product

  This step-by-step questionnaire will clarify the key pricing questions and strategies available to you.

  1. What benefits do your clients get from your product or service? List these in the benefit matrix in Chapter 1. We will refer to these as values. Think as broadly as you can – the examples provided in that chapter will help you see the kind of emotional and intangible values that are often at play alongside the more obvious ones.

  2. What other products or services do they get similar benefits from? List them alongside the values in the table at the end of Chapter 1.

  3. What units do these come in? Try to come up with a quantity which matches the most common single purchase size of your product. For example, if you sell a head massage product which is effective against headaches, work out how many painkillers a customer would need to use over the lifetime of your product to get the equivalent benefit. Or if you sell train tickets, work out for what length of time a person would need to own a car to travel the equivalent distance.

  4. How much do they pay for those products? Write down a range under ‘Price per unit’. If you’re using painkillers as an example, write down the generic price as well as the price for the leading brand. Remember to translate this price into the same units that you used in the ‘Units of value’ column.

  5. Now you must be ruthless with yourself. Ignore all but three of the benefits. Your customers cannot focus on dozens of benefits all at once; therefore you need to choose which ones you are going to talk to them about. The most valuable benefits are probably those with the highest comparison price. The benefits you choose are called the critical value dimensions.

  6. Write down the three critical value dimensions. You now need to analyse how your customers seek out and choose a product when they have a need in those dimensions. For example, if the critical value dimension is ‘pain relief’, ask yourself how your customers go about achieving pain relief. It may be to go to the cupboard and see if there are any aspirin left. It may be to go to the chemist and buy some more. It may be to take a bath or lie down in a darkened room. You are writing down the customer’s solution strategy for the particular need that you help them with.

  7. What do you think is the pricing conversation that goes on in the customer’s head when carrying out this solution strategy. What do they think about the price they expect to pay to solve this problem? What’s a solution worth to them? You first want to focus on the higher end of the price range: for example, what is it that a customer thinks when they are choosing to buy Nurofen Plus as opposed to generic ibuprofen?

  8. Your job is to construct an argument linking all three critical value dimensions, and add together the alternative price for each. You should now have an idea of the target price for your product. This is the highest price that a customer will pay
for an alternative solution to the same problem. Write this down.

  9. Now it is time to apply the psychological pricing techniques that will let you achieve this price. Start with Chapter 5 and, briefly visiting each chapter, consider whether you can use the techniques. The checklist between Chapters 18 and 19 may also be helpful.

  Appendix B

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

  This section of the book should be considered optional. Many readers will be happy to know how to apply the advice in the main body of the book without reading the theory behind it. However, if you know more, you’ll be able to understand how pricing psychology works and perhaps design your own techniques.

  This overview combines insights from biology, psychology, cognitive science and behavioural economics. You won’t find it replicated exactly in any textbook, but it’s all drawn from recent empirical and theoretical research in those fields.

  All theories of psychology, economics and human behaviour share some basic features. They study people and ask what makes those people act the way they do. Broadly, people try to make their experience of the world better, and they make choices in accordance with that objective.

  Traditional economists view these choices in a particular way. They consider the person’s experience of the world to be summarised in a variable called utility: the higher the utility, the happier the person is. At all times, people make the choices that result in the highest possible utility. Economists also tend to focus only on material choices – we achieve utility by buying or selling goods or services. And the key question in economics is: how much of one good do we exchange for another? That is, what is the price of each good? Economics is the study of how we exchange goods and services at certain prices to make ourselves happier.

  Psychologists mostly study behaviour at a lower level. They look at the way people respond to an external stimulus, how that affects the state of their brain, and what actions they take as a result. They examine some basic mental variables to see how they affect these processes.

  • Emotion – how does emotion affect the way we view the world or the actions we take?

  • Attention – if we are focused on a particular stimulus, can we still notice what else is happening or think about something else?

  • Learning – how quickly or reliably can we remember past experiences and use them to our advantage?

  Neither of these approaches is wrong, but they both expose only a part of the picture. To understand enough about human behaviour to set prices accurately, you need to know how to use both approaches and more besides.

  The problem with traditional economics is that it paints too simple a picture – the idea that people maximise utility is elegant but crude. This simplicity enables economists to study how a whole population of people and goods fit together, but it means that some of the results they get are wrong. The problem with using traditional psychology in business is the opposite – it is too complicated. Psychological research covers too many different details, many of which you cannot measure or control in a business environment, and if you try to incorporate every one of them you will have too many permutations to deal with.

  The cognitive theory that I lay out here strikes a balance between these two extremes. It takes into account some of the key psychological effects that are omitted from traditional economics, but puts them into a simple enough model to enable it to be practically useful for setting your prices. I call it ‘cognitive economics’ and it is a powerful tool for understanding how consumers really make a decision about buying your product and spending money on it.

  We start with the individual consumer. At any moment, they have some awareness of the world around them – an incomplete, imperfect awareness, but as valid as anyone else’s. This awareness includes both the outside world – the place in which they are physically located, the things they can see and hear, the people near them, the products they could buy – and the internal world, their feelings, desires and wants.

  The consumer always perceives some lack or deficit in the world. Technically, there may be moments when they think everything is perfect and nothing could be improved. But at those times, they will not take any actions. The only thing that can drive a person to act is the desire to make the world better in some way. This lack need not be an absolute lack, in the sense that something is missing; it could be an opportunity to improve something, for instance to earn some money. It’s a gap between how the world could be, and how it is.

  How we interpret the world and determine the lack is a function of our biology, combined with the relationships we have learned throughout our lives between external lacks and internal needs. The most basic lacks are straightforward physical needs – when we are hungry, tired, thirsty, in pain or horny our body informs our brain of that fact by releasing chemicals or sending nerve signals. Built on top of these are aspects of the external world – a lack of money, or the knowledge that the fridge is empty and we might want to eat later, or the belief that a good film is on at the cinema and we are currently missing out. And sometimes it is an interim lack, which we become aware of while we satisfy some other need. For example, to earn money we may decide to get a job; having done so, a new series of lacks will drive our behaviour, such as the knowledge that we have been assigned a task and it is not finished yet.

  We are continually learning about lacks in the world and new ways to address them. Sometimes this happens through trial and error, and sometimes through information given to us by a third party. When we are young, we are aware of only the basic lacks: food, water and warmth. As we grow older we learn that certain objects can satisfy these needs, and we learn to feel the lack of those objects instead. Those lacks can drive us just as powerfully as the basic needs themselves, and our brains can operate more efficiently by forgetting some of the relationships between the indirect and basic needs. Gradually over our lives we build up a hierarchy of these lacks. You may be familiar with Maslow’s hierarchy of needs, which is based on a similar insight.

  Sometimes a person – or company – will set out to deliberately make us feel a certain lack. Think of your favourite chocolate bar. Before you knew it existed, you didn’t feel the lack of it – you may have felt hungry sometimes, or even felt a lack of chocolate, but you didn’t miss this particular bar. But once the manufacturer advertised it, or encouraged you to try it in a shop, you learned that this product was one you enjoyed, and from time to time you want another one: or, in the language of this theory, you feel a lack of this particular chocolate bar.

  Sometimes the lack is placed in your mind consciously and using concrete language, for instance when a magazine tells you that such-and-such model of computer is a good way to get your work done. Then the lack of this computer may be something you become aware of through logical reasoning. Sometimes it is unconscious, as when you wear a jacket, then go outside and still feel cold: the jacket will be marked in your head as ‘not very warm’ – lacking in its ability to provide warmth.

  So in our theory we have people, and they exist in a world, and they have the ability to sense particular wants or lacks in the world. What do they do about it?

  The second key part of the theory is strategies. People have strategies to fulfil their wants. The strategy may be as simple as ‘when hungry: eat food’ or a bit more complicated, such as ‘when short of money: check balance on credit cards, count the days until I get paid, decide what I can go without or put off until after then, go through address book to see who I can borrow money from’, or much more complex than that: ‘when feeling a lack of purpose in life: take some time out to think about what makes me happy, read some books, talk to my friends, meditate, consider taking some time out from work, volunteer to help some people, have a beer …’ A strategy like this never really ends, but in order to start it we need to have learned enough about the connection between the lack and the actions we can take in response to it.

  A common strategy for s
atisfying our wants – the strategy mostly studied in economics – is the strategy of buying a product or service. When I’m hungry, my strategy for solving that problem is to consume food, which I am likely to buy from another person rather than growing it myself. If I don’t have money to buy food, I pursue a different version of this economic strategy by selling something – usually my time, but possibly my grandfather’s gold watch – which gives me money that I can then use to buy food.

  Because these buying and selling strategies are so important, our brains have learned a lot of details about how to carry them out. These techniques include processes such as:

  • comparing two different objects to see which one is better

  • placing a numeric value on things, and comparing those values

  • forecasting the feelings we’ll get from consuming a product, and determining whether those feelings will satisfy a lack.

  Each of these processes takes time and effort, and the more accurate we want the result to be, the more time it takes. Therefore, to get through our lives quickly we take shortcuts and accept approximations.

  Of course, we often cannot achieve what we want in a single step. Thus, when we set out to do something, these processes are layered on top of each other many times, or carried out in sequence; our minds construct a series of temporary wants in order to motivate us to get to the next step.

  There are a number of specific constraints on our ability to carry out these processes. We can pay attention to only a small number of wants at one time; our brain has the ability to handle multiple wants and strategies in parallel, but the numbers it can manage are small. We can act only on wants we are directly experiencing; any future or potential want can only be addressed by translating it into a current want. And our ability to forecast wants and fit strategies to them is approximate, because the amount of information and complexity involved in accurately understanding and predicting the world is simply too vast to be physically calculable by our finite brains.