We simply must get over the false idea that there is one optimal price for a customer. There is a range of optimal prices, commensurate with the value being created. Dutch economist Peter van Westendorp developed the van Westendorp Price Sensitivity Meter (PSM) by posing five questions, to which I have added two more:

At what price would this service be so expensive the customer would not consider buying it?
At what price would the service be expensive, but the customer would still buy it?
At what price would the service be perceived as inexpensive?
At what price does the service become so inexpensive the customer would question its value?
What price would be the most acceptable price to pay?
What costs can we afford to invest in at the target price and still earn an acceptable profit?
At what price would the firm walk-away from this customer (Reservation price)? What is the firm’s Hope For price? Pump Fist price?

Commercial from IBM about achieving premium pricing at a hotel minibar. "Satisfying the right need at the right moment".

The Psychology of Price

There is strong empirical evidence—from both the rational and behavioral schools of economics—that offering customers different options can often times result in them purchasing more, at a higher price, than merely offering one take-it or leave-it option.

This simply recognizes that different customers have different value perceptions, and firms that engage in price searching are deploying a more optimal pricing model.

In his book, Predictably Irrational, MIT behavioral economist Dan Ariely illustrates the utility of offering options by illustrating The Economist magazine’s offerings. First, he presented the following two options to 100 students at MIT’s Sloan School of Management:

Economist.com subscription $59: One-year subscription to Economist.com, including access to all articles from The Economist since 1997—68 students chose this option.
Print & web subscriptions $125: One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997—32 students.

Now compare those results to the actual ad that The Economist offered, which contained three options, not two:

Economist.com subscription $59: One-year subscription to Economist.com, including access to all articles from The Economist since 1997—16 students chose this option.
Print subscription $125: One-year subscription to the print edition of The Economist—0 students.
Print & web subscriptions $125: One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997—84 students.

Ariely concludes that there is nothing rational about this change in choices. The mere presence of an option that was not desired affected behavior, leading to a potential 42.8% increase in incremental revenue for The Economist, or $3,432. You simply will not get that level of return by improving efficiency.

Offering pricing options creates the anchoring effect, whereby the customer is now comparing prices to your highest offering. This is why Prada stores always display one incredibly high-priced article that acts as an anchor for all the other products.

All of these high priced items act as an anchor, even if the customer never buys them—throwing a halo effect over the other offerings, allowing for prices to be higher.

The first lesson from the above is if you do not offer a high-end premium package, how could you customers ever select one? Second, list your most expensive option first. The third lesson is that by offering three options, you almost always sell more of the middle option, and less of the cheapest offering.

Once again this confirms what most pricing experts know: people are not just price sensitive; they are value conscious.

A snippet from Dan Ariel's TED talk. This is a great illustration on the psychological effects of options pricing.

Seven Generic Customer Segmentation Strategies

According to Tom Nagle and Reed Holden in their book The Strategy and Tactics of Pricing, there are seven effective segmentation strategies to specifically identify different types of customers in order to capture the consumer surplus:

Buyer identification. Senior discounts, children’s prices, college students, non-profits, and coupons are all examples of ways to identify different buyers with different price sensitivities.
Purchase location. Dentists, opticians, and other professionals sometimes maintain separate offices, in different parts of the same city, or in different cities, which charge different prices based upon the economic and demographic makeup of each. Coca-Cola and other soft drinks sell at radically different prices depending upon where they are purchased, from discount retailers being the cheapest price per ounce and bars and vending machines being the most expensive. With the increasing use of the Internet to make purchases, being able to segment by location is becoming more difficult, but still feasible.
Time of purchase. Theaters offering midday matinees, restaurants charging cheaper prices for lunch than dinner, and cellular and utility companies offering pricing based on peak and off-peak times are all examples of segmenting by time of purchase.
Purchase quantity. Quantity discounts are usually based on volume, order size, step discounts, or two-part prices. Customers who buy in large volumes tend to be more price sensitive but less costly to service, and they have more incentive to shop for a cheaper price. Thus, they are offered volume discounts. Two-part pricing involves two separate charges to consume a single product. Night clubs charge a cover at the door as well as for drinks and food.
Product design. Offering different versions of a product or service is a very effective way to segment customers, either by adding more features, or taking some away. Premium gasoline, for instance, only costs the oil companies approximately 4 cents more per gallon to refine but sells at the pump for anywhere from 10 to 15 cents more. Pricers call low-end products a flanking product, a signal to competitors to not start a price war in the higher-value segment.
Product bundling. Restaurants bundle food on the dinner menu as opposed to à la carte, usually at cheaper prices. Symphonies, theaters, and sports teams bundle a package of events into season tickets. IBM and Hewlett-Packard bundle hardware, software, and consulting services to increase the value of their respective offerings.
Tie-ins and metering. Before the Clayton Antitrust Act of 1914, tie-in sales were common. American Can, for instance, leased its canning machines with the requirement they be used to close only American’s cans. Since the passage of the Clayton Act, the courts have refused to accept tying agreements, except for service contracts where it is essential to maintain the performance and/or the reputation of a new product. While using the tying method with a contract may be illegal, opportunities still exist to use this strategy without a contract. For example, Rrazor blade manufacturers design unique razors requiring customers to purchase its blades for refill, and a certain toner must be used on various leased copy machines.

In addition to the above seven generic strategies, other characteristics that can be used to offer different options to the customer include:

Guaranteed response time; start time; and turnaround time
Access to specific talent within the firm
Bundling education and training
Inclusion of the firm’s newsletter, special events, seminars, and so forth
Automatic upgrades or updates (relevant if changes in the law or technology are significant to your customer)
Offering older technology to achieve a lower price
Historical data conversion included or excluded
Prior tax or other government compliance requirements (e.g., bundling in five year’s worth of prior tax return filings)
A systems review, risk audit, or other Needs & Diagnostics your firm offers
Attendance at the customer’s board meetings
Intellectual Property ownership belongs to firm rather than customer (mostly for advertising agencies)
Different risk-sharing methods based upon the outcome the customer achieves
Offering warranties, guarantees, and other forms of insurance
Varying payment terms
Various financing options—purchase, lease, rent, etc.

Once again, the above is not an exhaustive list of criteria that a firm could use to offer different levels of options to its customers. The process of creating these options is one of creativity and innovation; there are literally an infinite number of combinations, limited only by a firm’s imagination.

Listener Questions

On Twitter, BJ Lee asks about payment terms, e.g., half paid upfront and half on completion.

Payment terms are pricing, and must be considered upfront. The general rule is: the lower the price, the fast you get paid, including 100% pre-paid (similar to a hotel’s best internet rate being pre-paid, no cancellations).

Another question we received, via email, was from Bryce, a practicing CPA:

Ron and Ed,

Love the show. I have a situation that I'd love to hear your opinions on.

We work with many HVAC and Plumbing companies. Most of them do not do hourly pricing/billing. Instead, if you need a repair, they charge a flat diagnostic fee and, once they've found the source of the problem, give a flat price for fixing it upfront that the customer has to sign off on.

This seems to be a way of pricing you would advocate for.

However, many of them run into questions about 'fairness' when the job is shorter than the customer expected. The customer often looks up the price of the parts online, subtracts that from the price they paid and divides the remainder by how long it took the company to fix the problem, arriving at what they perceive as the hourly rate. This number seems too large to them and they complain of being overcharged. (I've attached a screenshot of a recent complaint like this.)

What are your thoughts on this? How would you go about responding to these complaints? How would you educate the customers ahead of time to avoid these complaints? Would you change how these companies are pricing?

This is partly an educational opportunity: we must simply reeducate the customers away from thinking time spent = value. The airlines, cellular companies, etc., have been able to reeducate customers, so we know it’s possible.

Also, managing customer expectations upfront could also be deployed. A great example (example to our VeraSage colleague, Dan Morris) is Waters Plumbing Heating and Air. The explanation of its Flat Rate Pricing plan is brilliant.

Notice how they discuss how the customer has choices: repair the item, replace the item, or upgrade the item. They also waive the diagnostic price if they are hired to do the job.

We believe another strategy is to offer the customer options on when the work will be done. We’ll do it today for $x, tomorrow for $X - $Y, or next week for $X - $Y - $Z.

Obviously, this will change with the nature of the job (emergency, etc.), but it’s another arrow in the quiver that could be used in the right circumstances.