08.12.2022 - by Timothy Desmet
Pricing: art or science?
Traditionally “Price” is seen as one of the most boring of the 4 P’s in marketing. For every 10 books on branding, innovation or advertising you have 1 book on pricing. And my students have a Pavlovian reflex to fall asleep when I announce that the class will be about price setting strategies. Today however, pricing - and especially the pricing power of companies - has become a hot topic.
Recent academic neuroscientific research reveals that the consumer brain often reacts to price points in an irrational, illogical way. These findings offer explanations why sometimes price increases actually lead to more demand instead of less demand. More importantly, the scientific evidence debunks a number of pricing myths and even shows us the way to raise prices without losing customers, thus preserving or even increasing profit margins.
Myth 1: My customers know the price of my product
One barrier towards raising prices, is the perception that customers have a relatively accurate knowledge of the price they pay for the stuff they buy. Research consistently shows however that this is not the case.
People who are familiar with the longest running American game show “The Price is Right” - or one of its international variants - already know this. The format of the game show is as simple as it is popular: contestants chosen from the audience (”come on down”) can win the show by guessing the price of products as accurately as possible. Analyses of all the price points mentioned by contestants during the 9.000 plus episodes show that their guesses are off by 20% on average.
Academic research confirms this result. In a seminal study by Columbia Business School, Hooman Estelami, Donald Lehmann and Alfred Holden ran a meta-analysis, which is an advanced statistical technique that cleverly combines the results of multiple studies. They pooled the data of 297 scientific studies on consumers’ price knowledge, covering over 50 product categories in more than 50 countries over a period of more than 40 years. They wanted to find out whether 4 decades of scientific research and a huge pile of data could tell us anything about how reliable consumer price knowledge truly is. On average the price recalled by consumers was 14% off the actual price. It is clear that from a consumers’ price knowledge point of view – or rather a consumers’ price ignorance point of view – it is a no-brainer that you can easily increase your margin with 1%, 5% or even 10%.
Given that this study looked at more than 297 studies a lot of interesting patterns were revealed. One very relevant pattern for the times in which we live, is that inflation had an effect on price knowledge. When inflation was low, the average recall error was just above 10%. But the studies showed that when inflation was above 6%, the average recall error was almost 20%. When inflation is high, prices change a lot which makes it more difficult to accurately recall the price of products.
So the truth is that people are quite bad at knowing what the price is of products that they buy, and this is especially true in times of inflation. This should make it easier for companies to translate the increase in their costs in an increase of their own prices, limiting the loss of margin they can hold.
Myth 2: Quality drives prices
Another barrier to increasing prices is the belief that only companies that provide high quality products or services can easily raise prices. In other words, quality drives price acceptance.
A neuroscientific study showed that the relationship between quality and price might actually be exactly the opposite, namely that price drives quality perception.
In the study done by researchers at the Stanford Graduate School of Business and the California Institute of Technology, graduate students were asked to drink wine while their brain was being scanned by an fMRI scanner. The study revealed that when the students were drinking wine that was $45 per bottle, the pleasure center of their brain fired much more than when they were drinking wine that was $5 per bottle. In reality however, in both instances they were drinking exactly the same wine (https://news.stanford.edu/news/2008/january16/wine-011608.html). So the experienced pleasantness of the wine was completely driven by the price tag. The study has been replicated multiple times in other labs and using other products.
It is very interesting to think about the success of some products and wonder why they are so successful. Thinking about the iPhone, literally the most sold product on the planet, is it so popular because it is so expensive or because its components are the best in the market? When you know that the iPhone XS is sold for $1.250 and costs only $450 to make, and that most iPhone buyers are very proud owners with a high experienced pleasantness of usage, it might be worthwhile to think back of the wine drinking study. (https://www.forbes.com/sites/jeanbaptiste/2018/09/27/the-1250-iphone-xs-max-costs-apple-450-to-make-nearly-a-200-profit-margin/)
Myth 3: Price is determined by the product features
Finally, marketers and price managers often object and say that price acceptance is driven by the product itself: its features, the advantages or benefits it brings and so on. If you don’t improve the features or experienced advantages, you cannot increase the price.
Many psychological studies actually show that price acceptance can be influenced by aspects that have nothing to do with the product. Have a look at the Economist subscriptions below: you can opt for an online subscription for $59 per year, a print subscription for $125 per year or a print and online subscription for $125 per year.
What option would you choose? If you are like most people, you will opt for the print and online subscription. In fact, 84% of people in a scientific study chose that option. 16% chose the online option. So far so good. However, 0% of people chose the middle option. Wait a minute? 0%? Why is there an option that nobody wants? Why doesn’t The Economist chose to remove an unwanted subscription? Well, it is simply there to make the cost of the print and online subscription - €125 - seem more acceptable.
Don’t believe it? What happened when the study only allowed two options: the online subscription for $59 per year and a print and online subscription for $125 per year? Indeed, instead of 84% of people choosing the print and online subscription, only 32% of people now chose that option. Although the features of the print and online subscription are identical whether you have 2 or 3 choices, suddenly the price of that exactly same offering becomes more acceptable when it is compared to an option nobody wants.
This psychological effect is called the decoy effect, but the list of similar psychological effects on price acceptance is huge and still increasing.
Price to the consumer brain
In conclusion, we can safely say that price perception in the consumer brain is far from logical and rational. As consumers we don’t have an accurate knowledge of prices and our price perception and price acceptance can be influenced by literally dozens of psychological effects. This offers a way for companies to beat inflation by raising prices without losing customers. Even stronger, increasing your prices might increase the perceived quality and actually increase customer satisfaction.
How Sapience can help
If you want to learn more about pricing and how research can optimize your pricing strategy, feel free to contact us for an introduction.