Priceless: The Myth of Fair Value (and How to Take Advantage of It) (21 page)

Hermann Simon is a man who can get upset about being offered a 35 percent discount on a Nikon camera (as he was recently). He was happily buying the camera when the salesperson insisted on knocking 35 percent off the price. This went against Simon’s core business philosophy, which one of his papers puts in plain language: “willingness to pay must be exploited to the full.”

The imperative tone of such pronouncements, coupled with Simon’s teutonic diction, can be startling at first encounter. Simon’s fascination
with “willingness to pay” is infectious, however. As much as any individual, he is behind the professionalization of pricing in the past couple of decades. In the early 1980s Simon was a University of Bielefeld business professor, occasionally consulting with corporations and often seeing his advice go unheeded. The psychology of price was becoming a hot topic. There was a confluence of reasons for that. For one thing, the ripples from Kahneman and Tversky’s work spread ever outward, sparking interest among marketers and retailers. Consider this survey question, published by Tversky and Kahneman in 1981 (itself loosely inspired by a puzzle that Jimmie Savage wrote about in 1954):

Imagine that you are about to purchase a jacket for $125 and a calculator for $15. The calculator salesman informs you that the calculator you wish to buy is on sale for $10 at the other branch of the store, located 20 minutes’ drive away. Would you make the trip to the other store?

Most respondents said they would. Another randomly selected group heard a different version of the question in which the jacket was only $15 and the calculator $125. The calculator was on sale for $120 at the other store. Was
that
worth the trip? Most said no.

Retailers spend their lives trying to understand what makes Joe and Jane Consumer willing to pay a higher price
here
than a lower price
there
. This was a provocative result (assuming that the survey applied to real consumers), and it was completely outside the understanding of standard economics. In both versions of the question, the buyer is planning to spend $140 total and the drive saves exactly $5. “Why are we more willing to drive across town to save money on a small purchase than a large one?” Richard Thaler asked. “Clearly there is some psychophysics at work here. Five dollars seems like a significant saving on a $15 purchase, but not so on a $125 purchase.”

The past decades have seen mounting optimism among psychologists and behavioral economists about the practical relevance of their work. Thaler envisions a benign future in which “choice engineers” use the science to help people make decisions better reflecting their inner values—to the extent that inner values exist in the brave new world of constructed prices and preferences. Sendhil Mullainathan, a former student of Thaler’s,
talks of using decision theory to help nations break out of the cycle of third-world poverty. “What we’re saying is that there is a technology emerging from behavioral economics,” Kahneman said. “It’s not only an abstract thing. You can do things with it. We are just at the beginning.”

The same decades have seen a parallel, less idealistic conception of what to do with the science: make money off it. Some of the academics, among them Thaler and Tversky, started connecting the dots for businesspeople in articles published mostly in marketing journals. There was a new scientific curiosity about venerable marketing tricks—prices ending in 9, rebates, discounts, outright gimmicks like “free” steak meals—and whether, or how, they worked. The Professional Pricing Society, founded in 1984, began bringing together Fortune 1000 businesspeople to share ideas.

Simon, though steeped in the work of the behavioralists, was skeptical about its application to the business world. A scientific result is valued for its simplicity and abstraction. The prospect theory paper is one example. The
Scientific American
crowd loves it because it’s a simple idea that explains
everything
. That in itself does not help businesses. Companies are more interested in specific solutions to their narrow, complicated (and sometimes
uninteresting
) problems.

A key development was technological. On June 26, 1974, a pack of Wrigley’s Juicy Fruit gum was scanned at Marsh’s Supermarket in Troy, Ohio. It was the first consumer product to be scanned at checkout, the culmination of an effort by IBM to design a scannable product code. Over the next years, scanners became common on both sides of the Atlantic. They produced a mountain of information. Everyone figured the data ought to be useful, but no one quite knew what to make of them.

One of Simon’s doctoral students, Eckhard Kucher, did his dissertation on scanner data. Kucher and Simon realized that the data offered a way to bridge price psychology and practical reality. They let analysts run decision “experiments” retroactively, looking at how consumers reacted (or didn’t react) to a price increase, sale, or rebate. The data capture any and all behavioral effects, as well as the traditional economic ones, and the results are specific to the business and its customers. Kucher proposed starting a consultancy offering businesses advice on how to fine-tune pricing. Simon was already thinking along those lines and quickly agreed. Their partnership went into business in early 1985.

A company may not be able to do much about its costs, Simon and Kucher argued, but it usually has freedom to set prices. The partners found that few businesspeople have any clear idea of what their customers are willing to pay, or how prices affect profits. This is one of the things that scanner data can help uncover.

Since the 1980s, the price consultant industry has burgeoned. Software is an important part of the toolkit. A supermarket or department store or online retailer has so many prices that only software can manage them all. Pricing software is in its fourth generation, according to Todd P. Michaud, CEO of Revionics. A client business inputs its scanner data and gets out profit-optimized prices (for each UPC code), illustrated with neat graphs showing why the price should be higher or lower. “Indeed, retail pricing software is now capable of teaching itself,” Michaud bragged.

It’s not just software, of course. Prices have become more creative than ever. Simon sees his consultants as architects of “price structures.” These are billing plans (think of your cell phone plan) that, one way or another, elaborate on the Big Texan gimmick of nonlinear pricing. The customer is encouraged to pay more than he intended in a paradoxical quest to get a low price. The psychology of decision making has much to say about why this works—and almost nothing to tell anyone who frets about its ethical ramifications. Many will feel that the customer has been duped into buying more meat, or minutes, than he truly wanted. The new psychology counters that “what the customer wants” is not nearly so clear-cut. It is constructed on the spot, influenced by details the conscious mind may believe to be immaterial. The price consultant’s job, needless to say, is to devise situations favorable to the client.

One SKP maxim runs, “Pricing is a dangerous lever.” A small change in prices can make a huge difference in profitability, for good or bad. Simon estimates that optimizing a company’s prices typically increases profit margins by about 2 percentage points, say from 5 percent to 7 percent. Michaud claims a similar 1 to 4 percent as a representative range. Because profit margins are small to begin with, adding a percent or two can boost profits immensely. Very few interventions can have such an effect on the bottom line. For hundreds of corporations, this sales pitch has been well-nigh irresistible.

You’ll find one of the most Machiavellian applications of coherent arbitrariness at any checkout stand. It’s the supermarket “loyalty card.” Customers who use loyalty cards are a self-selected group of cheapskates. They identify themselves as such every time they fumble to swipe a card because they can’t bear the thought of missing a 50-cent discount on Brawny towels. These are the customers who just might drive across town to save $5.

Loyalty card data tell the market what brands and items their cost-sensitive customers buy most regularly. According to Jim Hertel of Willard Bishop, a supermarket consulting firm, chains generally set aside their five hundred or so most frequently purchased items for special treatment. Markets know that customers will notice price increases on Coca-Cola or beef or Maxwell House coffee. As much as possible, they try to raise prices where it’s least likely to be noticed. Hardly anyone gets upset when they raise the price for chervil—or other infrequently purchased items like gourmet pasta sauce, pomegranates, goat cheese, or fresh-squeezed orange juice. “There’s an opportunity to make some margin back on those items,” Hertel explained. That’s because customers can’t remember what they paid last time and don’t otherwise have a precise notion of what these items should cost.

Supermarket consultants leave few stones unturned in determining what boosts consumers’ willingness to pay. One of the more intriguing of recent findings is that shoppers open their wallets wider when moving through a store in a counterclockwise direction. On average, these shoppers spend $2 more a trip than clockwise shoppers.

This was determined in studies of shopping cart movements. Herb Sorensen of Sorensen Associates has fitted carts with RFID tags emitting a radio ping every five seconds. This PathTracker technology allows sensors to triangulate each cart’s location, map its motion, and tally what was bought and at what price. No one is quite sure why counterclockwise shoppers buy more. Paco Underhill, CEO of Envirosell, mentions one popular guess, that North Americans see shopping carts as “cars” to be driven on the right. “If you want to get my attention,” Underhill said, “it better be to my right.” By this theory, the right-handed majority finds it easier to make impulse purchases when the wall or shelf is to the right. Sorensen’s findings have been widely adopted, with markets putting their main entrance on the right of the store’s layout to encourage counterclockwise shopping.

One of Richard Thaler’s best-known thought experiments concerns a grocery store. You’re lying on a beach on a hot day and desperately want a cold beer. A friend offers to go get a beer from the only place nearby, a small run-down grocery store. He warns it might be expensive, so he asks how much you’re willing to pay. He’ll buy the beer only if the store’s price is no greater than your limit.

When Thaler sprang this riddle on executives in the early 1980s, the average reserve price was $1.50. Another group heard the same story, except that the place selling the beer was said to be the bar of a fancy resort hotel. For this group, the average price was $2.65.

Both versions of the story made it clear that the friend was buying a bottle of your favorite brand of beer. It was the same product no matter where it was purchased. The ambience of the hotel was irrelevant because the beer was to be consumed back on the beach. Nevertheless, the average executive was willing to pay $2 for a bottle of beer from the fancy hotel, but not for the same bottle from the run-down grocery. The hotel bar that charged $2 was understood to be offering a fair price; for a run-down grocery, that $2 was price gouging.

Thaler considered what his imaginary grocer could do to boost beer sales. He advised “investing in seemingly superfluous luxury or installing a bar.” This would raise expectations about what the proper price of beer would be, resulting in more purchases.

Another suggestion was that the owner of the shabby grocery sell beer in unusually large containers, maybe 16 ounces instead of the usual 12. Consumers remember what a 12-ounce bottle of beer sells for. They may not know what 16 ounces should go for. (They could figure it, but most won’t.) Also, it’s easier to sneak extra profit onto a bigger quantity of beer than a smaller one.

Both of Thaler’s ideas can be observed in today’s supermarket industry. Upscale markets like Whole Foods make the most of “superfluous luxury.” This allows them to charge prices that wouldn’t be tolerated otherwise. Every Whole Foods store features a spectacularly styled produce department. “How cute are these?” asked a folksy sign next to Russian Banana fingerling potatoes in Manhattan’s Time Warner Center store.
Cuter than your basic spuds
, apparently—and don’t you dare go comparing prices.

Warehouse stores like Costco and Sam’s Club sell gallon drums of blue cheese salad dressing and thirty-roll packs of toilet paper. You are supposed to think you’re getting a good deal by buying in bulk. Sometimes you are . . . Other times, the deal isn’t so good as you think. It’s hard to tell. Not many shoppers know what a six-pound can of pineapple chunks ought to cost.

The “organic” and “green” designations have been windfalls for markets upscale and downscale. Whatever those terms mean, they also mean that the premium price doesn’t seem like such a rip-off.