What Behavioral Economics Can Teach Us About Pricing
Back in February I helped organize a day on pricing strategy at the MaRS Discovery District in Toronto. The day was a mash-up that brought together people focused on the impact that big data, predictive analytics and the Internet of Things are having on pricing with the thought leaders in the emerging practice of behavioral pricing.
Behavioral pricing approaches are fascinating. The work is an application of the insights of behavioral economics to pricing strategy. Behavioral economics comes from the work of Amos Tversky and Daniel Kahneman. They basically applied insights from studies of the effects of psychological, social, cognitive, and emotional factors on the economic decisions of individuals and institutions.
Here’s a classic example: Someone is given $100, but in order to keep any portion of that money, they have to make a deal with someone else. By the laws of economics, you’d expect the first person to give up as little as possible with the counterpart willing to accept anything over nothing. But, it rarely works out this way. In fact, most people tend to offer between $30 to $50 dollars to make the trade. This makes no economic sense, at least not under classic economic theory, but very few of us make decisions as ‘Homo Economicus.’ Basic notions of fairness and equity shape our decisions even though they are not always the most rational.
One person who has studied behavioral economics and applied it to pricing is Florian Bauer, principle at the management consulting firm Vocatus. He gave a scintillating talk in Toronto, but most of the ideas and examples came from large companies. So I reached out to him and asked him to share his ideas with us and how they can be applied to early-stage innovation.
Steven Forth (SF): How did you become interested in behavioral pricing?
Florian Bauer (FB): Well, as a psychology student I was most interested in the question how people decide. What are drivers of their choices, what kind of “mistakes” do they make. As I was not interested in the clinical side of psychology, I was focusing on everyday decisions, i.e. mostly on consumer choices. One place to study the heuristics and biases of everyday choice making is to understand the role of the price in the customer’s decision making. Price is given in any consumer purchase decision. It is a quantitative dimension that offers the advantage of being able to prove if a choice was “irrational” or not without referring to hypothetical constructs such as “utility.”
At that time – in the late 80s and early 90s – the term “Behavioral Economics” was not yet coined, let alone “Behavioral Pricing,” but research in the area was well underway, especially in the US. This is why I moved to Boston to run my own research projects. After my masters, I moved on to strategy consulting for some years. Later, while taking a leave of absence to do my PhD, I combined my initial research interest in Behavioral Pricing and consulting experience and worked on the “psychology of price structure.” Following that, I founded my own consulting company in 1999 with two colleagues from Booz, Allen & Hamilton. Since then, we focus on Behavioral Pricing strategies and help clients across the globe to leverage the potential of this new perspective on pricing. In a, sense, Behavioral Pricing was what I was most interested in, and I was lucky enough to build my career and business on it.
(SF): What are the key principles of behavioral pricing?
(FB): Classical pricing research and methods are built on the assumption that people decide rationally. It is simply impossible within this approach to leverage the margin potentials given by the predictably irrational behavior real people show. Behavioral Pricing builds on a totally different set of insights. For example, Behavioral Pricing has empirically proven that the notion of people having a predefined “willingness to pay” is wrong. Rather than having a willingness to pay, people tend to develop a price acceptance throughout their decision making process. This in turn implies that companies pricing strategies should not only react to a predefined and quantified willingness to pay but should focus on actively enlarging price acceptance.
Price acceptance is not driven by value as is assumed in value-based pricing. This would imply that people only pay for the product features (as measured by conjoint analysis). In fact, people pay for much more than product features. Context and decision dynamics very much define price acceptance. Companies’ strategic pricing goal should be to actively design and manage the decision architecture across the relevant stakeholders and touch points.
The strategic management of choice architecture involves more dimensions than classic pricing can handle. In order to skim all sources of price acceptance systematically and ease price execution, companies have to not only define price levels but design price structures, price dynamics, price communication and price dramaturgy. Behavioral Pricing enlarges the scope on the customer side (more sources of price acceptance) and on the companies’ side (provides more facets of a pricing strategy to leverage).
(SF): What is a compelling example of behavioral pricing at work?
(FB): First of all, there is no case where Behavioral Pricing is not at work, because it is how people make decisions. There are good examples where companies were able to leverage the potential of Behavioral Pricing, and there are bad examples, where companies destroyed a lot of margin by believing in the traditional pricing model.
A famous example of the latter is Praktiker a formerly leading DIY retail chain in Europe. Believing their customers were focused on prices (as many retailers do), they launched a long lasting campaign saying “20% discount on everything except pet food.” Towards the end they ran this campaign every other month. It always brought a lot of customers into the store – and kept them out when the campaign was not running. Praktiker trained their customers to become bargain hunters. People going to Praktiker when the campaign was not on started to feel ripped off by 20%. This is a classical example of anchoring. The discounted price became the “new” normal price. Praktiker went out of business in 2013 (after running an innovative “30% off everything campaign”) and a €3bn company with 20,000 employees was ruined by the wrong pricing approach. This was not an accident; the company deliberately rejected a Behavioral Pricing approach. They insisted in believing the classical retailers myth that discounts are always good. Reality proved them wrong.
Looking at our own projects: We once developed an independent price comparison engine for Europe’s biggest last-minute travel agency. People who were about to book there were provided a price ranking for the selected holiday. This sounds counter-intuitive as the ranking also showed if there were cheaper offers on the market. Why should a company – especially in a price sensitive market like last-minute holidays – tell their customers if others offer the same at a lower price? It may be counter-intuitive but it brought a 70% higher conversion without lowering the prices. The reason for this is, that there are five different types of behavioral decision making strategies: bargain hunting, risk aversion, price accepting, loyal and indifferent. We call them the GRIPS types. The different types react differently to the result of an independent price comparison. Understanding and predicting this, is the core of Behavioral Pricing. For more details on this and other cases you may have a look on our website!
(SF): Some believe that behavioral pricing is mainly relevant for consumer companies, what is its relevance for B2B?
(FB): This is definitely not the case. As long as humans make decisions they will have predictable biases. This is probably even truer in B2B as in B2B decisions there are often more people involved. With more individual motivations over a longer period of time there are more opportunities for behavioral economics to come into play. Just think a about the famous B2B justification for a specific choice “no one ever got fired for buying IBM.” This is behavioral economics at work as it shows that decisions are not just about utility maximization but about aligning different decision agendas. In our experience, the opportunities to leverage Behavioral Pricing are even bigger in B2B.
(SF): How would you suggest an early-stage B2B company engage with behavioral pricing?
(FB): Build in pricing and selling strategy from the beginning. Many innovations have failed because people started to think about pricing only after the product was ready for launch. We have had cases where seemingly simple things, like product naming, led to the wrong positioning. This led to significantly lower price acceptance. This is especially true of innovative products, where the product value is often intangible for most customers. There is no predefined willingness to pay and the challenge of the company is to set a positioning that helps them to achieve higher price acceptance. In short, pricing innovative products is an ideal playground for the holistic perspective of Behavioral Pricing. Practically speaking, you need to manage the psychology of the people you are targeting in order to win market acceptance.