• Of course, competitors can do the same to you. Competition is more dangerous when the competitor’s product is very similar to yours.
• If possible, avoid a straight price cut in response to competition. This creates a race to the bottom in which nobody can make any profit.
• The ideal strategy against a competitor is a ‘squeeze’, where you introduce two products – one slightly better quality and more expensive, and one slightly cheaper, than the competitor’s product.
In focus
Pricing publicity
Every so often a pricing story hits the news. Usually this is for one of two reasons.
The good reason is that you’ve designed a clever pricing approach which may revolutionise your industry. Low-cost airlines were a big story in the 1990s, and everyone from estate agents to iTunes have made hay out of new pricing schemes, especially those that are clearly better both for customers and for the company.
The bad reason is when you are being portrayed as overcharging. Fortunately for most of us, there is so much overcharging out there that only the biggest companies are likely to be written about. Prominent examples included the following.
• Airlines being accused of adding on excessive fees and charges to their advertised price.
• Mobile phone companies billing £30,000 for data roaming.
• Bank of America’s $5 per month fee for using a debit card.
• Verizon settling lawsuits for millions of dollars for overcharging and rounding up data charges.
• Orange unilaterally increasing its phone subscription charges halfway through a contract.
• UK electricity companies regularly being accused of increasing prices when the oil price goes up, and not cutting them when it falls.
Whether or not these accusations are based in truth, whether they are fair or not, the publicity is damaging. Social media in particular offers a new channel for customers to communicate and organise a campaign against a company. Bank of America backed down from its plans to charge that $5 fee after extensive protests on Twitter and Facebook.
If you’re a small company, the chances of a campaign like this are correspondingly small. People tend to assume that big corporations have market power, while it’s easier to walk away from a small firm if you’re not happy. Still, it’s worth being aware of what kind of pricing is likely to lead to objections.
Charging for something that has previously been free is one risk. So is charging one set of customers who were previously cross-subsidised by another. Bank of America made both of these mistakes: the transaction fees they earned from retailers were capped by a new law, so they tried to make up the money by charging account holders instead. Airlines that started to charge large fees for debit card use opened themselves up to the same complaint.
Charges with no convincing basis in cost are sometimes open to attack. Those airlines again: charging one transaction fee for a debit card payment was perhaps justifiable, but to charge £5 each way for each passenger in a single transaction – £40 for a for a return trip for a family of four – was hard to stand behind.
Offsetting one charge with another is often a good defence – low-cost airlines can argue that their charges are a reason why the base ticket cost is so low. Keep an eye on the net effect, though. If you have to cut one charge by more than the amount you make up on the other, there’s little point.
Increasing the amount of an existing price, by contrast, rarely provokes much protest. Most consumers share a general assumption that companies should be allowed to charge what they want – the objections are often to the charging model rather than the total amount.
Sometimes the issue is genuinely out of your control. Energy companies in the UK can make a good argument that their high prices are a direct result of oil and gas prices; their profits at time of writing are only around 9% of sales, which doesn’t seem unreasonable on the face of it. However, they could undoubtedly do a better job of reframing their price structures to reduce consumer resistance.
Of course, you might choose to ride out the objections. Netflix recently provoked a storm of protest by splitting its $10/month combined DVD + online streaming subscription into two separate $8 subscriptions. But they lost only 3% of subscribers in return for a 30%–50% increase in revenue. Ryanair has revelled for years in its harsh image, which combines ruthless cost-cutting and ruthless charging for anything beyond the basic service.
And some pricing objections are so irrelevant that they don’t matter to normal customers at all. When a restaurant announces a £13,000 gold-plated truffle-and-foie-gras hamburger, it will probably neither gain nor lose any customers within the admittedly specialised truffle-and-foie-gras hamburger niche. But it might attract a few who will pay £75 for a steak based on the hamburger’s publicity.
A general principle is: if your company is famous enough that its pricing becomes a news story, you already have a big advantage. If your company gets famous through its pricing initiatives, then no matter whether customers like your prices or not, at least you’re famous now.
Chapter 9
Decoys
Asymmetric dominance: the bowler hat theory
Maybe it’s worth mentioning where I first met Maggie.
My friend Keith decided two years ago finally to join the world of digital photography. On the basis of recommendations from friends (not me – I know better than to risk getting blamed for somebody else’s purchase) he narrowed down the options to two cameras: the Sony Cybershot and the Nikon P510.
I went with him to buy one at the local camera shop, owned by a couple who seemed to have been there forever. Both models were there on the shelf. The Sony is light, small and easy to use. The Nikon has a longer battery life and a better-quality optical zoom. Here they are:
• Nikon – 10 hours’ battery life, 20x optical zoom, 600g, 5cm thick: £329
• Sony – 5 hours’ battery life, 16x zoom, 350g, 2cm thick: £284.99
Each has strengths and weaknesses, and Keith really wasn’t sure which one he wanted.
The owners’ daughter was working in the shop that day, on a break from her university course. As she came over to help us. I glanced at her name badge – Maggie.
After talking over the options with Keith and understanding his criteria for choosing between the products, Maggie asked him to wait a moment. She disappeared into the stockroom for a moment and brought out a bowler hat with a price label on it: £335.30. She placed the hat on the shelf next to the cameras.
Keith looked at this extra option for a while and decided to buy the Nikon. He thanked Maggie for her help and left the shop. Maggie, satisfied with her work, returned the hat to the back room and awaited her next indecisive client. I heard a few months later that the shop’s landlord, a company called CLH Property, had refused to renew their lease – forcing the shop to close after 25 years. So they never had the chance to scale up Maggie’s psychological pricing methods to a bigger scale.
Bizarre story, don’t you think? The store offers a completely irrelevant product which the customer doesn’t want – and is too expensive anyway – but it influences him to buy the product the shop wants him to. How could that possibly work?
Well, I have a confession. I’ve changed one little detail, but apart from this, the story is true.
In fact, the irrelevant product is not a bowler hat but another camera. It’s another Nikon camera – last year’s model, the P500. The battery life is only nine hours and the zoom 18x. And it costs £339.
Diagram 4
Decision 1. Comparing the different brands is hard. The Sony is cheaper, but the N400 has more battery life. Neither is clearly better than the other.
Decision 2. First compare the two Nikons. The N400 is clearly better than the N393 (or the bowler hatl) – both on price and battery life. The N393 acts as a‘decoy’ and people subconsciously assume that the N400 is better than the Sony too.
Clearly nobody would buy the P500. It has no advantages o
ver the P510, and it’s more expensive too. Just like the bowler hat.
And yet it really does influence people to choose the other Nikon in preference to the Sony.
The reason? People find it hard to compare two products which have different advantages or different attributes. It’s tough to know whether a more compact, lighter camera will be preferable in more situations to a higher-quality one with longer battery life. But it’s very easy to compare it to a product with similar, slightly inferior attributes. Thus the P510 is definitely better than the P500. But the Sony is not clearly better (or worse) than either the P500 or the P510. So out of the three products, the P510 is the only one that’s clearly better than any of the others. This is enough to make people choose the P510.
As we can see from the bowler hat example, this behaviour is not really logical – but many experiments have shown that it does happen, consistently. Technically, the effect is called asymmetric dominance and it happens whenever two products (A and B) are each superior to the other on a single dimension. For example, one may be better on quality and the other on price.
By introducing a third product, C, which is clearly inferior to B (on both dimensions), you make your consumers more likely to buy B than A.
And the simplest way to introduce an inferior product is to make it more expensive. So any time you have two products which compete on quality and price, and you’d like people to buy the more expensive one, simply add a third which is even more expensive, but no better in quality.
Case study
Decoys on services
The decoy technique applies just as well to services as it does to products.
A midsize law firm, Smith & Bloggs LLP, has a private client department that handles personal legal and tax matters for reasonably wealthy customers. One of the services it offers is drawing up wills for its clients. This is an in-depth, high-quality service in which it works out all the tax advantages of different trust structures, makes the appropriate recommendation to the client, and draws up the full documentation of the will, ensuring that all the implications are understood by the client and that they have the option to assign appropriate legal powers to a spouse or child. The will-writing service typically costs around £900 (with further set-up costs if a trust is established).
A local high-street firm that competes with Smith & Bloggs takes a simpler approach, without exploring the tax implications of the will, and charges only £400.
The critical benefit dimensions here are (1) tax savings and (2) price. How should Smith & Bloggs design a decoy service to attract more clients from its competitor? The answer is to offer a second will-writing service with smaller tax savings, but at a higher price. This might be a ‘will for corporate assets, without trusts’ service at £1,100. It would exclude the detailed tax and trust analysis but would allow the client to incorporate distribution of company assets in the will. This service is provided not by the original solicitor with all their tax expertise, but by a corporate lawyer with less experience in personal tax strategies. The extra expense comes from the fact that the corporate lawyer’s chargeout rate is higher, and they are less experienced at preparing wills. For most clients, who do not have corporate matters to handle, this service will be inferior to the standard will-writing service. Very few clients will buy the corporate service, but it will increase the number of people buying the standard service at the expense of the high-street competitor.
Price-level decoys
As we saw in Chapter 1, people are often bad at estimating the value and benefits of a product. This is especially true when the specific product is unfamiliar (for instance many wines) or highly complex (mobile phone contracts or many business-to-business consulting services). In these cases, customers often use the price itself as a way to estimate value.
Would you expect a £40 bottle of wine to be better than a £7 bottle? Most people do. In fact, experiments show that consumers in a taste test usually say that a £40 wine tastes better than a £7 wine, even when it’s actually the same wine with two different labels.
One group of researchers went a step further, in case the consumers were just saying that the £40 wine tasted better because they didn’t want to look like they don’t appreciate posh wine. So they put the consumers into an fMRI brain scanner and tested how their brain reacted to the wines. Even though the two wines were exactly the same, the consumers showed greater activity in those parts of the brain related to sensing pleasure when they believed it was more expensive.
In cases like this, price and value are collapsed into a single dimension. It’s not possible then to use the asymmetric dominance style of decoy described above.
Instead, a decoy can be created through price alone. Let’s see how that can work.
After buying his new camera, Keith walked into the bar next door to relax with a glass of wine. On the menu were two white wines by the glass: a French vin de pays at £3.45 and an Italian pinot grigio at £4.15.
Keith was about to order a glass of the £3.45 wine. Like most people, he is more likely to choose the cheaper product when he has little information to guide him. In our experiments, around 70% of people will choose the lower-priced wine from two options.
As he was about to order, the bartender blatantly ignored him and turned to another customer who, Keith was sure, had not been waiting as long. Annoyed, he decided he didn’t like the music in that place anyway and decided to go around the corner to a quieter pub. In this one, the menu was slightly different.
• French vin de pays: £3.45
• Italian pinot grigio: £4.15
• New Zealand sauvignon blanc: £5.20
The only difference: the addition of one, more expensive, option to the menu. This option wasn’t particularly of interest to him – it was quite expensive, and, like most people, Keith was not confident that he would appreciate the difference in taste of a higher-end wine.
But in this pub, Keith, still a typical consumer, ended up choosing the pinot grigio – not the cheapest but the middle-priced wine. He spent 80p more, increasing the pub’s profits by about 60p. Why does this happen? The way he makes his decision this time is similar to the cameras, but a little different.
The key effect is that we don’t like to pick extreme options – we like compromise and balance, because it feels that way we are less likely to make a mistake. This is sometimes called the ‘Goldilocks effect’ after the girl who chose porridge which was not too hot or too cold, but just right. When there are only two options, as in the first bar, both choices are extreme. One is the highest and the other is the lowest option, so people can’t use this as a criterion. When there are three, the middle option becomes very attractive regardless of its intrinsic benefits.
The other explanation for this – and both reasons are true to some extent – is called diminishing marginal utility. This essentially means that the taste difference between the best and second-best wine is smaller than the difference between the second and third. But the price difference is just as great, or in this example greater. Thus, when Keith compares the two cheaper wines he’s quite likely to want to upgrade to the higher of the two. When he goes on to compare with the most expensive, he’s less likely to want to upgrade a second time. This effect, combined with the anchoring phenomenon explained in Chapter 7, explains the effectiveness of the third option.
Years later, when I saw the variety of extra teapots being launched in the supermarket chain particularly – with their different flavours, sizes and chocolate quality – I recognised the same decoy effects at work. I was never quite sure which of the teapots were the decoys and which were the real products, but total sales were consistently higher in the stores that stocked the decoys than in those that decided not to.
How to apply it
There are two different approaches to implementing decoys in your business. The first is the asymmetric dominance approach, as used in the camera example in this chapter.
The analysis of values and benefit
s you did in Chapter 1 revealed the critical value dimensions of your product or service. For a tangible product like a camera, these dimensions may be features such as zoom level or battery life. For intangible services the dimensions may be the years of experience and expertise you have as a lawyer, and the insurance you carry to protect your clients from risk.
Look at the buying situation, where the customer is comparing your product or service with those sold by a competitor. Work out on which value dimensions (or benefits) your offering is better than theirs, and on which dimensions theirs is better. If your product is better in every dimension, the customer would already have bought it! So the competition must have some kind of advantage, even if it is only a cheaper price, or a more familiar brand.
Let’s say that your product has a longer battery life (eight hours versus five), but theirs has a better zoom level (18x versus 16x). This gives people a genuine reason to stop and think: which product they choose depends on them trying to figure out whether battery life is more important than zoom. Now you invent a new decoy product which is dominated by your original product. In this case, the decoy has a slightly shorter battery life (seven hours) than your original product, and is about 3% more expensive. Clearly nobody will want to buy that one. But adding it to the shelf will make your real product more attractive.
The general principle is to introduce a second product which is slightly inferior to your main product in all (or most) of the benefits. This will distract the customer from the competitor’s product.
Price-level decoys are a simpler technique to implement. Whatever your service, simply look at the options you are offering to a typical client. If you offer three options already – as long as they have different price points – you don’t need to do anything. You are already implicitly offering a decoy.
The Psychology of Price Page 9