Psychology of Pricing: How to price your products effectively

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There’s a science behind pricing your products accordingly, and yet, it’s still one of the hardest things to get right. If we set the price too high, we might be setting ourselves up for too hard of a sell. If we set it too low, we run the risk of not making a profit. So where is the middle ground?

We have to assume that if a customer feels they would save $10 by using a service, they should be willing to pay as much as $10 to use it. But how do we put a price tag on their expectations of value? We also have to consider that a buyer will only purchase if the service is within their budget or if the value they perceive or expect is more than the cost of payment. So what determines the perceived value?

These questions are crucial for coming up with a reasonable price tag. Large organizations can engage in market research to try and assess price sensitivity, price elasticity, and the demand curve (the demand of a product at multiple price points). Further market research can uncover some of the factors that help determine the perceived value, what impacts customer decisions, and also their willingness to pay (WTP). A great example of the impact of perceived value is generic drugs. A pack of Advil sits directly next to a generic pack of Ibuprofen on a pharmacy shelf; the Advil costs 50% more – but why? Advil is Ibuprofen. The fact that customers are willing to pay more for the same chemical because it is a known brand suggests that they perceive it to be more valuable. Less experienced sellers face a larger problem. Indeed, evidence from Ebay sellers suggest that while more experienced sellers set ‘buy it now’ prices, less experienced ones choose to sell via auction (in which case the market determines the best price).

Pricing on the Internet presents new opportunities, but also some challenges. When eCommerce was born, there were those who predicted the end of pricing practices as we knew them. If customers incurred no costs to go check a competitor price, there would be no ability to differentiate pricing, ability that in the traditional world of brick and mortar stores was driven, at least in part, by the costs associated with such search (e.g., driving to the other side of town). This forecast of a new era of pricing turned out to be wrong. Factors like brands, habits, and relationships, turned out to be friction enough to support the familiar structures of pricing. What is vastly different, though, is the availability of data, and the ease of making price changes and testing the market response (the aforementioned auction pricing mechanism as one example).

Combining traditional principles with new data driven insights, there are a few things that every seller can do to improve their pricing:

Manage Perceptions

Perceptions drive the world. They generate emotional and cognitive reactions, and are ultimately what people base their decisions on. So what are the major factors that influence perceptions of value when it comes to pricing? How do customers ‘know’ that one store offers greater value than another, or that they should expect higher prices for one type of car than for another? One of the major drivers of perception is, of course, the brand. The brand could be a well crafted image of a major firm, or could the name of a particular actress or individual. In both cases, the brand serves as the cue that elicits information and associations from customers’ memories (e.g., if people hear the term “Volvo”, they usually think “safety”, but when hearing the term “Rolls Royce” they think expensive). This may involve past experiences, attitudes, reputations, and accessible knowledge.

Similarly, any additional information  — be it graphic, auditory, text, or numeric  — will serve as a retrieval cue to generate and shape the perception of value. For example, if a sales person you have never met before wears a well tailored suit, you may infer that they are professional, competent, and will deliver value. Similarly, if entering a hotel you observe slick, quality decor, you may expect the price to be high. In a famous thought experiment, Nobel laureate Richard Thaler asks people to imagine sitting on the beach with a friend. The friend then gets up and tells you he is going to buy beer. He offers to get you one as well, but is not sure of the cost. He asks you for your maximum WTP, so that if the price is that or less he would buy the beer and bring it to you. The experiment comes in where half the people hear that the friend is going to purchase the beer at a nearby luxury hotel, while the other half at a run-down grocery store. Note that despite the actual experience being exactly the same — you would drink the same can of beer on the beach — people are willing to pay nearly twice the price when the friend is going to buy the can at a hotel. This, of course, seems crazy. It is not, though, if we realize that people expect beer to cost more at the hotel, and when asked about the maximum they are willing to spend, they respond with their expectations, rather than any true valuation. In other words, people respond to an offer differently, because perceptions drive behavior, not ‘true’ value indicators.

Tip: Every aspect of an online offer can influence its perceived value. From the language used to describe the offer, through the images and cues provided, to the manner in which the interface with the customer occurs. Plan all of these with care to achieve the perception you intend.

Manage reference points

One of the insights from the beer on the beach example is that, as a wise man once said, everything is relative. In particular, decades of research suggest that value perceptions are especially susceptible to relativism. The main question, then, is relative to what? The professional term for this answer is the reference point. What is more interesting from a practical pricing perspective is that this reference point is malleable. For example, when pricing a new product the seller can compare it to the old one, causing the value to be directly compared to that one, or she could compare to a competitor product to show greater value. Additionally, when offering a discount off the listed price, the seller is essentially placing the reference point at the list price, rendering the new price a clear gain in value. Conversely, price increases can be seen as a loss relative to the previous lower price. Since we know that emotional losses loom larger than gains, price increases should be handled with extra care. This could perhaps explain why gas prices creep up in very small increments, but drop in large, noticeable jumps. The manner in which a seller positions the offering can have a great deal of influence over the specific reference point the buyer is likely to use. For example, when offering a motivational video, the seller can label it as a short film or as a long clip. This labeling may determine what reference point a potential buyer might use.

Tip: Customers will rely on the most accessible reference points when assessing value. Understanding which ones they might use and ensuring they are the most appropriate is key in determining the right price.

Manage goals

The analysis of which reference point we would like the buyer to employ derives directly from the pricing goal. While the fundamental goal of a price is to facilitate the transaction of funds, the business goal of pricing might vary. Consider the case of books in the US, for example. New books are launched with a certain list price printed on the cover. The actual price customers pay, however, varies along the lifetime of the book. Early, before and after launch, one may find the book at a discounted price (e.g., 30% off); this discount slowly erodes as the price rises towards the printed level; eventually, the book is again discounted, and if successful, is published in a much cheaper soft cover. This dynamic in the price over time represents different pricing goals over the lifetime of the book. Early, the goal is to generate greater readership, and subsequent word of mouth to drive greater market penetration. When there are sufficient endogenous market forces, there is little need of an added incentive and the price converts to the pre-calculated optimal level to increase margin and profits. Eventually, when most of the addressable market has been reached, the price is again reduced to capture laggards or readers with less avid interest levels. This dynamic reflects three common pricing goals. There are others. Luxury or high end products are often priced relatively high to signal to the buyers what they are. Buyers, as discussed above, employ a strong price-quality heuristic (i.e., they hold strong beliefs that the price and quality are highly correlated). Simple pricing as opposed to complex schemes, are those that are rather uniform and do not vary signal customer orientation (e.g., one complete price with no added or hidden additions). The key is to determine the pricing goal ahead of time and ensure the tactics and price levels are consistent with the strategy. I once asked a manger who needed help with pricing what their goal was and received “profit” as an answer. That manger clearly did not understand the question.

Tip: Start your pricing consideration from your business goal. Price is a means to an end. It is hard to get it right without a clear end in mind.

In sum, awareness and knowledge of the various potential implications of price levels and the manner in which they interact with the rest of the strategy and execution can lead to higher conversion rates and more satisfied customers. Understanding the interplay between perceptions, reference points, and pricing goals is the first step towards better pricing practices and long term profitability.

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On Amir
Chief behavioural science officer at Fiverr. On holds a PhD in Marketing and he is the associate dean of student experience at the Rady School of Management, UC San Diego.
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Fayzan Asad
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Fayzan Asad

Great article, Its very helping I must say.

Claudia
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Claudia

Great article, Thanks for sharing.

Najmul Hasan
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Najmul Hasan

Good information. Tips at the end would make it better.

GraceB66
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GraceB66

Very informative thank you

Farwa
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Farwa

This article is very helpful in understanding Psychology of pricing.

Seocontent0
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Seocontent0

This article is awesome and helpful. Thanks for sharing.

Emmykey
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Emmykey

Great, this is really helpful.

Emmykey
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Emmykey

Thank you for sharing