Is price just the number on the price tag?
Conversations about pricing can quickly come to focus on the number on the price tag. We start asking questions like:
- Is this the right number?
- Should the number end in ‘5’ or ‘7’ or ‘9’?
- When and how should we discount from this number?
People involved in price setting and price optimization seem to be especially susceptible to the “price is the number trap.”
I am currently reading Pricing Analytics: Models and Advanced Quantitative Techniques for Product Pricing by Walter Paczkowski. This is a wonderful book on many levels. It gives one of the best practical explanations of price elasticity I have seen and an excellent introduction to quantitative research methods such as conjoint analysis, discrete choice and other approaches to quantifying buyer preferences for different price points. Anyone with a serious interest in pricing should read it. But it will not help most product managers set a price. Why is that? It is focused on the number that goes on the price tag, and that is only part of the story.
The first question most product managers (and service designers) will ask is what should the product be? That is to say, “What are the packages of functionality, data, integrations and services that fit different market segments?” To answer this question, they need to understand what the different market segments are. Market segments are not defined by industry, company size, location or other firmographics. The best definition of a market segment is
“A market segment is a set of potential customers that get value in the same way and that buy in the same way.”
This is where the value-based pricing approach begins. It does not start with setting a price or estimating willingness to pay (WTP).
Once you understand the market structure, as defined by value, and have selected targets and designed packages for each target, the next question is “What are the value metrics?”
“The value metric is the unit of consumption by which a customer gets value.”
The value metrics are discovered during the value-based market segmentation research. The next step is to choose a pricing metric. This is what the price tag represents, and not the number on the tag.
“The pricing metric is the unit of consumption for which the customer is charged.”
The essence of value-based pricing is to find ways to connect the value metric to the pricing metric. The following sketch shows how all of these pieces fit together.
Are we now ready to set the price on the price tag?
Yes, but there are other things to consider.
The price is not just a number. It frames how buyers will perceive value. This is where behavioral economics comes in. Buyers do not evaluate prices alone. They do so in the context of their alternatives. Value-based pricing is built on differentiation value.
Behavioral economics teaches us to be concerned about two things: anchoring effects and framing effects. Both of these play a big role in pricing design.
Anchoring effects: The anchoring effect is a cognitive bias whereby an individual’s decisions are influenced by a particular reference point (or ‘anchor’). Once the value of the anchor is set, subsequent arguments, estimates, etc. made by an individual may change from what they would have otherwise been without the anchor.
Guiding a buyer to an anchor that positions value in a way that emphasizes positive differentiation is critical to effective pricing.
An example: One company had brought to market an innovative new tool for consensus-based decision making. They had positioned it relative to survey tools and were charging about $2,900 per month. However, after conducting some pricing analysis and consumer research, they were able to reposition their solution as an alternative to consultants and were able to increase the average sale to $19,000 per month. What the offer is compared to has a defining impact on how it will be priced. Think very carefully about anchoring effects.
Framing effects are a cognitive bias where people decide on options based on positive or negative connotations (e.g., as a loss or as a gain). People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented. In other words, most people prefer to avoid a loss rather than achieve a gain. This is one reason why reducing costs can be better received than increasing revenue. One needs to take framing effects into account when constructing value messages.
Note though that there is a segment of people with the opposite behavior. These people, who are disproportionately represented among salespeople, entrepreneurs and early-stage investors, prefer the chance of a gain more than they fear the risk of a loss.
What is in a price then?
Price is a composite that integrates the solution, the value drivers the solution offers and a connection between the value metrics and the pricing metrics. It is more than a number. Even as a number, how a price is perceived is determined by anchoring and framing effects. There is no way that a simplistic estimation of pricing elasticity or willingness to pay is enough to guide pricing decisions. It is not even enough to put a number on that price tag!