How to Price your product

It is not the business that earns a profit adequate to its genuine costs of capital, to the risks of tomorrow and to the needs of tomorrow’s worker and pensioner, that ‘rips off’ society. It is the business that fails to do so - Peter Drucker

General

The most difficult decision that I, as an Entrepreneur, grappled with was how to price my workshops. What was the 'sweet spot' that would find minimum resistance from clients and yet give me sufficient profit margins. In my quest I went over books, articles, research data and spoke to business owners across business domains both in India and overseas. Based on all the information gathered I figured out what is required to be done. This article is the result of all the academic and practical knowledge that I gleaned and then used.

Academics versus Ground Reality

As per the principles of economics that I learnt in college, it is assumed that buyers and sellers act rationally. Suppliers try to maximize their profits, while buyers try to maximize their value, or their 'utility' in the language of my Economics Professor. Under these principles, all parties have complete information. The sellers know how the buyer will respond to different prices, which means that they know their demand curves. The buyers know all available alternatives and their prices, and can make qualified judgments on the utility that each alternative provides, independent of its price.

These assumptions about rationality and information first came into doubt through the work of Herbert A. Simon (Nobel Prize, 1978). In his view, people have only limited capacity to absorb and process information. This, of course, stems from the concept that the human brain can only process 7+ 2 chunks at any given point in time (George A Miller). For this reason, consumers do not strive to maximize their profit and their utility. Instead, they content themselves with a 'satisfactory' outcome. He coined the term “satisficing” to describe this behavior. Israeli-American Psychologists Daniel Kahneman and Amos Tversky published their groundbreaking paper on 'Prospect Theory' (1979) which ultimately gave rise to a completely new school of thought called behavioral economics.

Luxury Products

In his classic The Theory of the Leisure Class (1898), the American economist and sociologist Thorstein Veblen revealed that prices signal status and social prestige and therefore offer the buyer an additional level of psychosocial utility. This came to be known as the Veblen Effect. The price itself becomes an indicator for the quality and exclusivity of luxury products.

The demand curve for such products—at least within a certain range—has an upward (positive) slope, not a downward (negative) one meaning that a price increase leads to higher sales . This increases profits not only because of the higher unit margins, but also because of higher unit sales. This powerful combination results in a veritable profit explosion if the price is raised.

An example of this was Delvaux, a Belgian manufacturer of exclusive handbags, raised prices massively in conjunction with a repositioning of the brand . Unit sales rose sharply, as consumers now viewed the product as a viable alternative to Louis Vuitton. Another instance was in the 1970s, sales of the famous whiskey brand Chivas Regal were in the doldrums. In order to reposition the brand, the company developed a label with a more high-end look and raised the price by 20 %. The whiskey itself remained exactly the same. In spite of the price increase , sales rose significantly.

Price --> Quality

It has been seen in case of not so high end products as well - that consumers take price as an indicator of quality. A lower price can prompt a consumer to forgo a purchase, because the price raises concerns about the quality and in turn reliability and effectiveness of the product. Many customers act according to the motto 'you get what you pay for' and steer clear of low-priced products.

There are countless empirical observations of the role of price as a quality indicator. It has occurred for products as diverse as furniture, carpet, shampoo, toothpaste, coffee, jams and jellies, and radios. Researchers have reported that unit sales rose after a price increase for nasal spray, ink, and electrical goods. For one electric razor, sales increased by a factor of four after the company raised prices sharply in order to come closer to the prices of Braun, the market leader. The price difference was still sufficient to offer a purchase incentive, but no longer so large that consumers would start to doubt the razor’s quality.

In my research, I have found similar effects in the service sector, particularly in restaurants, hotels and also what Coaches and Consultants ask for once their credibility has been established.

Placebo Effect. Another thing that works as per psychology is the placebo effect. If a person has paid more for something, unconsciously they expect it to be better than cheaper variants. After consuming a power drink priced at $2.89, a group of athletes reported significantly better training results than a group which drank the exact same power drink priced at a discounted price of 89 cents.

Aggressive Sales without establishing brand. If a supplier wants to increase its market share through aggressive pricing, the attempt will fail. IN fact, it is highly likely that both unit sales and market share will actually drop rather than increase. These effects make it very difficult for an unknown supplier or an unknown brand to break into a market where these phenomena exist. Attempts to win over customers through lower prices don’t work. These effects also explain why discounts on no-name products or weaker brands also fail to work: customers associate the reduced price with lower quality or with low prestige.

Magic of the Middle

The less a buyer knows objectively about the quality of the products and prices in an assortment, the stronger the pull of the 'magic of the middle' will be. We can keep arguing that this purchase behaviour is rational, as the buyer tries to make the best possible decision with very limited information. By selecting a product from the middle of the price range, buyers simultaneously reduce the risk that they buy something of poor quality and the risk that they overspend. Sellers should not go to extremes to take advantage of this, however. They should be cautious setting price anchor s at extremely high or extremely low levels. An extremely high price may scare off buyers who don’t want to spend that much, whereas an extremely low price may scare off buyers who become suspicious of the quality.

The Anchor Effect

A customer enters a luggage store to purchase a new suitcase.

The saleswomen asks how much he is willing to spend. “I was thinking about $200,” the customer said.

“You can get a good suitcase for that amount,” the saleswoman responded. “But before we take a closer look at the suitcases in that range, may I show you one of our finer pieces?” she asked. “I’m not trying to upsell you to a more expensive suitcase. I just want to inform you about our whole product range.”

The saleswoman then brings out a suitcase for $900. She emphasizes that in terms of quality, design, and brand name, it is truly a top-of-the-line model.

Then she returns to the products in the customer’s desired price range, but also calls his attention to some models with slightly higher prices, between $250 and $300.

How will the customer react? It is highly likely that he buys a model in the $250–$300 price range and not something near his original target price of $200.

The anchor effect created by the $900 model drew the buyer’s willingness to pay upward. Even if the store never sells even one $900 suitcase, it makes sense to keep it in the assortment, purely because of the anchor effect it creates.

Prospect Theory - Behavioural Economics

Kahneman and Tversky worked on what they called the 'Prospect Theory'. This was the first time psychology of consumer behaviour was being studied in Economics which was hitherto fore about theories and academic concepts which did not take into account the 'human psyche.'

They found that 'paying a price generates negative utility'. The money that an individual parts with - psychologically it is like a sacrifice, or a loss. Only the other hand, the purchase and use of a product or service, in contrast, represents a gain and generates 'positive utility' The asymmetry between the utility from gains and losses can cause some unusual effects.

One is known as the Endowment Effect, which gives out that the negative utility of giving up something we already own is significantly greater than the positive utility we get from a good that we first need to buy. We are all reluctant to part with what we have. If we own something, miraculously, the value it has increases in our minds.

How Cash Back Works

Cash back. When you buy something, there is the negative utility of paying. More in paying by cash than paying by credit card. Add to the mix the positive utility of owning what you bought AND the positive utility of getting cash in return. The negative utility from the original booking—which you paid for via credit card—would be less than the positive utility from the cash amount offered.

Mental Accounting

University of Chicago Professor Richard Thaler developed the theory of Mental Accounting, which claims that consumers allocate their transactions into different mental accounts. How easily or carefully they spend their money depends on which account the money is in.

These accounts may be based on different criteria or needs such as food, vacation, hobby, car, or gift-giving. This kind of categorization (mostly in the head, however, I have come across people who actually write this down) helps consumers to budget their money, plan expenditures, and monitor their spending.

Each account is subject to different spending behaviors and price sensitivities.

Each account will have its own negative utility curve.

Thaler conducted an experiment in which participants were divided into two groups. The participants in the first group were informed that they were standing in front of the theater and had lost their ticket. The participants in the second group were told that they would need to buy a ticket at the window, and that they had just lost $10 moments earlier. Among those in the group who lost their ticket, 54 % decided to buy a new one. Among those in the group who had lost the $10 bill, some 88 % decided to buy a ticket.

Mental accounting helps explain this apparent discrepancy. The ones who lost the ticket booked both the price for their lost one and their new one to the 'going to a play' account, whose mental price now rose to $20. That price was too expensive for 46 % of the participants. The ones who lost the $10 bill, however, booked that loss to their 'cash' account. Since their mental price for the theater ticket remained unaffected at $10, the vast majority of them decided to buy the ticket for $10.

Price Bundling

When a seller packages several products together and charges a total price less than the sum of the individual product prices, it is called price bundling . Bundling is a very effective way to differentiate prices.

Whoever buys multiple products at once rather than a single product receives a bundle discount . Widely known examples of such bundles are the combo-meals at McDonald’s (burger, fries, and soft drink), the Microsoft Office suite, and the all-inclusive packages from travel agents, which include flights, hotel, and airport pick up and drop.

Corporate Pricing

Revenue is the product of price and volume.

Profit is the difference between revenue and cost.

This means that every business has only three profit drivers: price, volume, and cost.

Even though all of these profit drivers are important, they affect profit to different degrees. Anecdotal evidence, studies, and my own experience in discussing price with business owners and accountants have projected that most business owners dedicate most of their time and energy to cost cutting, 'efficiency improvement' if you want to call it, as a means for increasing profits, especially in tougher economic times.

If I were to guess the percentages, I would estimate that managers allocate 70 % of their time to cost issues, 20 % to volume, and only 10 % to price. The second most 'popular' profit driver among business owners is volume or unit sales. They are willing to invest in better sales tactics and support, building their sales forces, and refining their competitive strategies. Price typically comes in last place, and in some cases comes into consideration only as the handmaiden of managers waging a price war . The irony is that this prioritization runs in the opposite order of the effects these drivers have on profits.

Prices get the least attention, but have the greatest impact.

The obsessive pursuit of the wrong goals—customer counts, revenue, and market share —leads even the sharpest managers to neglect the effects that discounts and promotions have on profits. It is hard to determine how many of the customers these promotions draw in will become repeat buyers at regular prices. But this doesn’t change the simplicity and elegance of what my gardener knew: when you grant customers appealing and addictive goodies in the form of discounts, rebates, tax-free shopping days, free shipping, and on and on, you will typically see increases in interest, traffic, sales volume, and most of the time (but not always) revenue. That is what makes these discounts so alluring and so tempting. They look like successes.

But that success is often only an illusion.

Pricing’s high-speed, high-impact power has other downsides. Because prices are so easy to change, competitors can respond very quickly to neutralize any advantages you stood to gain from a price move. These competitive responses are usually swift and strong. This phenomenon alone helps explain why companies rarely win price wars. Unless you have an unbeatable cost advantage which prevents your competitors from responding in kind, it is almost impossible to establish a sustainable competitive advantage through lowering prices.

Remember, price is the only marketing instrument you can employ with no upfront investment. This makes it an especially powerful marketing tool for small business or start-ups with tight financial resources.

Conclusion

I hope what I have covered in this article can give you a head-start toward setting an optimal price, or at least weeding out dangerous options.

Developing an advertising campaign, building a sales force, and conducting research and development are all essential parts of business success, but they all have a delayed payback and require substantial up-front investments. Optimizing these elements is critical, but is often not immediately financially viable for a small business or a start-up.

So after you set the 'right price', remember the next part is about how you communicate it. Are you talking about the positive utility that the buyer will get once he owns your product or avails your service? Is your entire marketing campaign built around the experience - or are you still competing in the realm of price?