Getting Price Right, by Gerald Smith (chapter 1)

GETTING PRICE RIGHT The Behavioral Economics of Profitable Pricing

GERALD SMITH

1 Pricing Orientation | Pricing Strategy

How does pricing get done around here?

The question gets at the behavioral economics of pricing and how price-setting can sometimes seem irrational. When I asked this question of pricing professionals during my field research, one corporate pricing manager responded: “Pricing gets caught between the cracks. Everybody wants to be a part of it. Yet, nobody really owns it. Pricing is ad hoc.” In fact, pricing is often a contentious activity within corporate business units and within small companies. At one corporation, “A pricing analyst described how at one of the early pricing strategy meetings, a representative from the marketing group and one of the members of the sales force ‘were shouting back and forth, . . .’ and the argument became so heated that ‘I thought they were going to throw punches.’ ”1 There is a psychological, but also a social, orientation to the behavioral economics of pricing.

Why would price-setting be so irrational? First, it is rare that a single person or functional department “owns” pricing; instead, different persons or departments have adjunct responsibility for smaller pieces of the pricing process and usually compete vigorously to influence pricing outcomes—and they bring their own unique biases to the task. Finance and accounting personnel own responsibility for costing and financial profitability; field sales personnel own revenue generation and customer

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relationships; engineering owns product design and customer experience; and marketing owns competitive positioning, customer value, and market demand. In your pricing situation, who is tasked with owning pricing, and what biases do they bring? Is pricing shared among different leaders or departments within the business?

Second, pricing decisions have significant leverage to drive competing dimensions of business success that are often tactically and short-term oriented. For example, higher prices increase unit margins and short-term profits—a financial accounting goal. Lower prices stimulate short-term sales volume—a field sales goal. Lower prices influence market share and retaliate against competitors; and higher prices signal quality and prestige or create exclusivity—both marketing goals. These competing pricing dimensions, driven by competing departmental factions, show the potential for different behavioral biases to distort the price-setting process.

Pricing is a persistently thorny area for business management. Few managers have any training in pricing, leading to broader pricing illiteracy. According to a recent survey by Bain and Company, “most CEOs and Owners do not have a formal methodology when it comes to pricing their products and services. . . . Most companies call pricing a high priority, but 85 percent say they have significant room for improvement in pricing.”2 Consider your own experience. Did you take a pricing class in college or business school? How many of your professional colleagues involved in pricing your company’s offerings received professional pricing training?

How does pricing get done in your business—is it strategically planned and executed, or more fluid and ad hoc?

Toward Another Paradigm in Pricing

This book presents the research foundation for another paradigm for pricesetting. The paradigm rests on two conceptual foundations. The first is the field known as behavioral economics, which by now has accumulated over a half century of research findings. The second is my own concept of pricing orientation, which is based on three decades of research and field consultation.

As you will see, these conceptual foundations make it possible to build an actionable, profitable, and organizationally healthy pricing strategy building on the useful price-setting skills you already have but without the hindrance of the price-setting biases inherent in your current pricing orientation.

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The Behavioral Economics of Price-Setting

There has been a flurry of scholarly and popular interest in behavioral economics and the psychology of decision-making, with highly regarded books from Dan Ariely (Predictably Irrational), Daniel Kahneman (Thinking Fast and Slow), Richard Thaler (Nudge), Karl Weick (Sensemaking in Organizations), and others. Two of these authors are Nobel Prize winners in economics: Kahneman in 2002 and Thaler in 2017. The New York Times published a long piece celebrating Thaler’s prize in October 2017, entitled “Why Surge Prices Make Us So Mad.”3 Behavioral economics helps us understand how human actors make decisions and predicts the types of decision biases we can expect in various situations. In business, behavioral economics helps us see how managers act predictably, even if not necessarily rationally, as viewed through the lens of traditional normative strategy or economic theory.

Scott Huettel, a leading researcher at the intersection of behavioral economics, functional brain imaging, and decision science and a professor of psychology and neuroscience at Duke University, does a good job summarizing the contribution that has been made by behavioral economics: Over the past half-century, decision scientists have identified anomalies, or biases, in people’s behavior that can’t readily be explained with traditional economic models. This research has sparked a new field of inquiry now called behavioral economics that integrates economics and psychology—and, recently, neuroscience—toward the goal of better explaining real-world decision making.4

The book you are reading now is the first to explore in depth how behavioral economics applies to price-setting. The connections are fascinating, illuminating, surprising, and often counterintuitive. They will be explored in depth in chapters 2 through 4 and in application to cardinal pricing orientations most often observed in pricing practice in chapters 5 through 8, which examine four key drivers of pricing success—and pricing bias: costing, customer value, customer willingness to pay, and competition.

Each of us makes hundreds of routine decisions every day, usually following intuitive and predictable “rules,” such as choosing to not buy milk or meat too near the expiration date. Such behavior on the part of buyers is well documented in behavioral economics—where it is termed

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risk aversion—and it seems rational. However, when we engage in pricesetting, we adopt an entirely different orientation, with surprisingly counterintuitive behaviors that contradict what traditional economists might have predicted. We oversimplify our decision-making, we fall back on familiar price decision rules, and we often consistently set prices lower than they should be. Whatever your decision-making orientation might be for other routine decisions, when it comes to price-setting, that orientation is often transformed into something decidedly different, characterized by decision biases that appear unique to the context of price-setting. (We will see research about this in chapters 2, 3, and 7.)

A consistent finding of behavioral economists is that people tend to follow two models of thinking when making judgments and decisions.

Sometimes decisions are made instantaneously and unconsciously. When you’re driving and suddenly see a ball rolling into the street, you instantly swerve to avoid the child you expect will come running heedlessly in front of you, even if you see the ball only in your peripheral vision and haven’t seen the child at all. Behavioral economists call this type of intuitive decision-making System 1 associative processing. It is driven by memory-based associations that take place automatically, instinctively, and intuitively and is therefore fast and easy to do.

Other decisions involve much greater effort, attention, calculation, and deliberation. When investing your year-end holiday bonus, for example, you must decide how much to allocate to different financial asset classes— equities, fixed income, cash investments—and then how much to invest in individual company stocks, bonds, or mutual funds. It takes considerable time and effort to determine the historical and prospective financial returns of these assets, the level of risk associated with each, and your own risk preferences. This type of methodical, effortful decision-making is referred to as System 2 analytic processing. It is driven by deliberate calculation and estimation and is therefore slow and challenging to do.

Consider now the task involved in pricing, whether undertaken by a corporate pricing department or an individual manager or proprietor.

A price-setter must make cognitively complex predictions in five pricerelevant domains; that is, he or she must estimate (a) customer value—the value, or worth, of the product or service to customers; (b) customer willingness to pay—reflected in customer or market demand at different price points; (c) competitive pricing—the impact on demand of the relative price and performance of competitive substitutes; (d) costing—the incremental cost to produce and deliver the product or service; and (e) the product’s

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profitability at the price that will be set. Predicting profitability, in particular, involves significant cognitive strain, as it requires integrating the four preceding tasks—with predictive uncertainty. All of this implies that pricesetting requires methodical, deliberate calculation and estimation and therefore is usually performed using System 2 analytic processes.

However, often this is not how pricing is actually carried out. Instead, the predictive calculation, estimation, and integration required of price-setters is deemed too challenging, either because of a deficit in price-setting skills or because the price-setting situation itself is so complex. In such situations, price-setters routinely default to using less effortful System 1 associative decision heuristics that simplify the decision to more cognitively manageable proportions. By “heuristics,” I mean mental short-cuts to a solution, counterintuitive behaviors that often contradict what traditional economic theory would predict. As Kahneman noted, when people go about solving a difficult problem, they intuitively “fall back on a simpler assessment that is made quickly and automatically and is available” from memory.5 At a recent antique fair, for example, I found an attractive cast-iron green model car. It had no price tag, so I asked the seller. He appeared startled—clearly, I had put him on the spot—but then he quickly looked at a neighboring yellow car with a price tag. “This one is $28,” he said, “and yours is larger, so its price is $40 or $45. Let’s say $40.” I offered $35 and he accepted. Given the pressure of the moment, he had quickly defaulted to System 1 associative price-setting using memory-based heuristics, assuming that the bigger the model car, the greater should be its price. That was the easiest and fastest heuristic he could call up from memory in the moment.

This type of price-setting happens all the time, as we shall see throughout this book. The complexity of the price-setting task is often so great that it compels you to adopt easy and fast System 1 heuristic price-setting to make the task more manageable. These are not comprehensive or complex pricing strategies that drive individual instances of price-setting; rather, they are practical micro-cognitive pricing decisions that—though they are not optimal—are deemed satisfactory to get price-setting done. When it is impossible or impractical to find an optimal pricing solution, using a heuristic often seems to yield a satisfactory solution. However, take caution: System 1 associative price-setting is vulnerable to System 1 heuristic biases, which can undermine pricing effectiveness if not managed and used to your advantage. The model car seller at the antique show, for example, displayed a bias in assuming that a bigger model was worth more than a smaller one. This might often—even usually—be true; yet the smaller car

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could have been a particularly rare model worth much more in true value than the larger one.

The first key to this new pricing paradigm is to understand the heuristic biases of System 1 associative price-setting and then to debias, and in the process to learn better behavioral soft skills to use in price-setting.

For example, psychological price-setting biases are characteristic of individual price-setting and problem-solving relating to personal cognition; we will discuss these in chapter 3. Social price-setting biases are characteristics of price-setting and problem-solving relating to team, or group, decision-making, involving others whose powers, opinions, and biases influence the outcome. We discuss these social price-setting biases in chapter 4.

Examples of psychological bias that we will study in pricing include pricing goals and goal-framing bias; rules of thumb and truisms that get rehearsed over and over in price-setting situations; canonized formulas, templates, and algorithms that are broadly accepted as true and correct; reliance on easily accessible price metrics (such as price per hour for the services of a consultant or attorney) because those are the dominant metrics used by other competitors in the industry; anchoring and adjustment; or availability heuristics, relying on information that is most quickly and easily accessed from memory (at the antique show it was the price of the nearby yellow car that provided a convenient price anchor for the seller).

Examples of social bias emanate from the six cultural “nations” of pricing influence, discussed in chapter 4: Finance, Accounting, Sales, Marketing, Production, and Pricing. The biases we see in these various cultural nations come from their professional origins, schools of learning, and traditions. They influence the price-setting that gets done in the organization, with subtle group biases such as overconfidence bias, confirmation bias, and narrow framing bias—cited often with Finance and Accounting Nations; action-oriented biases such as excessive optimism bias and loss aversion with Sales Nation; and ambiguity aversion in approaching price-setting with Marketing Nation.

Pricing Orientation

The second pillar of this book is pricing orientation, a conceptual approach I developed in 1995 that is grounded in behavioral economics.6 The key to this approach is asking, How does pricing get done around here? How is

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price framed for price-setting? Who is involved on our price-setting team?

Who is influential? What kinds of calculations do we usually make? What decision rules do we regularly use?

By repeatedly setting and resetting prices, a firm’s managers who are involved in price-setting tend to follow particular patterns and processes that can be observed, analyzed, and then categorized. Having done that, one is ready to ask, “How should pricing get done here?” That is, what prices should be set, or how should prices be configured, designed, and structured to maximize long-term profit contribution to strengthen your differential advantage in the market?

Notice that in this approach, the “ideal” depends very much on the “real.” What a firm ought to do might depend on reshaping and renovating what it is already doing. Rather than insist that a firm establish a pricing strategy, the gold standard, this approach identifies the strengths and weaknesses of the firm’s current price-setting, then uses those strengths as the foundation for improvement while using debiasing to free the firm’s pricesetting from its weaknesses—to therefore evolve a pricing strategy.

Figure 1.1 illustrates these key points. Pricing orientation is descriptive— diagnostic of how things are—whereas pricing strategy is normative— specifying how things should be. Sometimes, an intelligent, practicable approach is to base the normative—the optimal strategy—on the descriptive— the existing pricing orientation.

How pricing gets done

Pricing orientation

Pricing strategy What pricing should be

Figure 1.1

Twin pillars of everyday pricing.

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Behavioral skills, frames

Behavioral, intuitive

Analytic, systematic

Soft behavioral price-setting skills

Hard analytic price-setting skills

Types of skills: • Memory-driven • Relational • Tacit • Heuristic • Improvisational

Types of skills: • Data-driven • Procedural • Methodical • Structural • Deliberate

Analytic skills, expertise

Figure 1.2

Managerial pricing skill sets.

Two managerial pricing skill sets are usually found in a given firm’s or individual’s pricing orientation (see figure 1.2). Soft behavioral price-setting skills are typically more behavioral and intuitive: for example, price framing to reflect and influence customer willingness to pay (discussed in depth in chapters 2 and 7); or margin leverage, to intuitively sense how to best leverage profitability given the cost and margin structure of the price-setting situation (chapter 5); or competitive moves that interpret competitors’ prices in competitive context (chapter 8). These skills are sometimes organically driven; that is, they are spontaneous and extemporaneous behaviors that, over time, become established behavioral pricing patterns—and sometimes become ruts. Soft pricing skills are usually memory-driven, relational, tacit, and heuristic. They involve automatic thinking and often begin as improvisational. They can also be biased, heuristic, and shortsighted. However, they can—with training, insight, and focus—be adapted into soft skills that sustain and refine pricing and lead to more holistic behavioral outcomes such as employee productivity, employee satisfaction, and customer satisfaction.

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Kahneman described these soft skills as the learned intuitions of experts: [The] accurate intuitions of experts are better explained by the effects of prolonged practice . . . . We can now draw a richer and more balanced picture, in which skill and heuristics are alternative sources of intuitive judgments and choices. The psychologist Gary Klein tells the story of a team of firefighters that entered a house in which the kitchen was on fire. Soon after they started hosing down the kitchen, the commander heard himself shout, “Let’s get out of here!” without realizing why. The floor collapsed almost immediately after the firefighters escaped. Only after the fact did the commander realize that the fire had been unusually quiet and that his ears had been unusually hot. Together, these impressions prompted what he called a “sixth sense of danger.” He had no idea what was wrong, but he knew something was wrong. It turned out that the heart of the fire had not been in the kitchen but in the basement beneath where the men had stood.7

Hard analytic price-setting skills are typically more systematic, such as customer value modeling, breakeven sales calculations, or conjoint analysis.

They are thus the opposite of soft pricing skills, but the two are complementary when used in combination. Hard analytic price-setting skills are datadriven, procedural, methodical, and structured and involve slow deliberate thinking (see figure 1.2). Sophisticated price modeling systems and enterprise pricing platforms are often found in large corporations that can afford MBA-trained pricing consultants and are used to formulate economicsdriven pricing strategy. Hard pricing skills can be challenging to learn, and many price-setters with little or no formal business education just assume these skills are out of reach and therefore ignore them.

However, most businesses need to make hard skills more accessible to the personnel involved in pricing. With training, insight, and accessibility, such skills can add structure and guidance to people’s pricing orientation, leading to better longer-term economic outcomes.

Some of these hard pricing skills are in fact accessible and easy enough to work with; they simply require focus and effort. For example, customer-focused pricing analytical methods such as price band analytics and price waterfall analytics require slowing down to systematically track and identify outlier customer pricing transactions that cause profit erosion and customer relationship distortions; we discuss these in chapter 7.

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Objective customer value models and profit pools are used all the time by many professionals such as real estate professionals and wholesale distributors, to assess the value and attractiveness of different customer segments.

Even dynamic pricing—such as surge pricing, which adjusts with changes in demand, supply, and the economics of the pricing situation—is becoming increasingly accessible to many firms, even small and mid-sized ones. We discuss these in chapters 6 and 8.

Pricing Orientation Research

In this book we cite various examples from my research and field consulting and from firms in the public domain. My field research consisted of face-to-face in-depth interviews and focus group interviews with managers from a diverse set of manufacturing and services industries that ranged in size from fewer than twenty employees to many tens of thousands. Firms and industries included computers and software, wholesale and retail, health care, financial services, telecommunications, consumer goods, basic industries (e.g., steel, cement, pulp, and paper), automotive, and various consumer and business services. Respondent job titles included president, chief executive officer, vice president, senior VP, executive VP, general manager, director, manager, analyst, and others with professional jobs in finance, accounting, strategy, purchasing, pricing, marketing, general management, sales, customer service, engineering, operations, and more.

The Significance of Pricing Strategy

Over the past half century strategic pricing, or pricing strategy, has become the most influential and successful thought paradigm in pricing. Some corporations have built sophisticated pricing or revenue management departments that own pricing strategy, staffed by PhD economists and professional price-setters with MBA degrees who have access to leading-edge big data, analytics, and enterprise pricing systems. The Walt Disney Parks and Resorts Division has a revenue and profit management team that includes a primarily PhD-level Decision Science team and several Management Science and Integration business consulting teams tasked with ensuring analytic [pricing] solutions are successfully integrated into Disney’s

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business units. The Science teams’ extensive analytic capabilities include customer choice modeling, stochastic models, price optimization, machine learning, and demand modeling, among many others.8

According to Disney’s senior vice president for revenue and profit management, After initially proving the value of analytics in areas such as hotel and theme park pricing, the team was asked by Disney’s CEO to extend the application of science and analytics to other areas outside of Disney Parks and Resorts, including the movie studios, television networks, on-line media channels and Broadway shows. As a result, the [revenue management and pricing] organization has experienced phenomenal growth.9

Airlines, hotels, and car rental companies have similar pricing and revenue management divisions that dynamically set prices strategically based on the time of the year, time of the month, day of the week, and hour of the day. This pricing strategy is overlaid by customer price sensitivity indicators such as loyalty program status, frequency of purchase, time before purchase, amount of purchase, and response to various promotional offers.

Still, this kind of sophisticated strategic pricing is found mostly among the very elite of business corporations; it seems inaccessible to everyday price-setters in other settings. Only “a small percentage of independent hoteliers use revenue management [pricing] strategies and thus limit their revenue-generating potential,”10 said one hotel consultant. Even among Fortune 500 companies, the elite of the corporate world, 78 percent do not have a dedicated pricing organization, according to data compiled by Stephan M. Liozu.11 Moreover, 37 percent (184) have no pricing titles in their organization at all. Of those firms that do have pricing titles in their organizations (316), only 25 percent are led by a vice president of pricing with influence in the C-suite. Of the remaining, 41 percent are led by a director or head of pricing, and 34 percent delegate pricing leadership to a pricing manager, pricing analyst, or pricing specialist.12 Scholars studying one U.S. industrial corporation found that its total investment in pricing (including management time and expenses) amounted to 1.23 percent of its annual sales revenue, whereas marketing merited 25 percent, operations 20 percent, and R&D 8 percent. The largest price management expenditure in that company was for customer negotiation costs (43 percent of the total 1.23 percent), then customer communication costs (30 percent), internal decision-making costs (23 percent), and

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out-of-pocket expenses (4 percent).13 In this industrial corporation, pricing received a fractional investment of the firm’s resources, and even then, the vast majority of its actual pricing investment was spent communicating or negotiating price with customers.

Price-setters need better access to the best-in-class skills and capabilities that enable a firm to profitably develop long-term pricing strategy. As you will see, the key to leveraging those skills starts with this fundamental question: How does pricing get done around here? The behavioral tactics in this book reveal insights that might prove useful in one-off, ad hoc price negotiations or communications. But the full value comes from adopting a systemic pricing orientation that drives a consistent pricing strategy based on these behavioral principles.

The research from this book should be especially useful for those of you for whom price-setting and pricing strategy are challenging to get right, due to either the misaligned pricing skillsets you bring to the task or the challenges of a dynamic, competitive business environment. A coherent and consistent long-term pricing strategy is rightly considered the gold standard and should be your aspiration—not just an afterthought. The key is how to get there. Price-setting can be approached behaviorally—and often very effectively—by observing the price-setting that is already being done in your company and then refining it into an actionable, profitable, and organizationally healthy price-setting strategy.

Balanced Pricing Orientations

So, what does it mean to get price right? What is optimal price-setting, and what, therefore, would be an optimal pricing orientation? Most pricing thought leaders stress the importance of customer value in setting price; chapter 6 shows how. In addition, however, effective price-setting requires a complete and balanced view of those influences that drive the success or failure of price-setting. At its essence, a balanced pricing orientation requires two things: data diversity and decision diversity. Huettel, in his work on behavioral economics, described diversity as “the degree to which different people approach a decision in different ways. . . . [For example, for] many sorts of judgments and decisions, we care about intellectual diversity, where people bring different information and different approaches to the same problem.”14 The importance of balance and diversity arises from one of the foundations of pricing theory: the profit-maximizing rule of economic theory,

Praise for

GETTING PRICE RIGHT “An insightful and engaging integration of behavioral theory and pricing practice.”

— THOMAS NAGLE, FOUNDER OF THE STRATEGIC PRICING GROUP AND COAUTHOR OF THE STRATEGY AND TACTICS OF PRICING: A GUIDE TO GROWING MORE PROFITABLY “With Getting Price Right, Gerald Smith provides an accessible and perceptive look at the behavioral elements of pricing strategy.”

— HERMANN SIMON, FOUNDER AND HONORARY CHAIRMAN, SIMON-KUCHER & PARTNERS “This is the most important pricing book to come out in the past twenty years.

It provides the most thorough collection of alternatives for setting up the ‘just-right’ department, complete with strategic objectives and tactical detail. For any executive who wants to build or evaluate an existing pricing department and for students of pricing, Smith’s book is truly a master class.”

— REED K. HOLDEN, FOUNDER, HOLDEN ADVISORS “Pricing continues to be one of the most powerful yet underused strategic levers to drive sustainable earnings growth. Smith offers great insights into what gets in the way and provides actionable guidance on how to understand, reframe, and refine everyday pricing processes to drive superior financial outcomes and customer satisfaction. A must-read for anyone looking to unleash the power of strategic pricing.”

— GAGAN CHAWLA, PRINCIPAL, LARGE CONSULTING ORGANIZATION “For any business owner or manager, Getting Price Right is a must-read.

Gerald Smith is one of the preeminent voices in the field of pricing, and this book delivers, demonstrating why understanding, reframing, and refining pricing strategy in a rapidly evolving marketplace results in better profitability and customer and consumer satisfaction.”

— ERIC NYMAN, CHIEF CONSUMER OFFICER, HASBRO

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