How Should I Think About Behavioral Pricing?

Steven Levitt, Professor of Economics at the University of Chicago, along with journalist Stephen J. Dubner, is most well-known for his 2005 bestseller Freakonomics: A Rogue Economist Explores the Hidden Side of Everything, which has sold more than 5 million copies.

The book spawned multiple sequels, a film, a podcast, and a blog. (The blog gets extra points for featuring my Great Recession-themed album, Recession Sessions.) Freakonomics, along with his academic work, has also made Levitt in demand at companies looking to improve their performance. Although not a behavioral economist, Levitt’s lines of inquiry are similar to like behavioral economics in the sense that they look for findings that are perhaps unconventional for economics.

Levitt was a recent guest on the EconTalk podcast and had the following to say about his consulting work:

When I talk to companies, almost every company I talk to approaches me and they say, ‘We would love to use the tricks and insights of Behavioral Economics to revolutionize what we do.’

And, I usually say to them, ‘Look, I’ll try to help you with that. But, honestly, I think oftentimes that the tricks and the miracles of regular economics are a better place to start, because there’s often a lot more power in just getting the incentives right and getting prices right.’ (emphasis mine)

While I firmly agree, I was pleasantly surprised to hear Levitt put so much weight getting prices (as well as incentives) right. Pricing Done Right is the title of our CEO’s book, after all, and our work on sales incentives has brought strong results for clients (see our white papers for more on those).

As Levitt apparently experiences as well, companies too often waste time looking for tricks and hacks when they haven’t sorted out the fundamentals of their pricing strategy. This is not only a shame, but also a waste of energy, time, and resources. Behavioral pricing has its place, but companies must walk before they can run.

I thought this would be a good time to revisit my section on behavioral pricing published in The New Invisible Hand: Five Revolutions in the Digital Economy. Below is a condensed version of that.

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Behavioral economics has become an especially prominent topic in popular science due to its marriage of traditional economics with counterintuitive insights from psychology. The application of such insights to pricing is called behavioral pricing.

One well-known example is the center stage effect, which states that customers will tend to choose a middle option when presented with three or more options. The middle option appears as a reasonable compromise between the smallest (or cheapest) option and the largest (or most expensive) option. This effect can be seen in everything from menu ordering to product versioning.

Another example would be anchoring. Anchoring occurs when an individual is influenced on later decisions by an initial number. For instance, shoppers may purchase more of an item when it is marked “limit of ten per person” than without such a limitation, because that “ten” serves to normalize purchasing that many of the item. Another example would be a store, in which every item is always on sale, but in which every product still has a list price on the tag. A $25 item looks like a better deal when we are told it is normally $35. The $35 anchors shoppers at a higher price.

In a 2018 marketing stunt, Payless ShoeSource, a discount footwear retailer, convinced a group of customers to spend hundreds of dollars on their products by rebranding themselves as a luxury Italian brand named “Palessi.”

“I would pay $400, $500. People are going to be like, ‘Where did you get those? Those are amazing,’” said one woman surveying a pair of shoes that normally retail for $30.

It was an amusing and light-hearted prank, but it also illustrates how malleable customers’ perceptions can be according to circumstance and how companies can manipulate that. The stunt unfortunately didn’t stop Payless from declaring bankruptcy in early 2019.

Behavioral pricing, at the end of the day, is taking advantage of the psychological and perceptual peculiarities of being human to influence purchasing behavior. How should we think about this in terms of transparency and value-based pricing?

While behavioral methodologies are not secret, companies typically don’t broadcast their usage, so I would consider behavioral pricing to not be aligned with transparency. That isn’t to say it is bad, just that a strategy that depends on behavioral pricing techniques doesn’t lend itself to pricing transparency. If your company is aiming to increase its pricing transparency, it should rely less on behavioral pricing approaches.

An important additional point: behavioral pricing techniques are tactics, not strategy.

Deciding how to present different versions of a product is an important decision, but first comes the hard work of determining what customers value and how to solve their problems in a profitable manner. It is easy to be distracted by clever applications of behavioral pricing and forget the core issues of how to delight customers.

The risk of such an approach is having a well-designed menu that sells products no customer wants, or clever marketing stunts that add nothing to the bottom line.

“Consumers are more empowered and informed than ever before, and any pricing strategy that seeks to fool or mislead them is unlikely to be successful for long,” says Greg Loewen, CEO of pricing software company Digonex.

If you are looking for a hack to get around customer value, you won’t find one.