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Mastering the Art of Pricing: What the Textbooks Don't Teach You

Every student of economics is taught that a business maximizes profits by producing up to the point at which marginal cost equals marginal revenue. This is true in theory -- and irrelevant in practice.

Related: How Retailers Are Adjusting Their Playbooks to Get Your Cash

Every business that sells a product or service has to master the art of pricing. But, as you think about pricing your own product, remember that pricing is not a point; it’s a range. Between the lowest price at which you are willing to sell and the highest price at which the customer is willing to buy, what will determine the final figure?

What can producers do to move into the higher end of that range, or to even price the product so that the range itself moves upward?

Here are a few thoughts -- drawing on insights from gaming, venture capital and psychology -- to guide you as you set a price for your product.

1. Know the limits of research.

Unfortunately, in this age of analytics most research techniques simply do not work for predicting pricing. I recall the 1980s-era survey that asked viewers whether they would pay for cable television. More than two-thirds said “no.” Others said that they would pay up to $7 a month. Obviously, any media executives relying on this survey data would have made a big mistake.

Instead, nowadays the cable industry charges an average $54.92 per month for basic service, according to SNL Kagan; and, according to the FCC, the industry peaked in 2000 at a not-so-shabby 68 million subscribing households.

When consumers are asked about a new product, they generate a price point by thinking of other products with which the new product may be compared. So, in the case of cable television, consumers answered the survey by thinking about advertising-supported “free” broadcast television or radio. In fact, however, once viewers began to use cable, they saw that a more apt comparison was to fee-based movies, which cost $3 or more per hour.

So, when you yourself conduct research, don’t do what surveys typically do and ask consumers to price products for which they have no concept of price. Instead, ask about substantive value. If you want to know the price point for a television series like House of Cards, for example, ask respondents: “What would you trade me to see House of Cards right now?”

This draws consumers away from grasping for the nearest point of comparison and instead encourages them to really consider the value they would get from the new offering. As hard as it is to accurately research pricing, it’s even harder to set a price "from zero to something." 

2. Use "anchoring" to your advantage.

Because our thinking on price depends on analogs, setting the right point of comparison is key. Psychologists have established that we make judgments based on the first piece of information we have, even if that “anchor” is entirely unrelated to the problem at hand. In one study, participants were asked to spin a roulette wheel, then guess the percentage of United Nations countries located in Africa. Those who hit a higher number on the wheel -- thus “primed” -- made a significantly higher guess. Context can trump abstract calculations.

Related: How to Set Prices When You're New in Business

In retail, we harness this phenomenon by presenting three options of ascending quality: the cheapest option, the premium option and the luxury option -- commonly called “good-better-best.” Consumers will often pick the premium option even when they would not have picked it had it been presented on its own.

It’s much easier to justify paying $95 for oysters when you tell yourself that you’ve received much greater value compared with the $75 oysters, and have resisted the $145 oysters. This kind of relative anchoring can make a previously unreasonable price look eminently reasonable. And, anchoring subconsciously re-centers your sense of what “normal” looks like. If you set the anchor, you can change the price.

3. Rethink “fairness.”

We are hard-wired for fairness. Consider the “sharing” game, an economic experiment where the first person receives a sum of money and suggests how to divide it between himself and another person, who either accepts or rejects the proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects the plan, neither player receives any money.

As the “sharing-game” experiment shows, we will willingly incur a personal cost in order to punish others for being unfair. This makes fairness the most important rule in pricing. But what we believe is “fair” is more of an emotional response than a product of reasoning.

One study, for example, found that subscription rates increased by 20 percent when messaging changed from “a $5 fee” to “a small $5 fee.” In another study, customers preferred paying an $84 monthly rate for a full year rather than a $1,000 yearly rate -- even though $84 a month for 12 months costs more -- just to avoid having to do the long division. Still another study showed that 60 percent of the prices in advertisements surveyed ended in the number “9” (i.e., $19.99), a nod to the theory that psychological pricing can drive demand.

So, these are the types of cues -- the language, the prospect of reducing pain, the sense of what else “costs this much” and what we see as a “good” profit” -- that we consult to figure out whether the prices we are paying are fair. This is also where brands, which increase user satisfaction by offering trust in a recognized set of signals, make a big difference. So, know the importance of fairness and study how you can entice consumers to perceive the same bundle of goods differently. 

4. Focus on value.

If you make your pitch to the customer by focusing on price, you connote low quality. Instead, indicate high quality: Highlight unusual features, note endorsements or show users how they could benefit from consistent use of the product. Put the price on the product details page. By insisting on the benefits, you can let others come up with the price.

In the world of “freemium” business models, especially in today’s digital world, a focus on value is even more important, because customers usually don’t pay a penny until they have had a good experience. The era of "caveat emptor" (buyer, beware) is being replaced by “caveat vendor” (seller, beware). Set your prices where consumer sentiment, as measured by tools like Net Promoter Score, actually rises after consumers begin to pay. Now, that’s value.

Pricing, ultimately, relies on so much more than data analysis: It’s rooted in human psychology and a touch of game theory. The lesson, then, is to show substantive value to the customer, or offer a point of comparison to anchor pricing options. Also: Showcase the high quality of your product and experiment with the perception of the product’s “fair” and reasonable value.

The highest art is to set a price that rewards you and your customer for building a lifetime relationship. That’s when you know that “the price is right.”

Related: Evaluating the Merits of Building Negotiating Into Your Prices