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key barrier to profitable pricing methods

Quick…how would you feel if I said you had no choice but to raise prices on all your products by 20% today? Write down your immediate reaction.

I smell fear. And you don’t even have to tell me what you wrote.

When I first started in business, I thought pricing was a matter of understanding factual numbers like costs and profit margins. I was wrong. The question above shows there’s much more to profitable pricing than mere numbers.

How the Unconscious Mind Sways Your Pricing Strategy

Although numbers are indeed a vital part of the pricing process, emotions govern how pricing works to a far greater extent than you might imagine.

The best marketers figured this out decades ago. Yet brain science is just now catching up and confirms much of what advertisers and sales people have long known. The unconscious mind directs more of our conscious, rational thought than we might care to admit.

Steve Ayan, writing in the Scientific American about unconscious processes,

“Higher cognitive processing in the cerebral cortex can occur without consciousness. The regions of the brain responsible for the emotions and motives, not the cortex, direct our conscious attention.

Recent research indicates that conscious and the unconscious processes do not usually operate in opposition. They are not competitors wrestling for hegemony over our psyche. They are not even separate spheres, as Freud’s later classification into the ego, id and superego would suggest. Rather there is only one mind in which conscious and unconscious strands are interwoven. In fact, even our most reasonable thoughts and actions mainly result from automatic, unconscious processes.”

If you want to see evidence for yourself, ask a fellow business owner the question I asked in the beginning.

Reactions of course will vary. But I suspect that in their answer, you’ll see defensiveness and rationalizations in support of the status quo. That’s evidence of the unconscious at work in us as business owners.

You also see the unconscious at work in consumer behavior. In Pricing and the Psychology of Consumption on the Harvard Business Review, John Gourville gives this example.

“Two friends, Mary and Bill, join the local health club and commit to one-year memberships. Bill decides on an annual payment plan—$600 at the time he signs up. Mary decides on a monthly payment plan—$50 a month. Who is more likely to work out on a regular basis? And who is more likely to renew the membership the following year?”

Rationally speaking, you would guess that both are equally likely to renew since they’re paying the same amount. They can each get the exact same value by working out the same.

Yet their research shows Mary is far more likely to both work out and renew at the end of the year.

When Mary is reminded monthly of her cost, she is more inclined to use her membership. That’s her subconscious at work. At the end of the year she sees results from the regular workouts. And the health club sees results from her renewal. Bill’s usage declines as his one-time payment fades into memory.

Of course, drawing attention TO the price is extremely counter-intuitive for business owners. We tend to minimize the price in bundled packages, season tickets, advanced pricing, etc. Harvard’s research shows that “hiding” or minimizing prices reduces customer usage of the product, which in turn reduces customer retention.

Now I’m not saying you should raise prices 20% or change all your pricing methods today. I’m simply suggesting that emotions—yours and your customers—need to be factored into your pricing decisions.

In talking to many business owners through the years, I’ve found that the reluctance to increase prices is frequently based on something in the owner’s mind rather than in the consumer’s.

Because the psychology of pricing is frequently counter-intuitive and puzzling, researchers have been investigating it for years. One popular tactic has been in use as long as people have been selling products. For decades researchers have tried to disprove it, yet they can’t stop it from working, even when their subjects are aware of it.

Here’s what happens.

Your Pricing Strategy and The Ultimatum Game

Scientific studies about how the brain works are proving what advertisers and marketers have long known—emotions and the subconscious rule our pricing decisions.

For instance, how would you feel if someone offered you $100? Pretty good.

“How would you feel if the $100 was your share of a $1,000 windfall—and your “partner” [the proposer] had unilaterally decided to keep $900 for himself? That wouldn’t feel so good.”

That’s from William Poundstone in Priceless—The Myth of Fair Value (and How to Take Advantage of It). (Well worth reading if you want to master pricing strategies!)

The contrast between the two scenarios stirs up emotions about fairness and these emotions will always influence actions. In study after study, it’s been found that everyone has a “reserve price,” a point at which they reject such an offer, even though they would be receiving free money. Such a scenario has come to be known as the ultimatum game.

The first study on the Ultimatum Game was published by game theorist Werner Guth in 1982. Since then, studies of the ultimatum game are practically an academic industry. The basic setup is that one person (the proposer or offeror) must split a windfall with a responder. The responder either accepts or rejects the offer. Rejection means no one gets any money.

One of the original studies found that the reserve price averaged $2.30 on a $10 windfall. In other words, if someone found $1000 and offered you $230 or less, you’d punish yourself and the proposer for violating your idea of fairness. No one gets any money.

If we were rational about money, the responder would never turn down free money, even a pittance. It doesn't make sense.

If we were rational, the offerer wouldn’t worry about the amount being offered, knowing that the rational responder will take whatever he offers.

Since that original study, academics have been trying to disprove it, because it goes against classical economic theories about man, which claim that we are governed by rational decision-making.

Yet every study confirms that strong emotions are at play when it comes to money. It’s been found that even when study participants know how the ultimatum game works, they still fall prey to emotional, irrational responses. In other words they decide to deprive everyone of a windfall because it doesn't "feel" fair.

So what does all this mean when it comes to setting prices for our products and services?

1) You can’t ignore emotions, especially the perception of fairness. But what is fair? How can we know if we’re doing something that will be perceived as unfair? After all we’re talking about emotions here, along with cultural norms for fairness, both of which change with the nightly news.

2) Price is not a math problem, says Poundstone. He continues, “…it’s an expression of desire or a guess about what other human beings will do (accept your offer or turn it down). You name a price that “feels” about right…price numbers are influenced by factors that the conscious mind would reject as irrelevant, irrational, or politically incorrect.”

Meet the Irresistible Force in Product Pricing Methods

One of the most irresistible forces in pricing strategy is “anchoring”. Its power comes, once again, from the human subconscious, and not the rational mind. As with the irrational idea of fairness in the ultimatum game, no one is immune from the effect of anchoring.

A couple of famous experiments illustrate how anchoring works.

In a University of Wurzburg experiment, a researcher took a ten-year-old car to sixty German mechanics and dealers, people who were considered “experts” on cars.

The researcher said his girlfriend dented it and he wasn’t sure it was worth fixing. He mentioned that he thought it was worth 2,800 marks and then asked if the mechanic thought the value too high or too low.

The average repair estimate was 2,520 marks. Next, the researchers did the same spiel with a different set of mechanics, but this time said they thought the car was worth 5,000 marks. The average estimate was 3,563 marks!

That’s 40% more, simply because the casually mentioned price was higher! Mind you, these experts in auto repair had the car right in front of them. Rationally speaking, the car's worth is irrelevant to the cost of repair.

No one is immune. The subconscious mind, in its quest to maintain the status quo, says, “Let me think of reasons to justify the price mentioned.”

More Examples of the Anchoring Effect in Pricing

Another controversial experiment by Northcraft and Neale at the University of Arizona tested whether experienced real estate agents could be unconsciously swayed in their perception of home value. A group of college students was used as a control.

A home was shown to both realtors and students. It had been appraised at $135,000 and listed at $134,900, but no one in the experiment saw this pricing.

Instead, they were given one of four fictitious listing prices: $119,900, $129,900, $139,900, and $149,900. They are then asked to price the home and were given MLS sheets for the house containing comparable listing prices and all relevant property info.

Here are their estimates according to the listing price they were given.

price anchoring study real estate

Remember, these people are all looking at the same house, and everyone had the same relevant data.

With a simple mention of fictitious higher listing prices, the amateurs increased their estimate by about $30,000.

The professional real estate experts increased their estimate by $16,000.

When presented with these findings, hostile real estate agents completely rejected the findings, claiming that anything can be proved with statistics.

But they missed the point. What matters is how the unconscious human mind works. It gathers huge amounts of data from the world around it, processes it, and offers us shortcuts to guide our behavior.

In our real estate example, the unconscious is telling the subjects that there must be a reason for the listing price.

Thus, they seek reasons to justify their price estimates in relation to it. The “anchor” always sways the subconscious, even if the anchor number is pulled out of thin air.

Ironically, anchoring is routinely used by real estate agents in negotiations. Low offers and high listing prices are anchors. All modern business or labor negotiations use anchors.

Think about jury awards. Anchoring is how lawyers present potential settlements to get huge awards.

In the notorious McDonald’s coffee case, a woman was awarded $2.9 million for spilling a coffee on herself. (It was later settled for $600,000—still an unprecedented award.)

How’d the lawyer get that unprecedented award? He said he was “only” asking for one or two days of McDonald’s worldwide coffee sales as an award. To prevent them from having to do any real math, he told them that number was $1.35 million dollars. The jury bit, completely influenced by the anchor.

Anchoring has been studied and is used in business negotiations, retail stores, casinos, and restaurants. (How many people actually order the $125 Wagyu steak? Not many. But it makes the $55 steak seem like a bargain.) A simple price tag like the one below is an example of anchoring.

example of anchoring on price tag

Here's another classic example to illustrate the power of price anchoring.

When Steven Jobs was introducing the iPad, his discussion on pricing starts with $999 displayed prominently on the screen behind him.

It remains there for a couple of minutes as he talks about the technical problems they had to overcome in creating the iPad. He finally announces a retail price of $499 to much relief and applause (at around 1:00 in the video.)

And of course, the iPad was indeed a great success. People were happy to pay $499 instead of the rumored $999.

For decades, academics have tried to prove or disprove the effect of anchoring on our behavior. To my knowledge, no one has disproved it. It’s a force of the sub-conscious human mind that shouldn’t be ignored, especially in business.

What are we to make of this as business owners?

Are we going to the dark side if we study and use anchoring in our pricing strategy?

Are there any limits to how far anchoring can move people on pricing?

Is there an antidote to anchoring?

Is Price Anchoring Right or Wrong?

So, how do you feel about price anchoring? Is it a shifty parlor trick or is it just good business?

And is there an antidote to anchoring?

Two Vital Components to Pricing

For me, pricing is first and foremost tied to two important factors—motivation and value.

A long time ago a colleague explained that if my product or service can help people, I have an obligation to get it out to as many people as possible. It changed how I thought about marketing and sales. It changed my motivation.

It wasn’t about trying to get people to give me money in exchange for a product or service. It was about my duty to be of value and service to my fellow humans.

That’s a good reason to get up in the morning. If your product or service improves the lives of others, it has tremendous value. You have a duty to bring it to the world, to everyone it might help.

But value is determined by the customer. Your job, then, is to convey that value to your customer and convince them that the price you set is but an honest fraction of the value provided. (That’s return on investment). A good price also covers your costs and makes a profit so you can stay in business.

The use of anchoring is simply a way to frame your value proposition so that customers are more emotionally open to it than they might otherwise be.

Had Steve Jobs started with $499, buyers would have felt differently about that price, more skeptical. Many people who today sincerely value their iPads may not have been inclined to buy.  Instead, thanks to smart use of anchoring, they were relieved.

The actual value of the iPad didn’t change one bit with his use of anchoring; only the perceived value did. Consumers were in a better state of mind to digest a $499 investment than they would have been without the anchor effect.

But this isn’t what I see in the real world. Instead there is a tendency to de-value, and thus under-price products, especially with new, inexperienced business owners. This is typically based on fear of not doing well and of not gaining traction against competitors.

As you might imagine, fear-based strategies don’t hold up. Fear is not a good motivation for the seller, nor does it center on value for the customer. It creates a race-to-the-bottom pricing strategy in which the owner believes low prices are of prime importance. It attracts dis-loyal customers who disappear as soon as they find a lower price.

With low-price competition, anchoring is nevertheless in play, except it’s pulling your prices downward.

Of course, you can’t ignore competitors and other factors in your pricing decisions. They are but one factor—not the only one—in how you present your value to the world.

Antidote to Price Anchoring

The antidote to anchoring is quite simple. When presented with a price as a buyer, take a moment to “consider the opposite.”

Think of reasons why that price might be unreasonable. Discuss those reasons with the person quoting the price and if needed, with others. It’s common sense but anchoring studies mentioned in Poundstone’s book prove it to be a good antidote.

As a seller, it’s reasonable to expect the buyer to consider reasons why your price may not be right…for that particular buyer. These are objections which need to be handled. And if you’ve done your due diligence, you’re prepared.

What if You’re Selling a Lousy Product?

Don’t. Either fix the product or find another company to work for or find a new line of products to represent.

If your product has minimal value and your motivation is to get a quick buck, you’re headed into a gray ethical area. Sure, you might do OK for a while but long-term, it won’t serve you well.

Long-term success is always tied to consistently delivering value. Crappy products and services don’t serve you or your customer.

How Do You Feel About Pricing Your Products or Services?

If conversations about pricing your products make you squirm a bit, it’s a sign there are underlying, perhaps subconscious beliefs, that could negatively affect your decisions about setting prices.

The same holds true for anchoring. If your motivation and value is solid yet the thought of using anchoring makes you uncomfortable, it’s time to step back and reflect.

Such emotional disturbances prevent you from getting the best price for your product or service. The key is to embrace these “price disturbances” as a positive signal for strategic pricing action.

The Key to Profitable Pricing Methods for Small Business Owners

I think we can all agree that powerful emotions influence our behavior towards pricing, whether we are setting the price or buying the product.

Dozens of studies have shown that we humans seem to be quite powerless over these psychological factors that affect our behavior, especially that of “anchoring.”

Yet whether we’re buyer or seller, we have a duty to ourselves and others when it comes to prices presented to us and prices we set for our products.

Our Duty as Buyers Towards Product Pricing

As buyers, we have a duty to be responsible with our resources (money) and with that which we buy or invest. The antidote to the anchoring effect is simple—consider the opposite. In other words, simply ask yourself if there are any reasons why the price being presented to you might not be right.

Once we’ve answered that question to our satisfaction (and others if we’re in a business setting) then we should be OK with our investment in that product or service.

Our Duty as Sellers Towards Product Pricing

As sellers, we have a duty to provide extraordinary value that surpasses the purchase price. After all, the buyer needs to get a proper return on investment, whether it’s a business or personal product.

As sellers, we also have a duty to make a profit so we can pay everyone, make a decent living, and stay in business.  This suggests that we should develop the skills and courage to set good, preferably premium, prices for our products and services.

Courage in the Face of Product Pricing Tactics

I mention “courage” because of the emotions that surround pricing, primarily fear.

Fear of losing customers,

...fear of being undercut by competitors,

...fear of losing market share,

...fear of leaving money on the table,

...and fear of failing.

Fear often prevents owners from setting and getting the best prices. It prevents them from living the kind of life they want and deserve.

Yet just as there’s an antidote to the anchoring effect, there is a way to remove the fears that hinder our pricing strategy.

There’s a way to eliminate those barriers and have your business start taking care of you, instead of you taking care of your business.

How would it feel to come in to work every day and not worry about cash flow?

To not have to worry about competitor’s prices because your positioning makes competitor’s pricing almost irrelevant?

To know you have money to invest in marketing, sales, or research projects that will grow your business even more?

To know you can pay your employees above-average wages?

It’s a good feeling. I’ve been at both ends of the pricing spectrum in my career.

In my first job as a print shop salesman, I was told to get down in the dirt with the price cutters. I did and it came to an ugly end. Many years later, I finally discovered and enjoyed the benefits of selling an extraordinary product with premium pricing.

What’s the Secret to Setting and Getting Good Prices?

It’s simple.

The best way to banish fear and emotion from decision-making is to rely on a system. A good system breaks the question of “what should we charge” into a step-by-step process that gives you a good answer based on everything but fear. And we can do this without sacrificing our intuition and experience.

A healthy, courageous approach to pricing is critical to success.

In one study of 1200 businesses, consulting firm McKinsey & Co. found that if companies raised their prices by just 1% while demand remained constant, profits would increase 11% on average. This small change to the consumer of a products' price meant a huge change for the companies themselves. It means huge improvement in quality of life for the owners.

The fact is, a good price strategy can get you price increases far beyond 1%. Yet too many owners fearfully resist any kind of talk about raising their prices.

How to Systematize Your Pricing Method

There are eight short steps to systematize your pricing method, for any kind of product or service.

First, always have an open mind. The Zen “beginner’s mind” is essential, especially when dealing with psychological hot buttons like pricing.

Second, define your customer. Get the right questions to ask about your customers so you can set prices that are affordable and demonstrate the right value to your target market.

Third, know your competitors. Research your competitors and market trends to avoid disastrous pricing mistakes.

Fourth, position your product or service. Take time to define your unique value and position in your market.

Fifth, create your pricing strategy. There are five major pricing strategies which can be used alone or in various combinations with each other. There are also seven powerful pricing tactics you can use within each strategy. More on this shortly.

Sixth, monitor your pricing. Keep track of relevant data that affects your pricing.

Seventh, get clear on when it’s appropriate to raise or lower your prices. Your customers give you signals that alert you it’s time to adjust pricing.  When it IS time to raise (or lower) prices, be sure you have the skills to do so without upsetting your customers. (And yes, it’s possible to raise prices peacefully. One time I was actually thanked by my customers for how we handled a price increase.)

Lastly, make your pricing methods a regular part of your management process. When you have a good system in place, it’s easy to set and monitor prices that maximize your profitability.

Final Thoughts on Pricing Strategies

As business owners we tend to focus on getting more leads and more customers, especially in a new business.

Yet a profitable pricing strategy can do more to change the way you live than almost anything else in your business.

You can certainly create your own pricing system from scratch by following the steps above based on your experience. Or you can quickly learn from my pricing experience and that of other successful business owners in many industries.

That’s why I’ve put together a new online course, Profitable Pricing Methods—How to Calculate the Best Selling Price for Your Product or Service.

It lays out a step-by-step plan to get you the prices your business deserves, without agonizing over every price decision, and without being unduly influenced by your own sub-conscious motivations and fears.

It gives you a working blueprint for the eight steps laid out above, so you don’t have to create them from the ground up.

Get more details on the Profitable Pricing Methods Course here.

Have a pricing story to share? Have a question about pricing? Let us know in the comments below.

And if you like this article, please share with your friends and colleagues using the social buttons.

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