People are inherently economic creatures. Not ‘economic’ as in ‘cheap’, but ‘economic’ as in ‘taking part in economic transactions’. In this sense, we’re Homo Economicus. Every day we do a number of transactions. We go to the supermarket to buy our groceries, order a new tv on Amazon, or try to sell a new product to one of our customers.
What these transactions all have in common, is that there is a price. There is a price for the groceries you just paid, and there is a price for the TV you just bought, and there is a price for the service you’re selling to your company’s customers.
And prices are super interesting. Because a price is not just an arbitrary number. A price is a signal. A signal entering your brain, providing information you use to make decisions. Whether you’re on the supply or the demand side of the transaction.
But this signal, this information, this data does not stand on its own. And although (some) economists like to say we’re rational beings, we aren’t. The way we see prices, and the way we use price information in our decision process is highly subjective, and it’s dependent on the context of the transaction. So while some may say that we’re homo economicus, we’re a being of a particular irrational kind.
Irrational Pricing: An Example
How can you quickly see that people are irrational when it comes to prices? Well, just start comparing products you don’t usually compare.
Suppose for instance that you’ve found this new great game on your phone. Something like Angry Birds. It’s fun, engaging, slightly addicting, and a great distraction from work when needed. The only downside is — it’s full of advertisements. Do you spend the €10 required to remove the ads and not be annoyed?
“Of course not! €10 is way too much for an app, let alone a simple mobile game”, you say. So instead, you grit your teeth and sit through these annoying ads every few minutes. Over the lifetime of you playing the game, perhaps you’ve watched a total of 3 hours of advertisements, but that’s totally worth it because you saved those 10 euros.
Now it’s two days later and you’re planning to have a drink with some friends. You go out, order a drink and happily spend €20 on a night. Depending on your preference, perhaps you spend €10 for the first cocktail alone, and then a couple of drinks after that.
Why is it that we happily spend this money on one night of drinks, and would strongly hesitate to spend half in order to be less annoyed and have more fun playing Angry Birds? If we were rational beings, we would think of exactly what time or enjoyment benefit each of those would bring, and decide for one or the other (and probably the ‘no-ad Angry Birds’ would be a no-brainer).
But we aren’t, and we usually don’t compare two transactions that would otherwise not be related (other than the money used in paying comes from the same bank account). But if we do, you see that irrational pricing is our modus operandi.
Different Ways to Price Things
So though we are not rational beings, and there is much more context to a transaction than just the price, we do sometimes need to price things. We need to put a price on things we sell, and consider whether we think a price is fair to pay for things we buy.
And there are several ways to price things. Business studies give us a few options. For instance, in competition-based pricing, you price the thing you sell on the basis of competition. Simply look at what others sells the product or service for, and choose the same price or go a bit lower or higher. In cost-based pricing, you look at the costs you make in producing the product and adding a percentage for other costs and profit. Using value-based pricing you would look at not what it costs, but at the perceived value of the product and what the customer is ready to pay. And certainly, there are a number of other pricing strategies (think freemium pricing, penetration pricing, dynamic pricing, etc.)
Whatever strategy you choose, many of these work pretty well if you’re on the selling side. If you’re a freelancer, it’s easiest to take a look at what other freelancers change and base your rate on that. Alternatively, if you manufacture products, cost-based pricing may make more sense.
So these things work well as sellers, but we don’t really explicitly use them as buyers. We never look at what a an app or round of drinks has cost to build — or even what the value we get out of this app or these drinks is worth to us. As such, this is another example of irrational pricing.
Nonetheless, we do use competition-based pricing. Take the app example; we find it expensive because we normally never have to pay for an app. So we do check out the competition and base our decision on that. In fact, we use a reference.
Referencing and Price Anchoring
And perhaps that’s the most interesting aspect of pricing and how we view prices. We simply cannot handle one price on its own. Suppose for instance that you go to another country where you don’t know the local currency. The first thing you do after landing is get a meal, and you soon hear that it costs 50 Rai stones. Now how do you respond? Is that expensive? Cheap? Just the right price?
If we don’t have other prices to use as a reference point, we’re lost. We need reference points to determine whether something is the right price. And from a rational point of view, it makes sense — it’s only when we know what a currency is worth, that we can determine what we want to pay for an item (a meal in this case) in that currency.
However, we really, really like these reference prices. Irrationally so. Take for instance a reference price taken from the same transaction; let’s say that you’re engaged in a transaction where pricing is not fixed, but based on negotiation. Perhaps you need to conduct salary negotiations, you’re buying things on a second-hand market, or you need to haggle for a souvenir in a Moroccan souk.
The party providing the first price sets the reference point: the anchor. Now when the other party does a counter-offer, he/she does that with the first anchor price in mind. And the weird thing is, you cannot undo you taking notice of that first reference point.
This is called anchoring and is in fact a cognitive bias (as also mentioned in the really interesting book Thinking Fast and Slow). But this type of irrational pricing is really difficult to overcome. If you’re selling items on a second-hand market and someone offers €1.50 for your €100 boots, would you still ask for the €50 price you had in mind? Probably not — you can’t undo having heard the €1.50 offer.
Homo Economicus Irrationals
So where does that leave us? Well, perhaps you already knew this, but we really are irrational beings. And it’s easy to see that we are irrational when it comes to pricing things* — whether you compare two unrelated transactions with one another, look at how we value things from a buyer perspective, or consider price anchoring.
On the one hand, that makes pricing slightly more difficult. Because people don’t actually act in according to what economic theory often tells us. Indeed, you could say we’re homo economicus irrationalis**.
But on the other, you can also take advantage of the fact that we’re irrational beings. And make irrational pricing rational.
For example, the next time you buy something, consider the value it will bring you — and whether that value warrants the price asked. Alternatively, use it in a work setting. If you’re pricing yourself as a freelancer, or if you’re in salary negotiations at a new job, and you have to indicate your previous salary, try to bend the truth a little and increase it. That salary will be the reference point for the negotiation; and your new employer will now start the negotiation in reference to that higher price.
* And I didn’t even mention the advantage of prices that end on a 9, like €1.99, which apparently actually really increase sales!
** Note also that in economics, the term ‘homo economicus’ is often used to mean economically rational beings, so perhaps this isn’t the right way of putting it either.