Wednesday, March 23, 2016

When Is The Price Right?

Much of conventional economic theory revolves around the assumption that an economy comprises rational actors seeking to maximize utility. One implication of this hypothesis is that, all else being equal, people will tend to favour a lower-priced product over a higher-priced alternative.

However, research by behavioural economists and psychologists—among them Daniel Kahneman of Princeton University—has cast significant doubt upon the thesis of Homo economicus. Contrary to the assertion that human beings tend to make rational decisions, scholars have consistently found that decision-making is influenced by cognitive biases, the perception of risk and reward, social pressures, oversimplified snap judgements or prejudices, and various other subjective factors that have very little to do with rationality.

This partly explains why many individuals choose higher-priced products, even when all else is apparently equal—the authentic Prada handbag versus a more affordable alternative; the glamorous Porsche, BMW, or Ferrari versus a high-quality, reliable vehicle for half the price; a painting by a famous artist for no reason other than its uniqueness and the renown of its creator.

In conclusion, trying to compete on price is not always an advisable strategy. But when can you reasonably expect that raising the price of an item will deliver higher revenue? When is it best to stay put or even go lower?

Subjective perceptions of price

I often pass by a restaurant that attracts long line-ups on the weekends, starting just before noon and continuing well into the evening. This establishment offers tasty Mediterranean-style comfort food, at a price that enables it to undercut its nearest competitors. Understandably, it is tremendously popular.

Yet even in this case, we can see less-than-rational economic behaviour at work. On rainy and chilly days, lengthy queues still form outside this restaurant—which suggests that in the name of a modest saving, customers gathered outside are willing to forgo both their physical comfort and their precious time. (Is it really worth it?) Adding to the complexity of the dilemma is the perception of sunk cost—the queuers may think to themselves “I’ve been standing here for half an hour already; I might as well stick it out to the end.”

On the other hand, in my neighbourhood there is a restaurant offering somewhat higher-quality Mediterranean fare for a higher price. This business has also enjoyed commercial success and recently expanded—but I have yet to encounter a line-up stretching out the door and halfway around the block.

Some customers may perceive products with higher prices to be superior, even if this is not necessarily the case. Do you want your enterprise to be perceived as a low-cost provider, a high-quality outfit that people will be willing to pay a little extra for, or somewhere in the middle? What value do you offer that others don’t? Answering those questions will help you not only formulate a pricing strategy, but more clearly define your brand identity too.

Merits of cost-plus and value-based pricing

As the name suggests, cost-plus pricing is based on tallying the fixed and variable costs that you incur to provide a good or service to your customers, and then adding a mark-up that enables you to turn a profit. On the other hand, value-based pricing is a reflection of what you believe customers are willing to pay for the product or service you offer.

Generally, cost-plus pricing is more apt for industries in which the items on offer are generic or easily substitutable, and there are many competitors. If your business is a convenience store, or sells items that are readily available elsewhere, you will probably need to maintain a cost-plus strategy and keep a watchful eye on local competitors’ prices.

Value-based pricing is better suited to industries in which the items on offer have some subjective quality—such as association with a particular brand or celebrity, atmosphere and ambience (as in a restaurant), or an inimitable experience or flavour. Businesses that deal in goods and services of this kind enjoy more pricing flexibility, and can often get away with raising prices gradually as their profile and reputation grow. On the negative side, this strategy can invite more competition, and complicates the task of establishing an appropriate price in the first place.

Determining the right price for your products is a challenge that doesn’t necessarily lend itself to a straigthtforward answer. Particularly in the early stages of a business, some trial and error may be necessary. Nonetheless, a coherent pricing strategy begins with defining the type of brand identity you want your business to embody.

1 comment:

  1. The price is always right, as long as the free market forces are in place, and both cost-plus and value-based pricing are valid way of setting the price. The price is objective in a social setting. I recommend you to read about market value in the book, Capitalism: The Unknown Ideal.


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