Much of conventional economic theory revolves
around the assumption that an economy comprises rational actors seeking to
maximize utility. One implication of this hypothesis is that, all else being
equal, people will tend to favour a lower-priced product over a higher-priced
alternative.
However, research by behavioural economists and
psychologists—among them Daniel Kahneman of Princeton University—has cast
significant doubt upon the thesis of Homo economicus.
Contrary to the assertion that human beings tend to make rational decisions,
scholars have consistently found that decision-making is influenced by
cognitive biases, the perception of risk and reward, social pressures,
oversimplified snap judgements or prejudices, and various other subjective
factors that have very little to do with rationality.
This partly explains why many individuals choose
higher-priced products, even when all else is apparently equal—the authentic
Prada handbag versus a more affordable alternative; the glamorous Porsche, BMW,
or Ferrari versus a high-quality, reliable vehicle for half the price; a
painting by a famous artist for no reason other than its uniqueness and the
renown of its creator.
In conclusion, trying to compete on price is not
always an advisable strategy. But when can you reasonably expect that raising
the price of an item will deliver higher revenue? When is it best to stay put
or even go lower?
Subjective
perceptions of price
I often pass by a restaurant that attracts long
line-ups on the weekends, starting just before noon and continuing well into
the evening. This establishment offers tasty Mediterranean-style comfort food,
at a price that enables it to undercut its nearest competitors. Understandably,
it is tremendously popular.
Yet even in this case, we can see
less-than-rational economic behaviour at work. On rainy and chilly days,
lengthy queues still form outside this restaurant—which suggests that in the name
of a modest saving, customers gathered outside are willing to forgo both their
physical comfort and their precious time. (Is it really worth it?) Adding to
the complexity of the dilemma is the perception of sunk cost—the queuers may think to themselves “I’ve been standing
here for half an hour already; I might as well stick it out to the end.”
On the other hand, in my neighbourhood there is
a restaurant offering somewhat higher-quality Mediterranean fare for a higher
price. This business has also enjoyed commercial success and recently
expanded—but I have yet to encounter a line-up stretching out the door and
halfway around the block.
Some customers may perceive products with higher
prices to be superior, even if this is not necessarily the case. Do you want
your enterprise to be perceived as a low-cost provider, a high-quality outfit
that people will be willing to pay a little extra for, or somewhere in the
middle? What value do you offer that others don’t? Answering those questions
will help you not only formulate a pricing strategy, but more clearly define
your brand identity too.
Merits of
cost-plus and value-based pricing
As the name suggests, cost-plus pricing is based on tallying the fixed and variable costs
that you incur to provide a good or service to your customers, and then adding
a mark-up that enables you to turn a profit. On the other hand, value-based pricing is a reflection of
what you believe customers are willing to pay for the product or service you
offer.
Generally, cost-plus pricing is more apt for
industries in which the items on offer are generic or easily substitutable, and
there are many competitors. If your business is a convenience store, or sells
items that are readily available elsewhere, you will probably need to maintain
a cost-plus strategy and keep a watchful eye on local competitors’ prices.
Value-based pricing is better suited to
industries in which the items on offer have some subjective quality—such as
association with a particular brand or celebrity, atmosphere and ambience (as
in a restaurant), or an inimitable experience or flavour. Businesses that deal
in goods and services of this kind enjoy more pricing flexibility, and can
often get away with raising prices gradually as their profile and reputation
grow. On the negative side, this strategy can invite more competition, and
complicates the task of establishing an appropriate price in the first place.
Determining the right price for your products is a challenge that doesn’t necessarily lend itself to a straigthtforward answer. Particularly in the early stages of a business, some trial and error may be necessary. Nonetheless, a coherent pricing strategy begins with defining the type of brand identity you want your business to embody.
