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The Price is Right—Or is It?

Is your store set up to reassure consumers that your prices are good value? Here's how to tell shoppers that the price you want is also the price they want.

For most items, customers do not have accurate price points they can recall at a moment's notice. But each of us probably knows some benchmark prices, typically on items we buy frequently. Many customers, for instance, know the price of a twelve-ounce can of Coke or the cost of admission to a movie, so they can distinguish expensive and inexpensive price levels for such "signpost" items without the help of pricing cues.

Research suggests that customers use the prices of signpost items to form an overall impression of a store's prices. That impression then guides their purchase of other items for which they have less price knowledge. While very few customers know the price of baking soda (around 70 cents for sixteen ounces), they do realize that if a store charges more than $1 for a can of Coke it is probably also charging a premium on its baking soda. Similarly, a customer looking to purchase a new tennis racket might first check the store's price on a can of tennis balls. If the balls are less than $2, the customer will assume the tennis rackets will also be low priced. If the balls are closer to $4, the customer will walk out of the store without any tennis gear—and the message that the bargains are elsewhere.

The implications for retailers are important, and many already act accordingly. Supermarkets often take a loss on Coke or Pepsi, and many sporting-goods stores offer tennis balls at a price below cost. (Of course, they make up for this with their sales of baking soda and tennis rackets.) If you're considering sending pricing cues through signpost items, the first question is which items to select. Three words are worth keeping in mind: accurate, popular, and complementary. That is, unlike with sale signs and prices that end in 9, the signpost item strategy is intended to be used on products for which price knowledge is accurate. Selecting popular items to serve as pricing signposts increases the likelihood that consumers' price knowledge will be accurate—and may also allow a retailer to obtain volume discounts from suppliers and preserve some margin on the sales. Both of these benefits explain why a department store is more likely to prominently advertise a basic, white T-shirt than a seasonal, floral print. And complementary items can serve as good pricing signposts. For instance, Best Buy sold Spider-Man DVDs at several dollars below wholesale price, on the very first weekend they were available. The retail giant lost money on every DVD sold—but its goal was to increase store traffic and generate purchases of complementary items, such as DVD players.

Research suggests that customers use the prices of signpost items to form an overall impression of a store's prices.

Signposts can be very effective, but remember that consumers are less likely to make positive inferences about a store's pricing policies and image if they can attribute the low price they're being offered to special circumstances. For example, if everyone knows there is a glut of computer memory chips, then low prices on chip-intensive products might be attributed to the market and not to the retailer's overall pricing philosophy. Phrases such as "special purchase" should be avoided. The retailer's goal should be to convey an overarching image of low prices, which then translates into sales of other items. Two retailers we studied, GolfJoy.com and Baby's Room, include the phrase "our low regular price" in their marketing copy to create the perception that all of their prices are low. And Wal-Mart, of course, is the master of this practice.

A related issue is the magnitude of the claimed discounts. For example, a discount retailer may sell a can of tennis balls for a regular price of $1.99 and a sale price of $1.59, saving the consumer 40 cents. By contrast, a competing, higher-end retailer that matches the discount store's sale price of $1.59 may offer a regular price of $2.59, saving the consumer $1. By using the phrase "low regular price," the low-price retailer explains to consumers why its discounts may be smaller (40 cents versus $1 off) and creates the perception that all of its products are underpriced. For the higher-end competitor, the relative savings it offers to consumers ($1 versus 40 cents off) may increase sales of tennis balls but may also leave consumers thinking that the store's nonsale prices are high.

Get me legal
Use of signpost items to cue customers' purchases and to raise a store's pricing image creates few legal concerns. The reason for this is clear: Customers' favorable responses to this cue arise without the retailer making an explicit claim or promise to support their assumptions. While a retailer may commit itself to selling tennis balls at $2, it does not promise to offer a low price on tennis rackets. Charging low prices on the tennis balls may give the appearance of predatory pricing. But simply selling below cost is generally not sufficient to prove intent to drive competitors out of business.

So far, we've focused on pricing cues that consumers rely on—and that are reliable. Far less clear is the reliability of another cue, known as price matching. It's a tactic used widely in retail markets, where stores that sell, for example, electronics, hardware, and groceries promise to meet or beat any competitor's price.

Tweeter, a New England retailer of consumer electronics, takes the promise one step further: It self-enforces its price-matching policy. If a competitor advertises a lower price, Tweeter refunds the difference to any customers who paid a higher price at Tweeter in the previous thirty days. Tweeter implements the policy itself, so customers don't have to compare the competitors' prices. If a competitor advertises a lower price for a piece of audio equipment, for example, Tweeter determines which customers are entitled to a refund and sends them a check in the mail.

Do customers find these price-matching policies reassuring? There is considerable evidence that they do. For example, in a study conducted by University of Maryland marketing professors Sanjay Jain and Joydeep Srivastava, customers were presented with descriptions of a variety of stores. The researchers found that when price-matching guarantees were part of the description, customers were more confident that the store's prices were lower than its competitors'.

Appearances can be deceiving
But is that trust justified? Do companies with price-matching policies really charge lower prices? The evidence is mixed, and, in some cases, the reverse may be true. After a large-scale study of prices at five North Carolina supermarkets, University of Houston professor James Hess and University of California at Davis professor Eitan Gerstner concluded that the effects of price-matching policies are twofold. First, they reduce the level of price dispersion in the market, so that all retailers tend to have similar prices on items that are common across stores. Second, they appear to lead to higher prices overall. Indeed, some pricing experts argue that price-matching policies are not really targeted at customers; rather, they represent an explicit warning to competitors: "If you cut your prices, we will, too." Even more threatening is a policy that promises to beat the price difference: "If you cut your prices, we will undercut you." This logic has led some industry observers to interpret price-matching policies as devices to reduce competition.

Closely related to price-matching policies are the most-favored-nation policies used in business-to-business relationships, under which suppliers promise customers that they will not sell to any other customers at a lower price. These policies are attractive to business customers because they can relax knowing that they are getting the best price. These policies have also been associated with higher prices. A most-favored-nation policy effectively says to your competitors: "I am committing not to cut my prices, because if I did, I would have to rebate the discount to all of my former customers."

Price-matching guarantees are effective when consumers have poor knowledge of the prices of many products in a retailer's mix.

Price-matching guarantees are effective when consumers have poor knowledge of the prices of many products in a retailer's mix. But these guarantees are certainly not for every store. For instance, they don't make sense if your prices tend to be higher than your competitors'. The British supermarket chain Tesco learned this when a small competitor, Essential Sports, discounted Nike socks to 10p a pair, undercutting Tesco by £7.90. Tesco had promised to refund twice the difference and had to refund so much money to customers that one man walked away with twelve new pairs of socks plus more than £90 in his wallet.

To avoid such exposure, some retailers impose restrictions that make the price-matching guarantee difficult to enforce. Don't try it: Customers, again, are not so easily fooled. If the terms of the deal are too onerous, they will recognize that the guarantee lacks substance. Their reaction will be the same if it proves impossible to compare prices across competing stores. (Clearly, the strategy makes no sense for retailers selling private-label or otherwise exclusive brands.) How much of the merchandise needs to be directly comparable for consumers to get a favorable impression of the company? Surprisingly little. When Tweeter introduced its highly effective automatic price-matching policy, only 6 percent of its transactions were actually eligible for refunds.

Interestingly, some manufacturers are making it harder for consumers to enforce price-matching policies by introducing small differences in the items they supply to different retailers. Such use of branded variants is common in the home-electronics market, where many manufacturers use different model numbers for products shipped to different retailers. The same is true in the mattress market—it is often difficult to find an identical mattress at competing retailers. If customers come to recognize and anticipate these strategies, price-matching policies will become less effective.

Excerpted with permission from "Mind Your Pricing Cues," Harvard Business Review, Vol. 81 No. 9, September 2003.

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Eric Anderson is a visiting assistant professor of marketing at Northwestern University's Kellogg School of Management in Evanston, Illinois.

Duncan Simester is an associate professor of management science at MIT's Sloan School of Management in Cambridge, Massachusetts.

Cue, Please

by Eric Anderson and Duncan Simester

Pricing cues, like sale signs and prices that end in 9, become less effective the more they are employed, so it's important to use them only where they pack the most punch. That is, use pricing cues on the items for which customers' price knowledge is poor. Consider employing cues on items when one or more of the following conditions apply:

Customers purchase infrequently. The difference in consumers' knowledge of the price of a can of Coke versus a box of baking soda can be explained by the relative infrequency with which most customers purchase baking soda.

Customers are new. Loyal customers generally have better price knowledge than new customers, so it makes sense to make heavier use of sale signs and prices that end in 9 for items targeted at newer customers. This is particularly true if your products are exclusive. If, on the other hand, competitors sell identical products, new customers may have already acquired price knowledge from them.

Product designs vary over time. Because tennis racket manufacturers tend to update their models frequently, customers who are looking to replace their old rackets will always find different models in the stores or online, which makes it difficult for them to compare prices from one year to the next. By contrast, the design of tennis balls rarely changes, and the price remains relatively static over time.

Prices vary seasonally. The prices of flowers, fruits, and vegetables vary when supply fluctuates. Because customers cannot directly observe these fluctuations, they cannot judge whether the price of apples is high because there is a shortage or because the store is charging a premium.

Quality or sizes vary across stores. How much should a chocolate cake cost? It all depends on the size and the quality of the cake. Because there is no such thing as a standard-size cake, and because quality is hard to determine without tasting the cake, customers may find it difficult to make price comparisons.

These criteria can help you target the right items for pricing cues. But you can also use them to distinguish among different types of customers. Those who are least informed about price levels will be the most responsive to your pricing cues, and—particularly in an online or direct mail setting—you can vary your use of the cues accordingly.

How do you know which customers are least informed? Again, those who are new to a category or a retailer and who purchase only occasionally tend to be most in the dark.

Of course, the most reliable way to identify which customers' price knowledge is poor (and which items they're unsure about) is simply to poll them. Play your own version of The Price Is Right—show a sample of customers your products, and ask them to predict the prices. Different types of customers will have different answers.

Excerpted with permission from "Mind Your Pricing Cues," Harvard Business Review, Vol. 81 No. 9, September 2003.