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Here’s an interesting thing about prices: they’re all over the place. The trick for brands is convincing customers that their prices are fair — all the while generating the most profit from those prices.
How do brands come up with their prices? How do they will customers to cough over more cash when prices hike without feeling taken advantage of? How do they manipulate customers to purchase items that have greater profit margins? More importantly, how do companies determine the price and product output that generates the level of profit they’re aiming for?
All of these questions are answered through profit maximization which is the process businesses go through to develop a pricing strategy that boosts their bottom line. If you look around, you see businesses everywhere attempting to utilize this strategy, but only the select few that get it right see big profit margins.
Below are a few things to carefully consider when it comes to utilizing pricing maximization for any business:
Throughout the years, Starbucks has proven prone to raising prices, but only in small increments—usually 1%—and only on its lowest margin items—usually, the tall (small) size coffee brew.
Why? Mostly so that the company can test consumer behavior without losing customers. Through testing, the company can determine how customers act. Do they continue purchasing the now more expensive item? How long will it take before customers start thinking differently and a new anchor price is set?
According to Michael Levin, a professor of marketing at Otterbein University, Starbucks’ price increases are “minimal and within the psychologically acceptable range.” Last month, customers in most U.S. markets started paying 10 cents more for Starbucks’ tall (12 oz), or small, and venti (20 oz), or large, cups of brewed coffee.
This translates to about a 1% price increase, which has been the company’s strategy for years.
In 2012, Starbucks stirred a sort of chaos among tall-sized coffee drinkers in Manhattan when it raised its prices by 10 cents to $2.01 after taxes. According to the New York Times, customers were confused. One customer, Libby Schmais, a novelist who works part-time as a researcher at JPMorgan Chase, told the NYT she didn’t have the extra penny and was “irked” by the price increase: “It’s the stupidity of it,” she said, “It’s what I’d call ‘the annoyance factor.’ It’s ridiculous. Why the extra penny? Who has pennies? Didn’t anyone think this through? Couldn’t they round down or even up? Why leave it at a penny?”
When the NYT examined more closely, it looked like the $2.01 total only happened in Manhattan. There was still a price hike in other areas in the Northeast and much of the Sun Belt, but those totals came out to under $2 so customers either don’t notice as much or didn’t care because they don’t have to go fumbling for one penny. So, why Manhattan? With higher-income customers, Manhattan is a good place to try out price hike experiments.
But eventually, customers got used to the price hike, so the next year, Starbucks did it again. And again, it was a 1% price hike to tall size brews, which comes out to be about a 10 cents increase for each order. The result? The company’s third quarter net income in 2013 rose 25% to $417.8 million from $331.1 million the year prior.
After the 2012 hike, famed behavioral economist Dan Ariely told the NYT Starbucks might be wanting to hike more of its prices in the future so its testing out increases with its lowest margins. Fast-forward three years, Ariely’s prediction seems to be true, as Starbucks is now testing the price hikes out on tall and venti size coffee brews.
Take a look at software tiered pricing model and you’ll see this happening often. For instance, take a look at The Economist’s subscription model:
Option One: A one-year subscription which includes online access to all articles from The Economist since 1997: $59.00
Option Two: A one-year subscription to the print edition of The Economist: $125
Option Three: A one-year subscription to the print edition of The Economist and online access to all article from The Economist since 1997: $125
If you’re like most people, you would choose option three, as Ariely explains in his TED talk. Therefore, option 2 only exists as a decoy so customers have something to compare option three to. Nobody actually chooses the decoy option. If the decoy option didn’t exist, then most people would choose the cheapest option. To get people to choose the more expensive option, you include a decoy option.
If you want to make your higher-end product look good, put something lower-end next to it, allowing customers to have something to compare it to. This strategy is called price anchoring and it works because of a principle called Weber’s law, which is basically the noticeable difference between two items because of its comparable magnitude against one another. Plenty of menus at restaurants use this strategy to encourage customers to choose higher profit items. Real estate agents and brokers are also prone to using this method. By showing customers lower-end apartments first, you have a higher chance of impressing them later with better options.
At Sacha Greif’s book launch of his eBook on UI design, he decided to discount his normal edition at $2.99 (regular price: $5.99) and his deluxe edition at $5.99 (regular price: $12.99). Through this pricing strategy, Greif sold many more copies of his deluxe edition because as one Hacker News commenter notes:
“For me the pricing model is perfect for something like this. $2.99? That’s right in my ‘don’t even think about it’ impulse range. $5.99 for additional features? I’m already paying $2.99. It’s not much more AND I get more stuff. Bravo!”
Any business strategist can look at Starbucks’ price hike and attribute it to profit maximization, but Starbucks can’t tell its customers that. Instead, the company blamed rising labor costs, higher rent, and non-coffee commodity—even though the price of coffee beans has been dropping since 2011.
Customers need justification as to why they’re paying more. They need to know that they’re not being taken advantage of and feel like they’re still paying for something of value. Good story-tellers can help customers feel this way. Need proof? Just take a look at antique stores, garage sales, and eBay. A lot of time, we don’t really know how much any of those used items are worth, but the ones with better stories attached to them almost always sell for more.
Rags Srinivasan, a management professional, explains this strategy on his blog:
“As you read [Starbucks’ reasons for increased pricing] multiple times you will find all kinds of reasons except, ‘We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we don’t expect any push back from these high income segment.’”
“A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay.”
If your business is like most, you’ll need to think strategically about profit maximization. The value of your product is set forth by you. Whatever you communicate to your customers helps them determine the value of the products you sell. Ariely explains how effective businesses can be at achieving this by looking at how black pearls ended up more valuable than white pearls:
“The interesting thing about black pearls is that when they were first introduced to the market there was essentially no way to gauge how much they were worth: were they worth more or less than white pearls? Most people instinctually believed that white pearls were still more desirable. But then the black pearl discoverers had an lucrative insight: take these unfamiliar black pearls to a famous jeweler and have them displayed next to the more precious gems: rubies, sapphires, and so on. The result still lives with us today: black pearls are now worth more than white pearls.”
Remember, value is a complex thing to grasp and all business owners have the opportunity to set—and communicate—the value they offer to customers.