Chapter Nine

Introduction to – Cognitive Pricing

The concept of Mental Accounting is a significant factor in the selection of product or service pricing. Professor Richard Thaler of the University of Chicago was the first to coin the term, Mental Accounting. He developed the following scenario. An individual called Mr. A is a lucky fellow as he has just won money from two separate lottery tickets, $50.00 on one ticket and $25.00 on the other. Another individual, Mr. B has just won $75.00 on one lottery ticket. From a strictly economic point of view, both of these gentlemen have increased their wealth by $75.  When individuals in the experiment were asked who they thought was happier, the overwhelming majority believe Mr. A was happier as he received the good news of a lottery win on two separate occasions. Mr. B, on the other hand, won the lottery only once. 

People agree that it's better for good news to be spread around. Now consider purchasing three Christmas gifts for your immediate family members. Would you wrap them all in one big box or would you wrap them individually and separate them out? For the most part, in our western culture, we would rather separate them out. When the news is good, it is natural to want to spread it all around.

What if the news is bad? Mr. A just received two unfavorable letters from two different tax authorities. The United States federal government informed Mr. A that he owes an extra $100.00 on his federal taxes. He also receives notice from the state of Pennsylvania indicating that he owes $50.00 on his state taxes. As a result of these letters, the poor guy has to come up with $150.00 to pay the tax authorities.
Now Mr. B also received some bad news as he learned he owes $150.00 in taxes solely to the federal government. Here again, we have two individuals who have both been given the same negative information, each of them owing $150.00. Because Mr. A has received two negative hits, most people polled in the experiment believe that Mr. A will be more adversely affected than Mr. B. This inference reveals that bad news should be integrated together, and good news should be spread around.
What does this mean for pricing? Suppose a company charged customers different prices for three or four different items. The company would be better off conveying its price information as one packaged price rather than itemizing each piece. If we think back to the financial crisis, there was an exciting example of this on a grander scale. You may recall the federal government of the United States bailed out banks and other institutions to the tune of about $750 billion. That resulted in a lot of negative information at one time. One would think that people would become especially annoyed when they saw that $50 billion was going to this bank, $100 billion to that bank, and so on. A highly detailed listing of negative items results in a disproportionately adverse effect. Bad news should be integrated all together.
Mixed news makes it intriguing concerning pricing. Imagine my friend Mary who prefers to commute here to school by bike. For the sake of argument, let's presume that poor Mary's bicycle is stolen. It's going to cost her $180.00 to replace it. Chris' bike is also stolen, as it was valued slightly more than Mary's; it will cost him $200.00 to replace his bike. On the way to get lunch in the Huntsman Hall cafe, Joe finds a $20 bill on the ground. Mary is out $180.00, Joe is out $200.00, but now that Joe found $20.00, he's just out $180.00. Well, who's happier?
It turns out that Joe is happier as a result of something called the silver lining principle. Here he was $200.00 in the negative, but the unexpected additional $20.00 made him feel slightly better. How does this translate into pricing? Suppose I'm trying to sell you a car for $20,000. Instead of charging the flat rate of $20,000, I might be better off pricing at $22,000 and then offering a $2000 rebate!
This strategy was used by Chrysler in 1975 during the Superbowl. Joe Garagiola, the former major league catcher, and MLB announcer with characteristic enthusiasm,  touted Chrysler’s Car Clearance Carnival. A festive event with balloons, marching bands, and a raffle to win the use of a new car for a year. However, the big announcement was that anyone who came on down and bought a new Plymouth Duster or Dodge Dart would get a check for $200 ($950 in today’s dollars) direct from Chrysler. Those who traded in specific competitor models—initially a Ford Pinto or a Chevy Vega—got another $100. The simple message “Buy a car, get a check!” reverberated with customers. Reference Hemmings stories
Your customers (and you) are constantly looking for cues on what to do and how to behave. Kristen Breman suggests that we make decisions based on  salient and relative comparision points. She provides four of the most salient behavior economics concepts as they relate to price in this article. How to price a product using behavior Economics At its heart, pricing is an expression of what people value, but this isn’t always based on our rational evaluation of value.
The next theory we will introduce is the Prospect Theory, which has compelling implications for pricing. Prospect Theory was developed by two psychologists, Professor Daniel Kahneman, who still teaches at Princeton University, and the late Professor Amos Tversky of Stanford University. Although Kahneman has also written several other important documents, the Prospect Theory is arguably most notable as it earned both professors the Nobel Peace Prize in 2002. Macroeconomics teaches us that you and I are supposed to be indifferent to outcomes that have the same expected value. As a simple illustration, let's imagine a friend Mary offers to give you a $100 bill outright, or you can take the following gamble. “The gamble is,” she says. “I'm going to toss a coin. If the coin comes up heads, I'll give you $200.00. If it comes up tails, I won't give you anything.”
Think about that. A guaranteed $100.00 is $100.00 in your pocket. The gamble also has an expected value of $100.00 because 0.5 times $200.00 plus 0.5 times zero also equals 100. Therefore, the expected gain from these two examples is identical. A rational, calculating person should be indifferent between these two options. Conceivably you have a preference, and I have one as I would take the $100.00 for sure. Professors Kahneman and Tversky found when guaranteed positive options were offered, such as receiving money, most people prefer the sure thing rather than the gamble even though the expected value was the same. From this line of thought, the Prospect Theory was developed.
The Prospect Theory has three essential points
  • People have an internal reference point where they expect certain things from stimuli such as price.
  • People respond differently to deviations from the reference point, regardless of whether the expected outcome is positive or negative.
  • Diminishing sensitivity.
The windfall gain of $0.25 made you happy. The transaction resulted in your reference point shifting from a $1.00 to $0.75 as it was affected by the experience that you just had. The next day when you return to Starbucks expecting to pay $0.75 and the price has gone back up to a $1.00, you have now encountered a loss of $0.25. The loss is the same size as the previous gain. This loss causes you to feel unhappy, emerging from a phenomenon called loss aversion that implies the pain of the loss might be twice as much as the pleasure of the gain. The idea here is that when a product has been discounted too often and then raised back to the regular price, the internal reference point is driven down. This results in a loss that consumers will negatively react to. A critical factor in loss aversion is that people will steer away from potential losses, an important implication of this theory.
“For most of human history, there truly was a strong correlation between cost and value: the higher the price, the better things tended to be — because there was simply no way both for prices to be low and quality to be high. Everything had to be made by hand, by expensively trained artisans, with raw materials that were immensely difficult to transport. The expensive sword, jacket, window, or wheelbarrow were always the better ones. This relationship between price and value held true in an uninterrupted way until the end of the Eighteenth century, when – thanks to the Industrial Revolution – something extremely unusual happened: human beings worked out how to make high-quality goods at lower cost  due to technology and new methods of organizing the labor force.”
“The price of something is principally determined by what it cost to make, not how much human value is potentially to be derived from it. We have been looking at prices in the wrong way: we have fetishized them as tokens of intrinsic value, we have allowed them to set how much excitement we are allowed to have in given areas, how much joy is to be mined in particular places. But prices were never meant to be like this: we are breathing too much life into them, and therefore dulling too many of our responses to the inexpensive world.” reference The Book of Life
The usual model of loss aversion is a process called value encoding: When a decision-maker first sees an option, they immediately compare it to a reference point—how much money they have, or what the price of an item usually is—and judges relative to that whether it is a loss or a gain. When it is time to decide the person picks the option that feels best compared to the reference point, with the sense that they have gained the most or lost the least.
Another potential mechanism is called value construction. In this process, people do not just store or encode a value for each option right away. Instead, they build up a preference as they learn about the different options available. Decision-makers do not objectively assess their options; however: each new piece of information biases what information they look for next  and what they make of it. Earlier studies of value construction have shown, Böckenholt says, that “people try to find, as soon as possible, something that stands out. And then, after they’ve found an option that stands out, they more or less try to confirm it by seeking out supporting information. This can be useful if they have honed in on the right option early on, or disadvantageous, if they are overlooking something better.” retrieved from The emotion of Loss a KelloggInsight based on the research of Martijn C. Willemsen, Ulf Bockenholt, and Eric J. Johnson
Recapping pricing to value, first and foremost, keep in mind the framework for inputs to the pricing process.
  • Determine the product's marginal cost and do not price below it as that is your floor price.
  • Determine the customer's willingness to pay as determined by their price sensitivity. This is the ceiling.
  • Learn how much the price may have to be reduced due to pressure from the competition.
  • Determine how much the final consumer price should be raised to give the distributor or business partner a margin to work with.
The fundamental pricing strategy question is: To maximize household penetration, should I take my average portfolio or brand price up or down? Many believe microeconomic theory dictates that the only way to increase reach is to lower prices. Yet pricing up is almost always better than pricing down in the long run. Extending reach requires innovation and marketing—and you need higher prices to fuel investment in both. Competitors have a much harder time following world-class innovation and marketing than they do lowering prices.
These are the four factors that regulate price. As part of the framework, we also discussed the notion of customer sensitivity and how it could be measured. Remember that pricing wouldn't be as much fun, complicated or intricate without all of the aspects of human psychology that come into play. Prospect theory, mental accounting, and endowment fate are all included here.
In assessing what material things are essential and worth paying attention to, we’re oddly prejudiced against cheapness – and frustratingly drawn to the expensive, for reasons that don’t necessarily stand up to examination. This video on the price history of the Pineapple from The School of Life is an interesting example. Enjoy!
For more information on pricing theory, read: Priceless, The Myth of Fair Value (and How to Take Advantage of It) and Price Cues and this Fast Company article describing the concept of allowing customers to determine their own price: Inside Five Businesses That Let Customers Name Their Own Price

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