20Jan

The Importance of Reference Price

Author: Dan Skodol

The body of research on the psychology of pricing and what influences consumers' buying habits is vast - way too big of a topic to explore in any depth in a short blog post like this one. For the sake of time, we'll focus on one key conclusion of this research: that human beings tend to make judgments based on contrasts. This helps explain everything from optical illusions to people's irrational fear of flying to why we feel like airlines nickel-and-dime us to death with fee upon fee.

Sale sign at a department store

 

Let's begin with an interesting true story. Williams-Sonoma had a bread maker they were selling at a price of $250. Sales of this bread maker were poor. They decided to introduce a second bread maker with more advanced features, with a price tag of $450. Upon doing so, sales of the $250 bread maker took off. They didn't change a thing with the less expensive bread maker aside from placing a more expensive unit next to it.

This helps to show that contrasts in pricing are crucial determinants of customers' purchasing behavior. A "reference price" is a price that forms a starting point in the minds of buyers. The reference price will affect the way consumers view all subsequent pricing they are introduced to. Regardless of how this price is derived, it's human nature that people like to achieve a better outcome compared to this starting point. Likewise, human beings are particularly averse to an outcome that is unfavorable to this starting point, such that they'll even go to great lengths to avoid it.

Reference Price Concepts and Examples

Advertised Reference Price. You've seen this everywhere, particularly in retail stores. It's the "30% off" or "50% off" or "buy one get one free" sale, and it sounds like such an attractive deal on that $100 sweater you've had your eye on. But what's to say that the sweater is worth $100 to begin with? Where does that initial price even come from? Many of these "advertised reference prices" (ARPs) are simply designed to make the large markdowns seem so appealing. In truth, very few items sell at the original tag price in these instances.

Product-Line Pricing. The Williams-Sonoma bread maker is one example of product-line pricing. Having multiple product options with different levels of features establishes a higher reference price based on that aspirational, "top-of-the-line" model. Luxury cars are another great example; an entry-level BMW at $30,000+ sounds like quite a bargain with their more upmarket models going from $70-$80k or even more. Most of the time, sales volumes of the lower-priced model are what matter most to the seller; at the end of the day, Williams-Sonoma probably couldn't have cared less about how many $450 bread makers were sold.

Anchoring. Anchoring is the mere presence of a number - a price or otherwise - that subliminally changes our perceptions. Anchoring is that $10,000 bottle of wine, that $1,000 dessert, or that $300 cocktail - a price so ridiculous that we doubt anyone but the richest of the rich actually indulge. But, it still creates a reference price that will change how we view every other (cheaper) option. Anchoring also applies in negotiations, where one party may open with a number that is absurdly high (or low). Regardless of how absurd it may be, it's been proven to ultimately affect the final outcome of the negotiation. In fact, research has shown that a number that is completely random - and that we are aware is completely random - can influence our behavior, even in non-pricing situations.

Think about how reference price relates to whatever product or service you might be pricing. Also think about how you communicate or present your prices to customers. Does your high-rise apartment building in New York City have a $15,000/month penthouse? Do you always quote your lowest-priced hotel room option first, or do you take a top-down approach? How do you display pricing on your website for an array of different options? Sometimes understanding the often irrational behavior of your customers and how they respond to price can be the key to successful selling!

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