3. Pricing Psychology

1. Product Pricing
2. Some Economics
3. Pricing Psychology
4. Pricing Pitfalls
5. Advanced Pricing
6. What a Price Says
7. Pricing Checklist
8. Bibliography & Credits

What is your product worth?

The demand curve, discussed in the previous section, might be dynamic and depend on many factors, but you can still exert some influence on its shape. In this chapter, I’ll talk about how people decide how much they’ll pay for a product, and how you can change this.

But first, you need to be able to answer a simple question: what is your product?

What is your product?

You might think that your software product is just the bits and bytes that your customers download, but you’d be wrong. In reality, your product is much broader than that. It’s not just the software – it’s the documentation, the help required to get it working and the promise of support when things go wrong. It’s the future roadmap of the product, the pledge to carry on developing future versions. In some cases, it’s a dream; a way of life.

One of the clearest examples comes from the accounting industry. At Red Gate, we use Sage’s accounting software. We’re not the only ones: Sage is a software business with 5.8 million customers, that employs 14,500 people and that has a market capitalization of nearly five billion dollars. It dominates the accounting market in the UK, and has seen off concerted attacks from, among others, Microsoft and Intuit.

But their software sucks.

It’s slow, and it’s hard to use. When I first used it in 1999, the buttons on the toolbar didn’t depress when I clicked them; they were just static pictures painted on a grey background. The application is so ugly that the product walkthroughs on the Sage web site barely feature the product itself.

These two facts, the awfulness of the product and the magnitude of its success, can be reconciled if you understand that Sage’s product is more than just the software.

When you buy Sage software, you are not just buying software. You are buying reassurance: when the tax laws change, the software will get updated too. You are buying familiarity: if you buy Sage, the odds are that your accountant or bookkeeper will already be able to use it. You’re buying support: if you don’t understand some of the accounting codes or procedures you need, then you can phone somebody for help. Forty thousand people call Sage’s help line per day.

The reason that Sage is so dominant in the UK is because Sage understands exactly what their product is. You need to do the same.

Perceived Value

Once you’ve determined what your product is, you need to consider
its value to your customers. In the case of the Time Tracker 3000, let’s say that it will save a particular customer, Willhelm, three hours of work and that Willhelm prices his time at $50 an hour. That means that Willhelm should buy the Time Tracker 3000 at any price under $150, assuming he has nothing better to spend his money on.

Of course, this assumes that Willhelm is the rational, decision-making machine that economists love. In fact, Willhelm is a flesh-and-blood, irrational human being who doesn’t price his time and calculate costs and benefits. He has a perceived value of the Time Tracker 3000, which may or may not be linked to its objective value.

The perceived value of a product may be higher than its objective value. In 2003, Gartner released a report that claimed that almost half of all customer relationship management (CRM) systems lie unused. That’s several billion dollars of software that smart people thought was worth it, but wasn’t.

Lottery tickets are another example where perceived values are higher than objective values. Buy a $5 lottery ticket and in the long run, based on probability, you only expect to get $3 back. But millions of people still buy them.

A product’s perceived value may be lower than its objective value too. A few years ago, I stumbled on somebody who insisted on using Excel as a word processor. According to this user, the additional expense of buying Microsoft Word wasn’t worth the benefits he’d gain. This was almost certainly a perception rather than a reality. That’s an extreme example of a very common situation. At Red Gate, we occasionally come across people who’d love to buy our software, but can’t justify the purchase to their boss. Here, the perception is that the several hours of somebody’s time that the tool will save aren’t worth the price of the software (a couple of hundred dollars). The reality is that the tool will pay for itself within a couple of weeks.

Back to Willhelm and the Time Tracker 3000. If you want to change how much Willhelm will pay for your product, then changing the product is one option, but only if you can also change his perception too. In fact, it turns out that you can change Willhelm’s perception of your product’s worth without touching the product at all. That’s one of the things marketing is for.

How people set their perceptions

So how do people generate their perceived value of a product? How do they decide how to think?

For a start, it’s extremely hard for them to do so in a vacuum. Try asking a British Member of Parliament how much a pint of milk costs, a con- testant on The Price is Right for the value of a chest of drawers, or the average supermarket shopper how much they should pay for a bottle of bleach. They’ll struggle.

People base their perceived values on reference points. If you’re selling a to-do list application, then people will look around and find another to-do list application. If they search the internet and discover that your competitors sell to-do list applications at $100 then this will set their perception of the right price for all to-do list applications.

When Microsoft released DOS 1.0 in 1982, they set a price of $50. At the time, an operating system for a mass-market computer was a brand new category. Since consumers had no reference point, and $50 seemed about right, it became accepted as a ‘fair’ price. When IBM launched OS/2 1.0 in 1989 and priced it at $340, consumers baulked. Not for an economic reason though: DOS and OS/2 were very different operating systems, and $340 could well have been a fair reflection of the additional economic benefit consumers would have extracted from the more-advanced OS/2. But Microsoft had already defined the reference point, and when IBM tried to challenge it they failed.

This doesn’t mean you need to copy the reference point. If your product genuinely is better than your competitors’, and you can demonstrate the value of this difference, or create a perception of that value, then you can charge more.

Of course, if your product is significantly less valuable than your competitors’ then you may have no choice but to charge less. Competing on price may be the only option you have. Take pharmaceuticals. My local supermarket stocks thirty or so different sorts of painkillers. You can buy a pack of 16 Nurofen for £1.97 ($3.40), or a pack of 16 Tesco analgesics for £0.32 (about 50 cents). The physical good – the 200mg of ibuprofen – is identical in both the generic and named brand product. But don’t forget that the entire product is more than the chemicals. It includes the marketing, brand name and packaging. Using this wider definition, Nurofen is the superior product, and the only way Tesco can compete is on price.

The value people perceive your product to have can depend on their taste. Some people are passionate about good wine and will pay $50 for a bottle, but others like the taste of $5 wine just fine. However, the tribe people belong to (see later) can affect how much they’re willing to pay. As Dave O’Flynn wrote to me:

“I never thought Apple products were worth the premium until I joined Atlassian. 12 months later, I gladly paid a large premium for a Macbook Air. The people I was surrounded with valued design and elegance. Prior to that, I was surrounded by people that valued bang for the buck and my laptop then was a generic AMD that weighed a ton in comparison. I was essentially the same person; the changes were in the expectations and sense of value of those around me.”

How much money they have affects their perception of value. Dennis Kozlowski, ex-CEO of Tyco, felt that $15,000 was a reasonable price to pay for a dog-shaped umbrella stand, but most of us don’t.

Knowledge influences the value people place on products. A laptop with a 1.4 GHz Intel Core 2 Duo processor, 4GB of RAM and a blu-ray drive running Ubuntu is worth more than one with an N-Series Intel Atom Processor and a DVD drive to me, but not to my mum.

It’s a cheap trick, but fives and nines exert another powerful psycho- logical effect on people’s perception of value. Just as $1.99 seems much less than $2 in a supermarket queue, $1995 seems significantly less than $2000 on a web site.

Increasing perceived values

The pharmaceutical industry holds another good example of how marketing can increase the perceived value of a product, without changing its substance. In 1981, when Glaxo wanted to release Zantac, their anti-ulcer drug, they faced a marketplace dominated by SmithKline’s Tagamet. Although Glaxo felt their drug was more effective than SmithKline’s, the US FDA rated Zantac as providing little or no benefit over existing treatments. Rather than marketing Zantac as a me-too product, at a similar price to Tagamet, Glaxo decided to spend heavily on saturating their sales and marketing channels. This ubiquitous promotion increased Zantac’s perceived value, and they were able to price the product higher to reflect this added value. By the end of the 1980s, Zantac had knocked Tagamet off its perch as the best selling drug in the world.

Here are some more ways of increasing the perceived value of your product:

Increase its objective value. Perceived and objective values aren’t identical, but they’re still correlated. As Joel Spolsky wrote in 2006:

“With six years of experience running my own software company, I can tell you that nothing we have ever done at Fog Creek has increased our revenue more than releasing a new version with more features. Nothing. The flow to our bottom line from new versions with new features is absolutely undeni- able. It’s like gravity. When we tried Google ads, when we implemented various affiliate schemes, or when an article about FogBugz appears in the press, we could barely see the effe􏰖 on the bottom line. When a new version comes out with new features, we see a sudden, undeniable, sub􏰗antial, and permanent increase in revenue.”

Give your product a personality. 37signals may not sell the best project management software in the world, but it has personality. The 37signals team stands for something: uncompromising simplicity. Want an extra feature? Tough. If you want features, buy something else.

Link your product to yourself, and then define, and promote, your- self as an expert. In its early days, before his company was bought by Symantec in 1990, Norton Utilities and Peter Norton were synonymous. All of Norton’s products featured a picture of himself, with his arms crossed.

Make people love your product. When Black and Decker introduced its DeWALT line of drills, it went to building sites and lumber yards at lunch times to hand out pulled pork sandwiches, give product demos and hold drill-off competitions, with prizes. They went to NASCAR races and rodeos, where their end users hung out. They made people love the brand, not just the product. Now the DeWALT drills have a massive following amongst amateurs too; people who are keen to associate themselves with the professionals. Despite the famous adage to the contrary, it turns out that people buy drills, not holes. And $400 drills, too.

Provide a better service. When somebody buys software, they want reassurance that it’s going to work and that you’ll be around if it doesn’t. If you’re a small company with big competitors, this is some- thing you can do better than they can. Capitalize on it.

Provide reassurance, through your reputation. Originally, brands were a mechanism for creating trust. Back in the 1880s, you were guaranteed that the next bar of Ivory soap you bought would be the same as the first. More recently, the first manufacturers of PC clones struggled against the common “nobody ever got fired for buying IBM” mentality.

Create a tribe. Products can be symbols of belonging. If you can turn your product into a badge that people wear to make a statement about who they are, which groups they belong to, and which they don’t, then that’s valuable. Amateur DIYers don’t need to spend $400 on a DeWALT drill, but they like feeling part of the ‘professional’ tribe.

Remind people of how much work you’ve put into your product. People are more likely to pay for years of your time than for an easily- copied software product. The twenty year old Bill Gates used this tech- nique in his now-famous ‘open letter to hobbyists’ in the Homebrew Computer Club newsletter in 1976:

“Almost a year ago, Paul Allen and myself, expecting the hobby market to expand, hired Monte Davidoff and developed Altair BASIC. Though the initial work took only two months, the three of us have spent most of the last year documenting, improving and adding features to BASIC. Now we have 4K, 8K, EXTENDED, ROM and DISK BASIC. The value of the computer time we have used exceeds $40,000.”

Appeal to people’s sense of fairness. When coffee shops charge an extra 10 cents for coffee made with Fairtrade beans, they’re lining their pockets with your ethics. How much of those ten cents go to the farmer who originally farmed the quarter of an ounce of coffee beans that went into your Fairtrade latte? Under a penny.

Sell more than just the physical product. The latest BMW adverts are absolutely explicit about this. Set to videos of beautiful people doing fun things, the voiceover says “We are a car company. But we don’t just make cars. […] We realized a long time ago that what you make people feel is just as important as what you make. At BMW, we don’t just make cars. We make joy.” How much is joy worth? Certainly more than just the price of a car.

Ultimately, it comes down to differentiating your product. It almost doesn’t matter on what – features, benefits, the way that you sell, the service that you provide, the country you’re based in – more or less anything will do.

Signposts

Now that you know that customers will find reference points to compare your product’s price against, you should do all you can to encourage favorable references and discourage unfavorable ones. If you want to sell a to-do list at $200, when the market price is $100, then you need to add a couple of features so your customers cannot make a direct comparison, and then promote comparisons to other companies’ $300 productivity suites, not their to-do lists. At the same time, avoid all comparisons to open source alternatives.

If your customers can’t find a reference point for your product, then they look for proxies, or signposts. Supermarkets take advantage of this: consumers decide whether luxury ice cream (something they don’t buy regularly) is reasonably priced based on whether diet coke (something they buy all the time) is good value. If a supermarket sells a can of diet coke for $2, consumers assume all their other products will be expensive too.

Say you sell two products: the Time Tracker 3000 and the Task List 400, a to-do list application. When somebody thinks of something they need to do, they store it in the Task List 400. Later on, they can prioritize their tasks, split them up into sub tasks, track their progress and smugly mark off the tasks as done.

Let’s say the Time Tracker 3000 has no competitors, but the Task List 400 has plenty. Your customers will judge your Time Tracker 3000 price on how you’ve priced the Task List 400. Charge a reasonable $25 for your to-do list application and customers will take your word that $300 is a good price for the Time Tracker 3000. Charge $1000 for the first app, and they’ll assume you’re fleecing them on the new one too.

If your product is unique, and customers can find no reference points or signposts, then you have a chance to set your customers expectations, and define their perceptions. If you tell your customers that the Time Tracker 3000 is worth $300, then the odds are they’ll believe you. We’ve already seen how Microsoft did that with the first version of MS-DOS.

If you have competitors in your market, then your customers will be more conscious of cost, but if your product creates a new category, then early adopters are less likely to be price sensitive. If you can create a teleporter, a brand new category of product, that will beam you, unharmed, from New York to Paris then not only can you define your price, but you can also raise your price from $20,000 to $25,000 and people will still buy it. But if you create a car, a new product within a category that already exists, and increase your price from $20,000 to $25,000 then your sales will suffer.