Issue 19 | 2016 Complimentary article reprint Who’s buying your pricing strategy? Applying behavioral insights to understand the psychology of pricing By Timothy Murphy and Richard Hayes About Deloitte Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about for a more detailed description of DTTL and its member firms. Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. 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Applying behavioral insights to understand the psychology of pricing By Timothy Murphy and Richard Hayes Illustration by Jon Krause Dust off your microeconomics text- book and read about “econs”: fully rational, always calculating indi- viduals who make decisions with actuarial precision. Econs view companies’ negotiation tactics and sales promotions as useless clut- ter, obstacles to avoid as they try to maximize their utility. www.deloittereview.com 158 Who’s buying your pricing strategy? In this vein, a few years ago, J. C. Penney de- running periodic sales and promotions. The cided to remove the noise and offer customers good news: Since reverting back to this model, straightforward prices that reflected “everyday J. C. Penney’s earnings have increased sub- low prices.”1 The retailer’s goal was to make stantially, even relative to the competition.4 things simple, cut through the distractions, These phenomena aren’t confined to only the and offer prices that would pave a path to purchaser experience. Frontline salespeople profitability while balancing consumer market also succumb to behavioral biases, which can demands. But what seemed like an attractive affect their ability to maintain price points. policy on PowerPoint yielded disturbing re- This means that organizational leaders should sults: Store traffic decreased by 10 percent and strive to ensure that their sales representa- sales plummeted by more than 20 percent.2 tives are complying with their firm’s carefully Though hindsight would suggest that this was planned strategies and not succumbing to a bad idea from the start, at the time it seemed these same cognitive inclinations. Two com- as rational as the economics textbooks would mon pricing pitfalls organizations face: advise. In fact, after the announcement to offer “fair and square” pricing, J. C. Penney’s stock 1. Underestimating the importance of immediately rose.3 But behavioral economics reference points. “Anchoring”—the ten- teaches us that straightforward policies do not dency to give disproportionate weight to an always yield straightforward results. Unlike opening number—can drive customers’ re- econs, humans instinctively consider a number actions to pricing far more than “objective” of other factors when measuring the merits of arguments. This suggests the need to pay a purchase. They are often accustomed to an- close attention to both the opening offer choring on reference points—that is, relying and any external perceptions of value upon heavily on an opening number, such as a car which customers may anchor. manufacturer’s suggested retail price (MSRP). They are also highly sensitive to how much 2. Allowing sales representatives to un- their neighbors paid for the same product. And dercut themselves—and the organiza- timing matters. Consumers can be fickle, and tion’s pricing strategy—even before the behavioral sciences suggest that is com- setting a price. For salespeople, losses pletely natural, even if not necessarily rational. can loom larger than gains; they often fear turning away an opportunity to close a deal. In the case of J. C. Penney, many customers “We can’t charge that!” is a common worry were accustomed to, and comfortable with, when salespeople lack confidence in the typical pricing practices—that is, presenting merchandise with relevant price points and www.deloittereview.com Who’s buying your pricing strategy? 159 company’s pricing strategy. Taking a step back, the numbers may suggest otherwise. If people are provided with rele- There is hope. By confronting these mistakes vant information, they have the head-on, organizations can set up guardrails ability to discern market value— that account for behavioral biases and faulty but our cognitive tendencies execution. Following are some tactics leaders find it more attractive to anchor can use to develop more behaviorally savvy on an easy-to-reference value. pricing strategies and help their sales organi- zations carry them through to execution. effects on their perceptions of value.6 Since IT’S A TRAP! HOW COGNITIVE BIASES then, further research has shown that the tie to HINDER WELL-INTENTIONED PRICING reference points goes even deeper—that people “You hear about how many fourth-quarter will often anchor on the chosen reference point comebacks that a guy has and I think it means even when other relevant market information a guy screwed up in the first three quarters.”5 is readily available to inform their decision —Peyton Manning making. OR fans, there’s nothing better than a big An experiment conducted on real estate values, comeback, and nothing worse than the in which trained negotiators were assigned the immense heartbreak that comes from let- role of either the seller or the purchaser, il- F lustrates this point.7 Participants were given ting it all slip away. People can be profoundly affected by where something starts and how a brochure with relevant property and mar- it finishes. And this doesn’t stop with fandom. ket information to inform their negotiations. When someone buys a new car, one of the first Four groups were randomly provided with things you might hear is how much of a dis- brochures that had one of four options: a high count they received from the list price. Or if an asking price, a low asking price, a market ask- airline adds a $30 surcharge for checking in an ing price, or no asking price at all. After the extra bag, a grumbling customer may feel tak- negotiation was completed, the results showed en advantage of (even if the total price is still that both sellers and purchasers systemati- cheaper than an alternative carrier). cally overweighed the importance of the ask- ing price, despite having other relevant market The role of reference points information readily available. Those with high Daniel Kahneman and Amos Tversky, in their asking prices started with higher opening bids Nobel Prize-winning work, demonstrated that and negotiated prices. The reverse occurred for the reference points people pick have drastic the low-asking-price group. And, as would be www.deloittereview.com 160 Who’s buying your pricing strategy? assumed, the market-consistent asking price bet unless they could win at least $200 for the held constant. The most interesting finding: risk of losing $100.9 This indicates that people Those with no asking price settled upon the ex- are loss averse: They hate losses twice as much pected market value when all that they had to as they enjoy gains. rely upon was the property and market infor- Even when market conditions suggest that mation. This suggests that, if people are pro- price increases are warranted, people may feel vided with relevant information, they have the like they are being taken advantage of; conse- ability to discern market value—but our cogni- quently, the feeling of “losing” hurts even more. tive tendencies find it more attractive to anchor Behavioral economist Richard Thaler demon- on an easy-to-reference value. strates how a market-based price change can Under these circumstances, it’s no wonder that elicit negative customer sentiment:10 people preferred J. C. Penney’s reference point The morning after a blizzard, a hardware discounts. They offered an easier means to store that has been selling snow shovels for determine or, more accurately, perceive market $15 raises the price to $20. Is that fair? People value—especially when other relevant market hate it. Now I asked my MBA students that value information was not easily accessible. question and most of them thought it was just One loss is worse than two wins fine. After all, that was the correct answer in a When developing pricing strategies, it’s also different course, right? In their microeconom- important to understand how people view loss- ics class, they would say there’s a fixed supply, es. According to traditional economic theory, if demand shifts to the right, and the price goes we win $10, we should be just as happy as we up. Now what do real firms do? Well, after a would be upset if we lost $10. In practice, this hurricane the cheapest place to buy plywood is rarely the case. will be at [for example] Home Depot in the regions where the hurricane hit.