Pricing Strategies

Everything on the class test, and where it is answered

Module 7, Smith chapter 5, in three parts. Open a part to see what sits under it; every line is a link to the section that covers it.

Smith, Chapter 5 · part 1 of 3

Influencing price acceptance

How customers judge value and price is shaped by many factors, and a lot of them are psychological, some probably rooted in evolution. The module's stance is practical: rather than trying to make buyers more logical, it is usually more efficient to work with the way they already think. That means four jobs:

The brain as a predictive machine

Neuroeconomics suggests the brain constantly predicts what to expect. Shown a chair you have never seen, you still guess its function, weight and rough price, from very little information. The circuits doing this turn information into impressions, preferences, judgements and predictions, and therefore into willingness to payThe most a customer is prepared to pay for something.The psychological effects work by shifting it.. People are cognitive misersA description of people as saving mental effort wherever they can.Hence the reliance on heuristics.: they save mental effort by relying on heuristicsMental shortcuts people use to decide quickly with little effort.They save effort but bias judgements in predictable ways., mental shortcuts, to decide faster.

The seventeen effects

The whole module hangs on one map, repeated through the slides. Learn the three groups first, then the effects inside each.

True economic costs

The first four effects look psychological but are really rational. Each comes from a hidden cost, usually an opportunity costThe value of the best alternative given up, such as the time spent shopping.The true economic cost effects all rest on it., that a sensible buyer would weigh.

1 Shared cost effect

Price sensitivity falls when the customer pays with someone else's money. A business traveller reimbursed by the company cares less about the fare; that is why airline loyalty schemes let airlines charge a little more, since the firm pays but the traveller chooses. Rebates work the same way to a smaller degree, because part of the price is effectively paid back.

The industrial lesson: because business purchases spend other people's money, they involve several decision makers and several decision criteria.

2 Switching costs

Economic switching costs are all the costs, direct and opportunity, of moving from one supplier to another. They arise from product-specific investmentsMoney, time or effort a buyer puts into one supplier's product, which is lost if they switch.They create switching costs and lower price sensitivity for existing customers. the buyer has made, which can be monetary or psychological. The key line: product-specific investments decrease price sensitivity for existing customers.

3 Expenditure effect

The bigger the price tag, the more it pays to shop around. Searching and comparing take time and effort that could be spent elsewhere. On an expensive item that effort is small next to the possible saving, so buyers compare hard; on a cheap item the effort stays the same while the saving shrinks, so they don't bother. Price sensitivity is higher when the purchase is a larger share of the budget. In business markets, a larger or more strategically important purchase draws more scrutiny and so more price sensitivity.

4 Difficult comparison effect

Making products and prices hard to compare raises search costs and the buyer's uncertainty. That discourages switching and lowers price sensitivity.

Smith, Chapter 5 · part 2 of 3

Effects 5 to 9 are purely psychological: no hidden cost explains them.

5 Price endings in 9s

If nothing psychological were going on, each digit would end a price about 10% of the time. Count real prices and 9 dominates by far, with far fewer 5s and 0s. The effect even reaches past the last digit. Of $24.99, $28.53 and $29.99, the lowest sells most, as theory predicts, but $29.99 outsells $28.53 even though it is dearer. That kink contradicts the downward-sloping demand curve.

6 Fairness effect

The book's reason: the brain handles buying with the same circuits used for sharing within families and friends, so people bring expectations of fair sharing to every transaction. Breaking them can turn into public outrage, not just a lost sale.

7 Overconfidence in future economic efficiency

People buy some products expecting to behave a certain way later, and they are consistently bad at predicting their own future behaviour. The gym study: members on a $70 monthly plan went about 4.3 times a month, paying over $17 a visit, when a 10-visit pass cost $10 a visit. They were also 17% more likely to stay past the first year than annual members, despite paying extra for the right to cancel at any time. The cause was overconfidence in their own future self-control and efficiency.

8 Small pie bias

From negotiation research. Negotiators keep underestimating the size of the bargaining zoneThe range between the seller's lowest and the buyer's highest acceptable price.Small pie bias makes negotiators think it is narrower than it is.: they think they are splitting a smaller pie than really exists. So they overestimate the share of the surplus they are getting, and sellers settle for too low a price. They also tend to anchor their expectation near their own walk-away priceThe point beyond which a buyer will not go higher, or a seller will not go lower.Negotiators tend to anchor their expectation near their own walk-away price..

9 Promotional influence

What you say, and who you say it to, decide how good a price you can capture.

Smith, Chapter 5 · part 3 of 3

10 Prospect theory

Economics assumes people maximise utility in every transaction. Study after study shows predictable ways they do not. Prospect theory, set out by Kahneman and Tversky in 1979, tries to define the heuristics behind that predictable irrationality by asking how people choose among risky prospects. Since every purchase carries some risk, it explains many buying behaviours and so many pricing opportunities. Newer research links it to brain circuits shaped by evolution.

Which offer would you accept?

The sure loss is cheaper on average, yet many people take the gamble. Facing a loss, people seek risk. That is a utility-maximising rule broken in a predictable direction, which is exactly what prospect theory describes.

The four findings

Prescriptions

The slides and the book each turn the findings into pricing advice. They overlap, so learn them side by side.

Effects related to prospect theory

11 Reference price effects

The prices a customer has seen before in a category set the price they now expect. Buyers often cannot remember what they recently paid, but whatever they do recall still shapes their willingness to pay, their reference priceThe price a buyer expects to pay, built from prices seen before.Promotions pull it down, so the later full price feels like a loss and demand drops.. Mostly studied in frequently bought consumer goods, it is expected to hold elsewhere too.

12 Endowment effect

People value something more once they own it. In the original experiments students were handed items at random and allowed to trade to get what they preferred, and far fewer trades happened than chance would predict.

The slide's mug study: decorated mugs worth about $5 went to a third of the group. Owners asked on average $7.12 to sell; non-owners would take only $3.12 instead of one. Simply owning the mug raised its value. This is why bazaar sellers put goods in your hands, car dealers push test drives, and trials work.

13 Anchoring

People set price expectations from information they meet early in the decision, and then find those expectations hard to change, since that means relearning or finding evidence the first impression was wrong. AnchoringFixing expectations on the first price heard and finding it hard to move off it.In negotiation the opening price becomes the anchor, so opening higher tends to close higher. strongly sets reservation prices. In negotiations the first price heard becomes the anchor, so opening higher tends to close higher.

14 Comparison set effect

The alternatives a customer is weighing shape the price they expect. Cheaper alternatives in the set pull expectations down; dearer ones push them up. So adjust the set towards a favourable group: compare a small car with a larger, pricier car, not with a motorcycle. And widen what is compared: a product with a higher upfront price but lower lifetime cost should be judged on total cost of ownershipThe purchase price plus the running costs over the life of the product.Judge on this when the upfront price is higher but the running costs are lower., not purchase price.

15 Framing effect

How a transaction is framed changes willingness to pay. The book's example: asked what they would pay for the same drink, people name a higher price if a friend is buying it at a smart hotel bar than at a grubby corner shop. Positive frames beat negative ones, so stress benefits over costs, and itemise the positives.

16 Order bias

Related to anchoring. The order in which prices are shown changes what people pick and what they will pay. With fast-moving consumer goods the highest average price came from presenting prices in descending order. Some studies found no significant effect for household appliances, but it is still suspected to hold beyond FMCG.

The same three products: on average buyers choose a dearer one when the list starts from the top. It links to loss aversionLosses hurt more than an equal gain pleases.It is why the value function is steeper on the loss side, so several small losses bundled into one charge hurt less.: having seen the best option first, dropping to a cheaper one feels like giving up benefits. Hence the common practice in cars, mattresses and other durables, and in business markets too, of showing the most expensive model first and working down.

17 End-benefit effect

Price sensitivity depends on how much the product contributes to the end benefit the customer really wants. A product that delivers a large part of that goal meets lower price sensitivity than one that is merely ancillary. So promote the link to the customer's goal rather than the features. Nutrisystem sells not packaged diet food but weight loss, and beyond that looking better, feeling healthier and making a good impression at special occasions.

Summary

The lists you must be able to write out from memory

Cover the answer, say the list out loud, then open it to check. Everything expands when printed.