Pricing

I'm reading this book (in swedish) about econimcs and pricing strategies. It has some really good information and points so I translated a small part of it into English. I know it might be a really boring read (even though I certainly don't think so),  but it's VERY useful and can of course be applied even in our world of business.

The Growth of the Behavioral Economics 

The principles of classical economics theory assume that buyers and sellers act rationally. Suppliers try to maximize their profits, while buyers strive to maximize their value or "utilization rate". According to these principles, all parties have complete information. The seller knows how the buyer will react to different prices, which means that they know their demand curves. Buyers are aware of all available options and their prices and can make qualified assessments of the benefits these options offer, regardless of price. These assumptions was questioned first by Herbert A. Simons, Nobel prize winner in 1978. In his view, people have only a limited capacity to absorb and process information. And based on this, they do not strive to maximize their profits and benefits. Instead, they are looking for a "satisfactory" result. Coupled with this growing doubt, psychologists Daniel Kahneman and Amos Tversky published their groundbreaking writing on "prospect theory" in 1979, thus giving rise to a new way of thinking: behavioral economics. Kahneman was awarded the Nobel Prize in 2002 and since then the number of books on the topic of behavioral economics has exploded. This type of research, which, remarkably, was not initiated by economists, may change economic theory permanently. Price plays a central role in behavioral economics, with surprising and often contradictory results, and thus consequences for price management. If you would like to read more in depth about behavioral economics, I recommend Daniel Kahnemans Best selling book "Think quickly and slowly”. 

Price's prestige effect 

Traditionally, the price has been seen in a purchasing decision that is only linked to the buyer's budget. The demand curve has a negative slope, which means that the higher the price, the less the customers buy. However there are exceptions of this rule, which has led to some irrational consequences. In the classic “The Theory of the Leisure Class”, the American economist and sociologist Thorstein Veblen revealed already 1898 that prices can signal social status and prestige and thus give the buyer another level of psychosocial benefit - called the snob effect. The price itself becomes an indicator of quality and exclusivity of luxury products. A Ferrari would not be a Ferrari if it only cost $50k. The demand curve for this type of product has an upward curve, at least within a certain interval. This means that price increases lead to increased sales. This increases profit not only because of higher margins per unit, but also a higher number of unit sales. This powerful combination gives a real explosion of profits as prices rise. There are real examples of this. There is a Swedish decorative glass manufacturer and they had a very popular product that accounted for almost 30% of their total sales. In one study, they saw that in a price increase, the expected fall in sales would clearly be matched by the higher margins; sales would only fall in the number of products sold but not in profit because of higher prices per unit. It consequently helped with a large price increase in connection with the Christmas sale and a variant of the existing product to justify the price adjustment. The result surprised the management. Not only did margins rise; the number of products sold did as well. A great success. 

Delvaux, a Belgian manufacturer of exclusive handbags, significantly raised the price when the brand was re-profiled. Sales increased dramatically, as customers now perceived the brand as an affordable alternative to Louis Vuitton bags. Sales of the whiskey brand Chivas Regal went slow during the 1970s. In connection with a re-profiling of the brand, the company invested in a label with more exclusive appearance and increased the price by 20 percent. The contents of the bottle were unchanged. Despite the price increase, sales increased substantially.

MediaShop Group, one of Europe's leading television networks in direct communication television launched a new makeup accessory for €29.90. Sales were slow and management withdrew the product to make room for more popular products instead. A few weeks later, the product was re-launched in a new sales offer and with a new price: €39.90, an increase of 33 percent. This time, the company had obviously found the perfect price as sales rose in just a few days and the product went out of stock. The makeup accessory became one of the MediaShop group's best-sellers, not despite the higher price, but because of it! When it comes to premium goods and luxury items, one must know whether the prestige effects exist and whether the demand curve has a part that slopes upwards. If so, then the optimal price is never within that part of the demand curve.. This gives weight to one of the most important lessons about pricing: you need to know what your demand curve looks like, the more accurate, the better. When companies do not keep track of their curves, they will grope in the dark in search of the optimal price, this is especially true when it comes to luxury items. If any uncertainty remains, it’s recommended to try to find the optimal price by gradually increasing it towards the higher range. And it is often wise to do as in the case of Delvaux and Chivas Regal and combine the price increase with new design and packaging 

Price as a quality indicator 

A phenomenon similar to the prestige effect is what happens when consumers perceive price as an indicator of a product's quality. A lower price can send signals of a lack of quality. Many customers act on the principle "you get what you pay for” and stay away from low-price products. And for many customers, this way of thinking works in other ways as well - for them the rule of thumb is higher price, better quality. In these cases, therefore, your price increase can lead to increased sales, but why has price become a quality indicator? 

There are several reasonable explanations: 

Experience: If the customer has previously had positive experiences with more expensive products, chances are that he sees high price as a quality guarantee.

It is easy to compare: Consumers can use price to objectively compare different products, this is especially true when the price is fixed and not negotiable. In situations where the price can be discussed, as in the case of industrial goods or goods at a bazaar, price rarely works as a quality indicator.

Based upon costs: Many customers believe that the price is closely related to the seller's costs. Consumers thus have a cost-based way of thinking. They believe that the seller sets their prices on the basis of material, freight and manufacturing costs. So when does consumers judge a product solely on the basis of its price? There is a greater chance that price is perceived as an indicator of quality when the buyer is uncertain about the actual quality of the product. This happens when someone buys something that is completely new to them or when you buy rare items. Consumers also tend to make decisions based on price when the absolute price is not very high, when they have little transparency in the alternatives and when they are under time pressure.

There are many empirical observations on how price can function as a quality indicator and how it is linked to the upward part of the demand curve. The effect has arisen for such widely varied products as furniture, carpets, shampoo, toothpaste, coffee, jam and radios. Researchers have noted increased sales following price increases for nasal spray, tights, inks and electronics. For an electric shaver, for example, sales increased four times after the company raised prices properly to approach Braun's market leader. The price difference was still noticeable and in itself gave incentives for purchases, but the price was no longer so low that it could be perceived as a sign that the shaver was of poor quality. Similar effects have been observed in the service sector, especially for restaurants and hotels, but also in b2b. A software company sold cloud services to companies for an extremely low monthly fee of $19.90 per workstation. The competitor's corresponding product cost more than $100. Several months after the launch they said that "small businesses love us for our prices. For the first time, they can afford this type of software. But larger companies have no confidence in us because of the low price. Low prices are an obstacle to sales rather than an advantage". The solution for this company was to work with product and price differentiation. They uploaded their product with new additional services and offered larger companies this package at a significantly higher price per month. The package was still quite cheap, but now it fit better into a standard price-value framework. By making this change, the company managed to get rid of the negative associations that the low price had brought.

Price's placebo effect 

Sometimes the effect of price as a quality indicator extends beyond the basic level of perception and creates real placebo effects. A placebo effect is an actual improvement in a patient who has received treatment without any real medical value. In a study, participants would test painkillers at different price levels. One group saw a price tag with a high price, and another group saw a low price. Without exception, the participants in the "high price" group experienced the medicine as very effective. In the "low price" group, only half of the participants felt that the medicine helped. But the fact was that both groups had been given placebo tablets with vitamin c that have no analgesic effects whatsoever. The only difference between the groups was the price that each group saw. Another study result: after drinking an energy drink for $2.89, a group of athletes got significantly better training results than the group who drank the exact same drink priced 9 cents. However, the most surprising result was a study that studied intellectual skills between two groups: "Participants who drank an energy drink that they bought for a discounted price did worse on a puzzle test than the participants who bought the same drink for the regular price". Price can indeed create significant placebo effects.

Price as a disarmament weapon 

If prestige, quality and placebo effects are present in the market, all these have a great influence on both price positioning and price communication. If price is a competitive weapon, then these effects disarm this weapon. If a manufacturer wants to increase market share through aggressive pricing, he will fail. One cannot exclude that both unit sales and market shares are actually declining instead of increasing, trying to attract customers through low prices does not work. These effects also explain why discounts on the no name products and weaker brands also do not work: customers associate lower prices with lower quality or lower status. According to car experts, Volkswagen's Phaeton was a good luxury car, purely objectively it could place in the same category as BMW, Mercedes and Audi. But Phaeton sold poorly, as it was not loaded with enough prestige. The Volkswagen brand, which is very strong in the company's mass market segment, did not have the strength to carry a product in the luxury segment. As a result, even low prices and leasing costs did not help increase Phaeton sales. If they were to offer similar prices for a strong more expensive brand, sales would instead explode as the usually high price has established the perception of the stronger brand's qualities. The same car with the same price would suddenly be percieved as cheap, rather than expensive, only because it would've been compared to the other products of the same brand. So what should a company do when you can't use price as a weapon in the competitive war? The best method may be to position your product in the price range that corresponds to the product's true quality and then end up with slightly lower sales figures to begin with. However, this requires a great deal of patience until customers have come to know the product, its quality and the relationship between price and value. Audi was in exactly that seat during the 1980s and it took 20 years to reach the place where the brand received the price and prestige it deserved. 

Price anchoring effects 

What should a buyer do when he or she has neither the knowledge nor the means to make a qualified assessment of a product's quality, nor any information about the general price range for the product category? One method is to obtain information by doing thorough research online, reading consumer tests or asking around among friends and acquaintances. This is undoubtedly a fairly time-consuming approach and is best suited for larger purchases, such as a new car. But what does the buyer do when it comes to something with a much lower value and it is not worth spending a lot of time on research? Well, then buyers are looking for reference points, or "anchors".

Here comes an old story about the effect of such a price anchoring. The brothers Sid and Harry ran a clothing store in New York during the 1930s. Harry sewed and Sid sold. If Sid noticed that a customer liked a suit, he played dumb. If the customer asked about the price, Sid shouted to Harry: "Harry, what does this costume cost?" "That nice suit? $ 42," Harry called back. Sid acted like he didn't understand or hear. “How much?". "$42” Harry shouted again. Sid then turned to the customer and said that the suit cost $22. The customer did not hesitate for a second but quickly put $22 on the counter and left the store with the suit. This approach could also work for larger ticket purchases, especially if combined with some kind of prestige effect. Two young workers wer frustrated because they couldn't join a local labour union in Californa so they decided to start their own company. Instead of describing themselves as masons, they called themselves "European masons, experts on marble and stone”. To substantiate this position, they measured in centimeters and meters when taking measurements at a potential workplace to then show the measurement results to eachother. They started discussing in German until the customer asked what was going on. "I don't understand why he thinks this patio should cost $ 8,000," explained the bricklayer who took the measures and took the client aside. "Between you and me, I think we can do it for $7,000." After a little more discussion with the customer and a little more discussion in German, the customer accepted the $7000  bid. In this way, these two newcomers tothe United States built a solid business until one of them left the industry to embark on a new path. The guy who took the measure in the workplace was a young Austrian bodybuilder by the name of Arnold Schwarzenegger.

The most widely used sources of information can prove to be price anchors. And this process does not even have to be conscious, as buyers often use price anchors unconsciously. But it is not only consumers who are affected by price anchors, the effect also affects professionals. In one study, car experts estimated the value of a used car. One person was standing next to the car, apparently just by chance, and spontaneously said that the car was worth "x". In a study with 60 car experts, the participants estimated the value of the car at $3,563 after the person by the car mentioned $3,800 as a price anchor. But when the person instead said that the car was worth $2,850, the experts' estimated average value of $2,290 landed. The seemingly spontaneous comment from a random person who happened to be on site affected the experts so much that the estimated price differed $1,000 for the exact same car, a difference of 32%. Similar effects have been seen in many other studies. The researchers concluded that "price anchoring is an extremely tangible phenomenon that is extremely difficult to avoid".

The magic of the middle, or how you buy a padlock.

Another interesting price anchoring effect is the "magic of the middle". How a price is perceived in relation to other prices has a strong impact on consumer behavior. An identical price of $10 can trigger widely different reactions, depending on whether it is the highest, lowest or middle price in an assortment. In the same way, the consumer's choice is influenced by the amount of alternatives in the range. Imagine, for example, that you should buy a padlock. Would you be able to answer straight up what a reasonable price would be? Probably not. Imagine if you go to the store and see that they are priced in the range of $4 to $20, which would you choose? If you do not have any special requirements for very high security, you will probably not choose the $20 one, but you will probably not choose the $4 one as you will doubt the quality and security of it. Most likely you will choose a range of $8-$12. 

What do we learn from this? When the buyer does not know the price range for a product category or has any special requirements (eg good quality, low price) then the buyer tends to move towards the middle of the scale. What does this mean for sellers? Simply that one can use the price range of their assortment to steer consumers toward a particular price level and away from others. If the prices of the padlocks above were in the span of $8-$30 you probably spend more money on your padlock. This would generate a higher sales and profit to the seller. 

Either the cheapest or the most expensive wine.

The same behavior is recognized when restaurant visitors should choose wine. After studying the wine list most people decide for a wine with a price that falls in the middle of the price range. Only a few aim for the most expensive or the cheapest option. The middle has a special, almost magical, allure. The same effect applies when we look at the dishes on the menu. Assume that the restaurant has entrees in the price range $10 to $20 and 20% of the customers buy the $18 entree.  If the restaurant however would add another entree for $25, the number of $18 entrees would increase. And if the restaurant adds a starter that has a lower price than the one that was previously the cheapest, sales of the next cheapest dish will probably increase, even if the previously interested very few guests. 

The explanation is simple. The price of the starter that was previously cheapest has now moved closer to the middle. The less a buyer knows objectively about the quality of a product and prices in the product segment, the greater the attractiveness of the “magic of the middle”. this is a manifestation of rational behavior as the customer tries to make the best decision based on very limited information, and by choosing something from the middle of the price range, the buyer reduces the risk of buying something of poor quality while the risk of paying too much is small. 

Through this price range you teach your customer what the product is worth, without committing to a single price point. Do you want a lower price? Just take a wine a little further down the list. By the way, you should always show the higher priced wines first; they create an anchor. However, sellers should be careful not to take this too far to exploit the effect. One should be careful about setting anchor prices that are extremely high or extremely low. A very high price can scare away customers who have to keep the money, and very low prices can make customers suspicious of the quality and thus also act as a deterrent.

A profit-generating product that no one ever buys.

Price anchoring effects can make it worthwhile to have a product in their range even if no one ever buys it. Let's illustrate this with an example. A customer enters a bag shop to buy a new suitcase. The store salesman asks how much the customer intends to put. "Around $200" says the customer. "You can get a good suitcase for that amount," says the store salesman. "But before I show you that bag, may I show you some of our very best bags?" she then asks. "I don't want to sell you a more exclusive bag, I just want to inform you about our entire range." She then shows a suitcase for $900. She emphasizes that when it comes to quality, design and brand this is really the top-of-the-line model. She then returns to the product in the customer's preferred price position, but she also shows a couple of models with slightly higher prices, between $250 and $300. How will the customer react? It is very likely that he buys a bag in the $250 - $300 range and not something in his original price range around $200. The anchoring effect that the $900 bag created increased the customer's willingness to pay. Although the store never sells the bag for $900, they profit from having it in their range solely because of the anchoring effects it generates.