Pricing Power

“Understanding the irrationalities inherent to human nature is every bit as important as understanding how to read a balance sheet and an income statement.” – Robert Hagstom

People make funny decisions with money sometimes. Here are three examples that I find fascinating and confusing yet not all that surprising.

1. Used Car Sales
A group of University of Chicago professors looked at how the mileage on used cars affected the price point people were willing to pay:

For example, cars with odometer values between 79,900 and 79,999 miles are sold on average for approximately $210 more than cars with odometer values between 80,000 and 80,100 miles, but for only $10 less than cars with odometer readings between 79,800 and 79,899. Regression analyses show significant price discontinuities at each 10,000-mile threshold from 10,000 to 100,000 miles. The size of the discontinuities is similar across each threshold, consistently on the order of $150 to $200.

Basically, even though the mileage was within a narrow band (79,800 to 80,100), where the odometer fell had a large impact on the price people were willing to pay. It’s not like the sellers of these cars were trying to trick people either. The numbers are right there for everyone to see.

Psychological heuristics such as what these authors term the left-digit bias (a new one to me) suggest that people can focus on one digit in a number and completely ignore the rest.

This is the reason that retailers price their products for $9.99 instead of $10.00 or even $9.89.

A few pennies or even a few hundred miles shouldn’t make a difference in our decision-making process but because of our peculiar brains, we continue to make these types of errors.

2. IHOP’s Menu
The next example in pricing peculiarities comes from the International House of Pancakes. IHOP redesigned their menu and have credited their changes with an increase in sales of nearly 4%, including additional items that many patrons of their fine dining establishment ignored in year’s past.

They added a few idea bubbles above some of the menu items with such catchy phrases as:

Breakfast never smelled so good

Yum, breakfast, lunch and dinner anytime!! 🙂

I think the smiley face is what really drove those sales.

They also added pictures of each item to grab your attention while decreasing the number of options on the menu to limit the number of choices diners have to make. They even differentiated pages on the menu for various age groups to make each diner feel special.

I’m sure you’re thinking to yourself that ‘A change in a menu couldn’t possibly sway me one way or another.’

Yet I know that this is how restaurants operate but this stuff still works on me every time.

Drink specials usually lead people to consume more than they would have otherwise. New menu items tend to attract adventurous eaters. And experienced wait staff know exactly how to nudge you in the right direction to try something extra or different (read: more expensive).

Just know that most of the time these places have won before you even walk through the door.

3. J.C. Penney Coupons
The final irrational pricing exercise comes from J.C. Penney. When former Apple executive Ron Johnson took over the company in 2012 he decided to simplify the company’s pricing strategy.

Before he came on board the company was running nearly 600 sale events per year! And nearly 75% of the merchandise they sold was on sale for 50% off or more. It seemed like these coupons filled my mailbox at least a couple times a week.

Johnson decided to change things up and shoot for an everyday low price strategy that didn’t rely on sales or coupons.

It didn’t work. Customers were too enthralled with the old system.

Consumers were addicted to the coupons and finding “deals.” This from the New York Times:

“It may be a decent deal to buy that item for $5,” said Ms. Fobes, who runs Penny Pinchin’ Mom, a blog about couponing strategies. “But for someone like me, who’s always looking for a sale or a coupon — seeing that something is marked down 20 percent off, then being able to hand over the coupon to save, it just entices me,” she said. “It’s a rush.”

Sales dropped by 25% and Johnson was out of a job a little more than a year later.

The customers had no idea what the value was on the items they were buying. They just knew that they were getting them marked down from a higher price so it had to be a good deal, right?

Pricing Lessons?
It’s amazing how companies can get into our heads and change our perception of value so easily.

One of the most important cognitive biases to understand from these pricing errors is anchoring. Anchoring refers to our tendency to focus heavily on the first piece of information that we see when making decisions.

J.C. Penney shoppers anchored their pricing decisions on the retail price before the coupons. They thought they were extracting value from those purchases by getting up to 50% off by using coupons.

The same is true of the tiny differences in mileage on the used cars as well as differential pricing strategies from restaurants like IHOP.

Investors fall prey to this trick all the time when they see an investment go down in price. We tell ourselves that if the investment can just make it back to the original cost value that we’ll sell it and move in.

Of course, this says nothing about the fundamental value of the investment from the perspective of the value at the new lower price.

Sometimes it makes sense to hold your ground after a large loss, but your initial cost should have zero weighting on the prospects of the investment going forward.

The same theory applies when making other purchases. Focus on value, not price.

Heuristic Thinking and Limited Attention in the Car Market (AER)
How IHOP’s new menu gets customers to spend more (Businessweek)
Sometimes, we want prices to fool us (NY times)