How Discounting Affects Product Value Perception?

It is fair to say everyone loves a discount. There is data to support the claim from years of Black Friday discounting that not only makes customers skip sleep and stand in cold weather for hours but also generates considerable revenue for the retailers. Then there are the group buying discounts made popular by GroupOn.

At the individual customer level, previous research done on customer preference for discounting point to both rational economic and emotional reasons.  Kahneman and Tversky showed, customers prefer discounts even if they saved lower amount in absolute terms.

Thaler in his work on Mental Accounting and Consumer  choice provide evidence of emotional (non-financial) reasons for why we may be motivated by discounts.

So we all value deals for rational and irrational reasons. But how much do we value the product after the initial buying decision? More specifically, since we do not know the absolute values, how much relative value do we place on a product bought on a discount vs. an identical and substitutable product bought without the discount?

There are three distinct possibilities.

Hypothesis 1: If we treat our customers as rational (ignoring the contradiction), once they bought the product at whatever price, the costs are sunk. How much relative value consumers get from each product should depend only on its own merits and independent of initial discount. At the very least, the choice between the two should be no different from  a random choice.

Hypothesis 2: If we treat our customers consistent with their previous action of seeking discounts for non-financial reasons, we should expect them to value the product bought at a discount higher than that of the one bought at full price.  This hypothesis is further reinforced by endowment effect and cognitive dissonance (I must really value this product, otherwise I would not have stood in line for it).

Hypothesis 3: Customers value the full price product more than the one bought at discount (remember the preconditions – identical and substitutable products).

So I conducted an experiment. The data and analysis show that  the last scenario, Hypothesis 3, is more likely than the other two.

The experiment was designed to get customers to reveal their preference by asking them to give away one of the two identical products of same price:

1. One they bought at full price
2. Other they bought at 50% discount

As it turns out, customers are more likely to keep for themselves the full priced product and happily give away half-priced identical product.  So while discounting may bring in customers, it may hurt by depressing the relative value of the product to the customers.

What does this mean to you as a marketer?

1. Think again before running 50% deals on any group buying site or allowing your product to be bundled and sold at a discount by other channels.
2. Attracted by large user base from giving away your product for free? Consider loss in perceived value to the customer.
3. Know the customer’s end use of the product. If they are predominantly buying it for their own use, discounting most likely will not help improve lifetime value of the customer.  If they are buying it for others, discounting helps.

Want more actionable insights? Talk to me.

Further readings:

Kahneman and Tversky – Choices, Values and Frames, American Psychologist,  1984

Thaler – Mental Accounting and Consumer Choice, Marketing Science 1985

Note on the Experimental Method:

I relied on convenient sampling and applied Bayesian hypothesis testing. Compared to conventional, run of the mill hypothesis testing, say testing for statistical significance at 95% confidence level using Chi-square test for this case, Bayesian Hypothesis testing allows to test multiple hypothesis at the same time and help state the results in terms of probabilities instead of as absolute truths.

Results are subject to sampling errors, and do not take into account segmentation differences. This is also stated preference study and not a revealed preference study.

Ask the Expert – Episode 2 – Using Cost Argument to Push Price Increases

Prices of commodities from sugar, wheat, cocoa to cotton are on the rise. Brands from Starbucks to Sara Lee to garment makers are starting to state their intention to pass on cost increases to customers. In a recent interview, CEO of Kroger, David Dillon said this about this cost argument made by brands,

I don’t see [rising manufacturers’ prices] as a problem for us. It is a problem for them

Since costs are irrelevant to pricing,  cost increases relevant to price increases?  Is David Dillon correct or should brands use this opportunity to pass on the cost increases and gain pricing traction? As part of my “Ask the Expert” series, I posed this question to William Poundstone, author of several books, including his latest, Priceless: The Myth of Fair Value. He blogs at Priceless-Blog. When I read his book and listened to his NPR interview I felt he took consumer perspective on pricing and it is very interesting to see his detailed response that is backed by behavioral economics research.

Brands from Starbucks to Jenny-O are using cost arguments to push price increases – Should commodity cost increase be passed on to customers?

Yes. Behavioral economics has demonstrated that people do accept the need for sellers to pass on their own increased costs. 1984 was “the year that behavioral economics began,” according to psychologist and Nobel laureate Daniel Kahneman. He and two economists, Jack Knetsch and Richard Thaler, became interested in “fair” prices. The term “fair” has no meaning in standard economics. Yet it’s a word that we all use. Listen to any negotiation, from a used car sale to a corporate buyout, and you’ll hear someone earnestly insist: “I only want what’s fair.”

Kahneman’s group set out to uncover the unconscious rules of fairness. There was then a Canadian public works project that hired college gradates to conduct nationwide telephone surveys. Kahneman, Knetch, and Thaler began supplying the survey-takers with questions about prices and fairness. One of their most famous hypothetical scenarios ran like this:

“A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.”

The Canadian public was asked simply whether they considered this “fair.” Eight-two percent said no.

There were many other questions along this line, in a which merchant raised prices to reflect low supply, high demand, or both. The public reaction was always the same: It was unfair for a merchant to profit from the most basic free market forces. As Kahneman, Knetsch, and Thaler wrote,

“Conventional economic analyses assume as a matter of course that excess demand for a good creates an opportunity for suppliers to raise prices, and that such increases will indeed occur. The profit-seeking adjustments that clear the market are in this view as natural as water seeking its level — and as ethically neutral. The lay public does not share this indifference.… the gap between the behavior that people consider fair and the behavior that they expect in the marketplace tends to be rather small.”

As a “man bites dog” story, this finding has gotten much publicity. It’s even led to a certain cynicism about behavioral economics among businesspeople. People are irrational, the message seems to be, so what can you do? Actually Kahneman’s group had a number of results that were less surprising but no less important. They found that the public did not automatically reject any price increase as unfair. In particular, the public was willing to accept price increases when the seller was passing on his own increased costs.

It’s therefore a sound psychological strategy for a company experiencing commodity cost increases to use that to justify a price increase. Of course, it’s necessary to communicate the reason through signage, ads, or other means. During the recent egg recall, prices for unaffected and organic eggs went up. This could be seen as raising the price of snow shovels after a blizzard. But my supermarket had a sign explaining that the store’s suppliers had raised their prices, and thus the market had to pass on its cost increases. This transferred any sense of unfairness to the middleman.

That’s important: No one wants to do business with someone who’s not being fair.

One further point: Don’t assume that the public understands inflation. One of the findings of Kahneman’s group was the public consistently fails to take into account changes in the buying power of the dollar. In one survey it was, for instance, “unfair” for a company to cut wages 7 percent (during a time of no inflation), but it was okay to give a raise of 5 percent during a time of 12 percent inflation. Of course, the workers’ buying power is cut by about 7 percent in both scenarios.

A company that hasn’t raised its prices in a few years may feel it’s overdue for a price increase, and no justification is necessary. But the public won’t automatically see it that way. Even a simple inflationary adjustment may need to be justified—and a psychologically savvy way to do it is to cite increased commodity costs.

—William Poundstone

Author, Priceless: The Myth of Fair Value (and How to Take Advantage of It)

See also:

Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler. (1986). “Fairness as a Constraint on Profit Seeking: Entitlements in the Market.” The American Economic Review 76, 728-741.

Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler. (1986). “Fairness and the assumptions of economics.” Journal of Business 59, S285-S300.

Price Realization Through Creative Packaging

Take a look at the picture below. Can you tell which container is 2 quarters and which is not? Or are they both same?

These are indeed two two different sized containers. One is 2 quarts and the other is 1.8 quarts. The taller one is the 1.8 quart container. What is happening here is price realization through creative packaging. Customers are trained on the price they pay – more often they buy a product at a price the more they become tuned to any price changes. The price they remember becomes their reference price – any increases over reference price will be seen negatively. So brands use the only other lever available to them for better price realization : reduce their marginal cost by 10-20%.

For the same price or even a little lower price, customers will get smaller package than they usually get, effectively paying higher price. But it cannot be done without regard to customer perception of size. While customers are more tuned to the price, they are also tuned to sudden size reductions.

The proven principle in creative packaging is, “Super-size in 1-D, down-size in 3-D”.

that changes in size appear smaller when products change in all three dimensions (height, width, and length) than when they change in only one dimension

In this case Tropicana seem to have refined the earlier findings – “Downsize by reducing the cross-sectional dimensions while increasing the linear dimension“.  As you can see, the width reductions are hardly recognizable but the height increase is very obvious.

Is this wrong? Ben and Jerry’s thought so. We have seen this in the battle between Ben and Jerry’s and Haagen Dazs. Ben & Jerry did a “A pint is a pint” campaign which they later discontinued. But I do not see anything wrong with this approach as long as the real volume is printed clearly so we can make informed decision.

The trouble however is we are not Homo Economicus, we are susceptible to nudges and cognitive biases.

Where do you stand on creative packaging?

Stick or Carrot – Traffic Tickets or Gas Vouchers?

This morning NPR reported on an experiment by French traffic cops

Instead of scanning the road for bad drivers, traffic police in one town south of Paris, are looking for drivers who are obeying the rules of the road. They’re pulling over good drivers at random, and handing them gas vouchers worth more than $60.

People respond to incentives but they respond more to disincentives or negative incentives. According to Prospect Theory the satisfaction from a gain of $60 gas voucher is not as intense as the pain from losing $60 (or more) to traffic tickets. Besides, I am not sure who would enjoy being pulled over even if it is for being presented with a gift for obeying traffic rules.

When it comes to changing behaviors sticks are better nudges than carrots.

Here is another study on the effect of Stick vs. Carrot  reported in today’s WSJ that validates the power of sticks over carrots:

Our main findings are that reemployment bonuses don’t seem to have worked, while benefit sanctions increased the job finding rate significantly,” the economists write.

So if you are trying to change to customer’s behavior, be it getting them to bring their own shopping bags or sign-up for electronic billing over paper billing – Sticks work better than Carrots.

Make It Very Easy for Your Customers to Buy Your Products

We all understand what sunk costs and opportunity costs are. That is our rational being, which usually fails to show up when making everyday decisions.  We are susceptible to many different biases that are rooted in emotions than rational reasons. This does not change when we are making purchases for our businesses. One such emotion is our response to  buying experience and associating it with product experience.

In my previous articles  I wrote about cognitive cost to customers in choosing a version from all available options.  The effect of choice proliferation and the cost it imposes has been reported before. A more striking finding was*,  the cost incurred at initial purchase remains sticky in the minds of your customers. Worse customers associate this cost with product experience. After a customer makes the purchase, the cost she incurred in making the selection is sunk and hence should have no impact on rest of the product experience. Unfortunately that is not the case.

In the recent Harvard Business Review  article, Dan Ariely  (Predictably Irrational) writes about his research on “The Long-term effects of short-term emotions”.  Ariely and Andrade found,

“emotions could influence how people make decisions even after the heat or anxiety or exhilaration wears off.”

In their experiments, they found that those who had an emotional response  carried that emotion even during later rational decision moments.  This is because people tap into their memory of decisions made earlier. So if the buying experience is really painful with multiple options to choose from, multiple questions to answer and forms to fill out,  your customer is bound to feel annoyed.  When someone asks them about product experience, they tap into their memory and recall this annoyed state and give bad overall rating for your product.

The good news from Ariely’s findings is, it cuts both ways. If the customers had a great buying experience its effect is felt long after the initial purchase.

It is not enough for you to focus on product UI and product experience – your buying experience should be exhilarating as well or at least not annoying to the customers.

*The Optimal Number of Versions: Why Does Goldilocks Pricing Work for Information Goods? Journal of Management Information Systems / Winter 2007–8, Vol. 24, No. 3, pp. 167–191.

Options Nudge Your Customers To Yes

The WSJ article on  President Obama won the Health Care vote describes how he changed the conversation:

Mr. Obama’s most effective move may have been calling for a bipartisan summit on health care, shifting the conversation away from Democratic paralysis. Aides knew there was little chance they would reach a bipartisan agreement, but it forced Republicans to put ideas on the table, framing the choice as between two sets of ideas, rather than simply a referendum on one.

Framing helped the President  make the conversation between two ideas instead of a referendum on what was labeled by some as Obamacare. The power of options and framing in decision making is extensively studied and reported in Behavioral Economics. With people like Cass Sunstein (author of Nudge)  working in his administration and  Dan Ariely who worked on his campaign, it is not a surprise to see the President use these methods in winning his most important campaign promise.

Be it a vote, negotiating a deal, charging for extras or pricing a product – make the decision be about selecting one of many available choices vs. a referendum on the only option you are presenting. It is easy to say no when the choice set has just one item, it is awfully hard when there are two, and with three you are most likely to get the middle option. [tweetmeme source=”pricingright”]

If one price is good, two are better!