After reading a short article by Cass Sunstein on The Power of Loss Aversion, the urge to translate this to pricing was unstoppable.
Loss aversion (i.e. Khanemen and Tversky’s prospect theory) indicates that people hate losses and go to great efforts to avoid them. Prospect theory said that people hate losses much more than they like wins. This indicates people will work harder to avoid a loss than to win. Here is one example from Sunstein’s article:
“The District of Columbia has tried to decrease people’s use of grocery bags. One approach was to offer a five-cent bonus to customers who brought reusable bags.That approach had essentially no effect. More recently the District tried another approach, which is to impose a five-cent tax on those who ask for a grocery bag. Five cents is not a lot of money, but many people do not want to pay it. The new approach has had a major effect in reducing use of grocery bags.”
Now let’s apply loss aversion to pricing:
1. Price increases – Whenever a customer sees a price increase, they interpret this as a personal loss. Hence we often see extremely emotional reactions resulting in lost business. One strategy, if possible, is to only increase prices on new customers, ones that don’t already have a history of transactions with you. Then, after you build a big enough market with these higher prices, it is much easier to raise prices on the legacy customers because they might be happy you treated them well for so long. Besides, if they leave you it’s less painful.
2. Reference prices – A reference price is what your customers expect to pay. If they are forced to pay more than this they consider it a loss. Less is a gain. Existing customers often use the last price paid as their reference price (see above paragraph). However, for new customers, you have the ability to influence their reference price. We often see retailers show MSRP and then a marked down price. This is to influence the reference price. Alternatively, you can choose to compare your product to one that is much more expensive in hope of increasing the prospect’s reference price.
3. Limited time offers – If Macy’s is willing to sell a jacket at 50% during a sale that ends Sunday, why wouldn’t they sell it at 50% off on Monday? The answer is loss aversion. If you’re on the fence about buying the jacket, you are more likely to go purchase it while it’s on sale. Once Monday comes you have lost the opportunity. If Macy’s doesn’t stop the sale on Monday you don’t have the extra incentive to go buy on Sunday. Loss aversion is one factor that drives the success of sales.
What other applications of loss aversion are there in pricing? Take a moment and think about it. Please share your thoughts with the other readers.
Mark Stiving, Ph.D. – Pricing Expert, Speaker, Author
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