How Product Managers Price Products For Irrational Customers

by drjim on January 30, 2009

Product Managers Need To Understand How Our Customers Make Their Buying Decisions

Product Managers Need To Understand How Our Customers Make Their Buying Decisions

Who has to deal with irrational customers – isn’t “irrational” just another word for “crazy”? If you’ve ever had to set a price for your product, then you know what I’m talking about. No matter what price you pick (or how you pick it) people are always going to be telling you that it’s the wrong price. Is everyone crazy?

When we bump into problems like this that don’t seem to have any answer, it’s always a good idea to go talk to an expert. In this case, the expert is Dr. Dan Ariely who is an expert in behavioral economics and who works at Duke University’s Fuqua School of Business. Oh, and by the way, he wrote the book on what goes on in our heads when we go to make buying decisions: Predictably Irrational: The Hidden Forces That Shape Our Decisions.

All of us with a technical bent will not be pleased to hear what Ariely has to say. His main point is that when we go to price our products, we need to take into account that our customers will be using their irrational human behavior when they are deciding to buy us or not. Dang -  I hope that he’s got some suggestions for us…

Ariely’s first tip is for those product managers who are dealing with a revolutionary new product – one that really does not have a direct competitor. Just what do you price something like this at? His suggestion? Price it so that your customer can compare it with something that they are already familiar with. Why do this?

It turns out that we human being find that making decisions is quite tough to do. So when we encounter a new type of product, we struggle to place a value on it because we see it as existing by itself – in isolation. More often than not, what we end up doing is relying on old, past decisions (including comparisons to other products).

A great example of this is the TIVO DVR product. Just how do you go about pricing something like that when it first came out? The value is time saved, but what customer is going to sit down and calculate how much their time is worth and then figure out how much time they might save if they bought a TIVO?

We all rely on our past impressions in order to infer value on new things. This means that product mangers who want to understand how our potential customers make decisions about our products will need to take the actual decision process into account. Which is why relativity is so important…

Ariely also thinks that we need to know that the relativity of prices is a critical part of the customer’s decision process. If you were the TIVO product manger and you told your customers to compare the product to a VCR, then your customers are going to be unwilling to pay $500 for your products. However, if you told them to compare it to a computer, then they’ll be more than willing to spend $500 to buy it. Or you can do what Apple did…

Ariely’s final point is that the price that you use to define the value of your product will stick in your customer’s mind for a very, very long time. The most recent case study for how this works is Apple’s iPhone.

When first introduced, the iPhone was priced at $600. Almost immediately they slashed the price to $400, apologized to initial purchasers and gave them price difference refunds if they asked for them. Silly mistake on Apple’s part or clever pricing?

It may have been clever pricing: now a $400 iPhone seemed like a great deal when compared to the initial $600 price. When the price dropped to $200 it now looks like a fantastic deal because we all still remember the initial $600 price.

Do you take into consideration how your customer make their buying decision when you are setting prices for your products? Do you provide your customers with a product to compare your products price to? Do you start out pricing your product high so that customers will feel as though they are getting a great deal later on when you start to discount? Leave me a comment and let me know what you are thinking.

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{ 3 comments… read them below or add one }

David Locke February 3, 2009 at 1:41 pm

Rationality turns up in game theory as originating in a stable set of preferences. When the market’s purchase criteria are stable, you can price rationally and avoid the irrational. But, we tend to average our markets, and preferences don’t average.

Pricing strategy encourages us to find islands of price where the market participants talk only among themselves. They don’t talk to people on other islands. This lets us price each island differently, so we can optimize our revenues. We, unfortunately, don’t break our markets down to island granularity. We average.

You might thing, hey, get with the market research, but we create averaged functionality as well, so we are stuck with an average market. Does the requirements elicitor or user story writer really know the difference between a traditional cost accountant, an ABC cost accountant, and a throughput cost accountant? Even in an IT shop you have this problem, because a department hires people over time, and people over time take up different methods within their domain. Developers don’t have mechanisms to deal with these paradigmatic boundaries even if market research could see the difference. Then again, sorting these islands out would still be a matter of which camp the boss is in, and his boss, and his boss. It gets messy quick enough. The same functional unit in different companies will likewise select its preferences, so at both the customer and the market level there are unrecognized islands spanning all aspects of the offer.

A price filters. A requirements filters.

As for the company with the never before seen functionality, the radical innovation, free works provided and only if there are market barriers, and only if the company is a primary vendor, not a complement, and really wants to win the race to be the market leader. It doesn’t work for consumer goods. It doesn’t work for SaaS, because SaaS, ideally, wouldn’t have exit barriers or large entry barriers in the sense of having to learn a lot before you can use it.

Deaverage. Deaverage, particularly now, in the recession, in the late market, in the consumer market. Find those islands of requirements and user stories. Find those islands of price. Find the island with the gold mine.

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John Peltier February 15, 2009 at 12:54 am

Thanks for this guidance. I’m currently working on a pricing strategy for a new SaaS offering that has competition, but which surpasses the competition. To a degree we have to price against the competition, but there’s additional value provided and we need to account for that. Difficult question!

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Dr. Jim Anderson February 16, 2009 at 9:27 am

John: good luck with that! It looks like you have a great opportunity to try to use “value pricing”. Finding out what your customers will no longer have to spend money on once they move to your SaaS product along with how much money they expect to generate once they start using it can be used to help you create pricing for a new product. Then you just have to convince your sales teams to not slash prices right off the bat when they go to sell it!

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