Pricing 101: Customer Behavior
Updated: Dec 1, 2020
Pricing products and services is complex. Many strategies fail to anticipate customers' often irrational behavior. An effective pricing strategy starts with understanding your customers and developing awareness of their potential responses to your (pricing) actions.
We as consumers have conscious and unconscious behaviors when it comes to the choices we make. Over the past decades, fields like behavioral science and economics have become more and more popular, and billions of little experiments are performed on us every day. Most without us even knowing it. Facebook for example is constantly testing what makes us click and scroll. Also in official research settings, our behavior is examined. Even though no two humans are the same and people’s actions can be unpredictable, there are some interesting insights that are worth keeping in mind when setting your prices. And otherwise, just fascinating to learn about!
The paradox of choice
Have you ever stood in front of an aisle in the supermarket and felt so overwhelmed with the choices that you just walked away? Well, you’re not alone. People tend to paralyze when they have too many choices. In a famous study by researchers Iyengar and Lepper, shoppers in a supermarket were presented either 6 or 24 flavors of jam on a table. When presented with 6 flavors, 30% of the testers bought one of the jams. When presented with 24 flavors, only 3% of the testers purchase a jam (source). A ten-fold drop!
An overkill of options makes people less likely to pick any option at all. This phenomenon is also known as the choice overload effect.
The same holds true for pricing. Online, you will often encounter 3 pricing tiers, also known as good-better-best pricing. It is believed that 3 is a manageable number of choices and research shows that customers tend to default to the middle option. Knowing this, you want to be smart about your middle option. If you want even more people to pick the middle option, marketers suggest highlighting that option (e.g. with colors or by adding comments like “most-popular option”). The highest pricing option is meant for your high-value customers, think of private classes for example, and should be intended for only those special customers.
So, keep your pricing simple. Have max 3 - 5 different pricing tiers and for each tier, have a customer segment in mind.
The anchoring effect – numbers around us
Researchers at MIT did an absurd experiment showcasing the anchoring effect. They let students bid on wines, while they were writing the last two digits of their social security number. What do you think happened? Students with high social security number endings bid up to 3.5 times more for the wines than the students with low social security number endings. The high numbers anchor us and make us more likely to bid higher. Crazy enough, this usually occurs without us being aware of it (Tversky & Kahneman, 1974).
Our perceptions are anchored in many ways: unrelated numbers we see around us (like the social security numbers), price endings, price discounts. We all know the $9.99 versus $10 price tags and we all think (I do at least) that we don’t fall for that. But it turns out that most of us unconsciously think $9.99 is closer to $9 than $10, and therefore cheaper than $10.
The anchoring effect – discounts
Discounts are a very popular and effective example of anchoring. You are shown the original price, and then the discounted price, making you anchored to the high price and as a result feel that the lower price is a good deal. But as you might remember, in our earlier blog we wrote about the risk of (regular) discounting.
For a starter, regular discounting makes customers used to discounts and expect them. This is particularly troublesome when the product you discount is offered by multiple providers, easily substituted by a comparable product, and not very time-sensitive (you can wait a week if needed). I never buy shampoo at full price, because I know that sooner or later one of the pharmacy stores will have it on discount. And in the worst-case scenario, I will buy a different brand of shampoo for this one time.
A second risk of discounting is the potential onset of a discount war. Imagine one studio giving a discount, and the second studio following suit and then a third, and so on. This could result in high losses on all sides. So before discounting, you should anticipate the response of your competitors.
A final reason to think twice about discounting is the effect on customer perception. For some products and services discounts can make us feel the quality is not that great. If you could choose between a surgeon that discounts his/her services and one that asks the full price, which one would you choose? I think I’d probably go for the full price surgeon. A discounted surgeon can’t be a sign of the highest quality, right? Despite knowing this doesn’t have to hold true, it’s hard to shake that feeling. For some of your special classes or workshops, you might also want your students to perceive they’re getting the highest quality. For these classes, you might want to avoid discounts.
So before you just apply discounts, think about your strategy. What is your goal, and are any of the above-mentioned risks plausible?
This is just the tip of the iceberg when it comes to human behavior. Understanding your customers' behavior will enable you to serve them better and run a more effective business. If this blog sparked your interest in behavioral economics and customer decision making, we recommend reading the books Nudge or Thinking, Fast and Slow. In this pricing 101 series, we rely on concepts learned in MIT Sloan’s pricing course by Prof. Tucker. If you’re interested, most of her lecture notes are available online. Next blog, we will discuss a roadmap to (re-)defining your pricing strategy.
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