Psychological pricing can be a great tool to achieve higher price points and increase sales. But did you know that you can also incorporate behavioral science into your pricing strategies when it comes to discounting as well? Pricing expert, Peter Harms, discusses how reductions on regular prices can trigger emotional responses in customers.
It’s typically assumed that price increases will result in a tradeoff in sales volume. But what if companies could use psychological pricing techniques to raise their prices without sacrificing sales units?
Why use psychological pricing?
Psychological pricing is the science of making prices appear more attractive to customers by shaping the price structure, context, and optics. In a rational world, only the product price level would affect whether a customer decides to buy an item. It shouldn’t make a difference how the price is presented, but it does.
There’s more to pricing than simply gauging customers’ willingness to pay and determining the optimal price level. The pricing process should actively influence how customers perceive aspects such as product exclusivity, price fairness, and price attractiveness. Companies can monetize the fact that customers don’t behave rationally when making purchase decisions through how they set and offer discounts, since this helps create the perception of a good deal.
Why is a discount important?
Discounting may seem counterintuitive to psychological pricing, which ultimately aims to achieve higher prices without losing sales or generate more sales without lowering prices. However, this is only a matter of perspective. Imagine starting with a higher list price and then granting a discount to arrive at an equal or higher price level than before. Can this really make a difference? Can a discount really have value on its own?
We have observed the power of discounting in many industries. The example in figure 1 below tests the deal effect in the context of car shopping. Two groups of customers were offered the same car at the same price. However, one group was given an estimate with no discount, while the other was given a higher estimate with a 12 percent discount. The size of the discount effect differs by industry, product, and discount size. In the car example, the effect was dramatic. There were twice as many customers in the discount group who were considering purchasing the car than there were in the non-discount group.
Figure 1: How discounts can improve price perceptions without impacting the net price.
Discounting works because there is both a deal effect and a quality factor at play. In uncertain or complex situations, customers infer the quality of the product based on its list price. An item that is highly priced is typically also well made. Customers react this way across many product categories if the list price remains within reason.
Companies need to consider five points before implementing discounts as a psychological pricing tool:
1. Choose the right discount level for the industry
What level of discount is profit optimal? To answer this question, it’s necessary to determine two aspects. 1) the cost of the discount to the provider; and 2) the value the discount provides the customer.
The relationship between these two dimensions isn’t linear. The value to the customer often follows an S-shaped curve, similar to the blue line in figure 2.
Discount levels that are too low give very little value to the customer, and the same is true for higher discounts once they surpass a certain threshold. To offer significantly more value to customers, companies should make sure they set discounts that fall within the discounting power zone for their particular industry and product.
Figure 2: Finding the power zone of discounts.
2. Choose the right kind of discount
Discounts don’t have to be monetary. There are many types of in-kind discounts companies can offer according to their industry or product. These discounts often have very favorable cost-to-customer value relationships. This is seen with the free roadside hazard policy and zero-percent financing from the tire industry example in figure 2. Discounts don’t have to be given for free. It’s good practice to link discounts to customer performance, e.g. deal size or cross-selling.
3. Always show customers their discount
As psychological pricing is about perception, the way companies display discounts is very important. It isn’t enough to simply communicate a lower net price; companies should show the old price, cross it out, and show the discounted price. This technique is particularly useful for repeat negotiations, such as yearly reviews, as starting negotiations at a price that has already been discounted leaves little room to maneuver.
4. Discounting is not just for B2C
It’s commonly assumed that professional buyers don’t make purchases solely based on discounts or the perception of a good deal. In fact, the opposite is quite often the case. Professional buyers are addicted to getting a bargain. After all, how else can purchasing departments demonstrate their performance to management other than by highlighting the great deals they have negotiated?
5. Set discounts carefully
Companies should be selective in setting discounts. It’s like adding the right seasoning to soup. A few discounts can be very effective, but the wrong kind or too many can make a business less profitable. It’s important to do market research. Finding the discounting power zone will involve talking to customers and conducting market tests.
Discounting also requires suitable checks and balances. If there are no restrictions in place, discounts have a tendency to grow over time. Companies need to set clear rules that specify when sales teams are allowed to give discounts and when they aren’t. In addition, there should be specific indicators to measure how effective a discount is.
Takeaways for your psychological pricing strategy
Psychological pricing is about actively shaping price perception to influence the price-value relationship customers associate with products and services. One technique to help companies is discounting, since this can make prices and deals appear more attractive. Used correctly, discounting is a very powerful tool that can increase profits by achieving higher sales and prices.