The strategy any business follows to set the price of its products and services has a profound effect on its revenue and overall outlook. According to McKinsey, 1% increase in prices results in an average profit increase of 7.4% – provided that the volumes stay the same. However, customers naturally react to price increases and, hence, volumes after a substantial price increase may go down so much that the seller loses not only customers but ends up with less revenue than before. Accordingly, understanding the fundamentals of customer behavior and psychology is essential for any company that wants to set its prices right so that it can make a profit, stay competitive, and maintain/expand its customer base, all at the same time. When will people accept price increases, when is it fair for a firm to increase, maintain, or decrease its prices?
Perceptions of price fairness or unfairness have a huge impact on any business revenue. According to research done by the Boston Consulting Group (BCG), if a product matches consumer’s needs and they consider its price fair, 85% of them will be likely to buy the product. In sharp contrast, if the price is thought to be unfair by people, 92% of them will be unlikely to buy the same product. But what are the processes involved in the initial assessment of prices, how does a customer arrive to the conclusion that a certain price for a given product is either fair or unfair?
When unfamiliar with a product, customers can collect information from e.g. ads and conversation with other people. They form a reference price and compare it to actual prices; if the latter is higher than the former, the pricing is generally considered unfair. Pre-purchase reference points can be based on multiple factors including previous prices and the seller’s perceived profits. Similarly, BCG points out some of the factors at play when perceptions of fairness/unfairness are being formed:
- Has ambiguous effects:
- Decreases perception of fairness:
- Monopoly power
- Seller uses private data
- Friends, peers pay less
- Increases perception of fairness:
- Seller’s cost of bringing the product to the market
- Better quality
- Location differences
- Customer buying characteristics (bulk, loyalty, etc.)
These are all amplified by familiarity with the product and/or seller, trust in the seller, social norm adherence, etc. Familiarity, for example, increases perceptions of price fairness by 40% on average.
Even when one has data from the market and keeps all the above in mind, telling what customers will perceive as fair, unfair, or unethical often remains challenging. When it comes to pricing, there is no solidly defined line of morality – simply following the law will not necessarily result in ethical pricing. There are, however, a few guidelines that sellers may want to consider, as collected by Price Intelligently: avoid price fixing, bid rigging, price discrimination, price skimming, and price gouging (we already touched upon this last issue in our blog: see the first part of this series).
In the literature, perceptions of fair prices are described by the principle of dual entitlement: the customer feels entitled to a reference price, and thinks the seller is entitled to a reference profit. If customers believe that the seller makes an unproportionately large profit, they will see the pricing unfair. Similarly, customers consider price increases to be fair basically in three scenarios: if the product or service improved; if the seller’s costs of bringing the product or service to the market increased; or if their preferences changed due to a shift in their reference points. The latter is called framing effect: an expressive and important utilization of such an effect involves opportunity costs versus out-of-pocket costs. People often underweight opportunity costs relative to out-of-pocket costs: this is the reason why cancellation of a discount or the end of a sale is perceived as more fair than an outright price increase; or why people think it is fair for a seller to maintain its prices if its costs decreased.
Importantly, the dual entitlement principle cannot be really applied to dynamic pricing, as both reference prices and reference profits are fairly stable. Introducing dynamic pricing comes with additional challenges, and sometimes it is outright said to be unfair, but mainly because of the assumption that today’s fixed prices are fair. This is certainly not the case.
For more details about the essentials specifically about dynamic pricing, its introduction, and the customer psychology around it, stay tuned until the next episode of this series!
Until then, contact us for our special offers at [email protected].
Curtis P. Haugtvedt, Paul M. Herr, Frank R. Kardes: Handbook of Consumer Psychology
Boston Consulting Group: The Future of Value Pricing is Progressive Pricing