3 Ways to Optimize Product Pricing with Psychology
Have you ever wondered how companies and retailers set their prices? If you’ve ever taken an economics class, your go-to answer is probably something about supply-and-demand, right? While these laws certainly have a large influence over pricing, another realm of study does as well: psychology. In this blog post, I'll introduce how to optimize product pricing with Psychology with three case studies.
(1) Left Digit Anchoring Effect and 9-Ending Prices
Lore and legend have it that the tradition of having prices ending in 9 (ex. $3.99 instead of $4.00) originated to keep less-than-honest store employees from pocketing dollar bills -- having a price ending in 9 ensured they would have to open the register in order to make change for the customer, thereby recording the sale and making it harder to steal from the store. But more recent research suggests that humans actually perceive these prices as significantly lower than the one cent higher price. In a 2005 study comprised of five experiments, Thomas and Morwitz outline “why and when” we make this judgment.
First, 9-ending prices are perceived as lower only when the dollar-place value changes. In other words, $3.99 is perceived as much lower than $4.00 but $3.69 is not perceived as much lower than $3.70, since the dollar-place -- $3 -- has not changed. The reasoning behind this is that as we look at numbers we translate and map them onto a mental number line. This encoding process may occur before we even process all the digits of a number and thus our brain sees $3.99 and maps it close to 3 since that’s the first digit. In the case where the dollar-place does not change, more digits are required to make an accurate mapping (since the first digit is the same) and thus a more accurate assessment in the difference of values is made.
Second, this effect is moderated by how far away the comparison price is from the 9-ending price. More specifically, the effect is dampened when the comparison price is further away from the 9-ending price. For example, the difference between $4 and $5 is perceived as very different than the difference between $3.99 and $5 (where the former seems like less of a difference) but the difference between $4 and $10 is perceived to be the same as the difference between $3.99 and $10. The reasoning behind this is most likely similar to the reasoning outlined above: In the first case, we have a narrower scale, only ranging from $3-$5 and $3.99 gets placed all the way to the left whereas $4 gets placed in the middle, leading to the difference in distance perception. However, when our scale is opened up to $3-$10, $3 and $4 are clustered closer together on the left hand side, roughly equally as far away from $10.
These two observations about 9-ending prices lead to two conclusions when it comes to considering setting a price that ends in 9:
1. The 9-ending price will be perceived as more significant if the price it’s being compared to is a full dollar-place higher. In other words, don’t expect much of a difference in sales between products priced at $5.69 and $5.70, but you might see an effect when it comes to $19.99 versus $20.00!
2. Reducing a price to one ending in 9 is most effective when the original price is relatively close to the reduced price
Lastly, 9-ending prices can be effective even when they are not compared to original prices. When we see a 9-ending price, we assume that if the seller could have charged one cent more, he would have and thus the price seems like it’s a discount. People love bargains (ever been to a mall on Black Friday?) and so this imagined discount is an incentive for buying.
(2) The Power of ‘Free’
As much as people love a discount, they love getting things for free even more. In one podcast, Dan Ariely describes a pricing experiment he and his colleagues ran. They offered participants either a Hershey’s Kiss for one cent or a Lindt Chocolate Truffle for 13 cents. Almost everyone chose the Lindt Chocolate -- better quality for only 12 cents more was a no brainer. But when they discounted each by 1 penny -- 12 cents for the Lindt or 0 cents for the Hershey’s -- almost everyone went for the free candy! The difference in price and quality was exactly the same in both scenarios, but there was something about getting an item for free that really motivated people.
In another podcast, he describes a pricing scheme used on an online store owned by one of his friends. Some products were sold for $5 with free shipping, some were sold for $2.50 with $2.50 for shipping and some products were free with $5.00 shipping. At the end of the day, everyone was paying $5 no matter which pricing scheme their product fell under, but the free products fared significantly better.
Clearly, the notion of getting something at no cost -- that is, with no downside to you, the consumer -- is an attractive one, and one that companies use all the time to lure people into making purchases. How many times have you seen “FREE GIFT with your purchase of $200 or more!” or “FREE SHIPPING on orders of $50”? These schemes work, probably even better than incentives like “$25 off your purchase of $100 or more,” or even announcements like “70% more!” on value-sized bottles of lotion since we are so drawn in by the buzzword “free”.
This has interesting consequences for how different promotions should be framed. For example even though “50% off!” and “Buy one, get one free” have the exact same outcome in terms of price paid, a BOGO promotion seems extra appealing. Interestingly, while most of the appeal probably comes from that magic F-word and the feeling we have somehow cheated the system to obtain value, an article in The Economist posits that many consumers are just really bad at interpreting the meaning of percentage-discounts but the meaning of ‘free’ is universal.
(3) Can Price Dictate Value?
The last topic I will discuss in this post is an oddity of human consumer behavior. It seems logical that value should dictate the price of something and consequently that perceived value would dictate the price a consumer would be willing to pay for something; but this is not always the case, as the following examples will illustrate.
We Get What We Expect
A study conducted in 2008 by Goldstein et al. found that people “do not derive more enjoyment from more expensive wine” when they don’t know how much the wine cost. But another study confirmed that when told a wine had a high price tag, participants gave that wine higher ratings. The effect doesn’t stop at pencil-and-paper ratings, however. Research looking at participants’ neurological responses to wines found that being told a wine was more expensive leads to more activation in brain regions associated with feelings of pleasantness! In other words, to a certain extent, consumers are letting the price that something is sold for dictate what they think the value of that something is!
On a similar note, Dan Ariely conducted an experiment in which they found that students who paid more for cold medicine reported feeling better than students who had bought the medicine at a discounted price. Another slightly different example of this are the ‘effects’ of placebo drugs: telling somebody something has a certain amount of value makes them really believe in that value. All of this goes to show that consumers may not be the best at defining how much value a good holds and are, to a certain extent, dependent on external cues like price to tell them what they should expect in terms of value.
A widely used strategy when trying to convince a consumer to buy your good is to explicitly point out it is less expensive than the competitor’s good. For example, many drugstores place their store brand items right next to the name brand items. However, research suggests when forced to make a comparison and then a choice, comparative disadvantages factor more into the ultimate decision than do comparative advantages. In other words, by forcing a comparison to a more expensive good, companies may be inadvertently focusing their customers’ minds on why their product is inferior, even though it’s almost the same and carries a lower price tag. One explanation for this phenomenon when it comes to comparison pricing is the same as the one above: forcing a consumer to compare two differently priced substitutes forces them wonder why they are priced differently and then conclude that they must be getting additional value from the more expensive one.