reference transaction

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We’ve been getting a few emails about the recent CalTech study (gated here) that finds that consumers are willing to pay as much as 50 percent more for goods they can see and touch versus ones they can only look at with pictures or imagine with words. It’s an interesting study, but the Nudge blog is cautious about extrapolating too much from it. For example, it doesn’t warrant drawing clear implications about online vs. brick-and-mortar retailers, specifically why the latter can automatically charge higher prices.

For one, the study uses an auction process to determine consumers’ willingness to pay for a good. In other words, the value they put on them. That’s of course not how consumers buy products in the real world. The role of the price tag is a key variable that’s left unexplored. Why should anyone expect perceived value to be unaffected by price? The behavioral economic lesson is that consumers obtain a utility from the good and a separate utility from the transaction. This second form of utility is critical to a purchase decision, but is not part of these experiments.

An interesting side note that doesn’t seem problematic for interpreting this study is made by consumer behavior researcher Andrea Morales.

Shoppers do feel more connected with products after touching them, but usually dig deep into the sweater pile to avoid buying one that’s been touched by strangers.

“Even though they want to touch them, they really don’t want other people to touch them,” Morales said. “This is one application of disgust at work.”

It’s pretty easy to keep most of the inventory in the back.

The study’s authors do highlight one place where the findings have clearer implications. If you work at a restaurant, at the end of a meal always bring out a dessert cart.

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Over at Iterative Path, William Poundstone answers the question of whether cost increases are relevant to price increases, and whether brands should always use moments when their input prices jump to pass them along to consumers?

Poundstone draws on behavioral economics research to deliver an answer that says yes, provided the rationale for the cost increase can be communicated as “fair” to consumers.

(Behavioral economists) found that the public did not automatically reject any price increase as unfair. In particular, the public was willing to accept price increases when the seller was passing on his own increased costs.

It’s therefore a sound psychological strategy for a company experiencing commodity cost increases to use that to justify a price increase. Of course, it’s necessary to communicate the reason through signage, ads, or other means.

The core piece of advice here is good, but there are many practical questions from the company’s perspective. How to communicate price increases? Rolling out a sophisticated marketing campaign is costly. When is it worth it? What kind of price increase requires one? Working on these campaigns will take time away from other marketing efforts to introduce new features and products. Isn’t there a better way to do this besides an official marketing campaign?

Here’s an idea: What if companies made some of their costs more transparent? Full transparency would be unwise; disclosing valuable information to competitors and potentially raising new gripes from consumers once they realized a company’s exact profit margins. No one is suggesting anything that silly. Take companies that operate in environments where 1) one of their major commodity costs is dictated by an open global market price that is constantly fluctuating and 2) that make their money primarily through volume, not margin. Think fuel for airplanes or beef for fast food companies.

What if every fast food restaurant devoted a small place on their menu board to communicate a message like, “The cost of beef has increased 40 percent in the last year, but our burgers prices has risen less than 5 percent.” These numbers are made up, obviously.

These messages could be rotated on an regular basis. A real-time beef price quote similar to a stock ticker would be unhelpful. Quarterly updates might be the appropriate interval. Prices won’t always rise. In some years, they will fall. Possibly dramatically. Here companies would face a dilemma. Should they say the year-over-year price fell 30 percent, but their burger still costs $4? Or should they take a longer time frame and communicate price increases over, say, the past 5 years? These sorts of decisions are contingent on customer expectations and reactions.

The basic point is that rather than having companies coordinate separate communication about commodity prices at moments of price hikes, wouldn’t a better strategy be to integrate market commodity costs into a communication strategy more generally? Companies might be able to better justify their price hikes, and in the interim periods of time, show customers the benefits they are getting from price stability.

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In a recent post, the Nudge blog linked to a piece pointing out how Amazon’s pricing strategy for e-books is causing a headache for Apple. Of relevance to this example is a 1986 paper by Richard Thaler, Daniel Kahneman, and Jack Knetsch, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market,” (gated copy here). In it, the authors develop the concept of a reference transaction in notions of fairness. A reference transaction is “a relevant precedent that is characterized by a reference price or wage, and by a positive reference profit to the firm.” Amazon’s $9.99 price for best-seller e-books was a money loser for the company, but that doesn’t mean its customers know that. After all, what does it cost to electronically publish a book? Blogs are free! As the authors point out, “The reference transaction provides a basis for fairness judgments because it is normal, not because it is just.” The $9.99 price has been around as long as the Kindle, which is long enough to be normal.

Reference transactions can change, and they will in the e-book world. Until then, since consumers are used to the current $9.99 price, the standard rules of prospect theory will apply. That means price increases are likely to lead to dissatisfaction, particularly since its not clear that the costs of electronic book publishing are any different now than they were three years ago. Why? Because of how Amazon marketed the first e-books.

Amazon can’t go back and re-run history, but it can learn for the future. When selling a new, or little used, product, it’s better to offer two prices. The first price is the price you’d charge for the product if it were popular and profitable. For Amazon in 2007, this might mean the price it would like to charge consumers in a 2010 world where e-books are no longer so strange. The second price is the discount price. This strategy is similar to the kinds of introductory trial prices that cable companies offer, although without the explicit time frame to start and end them. When the company decides it can no longer keep subsidizing the product, it ends the discount. Plain and simple.

This isn’t what Amazon did, though. $9.99 wasn’t a special discount price. Amazon didn’t make a big deal that the standard retail e-book best-seller price was $16.99, and that it was offering a 40 percent discount. $9.99 was just…the retail price. Raising prices usually irks consumers. But as any good student of prospect theory knows, taking away discounts is much easier for consumers to swallow than raising prices — even though it’s effectively the same thing — because of loss aversion and some consumers’ understanding of the retail price as the reference price. This logic even applies for hot products. The original retail price acts as the reference point against which consumers judge the price increase. Since they already thought they were gaining something with the discounted price, it hurts a bit less when it’s taken away, compared with simply jacking up the discount price when it’s not framed as a discount.

It turns out that Amazon’s actions aren’t just affecting Amazon at the moment. They are a costly externality for Apple as it tries to figure out a pricing strategy for books on the iPad. Unlike Amazon, Apple is starting fresh, which means it can adopt the two price strategy on iBooks. It hasn’t so far, but there’s still time.

Addendum: Amazon did advertise its Kindle book prices relative to the hardcover list price. But that wasn’t a useful reference point since customers did not see the two products as identical.

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