Pinhead Pricing

Blog – Week of May 24, 2009

Pinhead Pricing

Econ 101, you have a supply line and a demand line.

They meet at a point.

This is the blessed state of equilibrium. Voila, the price has been determined and established with absolute academic rigor.

Theoretically of course.

Turns our pricing only works like that on chalkboards, there are a couple of Nobel Prize winning economists wandering around today, hopefully unemployed but I doubt it, who applied their price theories very precisely to everything in the United States. Because of their brilliance at the chalkboard, they convinced a lot of bankers and hedge fund managers to invest according to their theories. A banking crisis was born.

Every real world business owner, or person who has ever run a garage sale, knows the truth. Prices are determined by what the customer can and will pay. Supply and demand matter, but so do a lot of other things, otherwise the Rolex watch would be extinct, just like T Rex.

Prices are sticky. Turns out, people judge the relative worth of items by preconceived idea of cost. Thus there was a time when virtually no one would pay $5 for a cup of coffee in a paper cup. Then came a time, when no one who was anyone would buy a $1.25 cup of coffee in a paper cup, we had to have that $5 cup. Now we make it ourselves for $1.25 a pot.

This has to do with anchors. An anchor is the price at which you last actively considered the price of an item, not just when you saw the price, but thought about it. Take jeans, you need some, there is a pair for $80. In fact you look around at several stores and see lots of jeans for about $80. This becomes your anchor. Now when you come across the same pair for $50, you think it is a pretty good deal.

Note, you do not know the supply curve. You have no way to know that stock is piling up in a warehouse in Taiwan. You don’t know that supply is strong or weak. You don’t know the cost of production or distribution. Econ theory claims all this information is contained in the price, so you are in fact rational to buy the $50 jeans; a little truth there, but it isn’t really how customers operate.

Thus every jewelry salesman knows, first show the customer the most expensive piece of jewelry in the category, or at least one far more expensive than the soon to be newlyweds could ever afford. This sets their anchor high. Later when they pay twice what they expected, it seems to be a terrific bargain. They anchored high, and it shifted their value perception.

I’m not trying to suggest being manipulative. The point here is understanding what drives opinions on pricing. Dan Ariely wrote a thought provoking book, “Predictably Irrational” about how consumers really act in the marketplace. It’s worth reading.

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