FEATURE4 February 2013
FEATURE4 February 2013
Behavioural economist Leigh Caldwell shows how tailoring price to customer value perceptions can significantly increase profits.
The traditional approach to this question is to work out a “demand curve”. It’s obvious that people will buy more if the product is cheaper, and less if it is more expensive. But if you make it too cheap, the lost profit margins may outweigh the additional volume. And if it’s too expensive, you might sell none at all, or too few to be worthwhile. Somewhere along the price range there is an optimal, most profitable price.
Figure 1 shows what a traditional demand curve looks like, with various different price points.
The standard economic reasoning goes like this: no matter what price you are charging now, if you increase the price
(£5 in this example) you’ll sell less, and if you cut the price you’ll sell more (£2 ). At some point in the middle, there’s an optimal price where you earn the maximum revenue – the point where the rectangle under the curve has the largest area – in this case £3.50 (figure 2 ).
But this research used a different approach. The first four customers had come in and started to look at the teapots on display. They each picked out a teapot and wrote down how much they’d be willing to pay for it.
“So how much should we charge per teapot if we want to make the most revenue from these four customers?” asked Maggie. I worked this out. The answer is 99p, which earns £2.97 from the three customers who buy. But then Maggie went to speak to John, who’d said 99p. She asked whether he’d be able to stretch to £1.10, if he knew the product cost a bit more to make.
He probably would, he said. It’s only 11p more. Maggie turned to me. “So there’s your first problem with the demand curve: customers don’t tell you the truth. They tell you a lower figure to get you to charge less. In fact, they don’t even know what they’re really willing to pay: it’s influenced by how much you ask for the product, what else is around them in the shop, what mood they’re in. Now we know John will pay £1.10, we can make £3.30 from these four customers, 10% more than we originally expected.”
Maggie then asked Elise, who’d written down £2.10, to come over and talk to us.
She asked: “What if the price you usually pay is £2.10, but you notice a different kind of teapot – not quite the one you wanted, maybe with a cheaper variety of chocolate – on sale at another shop for £1.10?”
“Not sure,” Elise said. “I suppose it depends on my mood. But I’d probably give it a miss and buy the one I originally wanted.”
Maggie thanked her and walked outside with me.
“You have a customer there who’s ready and willing to hand over £2.10 to you. But if you set your price at £1.10, sure, you’ll get John and Hibaq to buy from you, but you’re giving free money to Elise. She told us she’ll pay £2.10, but if we offer it for less, of course she’ll take advantage.
“Ideally, what we want is find out from each customer as they walk into the shop how much they are willing to pay, then set the price to exactly that amount. That way, we get the maximum from each customer. We might even be able to win over the 40p customer. If we can do that, we’ll make £4.75 from these four customers – 50% more than we first expected.
“You can’t tailor the price to each customer personally,” said Maggie, “but the reason Elise is willing to pay more than the others is that she puts a higher value on some aspects of the teapot than they do. If we can find out what those are, we can make different teapots for each customer, and each of those can have a different price. We can make a Green & Black’s teapot for Elise, a Dairy Milk teapot for John and a Basics own-brand teapot for Mark. Each customer pays the appropriate price and we get maximum revenue. We are looking into people’s minds and getting them to reveal what they’re thinking, not by telling us directly, but by which product variation they choose to buy.”
Nearly every market contains a range of customers: some who are willing to pay more, either because they value the product more highly or simply because they have more money; and others who are only willing or able to pay less.
If you sell a standardised product, you can use Maggie’s method of product differentiation to extract more money from higher-end clients. But if you sell a bespoke service, you can instead offer a range of different options and let the client self-select into their budget. You may have a rough idea – for instance in a public tender, the client may tell you they expect to spend £50,000-£100,000. Then you can pitch three options to cover this range. Or you may have no idea at all, in which case you can design a wider range of packages covering a broad price range.
And so the demand curve now looks like figure 3. Instead of earning the revenue in just one of the three rectangles, you can earn the combined area of all three. Often this results in an increase of up to 50% in total income, as Maggie discovered.
Working out what customers value is the first step to achieving this. Introspection helps – put yourself in the customer’s place and think about why you might buy the product or service. This process is called value modelling and is a basic step for many pricing research techniques.
Once you’ve identified some of the likely “values” of your market, recruit some potential customers and talk through their reasons for buying the product or service – unprompted at first, and then prompt them with some of the values you’ve listed yourself. Your list of values will expand.
Then take these values to new respondents and ask what kind of product they would associate with those benefits. In the teapot example, if the values are “top-quality chocolate” and “luxury brand image”, they might talk about Green & Black’s or Godiva chocolates. This will give you an indication of the price level you can charge if you position your product against those competitors.
I next saw Maggie on a street corner in the City of London. She’d asked me to meet her there to watch her interviewing people as they passed. Along with some straightforward questions on their tea drinking habits, a couple of the questions were more specific to pricing. “Here’s £10. If I asked you to go and spend some of it on buying tea, where would you go?” she asked, and “How much would you expect to pay for it there?”
Over the next half hour Maggie moved back and forth between two adjacent streets, and it was noticeable how much the answers were influenced by where people were standing. On one street there was a branch of Tesco, and people tended to point to it when offered their £10 note. On the next street there was no supermarket, but there was a Starbucks nearby. And most people on that street said they would buy at Starbucks.
“Most people don’t have strong opinions about, or even very clear memories of, the products they buy,” said Maggie. “So it’s quite easy to influence their answers by changing the way you ask a question or the environment they are in. In fact, one of the things that pricing research can best measure is not the actual answers to the questions, but how easy it is to influence the decisions people make.”
“So if you figure out that 60% of people will change their answer according to which street they’re standing in …” I said.
“… then we know that’s how many people are likely to be susceptible to being pointed towards one shop or another to buy the product,” she replied. “Quite useful in designing promotional offers or ads.”
After the research, Maggie showed me the segmentation (below).
Segmentation of this kind is important in any pricing strategy. Often, as in the teapot example, the range of customer willingness to pay (WTP) will divide into clear categories based on what alternative products people compare your product or service with.
It is hard to span distinct WTP categories with a single product. If you are able to attract a customer base at £2.50, it’s dangerous to also offer a 30p version of your product because customers might trade down, and the profit lost on the £2.50 consumer will be hard to make up unless you can sell huge volumes of the cheaper version. The more unusual your product is, the more you should aim for a premium price segment. On the other hand if you have close competitors you may have to
hit a particular price point to capture a volume market.
The best techniques for accurate pricing research are based on cognitive psychology and behavioural economics, two scientific disciplines that focus on how people make decisions – and also on the differences between what they say and what they do.
This science is why questions like the two examples above work. The first asks the customer to put herself mentally in a situation which is similar to the real buying environment, and asks her to make a real decision. This prompts her to go through at least some of the same mental processes that she goes through when buying a real product. Having done that, the price point she gives in response to the second question is more likely to be accurate, and to reflect what she might really be willing to pay for the product.
It’s risky to ask direct questions such as “How much would you be willing to pay for this?” Apart from the difficulty for the consumer of trying to predict their potential behaviour in a hypothetical situation, many people will deliberately give you an underestimate – in some kind of strategic attempt to influence you to lower your prices. As far as you can, you should structure your questions to replicate the real process and mindset of a consumer buying a product.
A powerful way to do this is to give the respondent real money and ask them to spend it on buying from a product shelf you’ve set up in a viewing room – or in a real retail environment. By doing this you can vary the price of the product you’re researching, but also other attributes such as the price of competitive products, the anchor price (the higher price of a premium version of the product) and the ways in which prices are communicated. With these alterations you can get a picture of which variables you can change to most strongly influence willingness to pay. This is just as important as finding out the actual price point where most customers will buy.
Leigh Caldwell is a behavioural economist and author based in London. He is a partner at The Irrational Agency (theirrationalagency.com), a research agency specialising in behavioural economics and pricing. He also writes the Pricing Revolution blog (pricingrevolution.com).
The Psychology of Price is published by Crimson and is currently available for £10.49 (normal price £14.99 ) at amzn.to/leighbook. The book’s website is psyprice.com