1. Use discrete measures of willingness to pay
One of the most important aspects of the retail process that retailers face is deciding how to optimally price their products or services. Charge too much and you may stifle interest. Charge too little and you’re leaving money on the table.
Kellogg professors Derek Rucker and Eric Anderson and a colleague surveyed the existing research to determine if there is a consensus on how best to determine customers’ willingness to pay (WTP). They found that existing methods were inadequate and left out key information that could improve efforts to accurately measure this factor.
“You might pay over $10 for your favorite beer at a fancy hotel bar, but only $5 for the same beer from a vendor on the beach,” says Anderson. “This difference in WTP may be perfectly reasonable and due to what alternatives are available. Asking consumers only what they are willing to pay misses a critical aspect of the measurement, which is the comparisons consumers consider.”
The team presented a new approachcalled the Comparative Valuation Method, which is adaptable to different situations and allows marketers to see what alternatives consumers are considering. The method always takes into account comparisons with competitors.
“As a marketer, you don’t just need to understand what your brand offers—you also need to understand who you’re competing against,” says Anderson. “We can’t become so brand-centric that we only focus on ourselves. We need to know what alternatives consumers have in mind.”
2. Don’t be afraid of dynamic pricing
Price change can also be slow for practical reasons. It takes time and labor to replace product prices in stores. However, new digital technologies have made rapid price fluctuations more common, including the notorious practice of “surge pricing” during periods of high demand.
For many customers, the adoption of surge pricing by companies like Uber raised red flags about its potential for misuse. When grocery giants Walmart and Kroger announced they would install electronic shelf labels, similar alarms went off.
“Some people might say that the fact that these stores are willing to put up so much money to install these electronic shelf tags is prima facie evidence that they intend to raise prices, because there’s no reason to install them otherwise,” he says.Robert Brayassociate professor of Operations at the Kellogg School.
But when Bray and his colleagues compiled transaction data from more than 100 grocery stores, they found that price increases in grocery aisles are highly unlikely for several reasons. Stores carry too many products, have too many separate contracts with suppliers, and see too little chance of winning individual products without turning off loyal customers whose return purchases are the heart of the industry’s profits.
In contrast, US grocery retailers claim that digital price tags will make stores more efficient and lower pricing costs. So far, it appears that these retailers have avoided making a profit through rapid price increases. If anything, digital price tags are more likely to be used to run signs that would help sell perishable products before their expiration dates pass.
“Now we see that keeping prices relatively stable was not a technological limitation, it was a sound business decision,” says Bray.
3. Profits increase through incremental price increases
One of the most fundamental relationships in marketing is between how much customers want something and the price they are willing to pay. But determining the demand curve of a product or service can be fraught with variation Suraj Malladiassistant professor of managerial economics and decision science at Kellogg.
Change prices too slowly—or too quickly—and you risk shrinking profit margins or losing customers. To avoid this, many businesses resort to the simple method of gradual, gradual price increases, testing where demand begins to fall.
“In other words, firms act as if the demand curve is ‘skewed’: falling prices will barely stimulate demand, but rising prices will quickly reduce demand,” says Malladi.
Malladi has developed a financial model to show the rationale behind this approach as well as how it can increase prices in the long term. The model simplifies the price determination process in several ways. First, it makes demand curves persistent—meaning that demand is constant over time. Then, the firms in the model do not know the demand for their product or service in the first place.
It also assumes that the company’s pricing experiments happen sequentially and relatively infrequently — “a high-stakes, low-velocity decision,” as Malladi describes it. This increases the consequences of poor pricing.
“Many businesses set flat prices and rarely change them,” he says. “For these businesses, it’s important to think carefully about the order in which you change prices.”
While the model considers only certain types of pricing factors—it excludes processes such as dynamic pricing and promotional sales and price changes to change demand—it illuminates how firms gather information about demand for products and services through incremental price increases.
“Venture investors and management consultancies give advice on how companies should change their prices, and the message is often ‘raise prices.’ The model gives an economic justification for why they might recommend it,” says Malladi.
4. Compare apples to apples
Among the factors that affect pricing is the target audience for a particular product or service. For example, products marketed to women are traditionally priced higher than those marketed to men. But are women paying more for the same thing – a “pink tax” that amounts to price discrimination?
This was a Kellogg’s question Anna Tuchman and colleagues looked at in a study that focused on factors that could account for the price difference. What they found was that the ingredients of the products themselves were different—using different ingredients, for example—and those differences accounted for the price gaps.
Their study focused on personal care products marketed to both men and women that were sold in Walgreens stores across the United States. While they confirmed that products marketed to women were more expensive, their ingredient makeup was substantially different. In accounting for these differences, an apples-to-apples comparison between products found that price differences “wash out across categories,” according to Tuchman.
This does not necessarily mean that women pay the same amount for personal care products as men. Cultural expectations mean that the volume and range of products marketed to women is much greater.
“The basket of goods is just bigger for women,” says Tuchman. “Within the basket, individual items may have the same price, but it’s a bigger basket.”
5. Choose a better price than free
One strategy available to companies looking to generate buzz about a new product is to offer it for free so customers have a chance to try it before opening their wallets.
But is the “zero price” strategy the best way to build an audience?
Kellogg’s Galen Bodenhausen and two colleagues conducted research to test whether free is always the most attractive price, or whether there are cases when charging a nominal fee might be preferable to customers.
“We wanted to know, what are the limits of the zero price offer?” says Bodenhausen. “We wanted to show that while it seems intuitive to offer a product for free, it’s not always in merchants’ best interest to offer a zero price. There are some cases where a low, non-zero price can do a better job of driving demand.”
The researchers found that when there are high incidental costs to the purchase—such as the time and effort required to purchase it—the purchase calculus changes. When the product is free, consumers pay more attention to these non-monetary costs.
In cases like these, the researchers looked at whether offering a low, non-zero price might be more attractive to consumers. They found that when consumers had to weigh the purchase and the effort to make the purchase, paying a small fee was more attractive than receiving a free product.
Therefore, zero values should be avoided when the associated costs are high — for example, when people have to travel to a location to receive their free product.
The researchers were surprised by this result, adds Bodenhausen. “I thought that maybe people would be suspicious of a 1 cent price, that maybe it might cause more scrutiny, but it was still much more effective than a zero price.”
