The Psychology of Price

by Leigh Caldwell

  “So what are you going to do?” I asked.

  “I don’t know yet. We tried to get them to offer a new promotion on teapots, but they wanted a 60% cut in our price to them. We can’t offer that because we’d never persuade them to put the price back up again, even if we tried to make it a temporary offer. But it’s critical to me that we get this chain back on board. Any ideas?”

  I had none. I’d grown used to Maggie controlling everything about the pricing proposition, so it took me aback a little to hear her admit the next move was a mystery. My drive back to London was a thoughtful one.

  Two days later, as I popped into a newsagent to buy that week’s Economist, I noticed a new magazine on the shelf. Business Innovations was a title I hadn’t seen before – looking more closely, I discovered this was just the second issue – which appeared to focus on new and unusual business ideas and innovative companies.

  It was priced at £4.50, a little more than The Economist. There was an interesting offer on the cover, though: a partnership with LinkedIn through which readers could be introduced to any two of the interviewees in the magazine. How unusual, I thought – and worth trying out.

  I wasn’t expecting to have time to read two magazines this week so I ended up skipping The Economist, though I ended up reading their “Economics Focus” and book reviews online as usual. So I bought Business Innovations and it turned out to be quite interesting.

  One of the articles was about a consultancy firm in London offering what was described as a revival of an old technique from the mail order industry. This firm was selling a new service to businesses – something to do with a newly invented marketing approach for websites – and they’d been having trouble getting people to try it out. Customers were being conservative: the firm believed in their service, but it was a newly developed technique which clients were a little wary of. Some prospective clients were pushing for price reductions as it was an untried technique; but the firm’s owners did not want to reduce the perceived value of their service by cutting the price.

  So they’d decided to offer a money-back guarantee on the first month of their service. The client could evaluate the service, decide whether it was giving them business value, and if it wasn’t they could ask for a full refund.

  Their sales had leapt about threefold. Sure, some clients did ask for their money back, but as a condition of the refund, the supplier insisted on detailed feedback and constructive criticism. This had helped to improve the service and, over time, the number of refund requests fell from 25% to only 10%. The money they lost on refunds was made up many times over by increased sales to clients who would never have tried the service otherwise.

  I used one of my LinkedIn contacts to connect with one of the partners in the consultancy, Michael McGarry. Here’s what he said:

  “The guarantee makes a huge difference to our customers’ perception of us. It takes away most of their perceived risk – when you tell them about the guarantee, they often don’t believe you at first as it sounds too good to be true, but you reassure them and they generally come round to the question – where do I sign? In fact, it’s enabled us to start turning away customers – we have developed a qualification process to see whether we believe they’re serious enough about getting value out of our service. And there’s an extra bonus: it shows clients that we believe in our own service, so they treat us with more respect and they seem more willing to believe in our advice.”

  Ultimately, he thinks, the money-back guarantee more than doubled the size of their business within a year and set it on course to grow significantly faster in the future.

  My other contact was with Helen Sutherland, marketing manager of a business-to-business florist. Her interview in the magazine explained a different way of encouraging new customers to try their service.

  “We realised that once a client has our flowers in their office every week, we have lots of ways to keep them loyal. We bring in special bouquets for birthdays and other events; we design flower arrangements in the corporate colours of our clients’ customers, to help them impress those customers in turn; and we provide all sorts of extras to make sure their office environment is always improved by our being there, and that they’ll miss us when we go. But before they’ve experienced us, they don’t know how good we are.

  “So we decided to offer a mini version of our service, just to make a little difference to a reception desk or entrance hall. We still charge for it – and it makes us a profit – but we use a longer-lasting pot plant, which is replaced just once a month, and deliver fresh herbs once a week to create a new aroma in the office. Some clients try it and then cancel after a couple of months; some stick with the mini service; but after a couple of months about 25% of them upgrade to the full service, which is where we make our real money.”

  Sutherland says that since adding the mini service, they are signing up about double the number of clients, though with many of them on the mini service, revenue has increased by only 40%.

  Two weeks later I visited Maggie again. Her response to these stories was to set up a series of experiments in different branches of a different café chain.

  In the first branch, CTC added a set of promotional offers to the teapots: competition entries or a voucher for a free biscuit. In the second, they tried a money-back guarantee – taste a chocolate teapot and if you don’t like it, send us this voucher for a full refund. In the third, they introduced a miniature version of the teapot – more strongly flavoured and espresso-sized, at 99p.

  Over the following weeks each of these offers increased the number of new customers recruited, by varying proportions depending on time of day and week. The promotional offers turned out to be the most effective of the three approaches.

  In the next month CTC aggressively rolled out the promotion across all their Cosanostra branches. Sales leapt right away. The café’s total revenue went up, so the head of retail was happy. Reportedly, Salmon was not happy with the thwarting of her competitive approach, but with her boss on board she had no choice but to put up with it.

  Competition has two faces. It can be a good thing – if you sell something very unusual, gaining a competitor is a powerful way to build credibility for your product category. You get to piggyback off their marketing, and the fact that there are two or more product choices gives customers confidence that other people are buying the product.

  But it is also dangerous, because it creates the risk that people will look at your product purely on price. If your customers start to compare you on price with competitive alternatives, you may have to reduce your price to beat theirs. They will be forced to cut their price to beat you, and ultimately you will both end up getting cheaper and cheaper until you have no profit left.

  To beat this, you need to distinguish your product from the competition so that customers can’t easily compare your offering with theirs.

  You might be able to do this by adding extra features to your product – though the competition may copy your features after a while. You can do it by using unusual package sizes so that customers have difficulty making a direct comparison – but you risk putting people off if they are used to buying the product in a specific size. And you can do it with specific offers, such as a money-back guarantee or extras such as a prize draw.

  Dominant market share: low price

  If you’re aiming for the dominant position, you want to reduce the complexity for customers of comparing your product with the opposition. Try to match the format (for instance the 330ml can), the positioning and promotion (for instance try to get on the same shelf space in your retailers) and make clear what your advantages are without differentiating the product too much. Your goal is to take advantage of buyer inertia. People already in the habit of buying Innocent smoothies may consider your alternative product if it appears to be a close enough substitute and the price is lower.

  The price differential you need to apply will depend on the strength of customer loyalty to the brand, and t
he significance of the purchase relative to the customer’s disposable income. If you are selling a Coca-Cola competitor in newsagents in the City of London, it’s unlikely that you will attract much switching unless your price is savagely lower – say 25p in comparison to the typical 69p retail price. On the other hand, if your goal is to sell a new flavour of fizzy drink to schoolchildren, the required differential will be smaller. In this case, the local newsagent will already be charging less – say 55p – and you will attract a significant number of switchers at 45p.

  Perhaps you are competing against a brand without Coca-Cola’s strength, such as Innocent smoothies, or one where the brand, though familiar, adds little value to the experience – think of Andrex toilet paper. In these markets, buying habits are much less ingrained and a smaller differential will be enough to tempt some people to change. To check this out, look at whether supermarkets have a successful own-brand line in the category. If they do, price competition has a good chance of working.

  High margin: niche positioning

  If, as is more common, you do not have the scale or capital to dominate the whole market, you are more likely to profit from a high-margin product with additional benefits.

  In the case of the cola market, you can see examples such as Inca Kola or Jolt Cola, which are aimed at specific niches (organic/authentic, and high-caffeine geek respectively) and priced accordingly. In the retailers where you can buy Inca or Jolt, they are priced at least 50% higher than Coca-Cola and Pepsi.

  The strategy is to pick one main benefit area where you can overwhelmingly exceed the quality of the competition, and aim for people who care a lot about that benefit. In the case of cola, there is a segment of people to whom organic food is important, and this is the niche for Inca.

  You can sometimes use additional benefits. Many people in this market object to large corporations like Coca-Cola, seeing them as symbolic of a capitalist system that they don’t like. Therefore Inca can use its independent image as an extra selling point: this benefit is highly compatible with the appeal of organic food. If the benefits are not compatible, there is a risk of ‘motivational crowding’ where the extra benefit is ignored, or makes it harder for the consumer to make a decision. If Inca Kola were to offer free tickets to Premiership football games with its drinks, this benefit might actually be counterproductive and reduce sales. It certainly wouldn’t bring enough extra revenue to be worth the cost. In fact, Inca is now owned by Coca-Cola, though most consumers probably do not realise the connection.)

  To calculate the price premium you will attach to your product, examine the strength of feeling that customers attach to your additional benefit. If your product is directly comparable to the competition, you are unlikely to achieve anything above 100% premium – and 50% is more likely. If you go too high, you are likely to break the comparison: a cola priced at £2.50 will not be perceived as an everyday thirst quencher, but might work as a health drink (see Purdey’s) or a high-end energy drink. The markets for these categories are much smaller, however.

  The psychological goal is to piggyback on existing demand – people who want to buy a can of Coca-Cola – while attracting them with the extra benefit to consider paying a little extra. Again, the degree to which you can achieve a price premium will depend on the share of disposable income this product represents. It’s easier to sell a bottle of Purdey’s in the City than in a school tuckshop.

  This technique is especially powerful in service markets, where it is usually relatively easy to vary the service you provide without investing in launching a whole new manufacturing process. Services are in any case less competitive: as they are less tangible, it is harder for people to compare two suppliers directly and these markets tend to be less commoditised than those for physical products.

  Combining the techniques

  You can combine a mass-market and a high-margin strategy, but you will need to decide which is your primary approach.

  If you choose the volume approach, you will be giving up margin from some customers who are willing to pay more. To capture more money from these customers, you can offer a higher-quality variation of your product (or indeed more than one variation). See Chapter 3 for more details and examples.

  If your main focus is the high-margin product, you may want to test a cheaper high-volume version in case it catches the market’s attention. You should be careful to distinguish this clearly from your main product so that it does not dilute the perceived value of that. Even if this does not take off, it might still introduce new customers to your brand who may later upgrade to higher-value purchases. Lindt have successfully followed this approach in the UK, launching a small truffle egg which is positioned against Cadbury’s Creme Egg, introducing new customers to the more expensive boxed Lindt products.

  Defence: when someone uses these techniques against you

  If someone is positioning above you with a premium niche product (if you are Coca-Cola and they are Inca), you may not need to defend immediately – they can take only a small percentage of your market and there may be better things on which to spend your time and budget. If you do have a product development budget, you may want to develop your own premium offering: once they have tested that a market exists, you can use your brand and distribution power to launch your own version.

  A competitive attack in the other direction is more serious. It is generally a bad idea to directly cut your prices in response to a competitive price cut. So refer to CTC’s three strategies to work out the best response.

  1. A promotional offer is a good way to add value to your product without a price cut. You are showing customers that it’s worth sticking with your brand because you invest in creating extra value for them; and by using time-limited offers, you reduce the customer’s temptation to try something new out of curiosity.

  2. A money-back guarantee is appropriate if your own product is relatively new, and if you are still trying to get people to try it out. This was the case for CTC, and is a good way to respond if a more established competitor cuts prices to try to keep you out of their market.

  3. A miniature or restricted version is a way to achieve a price point that competitors probably can’t match, without seriously damaging your margins or destroying the perceived value of your main product. In consumer products, this can be a smaller pack size; in services or software, it might be a simpler or less customised service; or even a deliberately limited offering with features removed (common in the software market).

  How to apply it

  Applying these defensive techniques in your own business can be fun. To do so, look at your competitor comparison charts and work out the reasons why people might choose their product over yours. See what you can offer that will counter those reasons – something tempting enough to get them to switch to you without cutting your core price.

  Developing a competitor comparison chart

  In Chapter 1, you created a list of key product benefits and identified the competitive products that you wanted to position yourself against. Now it’s time to look at the competition in more detail. For each of your product categories, pick two or three of the closest direct competitor products. Here’s an example:

  Price

  Your product 330ml Super Cola

  Competitor 1 330ml Coke can

  Competitor 2 330ml Pepsi can

  Their price points

  45p–65p

  42p–65p

  Competitive advantage

  Novelty

  Strong brand Traditional image

  Good brand Youthful image

  Fill out one of the following blank templates for your own products, or download more at www.psyprice.com.

  Your product

  Competitor 1

  Competitor 2

  Their price points

  Competitive advantage

  Your product

  Competitor 1

  Competitor 2

  Their price points

  Competitive advantage


  You now have a decision to make. Do you have the marketing budget to aim for a dominant market share? And is this the position you want? If so, you need to be competitive on price but also offer some other advantages.

  Or do you prefer to be a high-value, high-margin supplier with a niche position? If so, you should deliberately pitch your prices above those of the competitors and make sure that – within your niche – you have a series of product advantages so overwhelming that your competition can’t touch you.

  It is possible to achieve premium price and dominant market share at the same time, but it’s very hard to do, and if you aren’t the first into a market, you need to start with one of the other two strategies. However, you can achieve both quality and price positioning with a stratified pricing structure – as outlined under ‘Combining the techniques’ above.

  Chapter summary

  • When there is already a product in the marketplace with which you can with compete, you can get a shortcut to consumer acceptance by positioning your product as a better or cheaper version of theirs.

  • Customers will find it easier to compare your product with a competitor than to evaluate it on its own merits. Work out every way in which they could be compared, and try to make your product better on the majority of them.