The Psychology of Price.

This week we explore the psychology behind prices.

First, we'll look at how you're influenced by pricing. Like how the price of a bottle of wine has an enormous affect on how much you enjoy that wine, and how stores price one item really high to influence you to buy the slightly cheaper option. 

We'll analyze how restaurants design menus to steer you toward the most profitable dishes, and how retail stores use psychology to persuade you to spend more. 

We'll also explore the psychological power of the number "9" - how we're drawn to prices that end in "99 cents." And how we're willing to pay more for products that end in the number 9! 

It's all a numbers game. 

One day, a married couple named Mel and Patricia Ziegler decided to travel the world.

There was only thing stopping them... money. 

They both worked for a newspaper, but their salaries were small. So they decided to start a business on the side to earn more cash.

When Mel came back from an assignment in Australia wearing an interesting safari jacket he had bought for $5, the couple decided to start a  clothing company.

They had no business experience, no retail fashion experience, no backers, and only had $1,500.00 in the bank.

The good news was it was 1978. The disco era was in full swing, and it wasn't a great time for fashion. It was a Saturday Night Fever polyester world.

So the Zieglers went to a surplus store in town, and spent most of their savings on a shipment of paratrooper shirts that cost $1.75 each.

They sewed elbow patches on them, changed the buttons, and figured the shirts could sell for a profit at a local flea market.

They charged $6.75 - and sold four.

Which wasn't good.

So the next weekend, Patricia decided to wear one of the shirts. She belted it, rolled up the sleeves, and put a sign on the table that said, "Short Armed Paratrooper Shirts."

Then the Ziegler's did one more thing.

They doubled the price.

And immediately sold out.

That was a big business lesson for the Zieglers.

They learned the power of presentation, but more importantly, the concept of perceived value based on price.

Doubling the price of their shirts at a flea market was an outrageous decision. Who doubles the price of anything at a flea market?

But that new price point made people suddenly value the shirts more than they did the day before.

With that success, the Ziegler's decided to open a small store.

And they called it... Banana Republic.

Pricing is one of the most influential aspects of marketing.

Virtually every purchase decision you make is based on price. It tells you if the product is quality, if its luxury, if it's a commodity, if it's overpriced or if it's a bargain and a half.

But what's easy to forget is that most prices are determined, not by cost, but by psychology. Prices are very carefully designed to influence our purchases, to steer us to specific items and persuade us to spend much more than we planned on.

It's one of the most fascinating aspects of marketing.

And it's a numbers game.

The subject of "price" is usually the most important factor when it comes to deciding on a purchase.

You may like what the item does, like how it looks, you may even  lust after it - but if you don't like the price, you won't buy it.

Prices are a fact of life.

From the food we eat, to the clothes we wear, to the cars we drive, to the homes we live in, to the vacations we take - price ultimately determines every single decision.

Most people believe the price of a product is made up of three factors:

1. What it cost to make. 
2. A reasonable markup or profit.
3. What the competitive market will bear. 

But there is so much  more to prices than that.

Because there is enormous psychology at work.

There are many pricing strategies marketers use to subtly influence your shopping decisions. 

One of the most popular is called, "anchoring."

Anchoring is based on first impressions. If you are shown a high price for an item, your expectations for the value of that item will shift upwards.

It gives you a frame of reference, especially if you are a little uncertain about what you should be paying. 

So many retailers use an "anchor price" to influence your purchase decision.

Essentially, they will offer you a highly priced product. Then, they will offer you a slightly lower-priced option.

Suddenly, the lower priced item seems like a bargain.

It may not be a "low price," but compared to the high priced option - the anchor, in other words - the lower price is instantly desirable.

But - had you  not seen the anchor price, you might have thought the second price was high.

See how the concept works?

The retailer was using the high-priced anchor as a way to steer you to the real price they were hoping for all along.

Williams-Sonoma, a high-end houseware store, once used the concept of anchoring to solve an interesting problem.

When they introduced their bread machines, sales were slow and sluggish. So they added a "deluxe" version that was priced  50% higher.

Suddenly, the original bread machine started flying off the shelves.

Now, it felt like a bargain.

Anchoring can also affect how you value something.

In his book  Predictably Irrational, psychology professor Dan Ariely tells the story of a fascinating experiment he carried out with his students.

First, he asked each of them to write down the last two digits of their Social Security Numbers on a piece of paper.

Next, he showed them a bottle of wine, and described the flavour, the winery, and read a positive review from a wine publication.

Then he asked the students to guess the  price of the wine.

That's when the most interesting thing happened.

Students who had the highest-ending Social Security digits - from 80 to 99 - guessed the  highest prices for the wine.

The students with the lowest Social Security numbers - from 11 to 20 - guessed the lowest prices.

Look at what just happened there - by asking the students to write down a number  just prior to making a price guess -  influenced that guess.

Their Social Security numbers had acted as an anchor.

The bigger numbers influenced high guesses, the smaller numbers influenced low guesses.

That's how powerful anchoring can be.

Not even juries are immune from this concept.

It has been proven time and again that when lawyers ask for astronomical financial settlements, juries may not give the lawyer exactly what he's asking for - but they will almost always award a higher settlement, than if the lawyer had begun with a lower amount.

The astronomical ask was the anchor.

Restaurants use the concept of anchoring very effectively.

In his book,  Priceless: The Myth of Fair Value, author William Poundstone analyzes a typical menu, showing how they are carefully constructed to steer you to certain dishes.

As a rule, the upper right-hand corner is the first place your eyes go to on a menu.

Knowing that, restaurants put their most expensive dish in that spot.

It's an anchor. It's designed to make your eyebrows shoot up a little. Its purpose is to make everything else look like a relative bargain.

Right next to that dish will be the restaurant's most profitable items. Those are the dishes the menu is really trying to steer you to.

The order of items usually has less to do with how popular the dishes are, and more to do with how  profitable the dishes are - with least profitable at the bottom, often in smaller type.

Speaking of restaurants, recent studies have shown that diners will spend more if the prices on menus don't have $ signs.

In a recent experiment, diners were split into three groups and given three different menus.

One group was given a menu that had dollar signs in front of the numbers, the second group was given a menu where the dollar amounts were spelled out in full words, and the third group was given menus with numbers but no dollar signs.

As it turned out, there was no difference in spending between the menus with dollar signs and the ones with words.

But diners ordering from the menu without dollar signs all spent more money.

As pricing expert and author Leigh Caldwell says, people experience the act of paying for something almost as if it is a physical pain.

Clearly, the psychological removal of the dollar signs eased that pain.

How a product is presented affects how you value it.

Again, pricing expert Caldwell gives us this example:

If a new drink was poured into a wine glass, you'd compare it to wine prices. If it was poured into a champagne glass, you'd compare it to champagne prices, which are double wine prices. If it were presented to you in a shot glass, you'd compare it to fine whiskies - and consider paying  eleven times the price of wine.

In each case, you would make price assumptions based on the context in which the new drink was presented.

The wine category is always an interesting price study.

Most people can't distinguish a more expensive wine from a cheaper wine when the labels are removed. And that includes top wine experts.

When people are given a glass of wine, and told that the wine is expensive, it triggers a specific part of the brain that registers pleasure. This effect has even been observed in an experiment when the wines were sipped inside an MRI machine that recorded brain activity.

People were given five wines to taste, and told the wines ranged from $5 a bottle, up to $90 a bottle. All the subjects unanimously agreed the expensive wine was better - even when they thought the $5 dollar bottle was the $90 dollar wine. They still experienced more pleasure and the MRI brain activity proved it.

The same effect was observed in a pharmaceutical drug test. 

One group was given a drug to relieve pain, and told that it was expensive.

The other group was given the  same drug, but told it was cheaply priced.

The group who thought they had the more expensive drug claimed it worked faster and relieved pain longer than the group with the supposed cheaper alternative.

It raises an interesting point.

All pleasure is subjective. So how do you argue price isn't as important as the ingredients?

Higher pricing creates higher expectations - but it also creates higher fulfillment.

So if a highly-priced wine stimulates that part of your brain that registers pleasure, then you've experienced pleasure.

Plain and simple.

Another fascinating aspect of pricing is bundling.

In categories where competition is stiff and the actual product is a commodity, companies have to re-frame their offers.

If mobile phone companies only charged by the minute, for example, you'd easily pick the cheapest one, and the phone companies would be locked in a death race to the bottom - with no profit in sight. 

So what they do is "bundle" services. The per-minute call rate will be bundled with text, picture and video messaging, mailbox quotas, browsing options, data plans, favourite-number discounts, unlimited long distance calling, and even internet and cable options.

One of the biggest reasons for bundling is to make sure the packages can never really be compared. You won't find the same bundling at any two companies.

All of which prevents you from making direct price comparisons.

In a past episode, we talked about the "left digit effect." 

That quirk we collectively share of looking at a price like $19.99 and seeing it as nineteen dollars, instead of a penny shy of twenty. 

We judge prices by the left digit.

This method of not pricing items in round numbers is also called "Odd Pricing" - referring to the resulting odd price numbers like 69 or 99 cents.

The practice of odd pricing has been used for for more than a century.

I could track it as far back as 1875. At that time, a paper called the Chicago Daily News was founded. It sold for one cent.

The problem was there weren't enough pennies in circulation. So the owner of the newspaper went to the retail stores who advertised in his paper, and asked them to lower the prices on their goods by one cent.

The merchants agreed to help the paper out.

Then the newspaper owner had barrels of pennies shipped in from Philadelphia to provide the circulation of change.

At the same time, distant merchants began shipping their products to the Windy City via the new railroads, giving the local stores competition. But those Chicago storeowners noticed that the odd pricing helped them undercut these new competitors.

The odd pricing actually increased sales.

Over 60% of all prices in all stores end in the number "9."

Prices ending in 99 cents are powerful because we are conditioned to think 99 cents is a bargain, no matter how small the saving.

It's interesting that people don't perceive much difference in value between items priced at $20 and $25. But drop the price by  one penny, and they perceive  great difference between $19.99 and $24.99.

The power of the number "9" isn't confined to the cents column, either.

One American clothing retailer experimented by changing the price of a dress from $34 to $39 dollars and  increased sales by over 30%.

Meaning -  higher prices ending in a "9" will actually outperform lower prices - on the very same product.

The alluring thing about 99-cent pricing is that it feels like a sale price.

It's a game stores have played with us for decades.

And the CEO of one major retailer felt it was time that game was stopped.

Ron Johnson's claim to fame was that he had created Apple's retail stores for Steve Jobs.

He spent 12 years at Apple, revolutionized what a computer store could be, and generated a billion dollars of revenue in only two years.

With those stunning credentials, he was lured away to run an ailing JC Penney, a long-established discount retailer that was in need of a makeover.

Johnson had a vision for the store - he wanted to eliminate the "game" of retail pricing.

He felt that shoppers, namely women, were confused by the almost 600 sales JC Penney was offering every year.

He felt sale prices were just a tired scheme where regular prices were artificially inflated, just so they could be slashed down to sale prices. He believed couponing didn't just discount the product, it discounted the brand.

Johnson felt there was a disease in the pricing, and that disease was spreading. And that's why JC Penney was ailing.

He wanted to "Re-invent Retail" with a brand new kind of pricing.

So he introduced a new JC Penney pricing strategy called, "Fair and Square." 

The store would stop playing price games, drop prices by about 40% and offer those low prices everyday in round figures. They would also eliminate coupons, and only have 12 sales a year instead of 600.

Here is Johnson unveiling that thinking at JC Penney's investor conference in New York:

It was a radical change of direction, not just for 111-year old JC Penney, but for any major discount retailer.

Johnson then hired Ellen Degeneres to be their spokesperson:

The commercial ended with the words, "No games, just great prices. That's fair and square. JC Penney."

There was just one thing wrong with the plan.

It didn't work.

While there were many reasons why Johnson's new plan didn't succeed, it did reveal some truisms about retail pricing.

By removing the context for low prices, shoppers didn't know how to evaluate the  new price tags. Put another way, by removing the original price and not showing the markdown price, shoppers couldn't determine whether the "everyday low price" was a good value.

So if they saw a $14 dollar shirt, they might assume it was cheaply manufactured. But had they seen a $50 price tag marked down to $14, they would have seen that as a huge bargain.

As Time Magazine noted, it also showed how irrational shoppers can be. An end table priced at $150 under Johnson's tenure didn't sell. Later, the table was priced at $245, then marked down to $150, and it sold out.

Within one year under Johnson's new plan, JC Penney sales fell 28%. Revenues even dropped 40% during the critically important Christmas shopping season.

JC Penney's stock dropped 55%, cutting the retailer's market value in half.

In the middle of all the bad news, the JC Penney Board of Directors sent a signal to Johnson, and cut his salary by 96%.

The sales results didn't get any better. 

After only 15 months, Ron Johnson was fired as CEO.

It was clear that shoppers loved the urgency of sales. They loved coupons. They loved prices that end in "9." And they loved the hunt for bargains.

So JC Penney went back to being a traditional discount retailer, and ran this commercial as an apology to their shoppers:

What Ron Johnson had been trying to do was eliminate the  game of retail pricing.

His intention was admirable.

But in the end, shoppers wanted the game.

Every marketing category has competitors.

And those competitors fight every day to gain as much market share as they can.

The easiest way is to offer the lowest price. But if that was the only basis the battle was fought on, most companies would find themselves drained of profit at the end of the day.

The job of marketing is to make sure that never happens.

Marketing adds value to brands. 

It creates an identity, differentiates that unique identity from the competition, infuses it with personality, makes it highly desirable - and when you add all  that up, marketing makes a product worth more than the cost to manufacture it.

That's why there is so much influence exerted through pricing.

Just look at the magic of "nines" - we are transfixed by that number. To the point where we're more willing to spend $39 dollars for a product instead of $34.

We part with our hard-earned money more easily if a menu has no dollar signs. And we're steered to the most profitable dishes without even knowing it.

We like sale prices. We're addicted to the thrill of bargains. We love coupons. We love the game. 

And when it comes to price anchoring, not even juries are immune to its power.

Then there's the enjoyment that price  itself can stimulate. If a more expensive wine gives you greater pleasure than a less expensive wine - even though those wines are identical -  could you not argue that the price is not just as important as the ingredients - it might even be more important.

It's the secret sauce of marketing...

...when you're under the influence.