30 Sep 2002  Research & Ideas

Use the Psychology of Pricing To
Keep Customers Returning

When to charge for a product or service can be more important than how much to charge, says Harvard Business School professor John Gourville. If you want to build long-term loyalty with customers, you better understand the difference.

 

Editor's Note— Buyers are more apt to use a product right after they purchase it, a fact you need to ponder as you consider how to keep customers coming back for more. In this e-mail interview with HBS Working Knowledge's Manda Mahoney, Harvard Business School professor John Gourville discusses the psychology of pricing and the merits of billing over time. Also, see an excerpt from a recent Harvard Business Review article by Gourville and collaborator Dilip Soman.

Mahoney: What are some first steps managers can take once they have decided to tackle their pricing strategy? Are there critical points that must be considered when starting out?

Gourville: The first things managers need to do is to realize that price is multi-faceted. It's not just about "What price do I charge?" It's also very much about "How do I charge?" Factors such as how, when, where, and in what form all contribute to what we call the psychology of price. You can take the very same physical price and break it up into parts, bundle it with other items, ask for payment early, or ask for payment late, and change consumers'' perceptions of that price in the process.

For instance, in the current research with Dilip Soman, we look at how different pricing strategies affect the consumption of a product. We find that people are more likely to consume a product when they feel "out of pocket." When the price paid for a product is very salient, they want to "get their money's worth," so to speak. The net result is that consumers are more likely to consume when a price is vivid and fresh than when it is obscured or distant. In the case of a health club, this means that members are more likely to go to the gym right after having made payments than later on in their memberships. Similarly, people are more likely to go to a ball game when they have purchased tickets to a single game than when they purchased tickets to multiple games. In the first case, the cost of that game is quite salient. In the second case, the cost of any one game is bundled with the costs of all the other games.

Consumers are more likely to consume when a price is vivid and fresh than when it is obscured or distant.
— John Gourville

In other research, I have investigated how the unbundling of price into routine payments affects the decision to purchase. The classic example is the "pennies-a-day" effect. Chicago's NPR station asks people to donate by joining their dollar-a-day club. Framed in that manner, the donation seems quite reasonable—about the cost of a cup of coffee. Contrast that with what would happen if they asked people to join their "$365 a year club. Suddenly, we're talking big bucks in the minds of most consumers. We see similar efforts by magazines that advertise their low per-issue prices or insurance companies that break the cost of their premiums down to a low, per-day cost. All these efforts are attempting to take the very same cost and make it seem trivial. My guess is that in many cases, they are quite successful.

All of this points to the fact that issues of how, when, and where can have dramatic impact on people's perceptions of price. If managers fail to take them into account, they are tackling only half of the equation.

Q: You talk about sunk cost, the idea that people will use a product or service more right after they pay for it. How can companies make this work for them?

A: Sunk costs are a curious bit of psychology. Economists say that attending to sunk costs is not rational—when considering whether to go to a play or attend a football game, the amount of money you spent on the tickets should be irrelevant to the decision to go. The only things that should matter are the costs not yet incurred, such as cost and hassle of driving, and the benefits to be consumed, such as the enjoyment of the game. At the same time, almost everyone pays attention to sunk costs. We go to plays or concerts that, in retrospect, we'd rather not go to simply because we have a $50 ticket in the pocket.

Similarly, one of my colleagues describes a person who pays $300 to join a tennis club, only to come down with tennis elbow. Nevertheless, he continues to play in spite of the pain, reasoning, "I don't want to let my $300 go to waste." And some people even count on their own irrationality and buy season tickets to a play or symphony series, knowing that it will force them to get out of the house.

Is any of this rational? No. Is it a good thing? That's tougher to say. If people are happier to attend to sunk costs than to let the money spent on an item "go to waste," perhaps it's a good thing. Can it be used by companies to influence consumers' behavior? Absolutely.

Take your average health club. It faces two tasks: getting people to join and getting people to renew. (The churn at health clubs can exceed 50 percent.) Knowing that members are going to be more likely to renew in year two if they feel that they have "gotten their money's worth" in year one, a club should look to encourage attendance. One way to do this is through the timing of payments. Many clubs demand payment in full at the start of a year-long membership. The result is that people work out a lot in the first month or two, while that payment is still fresh in their minds, but gradually stop going as the payment fades from memory. In this case, the sunk cost effect weakens the further one is from that initial payment. Now consider the member who makes payments monthly. For him or her, the cost of membership will always be vivid and they will feel obliged to work out on an ongoing basis. At the end of the year, who is more likely to renew? Clearly, the person who worked out regularly will have a higher likelihood of renewing his or her membership.

(Managers) need to do everything they can to encourage consumption in the current period so as to increase the likelihood of renewal in the subsequent periods.
— John Gourville

The same concept can be applied to health care. In its current form, most of us pay for blanket health care coverage that entitles us to a number of periodic services such as checkups, shots, mammograms, etc. The problem is that the costs of these benefits are not particularly clear. I don't know what that annual checkup is costing me, so I don't perceive it as a cost. If health care providers could make the costs of these procedures more salient—perhaps by sending me periodic reminders that these procedures are costing me, say, $50 each regardless of whether I use them—they would be able to tap into the sunk cost effect. Patients would be more likely to say, "I'm paying for it, I shouldn't let it go to waste."

Q: Some purchases reflect the capricious nature of people. Is it ever better to get customers' $600 up front when they are inspired to get in shape at the gym, or in the mood to widen their artistic repertoire by getting season tickets to the opera? How can companies tell when they are taking advantage of the right opportunity, and when they are sabotaging their chances for future loyalty?

A: At one level, the decision of when to bill for a product depends on the faith that a manager has in the product that he or she is offering. For the manager who thinks he cannot retain a customer year to year, either because he has a poor product or because customers will quickly become satiated with that product, it may make sense to get the billing out of the way early. Given that such a manager has little hope of retaining this customer from year to year, there is little incentive to encourage consumption by billing in installments. Instead, he can minimize administrative hassles and maximize revenues by billing in full at the time of purchase.

This is more the exception than the rule, however. I think most managers hope for repeat purchases, whether they manage a health club, a theater, or publish a magazine. For these types of managers, they need to do everything they can to encourage consumption in the current period so as to increase the likelihood of renewal in the subsequent periods. Pricing in installments is one way they can do this.

In the case of the country club, I might advise that dues be billed in the middle of the winter when the ability and desire to play golf is low.
— John Gourville

At another level, the decision of when and how to bill for a product depends on the underlying demand for a product. Managers who offer a scarce resource, such as a private golf course, face a constant battle between maximizing the number of paying customers (in this case, club members) and minimizing congestion (in this case, the inability to get a tee time). For such managers, if every paying customer showed up at one time, the system would break down. One way to assure this is to bill in a lump sum as opposed to in installments. In the case of the country club, in particular, I might advise that dues be billed in the middle of the winter, when the ability and desire to play golf is low. By the time the summer months roll around, most members will no longer feel the pain of having made payment and will feel less of a need to "get their money's worth" by playing often. The net result is that demand to play golf on any given day will decrease, allowing the club to increase the number of memberships it offers.

Q: What do you think of price-optimization software? Can software effectively gauge the market and maximize profit margins? What would you recommend to business managers who are considering utilizing these types of systems?

A: Again, this is a question about the multifaceted nature of price. I think that price-optimization software is very good at the objective part of pricing—the questions of "What price should I charge?" and "How does demand change as I change price by 5 percent up or 5 percent down?" However, this assumes that all else is held constant—that the same terms and conditions apply.

In reality, these other factors, these terms and conditions, might have a dramatic effect on the optimal price. For instance, while price-optimization software might tell the manager of a health club that he can increase revenues or increase profits by raising membership fees from $600 to $700, it may not be able to tell him anything about the effect on revenues and profits by moving from an annual payment scheme to a monthly payment scheme.

A good example of this is the automobile industry. When buying or leasing a car, research has shown that consumers are much more sensitive to the size of the monthly payments than they are to the number of months over which they have to make those payments. As a result, potential buyers may have a bigger negative reaction to an increase from $300 per month to $350 per month than from an increase in number of months from 36 to 48. This is tough for price-optimization software to pick up. The behavioral aspects of pricing are things that optimization software has difficultly picking up.

Q: What projects or research are you currently working on?

A: There are a couple of things I am working on at this time. One has to do with the negative effects of product variety. The basic premise is that certain types of product variety increase the attractiveness of a brand and other types of variety decrease the attractiveness of a brand. In particular, variety that forces consumers to make difficult tradeoffs (do I want the leather interior or do I want the 4-wheel drive?) will tend to drive people away from a brand. In the end, a consumer may opt to choose a brand with fewer, easier to compare alternatives over a brand with more, but more difficult to compare, alternatives.

A second project stems from my MBA course, "The Marketing of Innovations." It deals with the question of why consumers don't buy. In particular, it makes the argument that consumers overvalue the features that they are being asked to give up in the current alternative and undervalue the features that they are gaining in the new alternative. Compounding the problem is the fact that the developers of the new product don't realize this. They are, by their nature, evangelists for the new product and value greatly the new features. At the same time, they have an inability to see the new offering from the perspective of a potential first-time buyer. The result? Developers see much more value in the new product than do potential buyers and they can't understand why potential buyers are not purchasing the product.

How to Link Price and Consumption

by John Gourville

We're not suggesting that executives throw out their current, demand-centered pricing policies and focus exclusively on encouraging consumption through pricing decisions. It wouldn't be realistic, and it wouldn't 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 20 percent if the proportion of season ticket holders is high but a no-show rate of only 5 percent 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 10- 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 à 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 would increase enrollees' likelihood of consuming the benefits (getting checkups, immunizations, and so on) they've 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 member's pain of payment will fade by the time the peak summer months come, reducing the need to get his money's 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 week's 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 ("I'm not going to let today's 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 that's 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.

Excerpted with permission from "Pricing and the Psychology of Consumption," Harvard Business Review, Vol. 80, No. 9, September 2002.