Chapter Nine

Introduction to – Cognitive Pricing

The concept of Mental Accounting is a major factor in the selection of product or service pricing. Professor Richard Thaler of the University of Chicago was 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 one $75.00 on one lottery ticket. From a strictly economic point of view, both of these gentlemen have increased their wealth by $75.00. When individuals in the experiment were asked whom do they think is happier, the overwhelming majority believe Mr. A is 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 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 various prices for three or four different items. The company would be better off conveying their price information as one packaged price rather than itemizing each piece. If we think back to the financial crisis, there was an interesting example of this on a grandeur 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 disproportionate negative effect. Bad news should be integrated all together.
Mixed news makes it intriguing in terms of pricing. Imagine my friend Amy who prefers to commute here to the Wharton school by bike. For the sake of argument, let's presume that poor Amy's bike is stolen. It's going to cost her $180.00 to replace it. Chris' bike has also been stolen, as it is valued slightly more than Amy's, it will cost him $200.00 to replace. On the way to get lunch in the Huntsman Hall cafe, Chris finds a $20 bill on the ground. Amy is out $180.00, Chris is out $200.00, but now that Chris found $20.00, he's just out $180.00. Well, who's happier?
It turns out that Chris is actually 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 charging $22,000 and then offering you a $2000 rebate! I'm confident you understand how the silver lining principle works.
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. In Macroeconomics, you and I are supposed to be indifferent between outcomes that have the same expected value. The following is a simple illustration. Let's imagine my friend Amy 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 a guaranteed $100.00. 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 completely rational calculating person should be indifferent between these two options. Conceivably you have a preference, I certainly 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. Thus, the Prospect Theory was developed. The Prospect Theory has three essential points to it that most other standard macroeconomic theories tend to lack:
  • People have an internal reference point where they expect certain things from a 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 effected 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. That is 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 simply 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 cheap prices, because of technology and new methods of organizing the labour 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, he or she immediately compares it to a reference point—how much money they have, say, 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 make a decision, the person picks the option that, essentially, 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”. reference The emotion of loss
Recapping pricing to value, first and foremost, keep in mind the framework for inputs to the pricing process. Initially determine the marginal cost and do not price below it as that is the floor. Next, determine the customer's willingness to pay as determined by their price sensitivity. This is the ceiling. Thirdly, determine how much the price may have to be reduced due to pressure from the competition. Ultimately determine how much the final consumer price should be raised in order to give the distributor or business partner a margin to work with. 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.
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 article on customers naming their own price: Inside Five Businesses That Let Customers Name Their Own Price

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