Willingness to Pay and Reference Price

Take a look at this Yelp review

 went through a mess of salons to get some price ideas for mens haircut and I am sorry, I’ve been paying 10-15 dollars for a haircut for 22 years. I cannot and will not pay $80. That’s the price of a new video game! I called the salon and I got a price of $16 for mens! $1 more than my maximum?

ref-priceWhat do we see here? An illustration of the fact that,  as customers we do not walk around with a price we are willing to pay for every product and service. To a large extent this number is shaped by experience and what we have seen and trained to pay. That becomes our reference price.

Any price above the reference price – like the $16 vs. $15 – is seen as a pain or price increase that need to be reconciled. And you can see how this reviewer felt after paying $1 over his old reference price.

Reference price is not a fixed number, fortunately for all of us marketers. It is malleable – newer products, cost justifications, options, or extras – can be used to move it. If the customer is convinced they are seeing value for the extras they will happily move to the new higher reference price and will settle there until next movement. The same reviewer ends with,

I can truly say with a tremendous amount of confidence. I have found my PERMANENT salon.

Back to Willingness to Pay – the $80 price limit this reviewer quotes is his absolute reservation price. No amount of benefits, features, brand, customer service etc. can move this user to pay $80 for a haircut. His willingness to pay is somewhere close (tad below ) that number. You should know that this is just one customer and may be there are lot of them like him while there are many others who are more than willing to pay hundreds of dollars for a haircut (or the salon).

What do these two parameters mean to you as a marketer or entrepreneur?

First stop asking questions like,

“Would you pay $3.99 for my product?”

Because customers do not know.

Second do not be afraid of raising prices, as long as you understand the effect of reference price and execute this change correctly.

Finally, if your product used to be free and you are considering pay model do not assume no one will be willing to pay that price. You need to find those who value it enough, target them and move their reference price sufficiently to get the price that is fair share of your value add.

How do you manage your pricing?

See also: Multi-version pricing at salons.

Customer Service Matched with Customer Margin

Take a look at these news stories


The first one is about a tech startup, Backup My Info

We love working with all of our clients, especially the smaller ones, but if we find ourselves spending all of our time helping the small customers get started with our service, we will not be able to grow into a $5 million-a-year business — or even remain profitable.

The second one is about Iron Man XC,

XC provides its 25 athletes with what it refers to as “high-touch” service: breakfast with the pros, a seat up front at the welcome banquet, Ford (a dedicated handler) at your disposal. He books your travel. He’ll find out your favorite snack is Oreos and have a pack waiting in your suite.

For non-XC athletes, a bike tune-up requires a sweaty, anxious wait at an overburdened cycling shop and lost sleep over whether a year of training will be lost to some stoner bike mechanic who fails to true a wheel. Not so for XC guys. Expected wait time: zero.

Was Backup My Info wrong to offer same great service to all customers regardless of what they spend with them?

What about Iron Man XC? Don’t you think the non-XC athletes who trained the whole year would love to have great mechanic service (with zero wait)? Why aren’t they offered the same great high touch service?

Customer Service and loyalty publications are rife with advice on how crucial it is to delight your customers, go the extra mile, keep them happy etc.  But such an advice is pointless or even downright dangerous in leading businesses down path to destruction. A generic one size fits all advice to provide same great service and experience to all customers is wrong.

The starting point of any marketing strategy is customer segmentation – finding out the needs of different customers, what alternatives are available them to fill those needs and what are they willing to pay for a service that offers to fill those needs.

For sure everyone would love to be treated as XC athletes if offered at same low price. But – if that high tough experience is not what they are hiring the product/service for or have no willingness to pay for such a service then it makes no business sense to offer that to them.

If you cannot charge for it you should not be offering it. That does not mean you start with same great customer service for all and try to distribute your costs as price to customers. You start with which customers value the service, find out what they are willing to pay and deliver that at costs that generate profit from each customer (Customer Margin).

Customer Margin is the total revenue a customer generates (from all transactions) less the cost to acquire and serve them.  You want a mix of customers that deliver positive customer margin – delivering same great service to all is not the way to get there.


Do you know your customer margin?

Other readings:

  1. Pricing the Customer’s Experience by Wim Rampen
  2. Beating Customer Expectations – An Experiment


In the Spirit of Price Unbundling

Want a boarding pass? That will be $5, please. Thirsty? Water is $3, though Spirit Airlines say it is safe to drink from the bathroom tap. Carry-on bag in the overhead bin? $30-$45 (soon to be $100). – Spirit Rewrites Airline Economic Model, WSJ

Five years ago I was working on Unbundled Pricing.  At that time it was just the beginning of airline baggage fees. My goal for unbundled pricing was not about nickel and diming but about coming with a segment driven approach to align price with value delivered. I defined unbundled pricing as,

Unbundling a value component that used to be included in the whole and charging for its value

Remember, no value – no price. But value does not mean you can charge for it. That was the reference price effect.

If the customers have never paid for it and there are no other comparisons then their reference price for a product/service is $0 regardless of the value delivered. For example, will you pay for email?

So when introduced without focusing on reference price, unbundling faced customer backlash and castigation by customer service gurus who strongly believe in enchanting and delighting all customers at any cost.

Fast forward to present day. Spirit is now the number one airline on profit per plane metric.  Despite what customer service gurus say about delighting customers, Spirit delivered no service other than safely transporting customers, did nothing remotely to delight its customers and yet saw its market value double since its IPO.

Let us return to the quote in the beginning of this article. What Spirit airlines has done may look like taking unbundling to the extreme. But it is actually taking a segment driven strategic approach to unbundling showing us all the power of customer segmentation.

Target Segment: Despite what most believe, it is not possible to serve all customers. Stated more precisely, it is not possible to fill all needs at all situations. Spirit is not going after the lucrative business segment that does not pay out of its pocket. They are going after price driven segment that makes purchasing decision purely based on price and is flying on their own dime.

Competition: They don’t see any of the major airlines as their competition. Having chosen the strategy of low price and no-frills, they see as competition other cheaper options available to customers. That is, Spirit sees Greyhound bus as its competition, not American Airlines. They are happy to yield other segments to other airlines. As Spirit CEO said, “want to check-in a few bags? Southwest is a better option for you”.

Price-Value Alignment:  When introducing Kindle Fire, Mr. Jeff Bezos said, “premium product at not so premium price”. That unfortunately is a price-value misalignment. Spirit does not say such a thing. Having chosen the low price it wants to offer, it designed a product that it can deliver profitably. The number one reason its target segment hires Spirit airlines is to get to their destination at the lowest possible cost. Spirit does that well.

Marketing : We hear a lot about marketing from management gurus like how delighted customers create word-of-mouth marketing. For Spirit a few dissatisfied customers are actually creating negative WoM. That is actually a result of these customers wrongly self-selecting themselves to travel Spirit airlines. Spirit does not want to attract those who expect any kind of service.  WoM, positive or negative is a non-issue for them. Their marketing, at 0.1% of their revenue, is reaching the price driven segment. Nothing more. It is not about stories, not about conversations and not about engagement.

What we see here is the need for strategy in running any business and not blindly following one size fits all advice. You cannot deliver premium product at low price to all customers. Everyone will be delighted to get a great product and service. But not everyone will pay for it. There exist a segment that is willing to opt purely on price just to get their most primary need addressed.

Despite what you see and hear about a businesses’s number one goal as serving its customers, if serving customers does not deliver profit you don’t have a business.

Do you have to enchant your customers to gain loyalty?

What does it take to gain customer loyalty?
Beating their expectations is one way. But by how much?
Do you have to beat their expectations by a mile?
Do you have to forgo profits in the form of lower prices and higher service?
Can your business profitably beat customer expectations?For any marketer trying to gain customer loyalty in the form of repeat purchase, these are valid questions. After all there is no point in gaining loyalty of customers at the expense of profit.This article is about answering these questions using consumer behavior research.

Background and Hypotheses Development

Sometime back Tom Hulme sent me a tweet on his experience with Nespresso. Tom enjoyed using  his Nespresso machine but one day the water container broke. Tom said,

Did Nespresso price its part correctly?
Did it have to price it so low to gain loyalty?

I posited that Nespresso gave away too much, priced it incorrectly and should have given choices.

These discussions  led me to propose the  following two hypotheses

H1: Brands do not have to beat customer expectations by too much. They can get the sameeffect by beating it just enough.

H2: When customers are given choices at different price points, they will self-select themselves to the right version and will exhibit same loyalty as those receiving large price discount.

The loyalty here refers to attitudinal loyalty as there is no easy way to measure behavioral loyalty.

Experiment Design

I designed a between groups experiment to measure the difference between the stated attitudinal loyalty of different groups.  There are four groups in this experiment, all of them are filled in on Nespresso and were primed with a fixed willingness to pay of $30.

Since customers do not not what they are willing to pay and some of my experimental subjects may not know the cost of parts I used the price of $30 to normalize their willingness to pay.

Different groups were given different price rent by quoting them different price for the replacement part.

Group A:   WTP = $30, Quoted Price = $2.99
Group B:   WTP = $30, Quoted Price = $25.99
Group C:   WTP = $30, Quoted Price = $19.99
Group D:   WTP = $30,  Choices: Basic $9.99, Exact $19.99, Premium $28.99

Group B and Group C are similar but test different price points.

I designed the experiment using survey format (thanks to SurveyGizmo and its very powerful split testing functions) and ran it as a survey on people in my network and bunch of MBAs from Haas School of Business, Berkeley.

Respondents were asked to state their likelihood of repurchase  on a 6 point scale (a measure of loyalty). I also asked them to rate their likelihood to recommend the brand to others, more on this later.


For testing the first hypotheses I compared the sample mean using 1 tailed t-test.  Between Group A ($2.99)  and Group B ($25.99) there was statistically significant difference (p=0.023) between the two samples. This could mean that beating customer expectation by a mile, in the form of very low price will have higher effect on loyalty than beating customer expectation just by a foot.

Between Group A ($2.99) and Group C ($19.99), the difference is not statistically significant (p =0.243). This is a critical finding. While $25.99 was no enough, $19.99 engendered the same level of loyalty as $2.99. That is a huge price difference. Brands do not have to give away the farm in  the name of loyalty. This also points to lost profit opportunity for Nespresso.

Next  let us take the second hypothesis that choices and self-selection (Group D) would perform at least as good as giving steepest price discount (the $2.99 option Group A).

Comparing sample means show there is statistically significant difference between mean likelihood ratings of Group A and Group D (p = 0.014). This is a big surprise for three reasons.

For one thing, when customers were given choices and self-select themselves to the version they prefer, they are more likely to feel ownership and increased utility.

Second, this Group was offered the same $19.99 price for the “Exact Match” version. This was the only option offered to Group C. While Group C showed no difference from Group A, this group did. Presence of choice negated any positive effect from $19.99 price.

Third,  if we looked at the sub-group  that chose the lowest priced Basic version ($9.99), there still is statistically significant difference between this sub-group and Group A.

One conclusion we can make is that presence of options for replacement parts causes customers to incur cognitive cost that is reflected in the form of low loyalty rating.  However, this requires further consideration before casting aside versioning.

One interesting corollary is the correlation between loyalty measured as intention to repurchase and likelihood to recommend. As I stated before, I asked respondents to rate both. There is very high correlation (0.99) between the two metric. Likelihood to recommend is not a better measure as contend.

Marketing Implications

Loyalty does not have to mean “delighting, enchanting, astonishing” customers. You can beat customer expectations by just enough. This is attitudinal loyalty and may not translate into behavioral loyalty. So in general using price discount to generate future sales is not recommended.

Statistical significance does not mean economic significance. The mean loyalty rating for lowest price group was 4.4 vs. 3.68 for $25.99 group. Will gaining loyalty at the cost of $22 per customer generate more profit in the form of future purchases?

For pricing replacement parts, brands need to do Willingness to Pay studies just as they do for the full product. There is no reason to sell the replacement part at cost due to fears of customer backlash. Same principles of value based pricing apply for parts.

While multi-version pricing is effective in most scenarios, offering choices for replacement parts comes at a cost to customer (See 4 costs of versioning). While versions enable profit maximization its effect on customer loyalty needs to be considered.

Product – Price Promotion Fit

I saw a Groupon promotion from BlockBuster Express that gives away $5 worth kiosk movie rentals for $2. The deal, at the last check,  had sold more than 25,000 Groupons. For more than one reason, many of which I explain in my book, this is a very good use of Groupon by BlockBuster and in general a very good use of price promotion for a product.

Product: This is a basic utilitarian product that competes on price. Regular rentals go for $1.   The rental choice is likely limited, only so many DVDs can be stocked in a kiosk. The rental period is also limited – just one night. This is a convenience product, something people hire when they run out of most options. It is by no means a premium product.

Customer: There is no direct contact between the customer and customer service reps. It is a vending machine – as impersonal as it can get. There is no reason whatsoever to worry about customer experience and delighting customers. The customer mix and whether or not the new customers will fit the brand’s target segment is not a concern. Even without the promotion, customers choose this product for price not anything else.

Costs: The costs are all sunk once BlockBuster decides to place one and stock it with DVDs. If there are DVDs sitting in it, they are not making money. The marginal cost is close to $0, (it is the opportunity cost of not serving a full priced customer).  It makes sense to put these idle DVDs to work by encouraging  rentals.

Capacity: BlockBuster has many such kiosks and the offer is valid at any of them. So they are not risking over crowding in any one location. By the general rules of random distribution, we can assume that all kiosks will be utilized uniformly. This is a great improvement of capacity utilization of kiosks – making sure DVDs do not sit idle. Even if a kiosk runs out there are no downside risks – no customer backlash, customers either come back another day or move to next kiosk.

Bring in new customers: BlockBuster is struggling to hold on to its current store customers, as more and more are switching to Netflix. On the low end they are behind Redbox rentals. They are new to the rental kiosk business. Before this Groupon promotion, many customers did not even know about BlockBuster Express and even if they did they may not stop to try it.  A $2 for $5 deal is great way to bring them to the kiosk and create awareness.

Repeat Customers: This is a convenience product, not a premium product. There is a specific job this product is hired for. So the logic of people falling in love with service etc do not apply here. Even if only very small percentage of these customers come back, it is a better option than any other available customer acquisition option.

Groupon Fees: A brand like BlockBuster  may have negotiated a better fee for Groupon than the usual 50% small businesses pay. Even if they did not, this is a good application of Groupon as a  Marketing and Sales channel.

Overall the price promotion aligns very well with the product and the target customer segment.

What about your business and your product?


Improving Customer’s Perception of Service Delivered

Consider the following two scenarios

  1. A service that consistently provides  good service. Nothing ever goes wrong, it just works.
  2. Almost same as above with some exceptions. Once in a while something goes wrong, be it a service failure or over-billing. But as soon as the customer calls it is resolved right there, be it resolving service failure or  removing  $300 over charge without further questions.

In which of the two scenarios will a customer feel they are getting better service? Do  occasional problems and their immediate resolution improve a customer’s perception of the overall service?  Previous studies have shown how recency and intensity affect our perception and recall. Could these be applicable in this case?

From another perspective, is the presence of both good service and bad service increase a customer’s utility more than just good service? We saw the work of Wertenbroch and Dhar that found that utility from consuming virtue increased in the presence of vice options. Here the customers are not making choices but the choice is made for them, nevertheless customers are reminded of the  “vice option” and steered back to “virtue option”.