Chapter 11
Use Behavioral Pricing Tactics to Persuade and Sell
Sometimes Your Customers Will Behave Irrationally
People make decisions based on both rational and emotional factors. For example, imagine you are on a beach on a hot day and you crave a cold beer. A friend offers to bring you one from the only place nearby that sells beer—a fancy resort hotel.
How much will you pay for the beer?
Now imagine you are on a beach on a hot day, craving a cold beer, and a friend offers to bring you one from the only place nearby that sells beer—a small, run-down corner store.
How much would you be willing to pay for the same beer now?
Remember: The beer is the same, the weather is the same, and, best of all, you don't have to move. Your friend is willing to make the beer run.
When asked, people typically are willing to pay twice as much for the beer from the resort as from the run-down store. From an economic perspective, this makes no sense; it is, in a word, irrational. Behavioral economics springs from this recognition that buyers are not always rational actors. Their willingness to pay (WTP) for your product is not solely based on the value they get from it. Psychological factors also can play a big role. We refer to the pricing tactics that play to this irrational side of customers as behavioral pricing.
The topic of behavioral economics is of growing interest in academic and business circles. It was first popularized by researchers Daniel Kahneman, Amos Tversky, and Richard Thaler in the 1970s and '80s. Dan Ariely's amazing book, Predictably Irrational, expanded the field's followers. But while a number of books have explored behavioral economics, the literature on behavioral pricing is sparse, especially as it relates to monetizing new products. This chapter attempts to address that gap.
In discussing the concept of value pricing and its components (especially WTP and value messaging) in Chapters 4 and 10, we explained how to appeal to the customer's rational side. We explored how to match the price of your offering with the value customers perceive that offering gives them. That's the rational side of pricing.
Behavioral pricing is a separate matter. It calls for refining your product offers and the messages you create about them to make it easier for customers to compare, decide, and purchase. And making it easier doesn't necessarily mean providing information for logical, rational analysis. Sometimes, that data only makes deciding harder. Behavioral pricing is the magic that happens when value pricing meets irrational customer psychology.
All of us are subject to behavioral pricing every day. Consider what happens when you walk into a movie theater. When you belly up to the concession stand, do you wonder why the price of the large soda ($5.99 at a theater near one of us) is just a buck more than the $4.99 small soda? The reason is the price of the small serving makes the large one seem less expensive, and thus more attractive, even if you're not that thirsty and the small soda is all you really want. Such offers, promoted to make another product look better, are called anchors. The small soda makes the more expensive option look like a bargain, and who can resist a bargain? That's the only reason for a $4.99 small soda at all.
Price anchors are one of several pricing tactics that play to the irrational side of customers. How you communicate your pricing to customers, and how you frame a conversation to deal with customer irrationality, can substantially impact how well your new product sells and the price you get for it.
This is an important step you should take at the very same time you factor your product's value to customers into your pricing. Pricing that doesn't consider the irrational aspects of customers is likely to be suboptimal.
If you think behavioral pricing applies only to consumer products and services, think again. It does not. In fact, behavioral pricing is just as crucial in business-to-business (B2B) settings. In both cases, you are selling to people, and understanding their psychology and how they buy is important whether you are pricing candy bars or bulldozers.
The Behavioral Pricing Dilemma of an Internet Start-Up Company
Back in 2012, we worked with an Internet start-up that wanted to increase revenue from service providers. The company already had a “good, better, best” product lineup. But close to 60 percent of its customers selected the good or entry-level offering. The firm launched a large study to determine whether it was possible to steer more customers to the more profitable premium offerings.
The study uncovered a number of insights, two of which were the most consequential:
- The firm's customers had key psychological price thresholds—limits to what most of them would spend, depending on the product configuration. Those price thresholds were $49, $99, and $199. Our client had three offerings priced at $49 (Basic), $79 (Standard), and $149 (Advanced). The fact that the firm's pricing was below customers' psychological thresholds suggested it could raise prices without hurting demand.
- Our client was giving away too much value in its low-end offering. No wonder almost 60 percent of the service providers had chosen it! More important, by providing too much value in the entry-level offering, the firm had unintentionally made its higher-priced offering less attractive. Even though the Standard offering had more value than the Basic offering, customers failed to appreciate that additional value (for the additional price). The Basic offering was too good, and the Standard offering looked expensive given the incremental value it offered.
The findings pointed to two recommendations that could raise average revenue per subscriber: increase prices of the Standard and Advanced offering to customers' psychological price thresholds, and make those offerings more attractive. The company's CEO reduced the functionality of the Basic offering but kept the same price. The price of the Standard and Advanced offering were increased to $99 and $199 respectively. The CEO also redistributed the existing features among the Standard and the Advanced offerings to make each of them more compelling. Last but not least, a fourth offering, an ultrapremium offering with new functionality (aptly named Premium), was created and priced at $299.
The impact was immediate and substantial. The number of Standard and Advanced premium products sold rose significantly, even though their prices went up. The financial impact was substantial: an average revenue per user (ARPU) increase of 36 percent and a 29 percent increase in monthly recurring revenue (MRR) from new customers. The company's annual profit jumped many times because the new products came with little additional cost to the firm.
Of the 29 percent total increase in MRR, the firm attributed roughly 14 percentage points to behavioral pricing and 15 percentage points to changes in the core product configurations. This is behavioral pricing at its best.
If you work at a multibillion-dollar company, you aren't likely to get a 14 percent revenue increase using behavioral pricing; a 1 percent to 3 percent sales boost is more likely. But remember, the pricing tactics we're talking about here don't necessarily require rejiggering the functionality of your product offerings. You won't need to increase your costs very much to get that revenue increase. In other words, all of that extra revenue goes directly to your bottom line.
Why is that kind of revenue and profit boost possible? Why did the Internet start-up company's customers flock to its higher-priced options? Three reasons stand out.
One, reducing the functionality of the entry-level Basic offering made the offering immediately above it much more attractive to buyers who previously would have been misclassified as price-sensitive.
Two, the Premium offering came with a premium price: $299. That made the Standard and Advanced products look more attractive. The Premium offering was the anchor, the Internet start-up company's version of the movie theater's small soda. The offering's sole purpose was to make the other products look like bargains. It drove a higher percentage of customers who wanted a high-quality solution—but still loved getting a deal—to choose the Standard and Advanced product.
Three, a few customers were willing to pay the premium price for the premium offering with the most functionality. We have seen this time and again: Certain customers will always go for the most expensive product in a lineup, the one they perceive to have the highest quality. They believe you get what you pay for and that they deserve the best. As pricing experts, we have come to accept this as a fact of life.
In the end, behavioral pricing helped turn a good vanilla cake into a four-tier torte with gourmet toppings (see Figure 11.1).
Figure 11.1 Redesigning an Internet Marketplace's Product Lineup
While such stories make behavioral pricing exciting, we need to temper expectations. You can't base your price-setting strategy only on behavioral techniques. Rational tactics, those that discern what customers value and what they are willing to pay, are prerequisites. Combining rational and behavioral pricing approaches is the most effective strategy.
With that caveat, let's explore six behavioral pricing tactics that work really well for new products. They work even better than you might imagine.
Six Behavioral Pricing Tactics That Make the Difference
These tactics can markedly increase the success of a new product launch. Based on behavioral economic theories we've tested in many different customer settings, these six tactics become more powerful when you combine them. Here they are, along with examples that illustrate them:
- Compromise effect: Make decisions easier for people who can't choose.
When given a set of choices, people will avoid extremes. For example, imagine you are in a wine store and want to buy a bottle. You find three options: a $10 bottle, a $25 bottle, and a $40 bottle. Which one would you pick? When asked this question, most people would pick the $25 bottle to avoid the extremes ($10 seems cheap; $40 is costly). Of course, some price-sensitive people will pick the $10 bottle, and some quality-conscious people will pick the $40 bottle. But by introducing the $25 wine, you just made the decision process much easier for everyone, including those who can't decide whether to go with price or quality. They'll choose the middle option. This strategy is very common in both B2B and business-to-consumer (B2C) companies. Imagine you work in sales at a B2B company and you're negotiating a deal with a potential customer. You can steer the conversation based on whether the customer is price- or quality-conscious and force a compromise. Recommendation: If you are launching a new product, plan on having a compromise option.
- Anchoring tactics: Set the context for value.
We illustrated two examples of anchoring—the movie theater concessions and the Internet start-up company. Anchors make the other options look attractive. Another illustration of anchoring is The Economist magazine's A/B pricing experiment, which Dan Ariely described in his book. The experiment divided people into two groups, A and B. The A group was given two choices: $59 for an online-only subscription and $125 for a print-and-online combination. The B group was offered three choices: $59 for online only, $125 for print only, and $125 for the print/online bundle. The $125 print-only option was an anchor. It made The Economist's print/online bundle for group B look like a great deal; the online edition seemed like a freebie, a throw-in. Some 84 percent chose the print/online bundle in group B versus only 32 percent who chose that bundle in group A.
We have helped companies in a variety of industries—Internet, media, and financial services, to name just a few—institute such successful anchoring strategies.
Anchoring is a crucial behavioral pricing tactic in B2B sales negotiations. If you start with a high price, inevitably you will end up at a higher net price when the negotiation concludes. Anchoring lets you establish a reference point that will influence subsequent offers and shift the range in your favor.
An anchor works because it shapes the customer's perception of the possible price outcomes. It also creates room for price concessions. To prepare for such concessions, one of our clients always opens a negotiation with a statement such as: “This new proprietary part is priced at a 40 percent premium over standard versions because of significant development costs and superior technical advantages. But since you have been a great customer, we can bake in some price concessions.”
This lets our client frame all subsequent conversations with customers who ask for discounts because it set the 40 percent premium as the starting point, the anchor. The firm always nets a higher price than if it had not used an anchor. Recommendation: Make sure you have an anchor product in your new product offering portfolio, and start every B2B sales negotiation for new products with a high anchor price.
- Using price to signal quality: If it costs more, it reinforces the customer's perception of quality.
A product's price sends a powerful signal about its quality. Low price equals low quality; high price equals high quality. The premium pricing for the iPhone when it first launched in 2007 was essential to positioning it as a quality product. If Apple's Steve Jobs had debuted the iPhone at $49, it would have been a terrible mistake. The price would have won market share by undercutting competitors, but it also would have depressed prices for all future smartphones, and Apple would not have become the most profitable company in the world today. Instead, the $599 price for the most popular iPhone signaled that the Apple smartphone was a quality product and always would be.
Pricing also has a psychological effect on how consumers view a product's effectiveness. In a 2008 study, Ariely and his colleagues gave two sets of participants the same pill, telling them it was a painkiller. Informed that the price was $2.50 a pill, 85% of the participants in the first group said the pill reduced their pain. Told the painkiller's price was discounted to 10 cents, only 61% of the second group believed the pill reduced their pain. Interestingly, not only were both groups given the same pill, but the pill was a placebo. The price—not the pill—relieved the pain.1
Let's be clear: We're not advocating deception; we're not saying you should sell people something that isn't worth the price. Rather, we're highlighting how a price can powerfully signal quality. Recommendation: Pricing your product too low is worse than pricing it too high. If you start high you can still go down; if you start low you can hardly go up. Therefore, when launching your new product, beware of a too-low price. It can ruin the perception of product quality in the mind of the buyer.
- Razor/razor blades: Get a foot in the door.
Customers are influenced by costs that are immediately in front of them. Even if they calculate their total cost of ownership of a product over time, they will be swayed by the initial costs. Let's say you are a manufacturer of a coffee machine, and you also make the specially formulated coffee that must be used with it. You plan to launch a new machine and new coffee bags. Let's also assume you are targeting a customer base that consumes an average of one pound of coffee a month per customer. You are considering two pricing schemes: Option A, which prices the machine at $480 and the coffee at $10 per pound per month, or Option B, which prices the machine at $120 and the coffee at $40 per pound per month. Even though a rational person would be indifferent to these options—over a 12-month period, the price for the machine and the coffee is the same—we have consistently found across industries that companies are better off with a scheme like Option B.
Why? The customer's upfront cost has a much bigger psychological impact than the total cost of ownership. Your pricing strategy should be to land a customer by showcasing the lower upfront costs and then expanding on a higher variable amount. Many companies now use this tactic. Computer hardware manufacturers sell cheaper and cheaper products but try to make more money on services. Consumer goods companies do as well—for example, a low upfront investment for a razor but, over time, investment in costlier razor blades; a low upfront investment in a computer printer but expensive ink cartridges.
To maximize your customers' lifetime value, you can use the same strategy to sell versions of your new product. First, sell a basic version of a product (land) and then upsell customers to an advanced version (expand) in due course. Software companies are famous for doing this. Retailers also offer certain categories of products at low prices (doorbusters) to pull more people into their shops and expand the number of products in each shopping cart.2, 3
Recommendation: Use this tactic only if you are 100 percent sure you can sell your downstream products to customers—your razor blades, printer ink, and so on.
- Pennies-a-day pricing: Reduce sticker shock and build loyalty.
Amazon.com, the largest U.S. Internet retailer, now owns another title: the largest provider of cloud computing services, also known as infrastructure as a service (IaaS). The technologies involved—the servers and cloud environments—are well-known and widely available. Amazon's innovation centers on its business and pricing models for Amazon Web Services and Elastic Compute Cloud (EC2).
For small companies, investing in computing power and servers can be prohibitively expensive. And renting physical servers does not necessarily solve the problem because setting them up and staffing them pose financial and resource challenges. Amazon's EC2 solves this problem by allowing customers to rent computing capacity, not servers, and for finite amounts of time. In other words, customers use and pay for servers only when they need them, not all the time. That lowers the customer's total cost. But just as important, it lowers the customer's formerly high barrier to entry for tapping into a powerful computing infrastructure.
Amazon's EC2, a great technology innovation case, demonstrates the potential of behavioral pricing and the psychological impact of price levels. The company quotes low prices to reduce the chance of sticker shock and customer resistance. Instead of displaying prices in the hundreds or thousands of dollars per server, EC2 shows prices in dollars or even fractions of a penny for hourly prices.
Aside from fundamentally changing your business model to be like Amazon's, are there easier ways to use pennies-a-day pricing? Absolutely. And the simplest is breaking up time.
Companies often look to establishing annual contracts to ensure predictable revenue. But yearlong contract prices can look prohibitively expensive. Breaking that cost down into monthly installments makes the cost appear more reasonable. Instead of charging an annual price of $120, payments of $9.99 per month can have a very different effect on customer signups. Recommendation: Put the proper thought into framing your price to make it look attractive—not just in coming up with the price.
- Psychological price thresholds: Avoid falling off the price cliffs.
You might wonder why you rarely see prices like $101 in retail; you almost always see $99 or $99.99. The reason is that customers typically have price thresholds in mind. The perceived difference between $99.99 and $101 is more than a dollar and a penny. More often than not, people will feel $101 is much more expensive than $99. From a study we did for an online subscription company, we demonstrate this phenomenon in Figure 11.2. You can see clear price thresholds at $40, $70, and $100. This company was much better off pricing its product at $69.99 than at $71. More than 20 percent of its customers wouldn't accept a $71 price. That was the price cliff. The $69.99 price helped the company avoid losing a sizable share of its audience.
Recommendation: Identify the price thresholds for your products and stay on the cliff.
Figure 11.2 The Price Thresholds of an Online Subscription Firm
Don't Guess: Put Behavioral Tactics to the Test
As this chapter shows, there are very good reasons to use each tactic. Since the options are many, you need to do careful tests, track results, and choose the best tactics for your innovation. If you use too many tactics, you will confuse customers. If you use too few of them, you won't fully monetize your new product.
You have several ways to test behavioral pricing tactics. Here are three:
- Focus groups provide customer feedback on potential behavioral tactics. They serve as small, controlled tests for understanding the thought processes driving product selection. You can watch how customers react as price anchors, deals, and other factors change.
The results can steer you toward or away from some behavioral pricing tactics. In one focus group test we conducted, we gauged the impact of premium product anchors on a four-product lineup. Customers told us they would get very confused and leave a store display with the four products. This tactic just didn't work in the tests. The number of choices made the decision too complicated. Had we blindly assumed the tactic would work as well as it did with the Internet start-up company mentioned earlier in this chapter, we would have led this company down the wrong path.
- For online offers, controlled A/B tests let you assess click-through and conversion rates on different behavioral pricing tactics. They give you statistically significant data on the options with the best outcomes. But you must set up these tests correctly, which includes clearly defining your control and test cases. You must also divide the sample in each group so the customer populations are similar.
- Run large-scale experiments when you need more information about customers than you can get from a controlled test. Studies can simulate a controlled test in survey mode; that saves you from having to launch a live test. This is particularly important in companies that must maintain price transparency at all times, and thus where launching a price test is not possible. An Internet company we worked with tested every behavioral tactic using off-line surveys before implementing them on its website. Such testing also allows you to try many ideas, even with the same people, because you can put them through many hypothetical situations.
As you can see, it's important to sweat these tests. They will help you set the right prices—and then stick to them.