Strategic Pricing:
Theory, Practice and Policy
Professor John W. Mayo
mayoj@georgetown.edu
The Psychology of Pricing
2
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.
• Snob effect
Examples???
Examples???
• ∂Ui/∂q1k <0.
• Veblen effect
• ∂Ui/∂p1k >0.
Examples???
The Bandwagon Effect
Let qi = f(p, Qα) for every consumer i
facing a market demand given by Qα. Then
A series of market demands can be drawn Dα … Dn
$/Q
The only “equilibrium” demand curve is
Given by the locus that aligns
The expectations of consumers and reality
Note that to the extent that
Demand for a product
Includes bandwagon effects, market
Demand becomes more elastic
Dα
α
Dn
n
Q
The Snob Effect
Let qi = f(p, Qα) for every consumer i
facing a market demand given by Qα. Then
A series of market demands can be drawn Dα … Dn
$/Q
The only “equilibrium” demand curve is
Given by the locus that aligns
The expectations of consumers and reality
Note that to the extent that
Demand for a product
Includes bandwagon effects, market
Demand becomes less elastic
Dα
Dn
α
n
Q
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”
$/Q
The only “equilibrium” demand curve is
given by the locus that aligns
The expectations of consumers and reality
(p,pn)
Note that to the extent that
Demand for a product with
Veblen Effects may be upward sloping
(p,pα)
3
Dα D2 D
Dn
Q
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
Number of Bidders
Low Ask price
Lower ask price attracts
more bidders
High ask price
Bidder “valuation
Bidder valuation
Number of Bidders
(n)
If bidders valuation =f(n), the presence
of other bidders will shift the distribution
Bidder “valuation
Which restaurant do you prefer?
13
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
Experiments 2,3,4: Test placebo-price effects for SoBe Adrenaline Rush.
Test: actual performance, paid prices with “expectancy” and price variation
Price
Regular
High
Expectancy
Low
Discount
You Get what you pay for…
Placebo Effects and Prices
Puzzles Solved
= discount price
= regular price
Low Expectancy
High Expectancy
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 Kramer
Marketing 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