Monday, July 8, 2013

The Psychology of Pricing

By Laura Iles- Senior Consultant, Integrated Insight

The sheer volume of recent articles on the subject of dynamic pricing, spanning publications from Forbes to Time to local news reports, underscores its success in a variety of industries. As dynamic pricing makes its way from the travel and hospitality industries into sporting events, consumers are faced with fluctuating prices in more and more areas of their lives.

Unfortunately, challenges linger and some customers remain wary of the strategy. Specifically, consumers are often frustrated with what they perceive as a lack of fairness, a system that is too complex, and the lack of transparency surrounding pricing.

Whether it’s a seat on a plane or in a stadium, discovering that the person next to you paid half of what you were charged will sour an otherwise enjoyable experience.

The company that surmounts these obstacles and provides a dynamic pricing experience which meets the needs of the customer, while still maximizing revenue, will pull ahead of the competition and garner additional loyalty from fans.

Cross-Disciplinary Solutions
In an effort to find such a solution, two professors from Northwestern University, Jeff Ely and Sandeep Baliga, have applied both economic theory and psychology in a controlled experiment. They are testing a new approach to optimize pricing and drive customer satisfaction, using a variant of dynamic pricing to sell tickets to the university’s basketball games.  

Ely and Baliga employed a reverse auction, beginning with the highest price and reducing it over time, to ensure they captured maximum value. A refund guarantee assured buyers they could purchase with confidence.  

In a recent podcast with Sarah Green of the Harvard Business Review, Ely and Baliga discuss their findings; the full podcast is linked at the end of this post.  Future blog posts will contain discussion of additional topics in the podcast, including the benefit of secondary markets, such as StubHub; the pitfalls of price matching; and the challenges of pricing to address both company goals and customer needs, but below, I highlight some of the interesting and unanticipated results brought to light through their experimentation.

An Innovative Test
How do you test consumer behavior at a variety of price points without damaging revenue streams OR upsetting the customer?

Their solution: A reverse auction, starting at the highest price and moving downward, and a guarantee to refund the difference between the price paid by the consumer and the lowest price sold.  Counterintuitive? Yes.  It’s also an extraordinary use of psychology to encourage exactly the behavior the firm wants to see.

Customers are given an incentive to purchase tickets at the precise moment the price reaches their acceptable threshold – they receive better seats and still have a guarantee of being treated fairly should the price drop.  This also has the added benefit of reducing incentives to use secondary markets, as the primary market is now more attractive.  The firm is able to observe customer behavior at a variety of price points, zeroing in on the price that will best support the firm’s goal. This strategy allows for flexibility, and the company is able to focus on maximizing revenue or attendance as needed.  Monitoring shifts in purchase behavior as the price is reduced - little by little - generates an understanding of the likely outcome of further shifts. This in turn prevents the company from reducing the price too much.

In the control studies, the final price set by the reverse auction & refund guarantee strategy matched the pricing suggested by the data based on the secondary market (StubHub).  While the reverse auction approach may work in industries with event driven, one time purchases, time will tell if the method has legs with less emotional based products and services, and a more frequent purchase environment.

Take Away
No strategy is a one size fits all solution, but embracing new approaches may just gain you a competitive edge.  The pricing strategy tested by Ely and Baliga has the benefit of maximizing profits while providing value to the customer through ease of use, transparency, and fairness.

Chasing revenue at the expense of your customers’ experience is a long-term strategy for failure. If you don’t discover that optimal balance of great customer service and profit-maximization, eventually one of your competitors will.

Are you out-behaving your competition?

The original podcast and associated transcript can be found here.

For additional articles on the pricing experiments of Ely and Baliga, please see the links below.

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