Pricing and the Psychology of Consumption

By Tracy Kennedy,2014-06-18 21:12
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Pricing and the Psychology of Consumption

    Pricing and the Psychology of Consumption

    The way you set prices does not just in fluence demand. It also guides the way buyers use your product or service and that can have a lasting impact on customer relationships.

    Ask any executive how pricing policies influence the demand for a product or service, and youll get a confident, well-reasoned reply. Ask that same executive how pricing policies affect consumption the extent to which customers use products or services that theyve paid for and youll get a muted response at best. We find that managers rarely, if ever, think about consumption when they set prices and that can be a costly oversight.

    Consider this example. Two friends, Mary and B ill, join the local health club and commit to one-year memberships. Bill decides on an annual payment plan $600 at the

    time he signs up. Mary decides on a monthly payment plan $50 a month. Who is more

    likely to work out on a regular basis? And who is more likely to renew the membership the following year?

    Almost any theory of rational choice would say they are equally likely. After all, theyre paying the same amount for the same benefits. But our research shows that Mary is much more likely to exercise at the club than her friend. Bill will feel the need to get his moneys worth early in his membership, but that drive will lessen as the pain of his $600 payment fades into the past, Mary, on the other hand, will be steadily reminded of the cost of her membership because she makes payments every month. She will feel the need to get her moneys worth throughout the year and will work out more regularly. Those regular workouts will lead to an extremely important result from the health clubs point of

    view: Mary will be far more likely to renew her membership when the year is over.

    For many executives, the idea that they should draw consumers attention to the price

    that was paid for a product or service is counterintuitive. Companies have long sought to mask the costs of their goods and services in order to boost sales. And rightly so if a

    company fails to make the initial sale, it wont have to worry about consumption. To

    promote sales, health club managers encourage members to get the payment out of the way early; HMOs encourage automatic payroll deductions; and cruise lines bundle small, specific costs into a single, all-inclusive fee.

    However, executives may be discouraging consumption when they apply those pricing practices. People are more likely to consume a product when they are aware of its cost when they feel out of pocket. But common pricing practices such as advance

    sales, season tickets, and price bundling all serve to mask how much a buyer has spent on a given product, decreasing the likelihood that the buyer will actually use it. And a customer who doesnt use a product is unlikely to buy that product again. Executives who employ those pricing tactics without considering their impact on consumption may be trading off long-term customer retention for short-term increases in sales.

The Psychology of Consumption

    Lets look more closely at why consumption is important and how pricing affects consumption.

    Higher consumption means higher sales. One of the first steps in building

    long-term relationships with customers, we believe, is to get them to consume products theyve already purchased. Research has repeatedly shown that the extent to which customers use paid-for products in, say, one year determines whether they will repeat the purchase the next year. One field study, for instance, found that health club members who worked out four times a week were much more likely to renew their memberships than those who worked out just once a week. According to another study, customers who regularly used an enhanced cable television service in one year were more likely to renew their subscriptions in the next year than those who used the service only occasionally.

    Consumption is important to the bottom line in many ways. In businesses that sell subscriptions or memberships like Time Warner, the YMCA, or the Metropolitan Opera

     customer retention is vital. But keeping customers is tough: Most magazines experience renewal rates of 60% or less, and health clubs retain just 50% of their members every year. As competitive pressures intensify and the cost of customer acquisition rises, a key to long-term profitability is making sure that customers actually use the products and services they buy.

    Consumption also helps establish switching costs. In the software business, for example, companies often make more money selling upgrades than selling the initial application. Once customers start using an application, they have to either buy upgrades or make the painful transition to another system. Companies whose software is purchased but never used shelfware, as its disparagingly called miss the opportunity to lock

    customers in for the long term.

    Consumption is no less important for businesses that rely on a two-part revenue stream. For movie theaters, sports arenas, and concert halls, ticket sales are just one source of revenue; parking, food and drink, and souvenir sales are a profitable second source. Team Marketing Report estimated that the cost for a family of four to attend a major league baseball game in 2000 was $121.36. Only half of that sum was used to buy tickets; the other half was spent on beer, soda, hot dogs, programs, baseball caps, and the like. Clearly, if ticket holders dont attend events, these high-margin secondary sales are lost.

    Still other organizations believe that their core mission includes encouraging certain kinds of consumption. HMOs, for instance, know that their clients overall health will

    improve and their own costs will be contained if patients can be persuaded to get

    regular immunizations and periodic checkups. But they have limited success making this happen. By one estimate, 15% of insured children do not get all the immunizations they need, 30% of insured at-risk women fail to get mammograms within any two-year window, and 50% of insured men over 50 fail to have physical exams within any three-year period.

    Finally, consumption is important to any business that relies on satisfaction to generate repeat sales and positive word-of-mouth. For products as diverse as wine, books, and PDAs customers wont purchase again or evangelize about products if they dont use

    them in the first place. Indeed, its difficult to think of any business in which consumption

    does not make a difference.

    Costs drive consumption. People are more likely to consume a product if theyre

    aware of its cost. This is known as the sunk-cost effect: Consumers feel compelled to use products theyve paid for to avoid feeling that theyve wasted their money. Its well

    documented that consumers routinely consider sunk costs when deciding future courses of

    action. In one example made famous by Richard Thaler, a behavioral economist at the University of Chicago, a man joins a tennis club and pays a $300 membership fee for the year. After just two weeks of playing, he develops an acute case of tennis elbow. Despite being in pain, the man continues to play, saying: I dont want to waste the $300.

    Pricing drives perceptions of cost. Our research also suggests that consumption is

    driven not so much by the actual cost of a paid-for product as by its perceived cost. This perception is influenced greatly by the manner in which the product is priced. Some pricing policies highlight the perceived cost of a paid-for product while other pricing policies mask the cost.

    Consider something as simple as the method of payment. A $10 cash transaction feels different than a $100 cash transaction. Counting out currency and receiving change make a buyer very aware of the magnitude of a transaction. But a $10 credit card transaction is, in important ways, indistinguishable from one for $100 both involve merely signing a slip

    of paper.

    Not surprisingly, people are better able to remember the cost of products if they pay with cash than if they pay with credit cards. In addition, they feel more pressure to consume products if they paid with cash than if they paid with a credit card. In one theater company we studied, the no-show rate for credit card customers was ten times higher than the no-show rate for cash customers. Other pricing tactics that mask rather than highlight prices like season tickets, advance purchases, and subscriptions also reduce the

    pressure to consume the product in order to get the moneys worth.

Putting the Pieces Together

    Because pricing has such a powerful effect on consumption, managers must make careful decisions about when and how to charge for goods and services.

    Timing. Companies often have great discretion about when to bill for goods and services. Some companies demand payment at or near the time the product is to be consumed this is true when you buy a Big Mac or a movie ticket. Other businesses require payment far in advance of consumption. Concert promoters and sports teams have long operated on this principle. Health clubs and country clubs also charge large, up-front initiation fees. Finally, some businesses allow customers to pay long after a product is purchased. Increasingly, automakers and consumer electronics companies advertise buy

    now, pay later schemes.

    Companies make these timing decisions based on either financial considerations (payment sooner is better than later) or demand considerations (buy now, pay later

    increases customer demand). But that may be shortsighted. Payments that occur at or near the time of consumption increase attention to a products cost, boosting the likelihood of

    its consumption. By contrast, payments made either long before or after the actual purchase reduce attention to a products cost and decrease the likelihood that it will be


    We analyzed data on the payment and attendance records of 200 members of a prestigious Colorado-based health club. All the members were contractually committed to one-year memberships that cost them $600 each. The clubs pricing policies allowed

    members to choose from among four payment plans: annual, semiannual, quarterly, and


    Members who made a single annual payment used the club most frequently in the months immediately following payment, reflecting a strong sunk-cost effect. But as time passed, the sunk-cost effect dissipated. By the final months, individuals seemed to be treating their memberships as if they were free and worked out at a rate that was only a quarter of what it had been in the first few months. The same pattern held for members who had paid on a semiannual or quarterly basis: Attendance was highest immediately following payment, only to decline steadily until the next payment. This resulted in a sawtooth pattern of usage, spiking in the first and seventh months for semiannual payment members and every three months for quarterly members. By contrast, the usage pattern of members who paid on a monthly basis was smoother. Since they were reminded of the cost of their memberships every month, they used the facility at a steady rate (see the exhibit Consumption Follows the Timing of Payments). The timing of payments is

    important because it influences the clubs retention of customers. Members who paid on a

    monthly basis used the gym most consistently, making this pricing scheme the most likely to generate membership renewals.

    Price Bundling. Organizations often bundle prices to increase the demand for

     but it may also products and services. This practice does increase short term demand

    reduce consumption.

    In our studies, we found that price bundling influenced consumption considerably. Quite simply, it is far easier to identify and account for the cost of an individual product in an unbundled transaction than within a bundled transaction. The one-to-one relationship between price and benefits in an unbundled transaction makes the cost of that item obvious, creating a strong sunk-cost effect and a high likelihood of consumption.

    Nowhere is the impact of price bundling on consumption more obvious than in the case of season tickets. The purchaser pays one bundled sum for a collection of individual events, making it difficult to allocate costs to any one performance or game. This reduces the likelihood of its usage. We tested this out by analyzing ticket purchase and attendance data at a Shakespearean summer festival. The festival ran from June through August 1997 and involved the production of four plays. Some ticket holders had purchased tickets to a single play, some to two or three of the plays, and others to all four plays. What we found was that the no-show rate for people who had bought tickets to a single play was 0.6%, indicating that almost all ticket holders showed up. But the no-show rate for those purchasing tickets to two plays was 3.5%; for three plays, 13.1%; and for four plays, 21.5%. As the bundling of tickets increased form one to four plays, the likelihood of a person not showing up for one of the plays rose 35-fold.

    One could argue that the higher no-show rate for those who had bought tickets to more than one play was due to other factors: boredom (ticket holders got sick of

    Shakespeare) or perhaps dissatisfaction (after the first play, ticket holders realized the quality of the performances was not very good). However, when we looked at only the first play each person had bought tickets for, the pattern remained the same. Compared with the no-show rate of 0.6% for the single-play ticket holders, the no-show rate at the first play for those patrons who had purchased tickets to two, three, and four plays was 2.8%, 7.8%, and 15.8%, respectively. So, the bundling of tickets had much the same effect as the advance selling of tickets in our earlier examples: It hid the cost of each ticket. Unable to link the costs and benefits of any given play, patrons who purchased tickets to multiple plays increasingly treated their tickets as if they were free. With little sunk-cost pressure, many of these customers did not use tickets they had previously paid for, reducing their likelihood of repeating their ticket purchases for the following season.

Linking Price and Consumption

    Were not suggesting that executives throw out their current, demand-centered pricing policies and focus exclusively on encouraging consumption through pricing decisions. It wouldnt be realistic, and it wouldnt be smart. Many companies lack the ability (or the

    desire) to restructure their pricing practices. In some cases, industry norms or consumer expectations dictate the use of advance selling or price bundling. However, we believe that executives should take consumption into account when they set prices. Here are some suggestions on how to do that.

    Practice yield management. Managers can run operations more efficiently by

    anticipating actual demand given the naturally occurring mix of bundled versus unbundled purchases or the ratio of advance to current purchases. Consider the case of a theater manager. She might forecast a no-show rate of only 20% if the proportion of season ticket holders is high but a no-show rate of only 5% if the proportion of season ticket holders is low. Armed with this knowledge, she could better manage costs by staffing according to actual, as opposed to paid, demand. Alternatively, she could increase revenues by overselling some events and not others. In much the same way that an airline oversells a flight in proportion to the expected rate of no-shows, a theater manager could oversell performances where the no-show rate is expected to be high.

    Stagger payments to smooth consumption. A second course of action, slightly

    more proactive but still within current pricing practices, would be to stagger billing cycles so that demand is smoothed over time. This is another form of yield management. Health clubs, for example, know that most of their new members sign up at specific times of the year, most commonly in January. But many still offer discounts to members who pay in full at the start of the calendar year. The net effect is that peak usage occurs in January, February, and March, which reduces customer satisfaction because of the strain it places on the facilities. Health clubs could stagger billing cycles to offset that trend. For instance, a health club could offer ten-or 14-month contracts, perhaps on a discounted basis, to

    break the cycle of January renewals. Over time, this change would help smooth demand and increase customer satisfaction.

    Time payments to maximize consumption. Some executives can do more than

    react to demand: They can use their pricing policies to actively encourage consumption. Perhaps the most dramatic way to do this is to link payments more closely to benefits. Consider Boston Red Sox season ticket holders, who are asked to pay for tickets five months before the season begins. To promote attendance over the course of the season, Red Sox executives could spread out that one large payment. They could, say, bill patrons in four installments. Customers might even prefer this approach because smaller installments are financially more manageable. Similarly, the health club we studied could increase usage and, thus customer retention, by promoting annual memberships with monthly, rather than annual, payments.

    Psychologically link payments to benefits. Some companies view price bundling

    as a necessary tool to promote initial sales: If they eliminate price bundling, they could eliminate the sale. However, organizations could psychologically unbundle those offerings to promote consumption. One way of doing this would be to highlight the prices of individual items in the bundle after the payment has been made. For instance, travel companies could itemize the approximate cost of offerings in vacation packages. Some all-inclusive cruise ships already make guests pay for drinks, meals, and entertainment with beads to highlight the fact that nothing is really free. Restaurants could offer the same dishes both a la carte and as part of a fixed-price dinner, so that the cost of each item in the latter becomes clear. In the same way, HMOs could promote preventive care by itemizing the cost of individual services within the bundled fee, making the cost of those services more apparent to the customer. This could increase enrollees likelihood of consuming the

    benefits (getting checkups, immunizations, and so on) theyve already paid for.

    Reduce consumption. Not all organizations want to encourage consumption all the time. Consider the manager of a truly scarce resource, such as a private golf course on a beautiful Sunday morning in June. Managing peak demand is the main concern. The current alternatives are to limit the number of customers admitted, as when a country club caps membership, or to accept all customers and run the risk of dissatisfaction when the facility is at capacity. The first solution limits revenues; the second increases customer frustration. By managing when and how payments are made, executives can maximize the total number of customers who pay for their services and, at the same time, limit peak demand. If the golf course manager charges annual membership fees in January or February, long before the golf season has begun, a members pain of payment will fade by

    the time the peak summer months come, reducing the need to get his moneys worth. That

    should allow the club to maximize its membership base without turning away members wanting to play during the peak period. By contrast, if the club bills its members just prior to the peak season, say in May or June, it will be inadvertently promoting demand at its busiest time. Similarly, when vacationers at a ski resort buy a weeks worth of lift tickets,

    the resort has the option of providing them with seven daily tickets or a bundled pass. The former will encourage consumption every day (Im not going to let todays ticket go to

    waste!), while the latter will mask the cost of skiing on any given day and reduce crowds on the slopes.


    Managers spend a lot of time thinking about how to get customers to buy their products and services. But thats just half the battle. If organizations wish to build long-term relationships with customers, they must make sure their customers actually use their products. A first step is pricing.

Case Study: A problem in identifying and retaining profitable customers

    Work in groups to understand the problem in the case. And then discuss it and answer the questions. Be ready to do an oral case report.

    Hedging Customers

    Janice Watson is the director of marketing for Myron Corporation, a global leader in the personalized business gift industry, with a budget of $5 million to invest in customer acquisition and retention.

    Myrons traditional customer base consists largely of manufacturing firms in low-tech industries whose salespeople distribute Myrons product to their customers. But

    recently the company acquired new customer groups of insurance agencies and real estate firms.

    Traditionally, Myron ranked its sales leads according to their potential lifetime value (LTV). It calculated the LTV of a customer by taking its expected cash flows over a number of future periods and computing the present value of that cash by applying an appropriate discount factor or required rate of return.

    Myrons managers had hotly debated over the traits of an attractive segment of

    customers. Most came to agree that segments with both higher total cash flows and different patterns of variation were the ones worth hedging. Regarding this, the segments consisting of insurance agencies and real-estate firms seemed qualified. They differed strikingly from Myrons traditional customer base in being dominated by service


    However, in reviewing the insurers spending patterns, Watson noticed they had

    responded to changes in economic conditions in systematic ways. For example, an increase in unemployment in their business region had been associated with a surge in property and casualty claims. The claims usually shrank the insurers’ marketing budgets,

    limited their purchases, and put a big dent in Myrons overall returns.

    Should the corporation expect its new customers to constitute a large percent of its budget and produce more return on the cost of acquiring them? Watson hesitated and asked opinions from the group leader of the marketing department.

    Joshu Golder, the vice director, doubted the attractive new customers would generate steady cash flows. LTV calculation was not always reliable because customers that have made relatively large purchases in the present are more likely to stay valuable than customers that made only a few small purchases at wide intervals some time ago. So, he suggested the biggest fraction of that $5 million should go to their steady customers, as repeat purchases by established customers usually require less marketing effort than do initial purchases by new customers.

    Jeanne Desail, the assistant to Watson, claimed that the LTV calculation did not consider how the volatility of a customers past purchasing behavior might affect the

    customers patterns of consumption in the future, or how selectively the patterns of various customers can be affected by market or macroeconomic forces. The company should also place individual customers in segments defined on the basis of customer characteristics, such as industry, location, and historical purchase patterns. Then, they could identify the best combination of customers to be acquired.

    How could Watson make the most of the marketing budget?


    1. Should Watson accept Jeannes point of view?

    2. How can Watson identify the most beneficial customer prospects of Myron? 3. How can Watson reduce the level of risk the company has assumed without depressing

    its return?

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