Strategic Pricing: Theory, Practice and Policy

1. Strategic Pricing: Theory, Practice and Policy Professor John W. Mayo mayoj@georgetown.edu

2. The Psychology of Pricing

3. The Psychology of Pricing • Normally, the foundation of demand begins with a consumer’s dependent on the goods she consumes: Ui=U(q1i,q2i, …qni) • But what if consumers’ utility also depends on the consumption of other consumers: Ui=U(q1i,q2i, …qni;q1k,q2k, …qnk) • In this case an individual i’s utility depends upon the quantity of goods consumed by consumer k • Seminal work is Leibenstein (1950)

4. Functional and Nonfunctional demand • Functional demand: demand attributable to the inherent properties of the good or service • Nonfunctional demand: demand attributable to other factors

5. Nonfunctional demand • Ui=U(q1i,q2i, …qni;q1k,q2k, …qnk) • Bandwagon effect • ∂Ui/∂q1k >0. Examples??? • Snob effect Examples??? • ∂Ui/∂q1k <0. • Veblen effect Examples??? • ∂Ui/∂p1k >0.

6. The Bandwagon Effect Let qi = f(p, Qα) for every consumer i facing a market demand given by Qα. Then A series of market demands can be drawn Dα… Dn $/Q The only “equilibrium” demand curve is Given by the locus that aligns The expectations of consumers and reality Note that to the extent that Demand for a product Includes bandwagon effects, market Demand becomes more elastic Dα Dn Q α n

7. The Snob Effect Let qi = f(p, Qα) for every consumer i facing a market demand given by Qα. Then A series of market demands can be drawn Dα… Dn $/Q The only “equilibrium” demand curve is Given by the locus that aligns The expectations of consumers and reality Note that to the extent that Demand for a product Includes bandwagon effects, market Demand becomes less elastic Dα Dn Q α n

8. The Veblen Effect Let qi = f(p, pα) where p is the “real” price and pα is the price that other people believe the consumer paid for the good. Then a series of market demands can be drawn Dα… Dn that correspond to consumers beliefs that α…n are the “conspicuous prices” $/Q The only “equilibrium” demand curve is given by the locus that aligns The expectations of consumers and reality (p,pn) Note that to the extent that Demand for a product with Veblen Effects may be upward sloping (p,pα) Dn D3 Dα D2 Q

9. The Role of “the first price” in final transaction prices • Consider real estate market, car market, flea market • Seller establishes a high price to “anchor” the final price • But might a low initial price ever lead to a high transaction price? • Ku, Gallinsky and Murnighan (2006)

10. Yes • Lower initial prices encourage more bidders • Bidders may (contrary to economic advice) view early bids as sunk and be subject to the “escalation of commitment” • A lower initial price attracts bidders, which attracts additional bidders • bidders may judge value by the number of other bidders chasing the good (the empty restaurant problem)

11. Bidder valuation Number of Bidders Lower ask price attracts more bidders Low Ask price High ask price Bidder “valuation

12. Bidder valuation Number of Bidders (n) If bidders valuation =f(n), the presence of other bidders will shift the distribution Bidder “valuation

13. Which restaurant do you prefer?

14. You Get what you pay for…Placebo Effects and Prices • Shiv, Carmon and Ariely, JoMR, 2005 • Well known that marketing can affect perceptions…high price can create the perception of high quality • But can high prices affect actual quality?

15. You Get what you pay for…Placebo Effects and Prices • Four studies • Twinlab Ultra Fuel (TUF) • Subjects were given TUF. Some were told that TUF was high price, some low price. Subjects rated (1) intensity of workout; (2) fatigue • Results: subjects reported greater intensity of workout and lower fatigue with high priced TUF. A placebo effect of prices? • Shortcomings: • (1) perceptions of performance, not actual; (2) no control group; (3) subjects did not pay for TUF; and (4) no ability to discern casual effects

16. You Get what you pay for…Placebo Effects and Prices Experiments 2,3,4: Test placebo-price effects for SoBe Adrenaline Rush. Test: actual performance, paid prices with “expectancy” and price variation Price Regular Discount High Expectancy Low

17. You Get what you pay for…Placebo Effects and Prices = discount price Puzzles Solved = regular price Low Expectancy High Expectancy Result: Expectancy mediates the placebo-price effect

18. Freeconomics:The Psychology of Zero • Country clubs reservations • Telephone calls in expanded local calling areas • What happens to aggregate demand if one of your products is “free”? • Washington Post and Washingtonpost.com • Gentzkow (American Economic Review 2007)

19. Pricing in Pieces: “Plus Shipping and Handling” • Many firms partition the price of their “final” good into pieces (e.g. a book plus S&H) • A “rational” consumer would be indifferent to the allocation of unavoidable charges • Yet, it is often suggested that consumers may have “mental accounts” that partition off these separate charges and only pay attention to the “list” price • Evidence?

20. Evidence • Hossain and Morgan (Advances in Economic Analysis and Policy, 2006) • 80 auctions on eBay of CDs and Xbox games • Varied reserve price (minimum payment) and shipping and handling • Result: Setting a low open bid and a high shipping and handling cost yields systematically more revenue than doing the reverse.

21. Big Sale: This weekend only!(“The Marlo Effect”?) • Consumers often “discount discounting”. Why? • General consumer skepticism of exaggerated claims • Consumers’ inability to correctly perceive discounts • If latter, then how to improve consumers’ ability to process price information

22. “Pay 80 percent” v. “Get 20 Percent off” • Norm in US is “X percent off” while in other places (e.g., Hong Kong) “pay 1-X percent” • Should this make a difference?

23. Kim and KramerMarketing Letters, 2006 • Ho: Consumers’ likelihood of purchase increases with “novel” presentation of price discounts • H1: Consumers’ recall of prices will be greater with “novel” presentation of price discounts • H2: Effects of “novel” discounts will be greater if denominated in percentages instead of dollars

24. Methodology • U.S. students asked to rate likelihood of purchase of a Sony Digital Camera • Results: (Ho)Novelty of presentation (pay 80 percent) significantly enhanced likelihood of purchase • But only US students … so repeat study with us and Hong Kong subjects. In each case “novel” presentation enhanced likelihood of sale

25. The Effects of Novelty Likelihood of purchase Get 40% off Pay 60% US Hong Kong Note that when test was run with discounts in dollars, effects of novelty dissipate