Book Summary

Pricing psychology

This evening, I re-read a chapter from a book I have called Predictably Irrationality, The Hidden Forces That Shape Our Decisions, by Dan Ariely. In truth, I tried writing this before but never got around to finishing it. I started sometime last year but in the spirit of New Years’, I decided why not try it again? The book attempts to challenge the reader’s assumption about rational thought. Ariely stated goal is “to fundamentally rethink what makes you and the people around you tick” and for me — I think he certainly achieved this goal.

In the chapter, The Truth About Relativity, Ariel argues humans don’t have an internal measure of how much a product or service is worth. Instead, we try to estimate the value by comparing the relative advantage one might have over the other. (For Instance, one might not know how much a 16oz jar of Terrance’s Old-fashion Peanut Butter may cost but it’s easy to assume it’s more expensive than an 8oz jar).

Decoy Effect

So let’s do a thought exercise. Imagine you’re a university student shopping online for textbooks. You come across the following example:

  1. Digital edition for $10
  2. Print edition for $18
  3. Print and digital edition for $18

Which one do you choose? With the print and print/digital edition being the same price, many consumers would choose the latter. Option #3 seems like a no-brainer; the digital edition appears to be free. However, this is a form of subtle manipulation. As you may not know whether the digital is better than the print edition, but you certainly know the print/digital edition is much better than the print only. Since our brains can’t naturally determine the intrinsic value, we use a few context clues to give us information. This incentivizes companies to design pricing strategies to shift consumer preferences; sometimes deliberately providing consumers with misleading information to maximize profits.

Let’s assume it’s this company’s goal to secretly maximize the sale of option #3. The company would purposefully place the inferior print edition for $18 as a decoy. Decoying is a pricing method that nudges consumers into a particular choice. Consumers naturally compare the print edition to the print/digital edition because they’re the same price. As a result, many would opt for Option #3 — thus increasing the company’s revenue.

Now let’s imagine if Option #2 — the print edition never existed and the prices were as follows:

  1. Digital edition for $10
  2. Print/digital edition for $18

Consumers would have no incentive in purchasing the bundled version and would opt for the digital-only version because it satisfies most of their needs for a reduced cost. This is also known as the compromise effect.

Compromise Effect

The compromise effect states that consumers would choose the middle option in a selection set rather than the two extremes. The belief is consumers are naturally risk-averse. There’s uncertainty in purchasing the cheaper product with fewer features and the more expensive product with features you may not need. Consequently, consumer preference often shifts towards the middle product offering. Or in the words of the author, “Like an airplane pilot landing in the dark, we want runway lights on either side of us, guiding us to the place where we can touch down our wheels.”

You can see examples of this everywhere. At the time of this writing, Netflix has three plans for video streaming: Basic, Standard, Premium. With the compromise effect in mind, it’s probably safe to assume the Standard is their most popular.

My Takeaways

Human behavior isn’t as always rational as it seems. Everything is relative and we naturally compare things to one another. We don’t know what shoes we want — until we see our favorite athlete in them. We don’t know what phone we want — until we compare several different models in stores or online. We don’t know what career we want — until we see a family member, friend, or someone we admire do it. Likewise, in consumer behavior, everything is largely contextual. Consumers do not have a natural way of determining the price of an item, rather they estimate the value based on the relative advantages it has against a similar item.

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