Prices are often irrational. So are consumers.
Almost two-thirds of retail prices end in a nine on some estimates. These “charm prices”—set just below a round number—are meant to lead consumers to round down rather than up. While some doubt their effectiveness, plainly Steve Jobs is a believer, insisting initially that all tracks on iTunes be priced at 99 cents, as is Jeff Bezos, whose Kindle was first priced at $359, later $299 and then $259.
In “Priceless,” William Poundstone explains charm prices and other common pricing anomalies. More broadly, he explores some of the basic notions of behavioral economics and argues that psychology matters as much as logic in many simple economic decisions. Most prices, Mr. Poundstone notes, are not the result of exact science but are “slippery and contingent,” relying on “coherent arbitrariness”: Consumers don’t know the “right” price for anything and mainly respond to price increases and the price of one thing compared with another.
Not surprisingly, retailers and marketers exploit consumer psychology to make consumers think that they are getting more for less and to divert attention from any attempt to charge more. Sometimes, for instance, manufacturers stealthily reduce the size of their product. Mr. Poundstone cites Skippy peanut butter, which recently added an indentation to its jars that reduced its size by 9%. Consumers tent to react less to this subtle price inflation than to a higher price tag—particularly for regularly purchased products whose price consumers will remember. Eventually, a company will run out of corners to cut and can then start over with an entirely new package and price that is hard to compare to the old one.
Another popular pricing technique is to use expensive “anchors” that consumers use as comparison points. Mr. Poundstone says, for instance, that Prada carries a few “obscenely high priced” items to make everything else seem affordable by comparison. Restaurants sometimes use similar tactics. The “$1,000 caviar and lobster omelet” on the menu at New York restaurant Norma’s is principally for show, not sale. Even if no one orders it, its astronomical price tag may tend to “bewitch” customers into spending more than they would have otherwise.
Whatever the pain of an irrationally expensive breakfast, it pales in comparison with buying an over-priced house. To avoid that mistake, however, a buyer may need to cover up the price tag and appraise the house without being influenced by the seller’s number. In one experiment, a group of licensed real estate agents were shown a house and told that it had been listed for $119,900. When asked to estimate a reasonable purchase price, their average was $111,454. When a different group of agents was told that the listing price for exactly the same house was $149,900, their average estimate was $127,318. The agents had subconsciously used the listing price as a reference point for their appraisals—even though they knew it was irrelevant.
Consumers, of course, are aware of all these tricks. And yet the evidence is overwhelming that they are influenced by them. Forewarned but not forearmed: Individuals are far less rational than they often believe.
This notion has been best explained by Dan Ariely in “Predictably Irrational” (2008), which Mr. Poundstone cites frequently. Mr Ariely explored some of the basic notions of behavioral economics—and showed how real-life decision-making differs from utilitarian economic models. At the core of much behavioral economics is “prospect theory,” a set of ideas that were developed by Daniel Kahneman (winner of the 2002 Nobel Prize in economics) and Amos Tversky.
The theory emphasizes how risk—or risk aversion—affects decision-making, and it helps to explain why actual prices often differ from what one might rationally expect, even for something that is easy to value—like money itself. Consumers tend to over-value certainty: When offered the choice between a certain $3,000 and an 80% chance of $4,000, most people choose the lower amount even though the alternative’s expected value—its average probability-weighted return—is $3,200. Similarly, individuals have an irrationally high aversion to loss: Most people turn down an offer to flip a coin and win $110 for heads and lose $100 for tails. A study of contestants on the TV game show “Deal or No Deal” found that more decisions were consistent with prospect theory than with maximizing the expected return.
The additional value that individuals place on locking in certainty and avoiding loss explains why consumers are willing to buy financial products that otherwise seem to make no sense—such as extended product warranties where the price of the warranty is greater than the expected value of the loss being protected. Similarly it explains why consumers over-pay for flat-rate plans—say, unlimited calling plans, when a limited plan would likely be cheaper: They want to avoid the risk of a huge bill.
While Mr. Poundstone explains the increasingly sophisticated techniques that businesses use to exploit human irrationality, he says little about the effect that the rise of e-commerce may have on all this pricing strategy. While there may still be some scope for psychological manipulation, consumers should be harder to confuse with access to instant price comparisons and product research online. Relatedly, the Web may offer opportunities for better customer segmentation and hence finer price differentiation—where prices take into account each consumer’s willingness to pay. Why give everyone a discount when some people will pay full price? Perhaps the customer that searched for “highest rated” will pay more than someone who searched for “lowest price.” Tailored offers and customized bundles can muddy the water for comparisons. As Robert Crandall, a former CEO of American Airlines, has said: “If I have 2,000 customers on a given route and 400 different prices, I’m obviously short 1,600.”
Mr. Philips is executive vice president of News Corp., which owns Dow Jones & Co., the publisher of The Wall Street Journal.
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