Use the Psychology of Pricing To Keep Customers

Returning
Editor's Note: Buyers are more apt to use a product right after they purchase it, a fact you
need to ponder as you consider how to keep customers coming back for more. In this e-mail
interview with HBS Working Knowledge's Manda Mahoney, Harvard Business School professor
John Gourville discusses the psychology of pricing and the merits of billing over time. Also, see
an excerpt from a recent Harvard Business Review article by Gourville and collaborator Dilip
Soman.

Mahoney: What are some first steps managers can take once they have decided to tackle their
pricing strategy? Are there critical points that must be considered when starting out?

Gourville: The first things managers need to do is to realize that price is multi-faceted. It's not
just about "What price do I charge?" It's also very much about "How do I charge?" Factors such
as how, when, where, and in what form all contribute to what we call the psychology of price.
You can take the very same physical price and break it up into parts, bundle it with other items,
ask for payment early, or ask for payment late, and change consumers'' perceptions of that
price in the process.

For instance, in the current research with Dilip Soman, we look at how different pricing
strategies affect the consumption of a product. We find that people are more likely to consume
a product when they feel "out of pocket." When the price paid for a product is very salient, they
want to "get their money's worth," so to speak. The net result is that consumers are more likely
to consume when a price is vivid and fresh than when it is obscured or distant. In the case of a
health club, this means that members are more likely to go to the gym right after having made
payments than later on in their memberships. Similarly, people are more likely to go to a ball
game when they have purchased tickets to a single game than when they purchased tickets to
multiple games. In the first case, the cost of that game is quite salient. In the second case, the
cost of any one game is bundled with the costs of all the other games.

In other research, I have investigated how the unbundling of price into routine payments affects
the decision to purchase. The classic example is the "pennies-a-day" effect. Chicago's NPR
station asks people to donate by joining their dollar-a-day club. Framed in that manner, the
donation seems quite reasonable—about the cost of a cup of coffee. Contrast that with what
would happen if they asked people to join their "$365 a year club. Suddenly, we're talking big
bucks in the minds of most consumers. We see similar efforts by magazines that advertise their
low per-issue prices or insurance companies that break the cost of their premiums down to a
low, per-day cost. All these efforts are attempting to take the very same cost and make it seem
trivial. My guess is that in many cases, they are quite successful.

All of this points to the fact that issues of how, when, and where can have dramatic impact on
people's perceptions of price. If managers fail to take them into account, they are tackling only
half of the equation.

Q: You talk about sunk cost, the idea that people will use a product or service more right after
they pay for it. How can companies make this work for them?
A: Sunk costs are a curious bit of psychology. Economists say that attending to sunk costs is
not rational—when considering whether to go to a play or attend a football game, the amount of
money you spent on the tickets should be irrelevant to the decision to go. The only things that
should matter are the costs not yet incurred, such as cost and hassle of driving, and the benefits
to be consumed, such as the enjoyment of the game. At the same time, almost everyone pays
attention to sunk costs. We go to plays or concerts that, in retrospect, we'd rather not go to
simply because we have a $50 ticket in the pocket.

Similarly, one of my colleagues describes a person who pays $300 to join a tennis club, only
to come down with tennis elbow. Nevertheless, he continues to play in spite of the pain,
reasoning, "I don't want to let my $300 go to waste." And some people even count on their own
irrationality and buy season tickets to a play or symphony series, knowing that it will force them
to get out of the house.

Is any of this rational? No. Is it a good thing? That's tougher to say. If people are happier to
attend to sunk costs than to let the money spent on an item "go to waste," perhaps it's a good
thing. Can it be used by companies to influence consumers' behavior? Absolutely.

Take your average health club. It faces two tasks: getting people to join and getting people to
renew. (The churn at health clubs can exceed 50 percent.) Knowing that members are going
to be more likely to renew in year two if they feel that they have "gotten their money's worth" in
year one, a club should look to encourage attendance. One way to do this is through the timing
of payments. Many clubs demand payment in full at the start of a year-long membership. The
result is that people work out a lot in the first month or two, while that payment is still fresh in
their minds, but gradually stop going as the payment fades from memory. In this case, the sunk
cost effect weakens the further one is from that initial payment. Now consider the member who
makes payments monthly. For him or her, the cost of membership will always be vivid and they
will feel obliged to work out on an ongoing basis. At the end of the year, who is more likely to
renew? Clearly, the person who worked out regularly will have a higher likelihood of renewing
his or her membership.

The same concept can be applied to health care. In its current form, most of us pay for blanket
health care coverage that entitles us to a number of periodic services such as checkups, shots,
mammograms, etc. The problem is that the costs of these benefits are not particularly clear.
I don't know what that annual checkup is costing me, so I don't perceive it as a cost. If health
care providers could make the costs of these procedures more salient—perhaps by sending me
periodic reminders that these procedures are costing me, say, $50 each regardless of whether
I use them—they would be able to tap into the sunk cost effect. Patients would be more likely to
say, "I'm paying for it, I shouldn't let it go to waste."

Q: Some purchases reflect the capricious nature of people. Is it ever better to get customers'
$600 up front when they are inspired to get in shape at the gym, or in the mood to widen their
artistic repertoire by getting season tickets to the opera? How can companies tell when they are
taking advantage of the right opportunity, and when they are sabotaging their chances for future
loyalty?

A: At one level, the decision of when to bill for a product depends on the faith that a manager
has in the product that he or she is offering. For the manager who thinks he cannot retain a
customer year to year, either because he has a poor product or because customers will quickly
become satiated with that product, it may make sense to get the billing out of the way early.
Given that such a manager has little hope of retaining this customer from year to year, there
is little incentive to encourage consumption by billing in installments. Instead, he can minimize
administrative hassles and maximize revenues by billing in full at the time of purchase.

This is more the exception than the rule, however. I think most managers hope for repeat
purchases, whether they manage a health club, a theater, or publish a magazine. For these
types of managers, they need to do everything they can to encourage consumption in the
current period so as to increase the likelihood of renewal in the subsequent periods. Pricing in
installments is one way they can do this.

At another level, the decision of when and how to bill for a product depends on the underlying
demand for a product. Managers who offer a scarce resource, such as a private golf course,
face a constant battle between maximizing the number of paying customers (in this case, club
members) and minimizing congestion (in this case, the inability to get a tee time). For such
managers, if every paying customer showed up at one time, the system would break down.
One way to assure this is to bill in a lump sum as opposed to in installments. In the case of the
country club, in particular, I might advise that dues be billed in the middle of the winter, when the
ability and desire to play golf is low. By the time the summer months roll around, most members
will no longer feel the pain of having made payment and will feel less of a need to "get their
money's worth" by playing often. The net result is that demand to play golf on any given day will
decrease, allowing the club to increase the number of memberships it offers.

Q: What do you think of price-optimization software? Can software effectively gauge the market
and maximize profit margins? What would you recommend to business managers who are
considering utilizing these types of systems?

A: Again, this is a question about the multifaceted nature of price. I think that price-optimization
software is very good at the objective part of pricing—the questions of "What price should
I charge?" and "How does demand change as I change price by 5 percent up or 5 percent
down?" However, this assumes that all else is held constant—that the same terms and
conditions apply.

In reality, these other factors, these terms and conditions, might have a dramatic effect on the
optimal price. For instance, while price-optimization software might tell the manager of a health
club that he can increase revenues or increase profits by raising membership fees from $600 to
$700, it may not be able to tell him anything about the effect on revenues and profits by moving
from an annual payment scheme to a monthly payment scheme.

A good example of this is the automobile industry. When buying or leasing a car, research
has shown that consumers are much more sensitive to the size of the monthly payments than
they are to the number of months over which they have to make those payments. As a result,
potential buyers may have a bigger negative reaction to an increase from $300 per month
to $350 per month than from an increase in number of months from 36 to 48. This is tough
for price-optimization software to pick up. The behavioral aspects of pricing are things that
optimization software has difficultly picking up.

Q: What projects or research are you currently working on?

A: There are a couple of things I am working on at this time. One has to do with the negative
effects of product variety. The basic premise is that certain types of product variety increase
the attractiveness of a brand and other types of variety decrease the attractiveness of a brand.
In particular, variety that forces consumers to make difficult tradeoffs (do I want the leather
interior or do I want the 4-wheel drive?) will tend to drive people away from a brand. In the end,
a consumer may opt to choose a brand with fewer, easier to compare alternatives over a brand
with more, but more difficult to compare, alternatives.

A second project stems from my MBA course, "The Marketing of Innovations." It deals with
the question of why consumers don't buy. In particular, it makes the argument that consumers
overvalue the features that they are being asked to give up in the current alternative and
undervalue the features that they are gaining in the new alternative. Compounding the problem
is the fact that the developers of the new product don't realize this. They are, by their nature,
evangelists for the new product and value greatly the new features. At the same time, they
have an inability to see the new offering from the perspective of a potential first-time buyer. The
result? Developers see much more value in the new product than do potential buyers and they
can't understand why potential buyers are not purchasing the product.

Manda Mahoney