The following is excerpted from Chapter 14 of Ron’s book, Pricing on Purpose: Creating and Capturing Value.
Price Elasticity vs. Price Sensitivity
Certainly mathematics has its place in pricing, allowing us to test, predict, and determine elasticity. Yet, since pricing is an art more than a science, judgments are also vitally important and cannot be substituted with mathematical precision.
Even if a company possesses a precise elasticity calculation it knows is accurate, it would only be part of the puzzle of pricing. Since elasticity normally lumps “consumers” together, it does not help us in segmenting customers into different value propositions, thereby offering individuals different bundles in order to maximize profit.
Ten Factors of Price Sensitivity
In order to assist those who are in charge of Pricing On Purpose in ascertaining and judging price sensitivity, the following ten factors should be examined to see which apply to your particular customer circumstances.
Thomas Nagle identifies ten factors affecting price sensitivity in his book, The Strategy and Tactics of Pricing.
1. Perceived Substitutes Effect
This effect states that buyers are more price sensitive the higher the product’s price relative to its perceived substitutes. New customers to a market may be unaware of substitutes, and thus pay higher prices than more experienced buyers. Restaurants in resort areas face less pressure to compete based on price (which locals may describe as “tourist traps”).
Branding can also overcome, to a certain extent, the substitute effect. Woolite, for example, has maintained a relatively expensive price because it positions itself as an alternative to dry cleaning, not a substitute to regular laundry detergent.
Customers have a reference price when there are many substitutes, and as long as the offering is within that range—sometimes referred to as a zone of indifference—it will be considered acceptable, the point being your marketing can influence which products customers will compare yours with, possibly pushing up the price they are willing to pay.
2. Unique Value Effect
Buyers are less price sensitive the more they value the unique attributes of the offering from competing products. This is precisely why marketers expend so much energy and creativity trying to differentiate their offering from that of their competitors.
Heinz ketchup, for example, developed a secret formula for making its product thicker and was able to increase its market share from 27 to 48 percent while maintaining a 15 percent wholesale price premium.
Auction houses rely on the unique value effect in order to command the prices they do among their bidders. Rare artifacts from the John F. Kennedy estate are known as “positional” or “expressive” goods, since the people who purchase them are trying to position themselves in society, or express who or what they are (art collectors, for example).
3. Switching Cost Effect
Buyers will be less price sensitive the higher the costs (monetary and nonmonetary) of switching vendors. Airlines that have a fleet of Boeing airplanes may be reluctant to switch to Airbus because of the enormous investment they have in their pilots, flight crews, parts inventory, and the mechanics of operating a certain plane.
Many people are unwilling to give up certain software products due to the learning and familiarity they have with their existing product. Personal relationships are most susceptible to this type of perceived cost, due to the emotional investment the customer has made in the relationship. Childcare providers, doctors, lawyers, veterinarians, and accountants all can benefit from this effect.
4. Difficult Comparison Effect
Customers are less price sensitive with a known or reputable supplier when they have difficulty in comparing alternatives. People eat at McDonald’s, continue to use AT&T, lodge at Marriott and shop at JC Penny because they are familiar with these offerings and perceive them to be less risky than unknown alternatives.
Stockbrokers price based on different criteria (shares of stock traded, or value of shares traded), making it difficult for the customer to compare one with the other. Cellular phone companies employ this strategy by offering different features among their myriad calling plans, making it very difficult to compare one company’s offering to another.
5. Price Quality Effect
Buyers are less sensitive to a product’s price to the extent a higher price signals better quality. These products can include image products, exclusive products, and products without any other cues as to their relative quality.
It is said that only 15% of Rolls Royce customers ask about price before purchasing. These types of prestige products are an important form of marketing. Witness designer clothing and accessories, along with American Express’ Gold, Platinum, and Black credit cards, which command enormous premiums over alternative cards.
Many customers still have a common visceral reaction that high price equates to high value (and quality). Marketers have discovered that utilizing a high price for new products is quite effective for signaling quality to the marketplace. Other marketing research has shown that while discounting familiar brands can increase sales, the same strategy for unknown brands can actually reduce sales.
6. Expenditure Effect
Buyers are more price sensitive when the expenditure is larger, either in dollar terms or as a percentage of household income. A one-office accounting firm may not pay much attention to the price of paper clips, but an international firm that buys in large quantities will.
Business purchasers look at the total amount of the purchase, while households will compare the expenditure to total income. Many people will not expend much energy shopping for the lowest price of soft drinks, but they will put more effort into searching for an automobile or a home. Higher-income customers often will pay higher prices because they do not have the time to shop as thoroughly as low-income individuals.
7. End-benefit Effect
This effect is especially important when selling to other businesses. What is the end-benefit they are seeking? Is it cost minimization, maximum output, quality improvement? The fulfillment of the end-benefit is often gauged by its share of the total cost.
For instance, steel suppliers selling to auto manufacturers know that the price of the steel comprises a large component of the cost of the car; on the other hand, when steel is sold to a luggage manufacturer, the steel cost is relatively minimal compared to the other material used.
The end-benefit effect is also psychological. Think of going out for a romantic anniversary dinner and paying with a two-for-one coupon. Most people view price shopping as tacky when the purchase involves something emotional. Wedding florists, caterers, and bands certainly understand this principle.
The larger the end-benefit, the less price sensitive the buyer. Think of the Michelin tire ads showing a picture of a baby in diapers next to its radial tire proclaiming, “Michelin. Because so much is riding on your tires.”
8. Shared-cost Effect
When you spend someone else’s money on yourself, you are not prone to be price conscious. This is one reason airlines, hotels, and rental car companies can all price discriminate against business travelers, because most of them are not paying their own way.
This also explains some of the success of the frequent flyer and other reward programs. Many business travelers value these rewards and will not accept alternative offerings, especially since they are reimbursed anyway. Also, publications, educational seminars, and other business expenses are tax deductible, and this also reduces the buyer’s price sensitivity relating to various business expenses.
9. Fairness Effect
Notions of fairness can certainly affect customers, even when they are not economically (or mathematically) rational. If a gas station sells gas for $2.30 per gallon and gives a $0.10 discount if the buyer pays with cash, and another gas station offers the same gallon at $2.20 but charges a $0.10 surcharge if the customer pays with a credit card, which station will sell more gas to credit card users?
The economic cost is exactly the same, but most people will psychologically prefer to deal with the first station and not the second because there appears to be something inherently unfair about being assessed a surcharge.
10. Inventory Effect
The ability of buyers to carry an inventory also affects their price sensitivity. Amateur cooks with large pantries will stock up on a good deal, but a single person living in a small apartment will not. The perishability of the item in question is another factor to consider.
Centralized vs. Decentralized Pricing
We discussed the debate between having pricing centralized versus giving pricing authority to the field. We are advocates of a centralized pricing function, since someone needs to own this function, study it, and turn it into a core compentency.
See our show from February 13, 2015, Who’s In Charge of Value?, for our discussion of the role of the Chief Value Officer.