We think we can rationally assess the true value of something, but we are strongly influenced by our emotions and the comparative price of other goods and services. By understanding such behavioural science, businesses can ensure they are maximising their profits.
Behavioural scientist Ayelet Gneezy is an expert on how we assign value to goods and services. One of her starkest insights into just how inconsistent we are when we do this came not in a study she devised, but when her mother-in-law was diagnosed with cancer in Israel.
After spending time uncomplainingly in a barely acceptable public-sector hospital, Gneezy’s mother-in-law was moved to an expensive and far more luxurious private hospital. “Within 20 minutes of checking in, she started complaining even though objectively everything was better,” Gneezy said. “She had good food, a clean room, and privacy, but she was essentially happier at the first place, which was free but not that great.”
It is a reminder that we are not the purely rational actors of economic models. Notions around how we attribute value to something and make decisions around price have been transformed in recent decades by behavioural economics and behavioural psychology from the likes of Gneezy, an associate professor at the Rady School of Management at the University of California, San Diego.
Behavioural science has revealed the extent to which we negotiate a world of complex and conflicting information by using mental shortcuts (often using unconscious processes) to make decisions that are often highly relative or emotional. Because of this, we are suggestible and subject to influence in the decisions we make.
“We like to think we know what price is the right one, but the fact is that we make relative comparisons,” said Bill Poundstone, author of Priceless: The Hidden Psychology of Value. “Behavioural economics has found that perceptions of price are like those of physical quantities, like dark or brightness and heavy or light. If you don’t have a benchmark for price, your willingness to pay is fluid and contextual, which is something companies can use.”
The small but growing number of specialist pricing consultants using behavioural economics theory suggests it is becoming a new area of competitive advantage. But for the most part, businesses are not yet working to systematically apply these lessons and insights, nor are they making the most of the increasing amount of pricing data available.
All too often they use conventional and sub-optimal ways to set prices. “Common rules of thumb such as ‘x per cent over cost’ do not consider what the customer is willing to pay or what they are thinking,” Poundstone said.
Part of the reason for this lack of engagement with behavioural economics is that creating pricing strategies that are informed by its insights requires a cross-disciplinary approach between finance and marketing, said Leigh Caldwell, author of The Psychology of Price and a partner at the UK’s The Irrational Agency. “Only by combining those two sets of expertise can you really use customer psychology and understand the numbers that you should set.”
Gneezy added: “Anyone involved in pricing has to understand people. It is wrong to think about pricing as a number discipline. It interacts with people, so if you don’t understand how they think, what bugs them and makes them happy, then you can’t make them buy.”
Gneezy offers the findings of a pricing study she conducted at a California winery as an example. It involved two bottles of wine — a high-quality wine and a low-quality wine. Increasing the price of the low-quality wine from $10 to $20 increased profits by 3%. But profits fell 10% when the price of the same bottle was increased to $40. For the higher-quality wine, a price increase from $10 to $20 boosted profits by 11%, while increasing the price from $10 to $40 resulted in a 5% increase in profits. The study enabled the winery to generate extra revenue that overcame demand cannibalisation of its other wines, resulting in an overall profit increase.
The potential to improve performance by using behavioural tools is immense, said Enrico Trevisan, a partner with pricing strategy and marketing consultant Simon-Kucher & Partners in Munich and Milan and author of The Irrational Consumer and Value Pricing. “Using or not using a behavioural approach can change revenues or cross-selling levels by 20 to 30%,” he said.
A pricing study Trevisan recently conducted for a bank tested customers’ willingness to pay (or not) for a current account product, comparing offerings with increasing levels of service and extras such as overdraft protection and debit and credit cards.
With only two choices — the free account and the €2 account — 60% of those surveyed opted for the free account. “When we introduced a third product for €4, we observed that people wanting the zero product decreased dramatically, and the people wanting the €2 product increased,” Trevisan said. “When they were also offered a €6 product, the preference distribution moved again towards the more expensive products, and the zero product lost market share. Every time we added a new product preference, they moved towards the more expensive product.”
The test raised the average price of the product portfolio without risking the loss of volume because the bank did not take away the zero-priced product.
The insights of behavioural economics cross borders, markets, and cultures. They apply to old and young, rich and poor, women and men alike, Trevisan contends. “Our brain machinery works in a similar way whoever we are.”
Behavioural economics-driven insights can offer a low-risk and rapid route to better sales and profits. Very often, clients will assume that such testing requires in-depth, lengthy, and costly market research. Not so, said Trevisan.
Preliminary testing and then small-scale trials can help identify optimal prices that generate higher profits without taking any big risks. “We usually have a sound hypothesis of what will happen, and the risks of a bad impact are small. You may not need to test your ideas with 3,000 people; maybe 300 will do.”
The right price? It’s all in the customer’s head
In formulating a pricing strategy that takes account of insights from behavioural science, Leigh Caldwell, author of The Psychology of Price and a partner at the UK’s The Irrational Agency, recommends:
1. Ask what your customers really want. What are their desires, needs, or wants, and what value do they put on satisfying those needs? You can determine the answers either through a market research process or simply by talking to them, and through approaches such as laddering — when they state what they want, simply ask why they want that, and repeatedly go to the next level until you understand the deep, fundamental need that they are trying to fulfil.
2. Ask how your customers think. What are their mental strategies for satisfying those needs? We all have limits on how much thinking we are willing to do in a given situation, so we use heuristics to find good-enough solutions in a complicated world. By talking to and empathising with your customers, and by using data produced by Google Analytics, for example, you can understand how they think about their needs or problems and how they find solutions for them. You can also use psychological tests to learn about their thinking style, which affects how much they use reflective, cognitive processes versus relying on instinct, emotions, and gut reactions.
3. Ask how they make their final choice of product. This is where some of the psychological heuristics and biases come into play, especially the following concepts:
- Anchoring: This is the human tendency to rely too heavily on the first piece of information offered when making decisions;
- Decoy pricing: This involves coming up with additional product options to create different price points while subconsciously telling customers which option is the “best value”; and
- Goldilocks pricing: This is also known as the “compromise effect”, which exploits the fact that people get tired of making mental trade-offs between products, so if customers are presented with three products with no clear best choice, they are likely to settle on the “middle” option. This stage of the decision is all about comparison and judgement, i.e., comparing a small number of options and judging which one is best.
At each stage of this process, you can apply the discoveries of behavioural science and carry out research with your customers to get a clear picture of how they make decisions.
The key outcomes of this process should be:
- Knowing what comparisons your customers make and therefore who your real competitors are. For example, what is the value of a luxury watch? For some customers, what they want from a watch is to tell the time, so the competitor to the watch is another watch, and the value is mainly influenced by the price your competitors charge for their watches. For other customers, what they want from the watch is to impress people — in which case the real competitor may be a BMW, and the value and price of the watch can be set accordingly.
- Knowing how to set and communicate your prices. By knowing how much information your customers want to process, you will know whether to simplify your pricing and your marketing or to include more data to answer all the possible questions. This will also tell you whether to wrap up your prices into simple bundles or break them out into many different line items that tell customers exactly what they’re paying for.
- Knowing the exact level — or levels — of price to charge. If you understand the decision-making processes of your different customer groups intimately, you will know how to offer them a set of different prices for different product options. In nearly every case, you should be offering at least three levels of product or service so that customers can self-segment into high, medium, and low spenders. Your research process will tell you the right number for each of these three prices based on customers’ needs and the comparisons they make.
It’s key not to lose sight of the bigger picture while putting in place a structured framework. While behavioural economics can give businesses potential influence over what their customers are prepared to pay, it is important not to alienate customers by creating the impression they are being exploited.
Although customers use imperfect shortcuts to assess the value of something, it does not mean businesses should assume that they are stupid or endlessly suggestible, Caldwell said.
“Companies that will succeed in the long run are those that understand how the brain works and help people get the most value by guiding or going along with those unconscious decisions rather than going against the grain and forcing them to do something they don’t want to do,” he said.