Strategic Pricing:

Theory, Practice and Policy

Professor John W. Mayo

mayoj@georgetown.edu

The Psychology of Pricing

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The Psychology of Pricing

• Normally, the foundation of demand begins with a consumer’s dependent on the goods she consumes: Ui=U(q1i,q2i, …qni)

• But what if consumers’ utility also depends on the consumption of other consumers:

Ui=U(q1i,q2i, …qni; q1k,q2k, …qnk )

• In this case an individual i’s utility depends upon the

quantity of goods consumed by consumer k

• Seminal work is Leibenstein (1950)

Functional and Nonfunctional demand

• Functional demand: demand attributable to the inherent properties of the good or service

• Nonfunctional demand: demand attributable to other factors

Nonfunctional demand

• Ui=U(q1i,q2i, …qni; q1k,q2k, …qnk )

• Bandwagon effect• ∂Ui/∂q1k >0. Examples???

• Snob effect Examples???• ∂Ui/∂q1k <0.

• Veblen effect Examples???• ∂Ui/∂p1k >0.

The Bandwagon Effect

Let qi = f(p, Qα) for every consumer i facing a market demand given by Qα. ThenA series of market demands can be drawn Dα … Dn

Dα Dn

α n

The only “equilibrium” demand curve isGiven by the locus that aligns The expectations of consumers and reality

$/Q

Q

Note that to the extent thatDemand for a product Includes bandwagon effects, marketDemand becomes more elastic

The Snob Effect

Let qi = f(p, Qα) for every consumer i facing a market demand given by Qα. ThenA series of market demands can be drawn Dα … Dn

Dα

Dn

α n

The only “equilibrium” demand curve isGiven by the locus that aligns The expectations of consumers and reality

$/Q

Q

Note that to the extent thatDemand for a product Includes bandwagon effects, marketDemand becomes less elastic

The Veblen Effect

Let qi = f(p, pα) where p is the “real” price and pα is the price that other people believe the consumer paid for the good. Then a series of market demands can be drawn Dα … Dn that correspond to consumers beliefs that α…n are the “conspicuous prices”

Dn

(p,pα)

(p,pn)

The only “equilibrium” demand curve isgiven by the locus that aligns The expectations of consumers and reality

$/Q

Q

Note that to the extent thatDemand for a product with Veblen Effects may be upward sloping

D3D2Dα

The Role of “the first price” in final transaction prices

• Consider real estate market, car market, flea market

• Seller establishes a high price to “anchor” the final price

• But might a low initial price ever lead to a high transaction price?

• Ku, Gallinsky and Murnighan (2006)

Yes

• Lower initial prices encourage more bidders• Bidders may (contrary to economic advice) view

early bids as sunk and be subject to the “escalation of commitment”

• A lower initial price attracts bidders, which attracts additional bidders

• bidders may judge value by the number of other bidders chasing the good (the empty restaurant problem)

Bidder valuation

Bidder “valuation

Number of Bidders

High ask priceLow Ask price

Lower ask price attracts more bidders

Bidder valuation

Bidder “valuation

Number of Bidders (n)

If bidders valuation =f(n), the presence of other bidders will shift the distribution

Which restaurant do you prefer?

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You Get what you pay for…Placebo Effects and Prices

• Shiv, Carmon and Ariely, JoMR, 2005• Well known that marketing can affect

perceptions…high price can create the perception of high quality

• But can high prices affect actual quality?

You Get what you pay for…Placebo Effects and Prices

• Four studies• Twinlab Ultra Fuel (TUF)

• Subjects were given TUF. Some were told that TUF was high price, some low price. Subjects rated (1) intensity of workout; (2) fatigue

• Results: subjects reported greater intensity of workout and lower fatigue with high priced TUF. A placebo effect of prices?

• Shortcomings:• (1) perceptions of performance, not actual; (2) no control group;

(3) subjects did not pay for TUF; and (4) no ability to discern casual effects

You Get what you pay for…Placebo Effects and Prices

Price

Regular Discount

Expectancy

High

Low

Experiments 2,3,4: Test placebo-price effects for SoBe Adrenaline Rush.Test: actual performance, paid prices with “expectancy” and price variation

You Get what you pay for…Placebo Effects and Prices

Puzzles Solved

Low Expectancy High Expectancy

= discount price

= regular price

Result: Expectancy mediates the placebo-price effect

Freeconomics:The Psychology of Zero

• Country clubs reservations

• Telephone calls in expanded local calling areas

• What happens to aggregate demand if one of your products is “free”?

• Washington Post and Washingtonpost.com• Gentzkow (American Economic Review 2007)

Pricing in Pieces: “Plus Shipping and Handling”

• Many firms partition the price of their “final” good into pieces (e.g. a book plus S&H)

• A “rational” consumer would be indifferent to the allocation of unavoidable charges

• Yet, it is often suggested that consumers may have “mental accounts” that partition off these separate charges and only pay attention to the “list” price

• Evidence?

Evidence

• Hossain and Morgan (Advances in Economic Analysis and Policy, 2006)

• 80 auctions on eBay of CDs and Xbox games• Varied reserve price (minimum payment) and

shipping and handling• Result: Setting a low open bid and a high

shipping and handling cost yields systematically more revenue than doing the reverse.

Big Sale: This weekend only!(“The Marlo Effect”?)

• Consumers often “discount discounting”. Why?• General consumer skepticism of exaggerated claims

• Consumers’ inability to correctly perceive discounts

• If latter, then how to improve consumers’ ability to process price information

• “Pay 80 percent” v. “Get 20 Percent off”

• Norm in US is “X percent off” while in other places (e.g., Hong Kong) “pay 1-X percent”

• Should this make a difference?

Kim and KramerMarketing Letters, 2006

• Ho: Consumers’ likelihood of purchase increases with “novel” presentation of price discounts

• H1: Consumers’ recall of prices will be greater with “novel” presentation of price discounts

• H2: Effects of “novel” discounts will be greater if denominated in percentages instead of dollars

Methodology

• U.S. students asked to rate likelihood of purchase of a Sony Digital Camera

• Results: (Ho)Novelty of presentation (pay 80 percent) significantly enhanced likelihood of purchase

• But only US students … so repeat study with us and Hong Kong subjects. In each case “novel” presentation enhanced likelihood of sale

The Effects of Novelty

Likelihood of purchase

Get 40% off

Pay 60%

US Hong Kong

Note that when test was run with discounts in dollars, effects of novelty dissipate