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  To Get People to Pay, Understand How They Think: The Psychology of Pricing  Premium

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"Can I Venmo you?" While older consumers may not get the question, a growing number of millennials do. In 2016, the peer-to-peer (P2P) online payment system processed more than $1 billion in a single month. Venmo allows users to make and share payments with family and friends directly via their bank account. The platform is especially popular among younger consumers, who prefer mobile apps over cash or cards.

When going out to eat, for instance, customers conveniently "Venmo" each other, with each person transferring money, even very small amounts, directly to another user's account. In 2017, the U.S. banking industry rolled out its own P2P payment network called Zelle, which links banks together and can process payments even faster than Venmo, in a matter of minutes versus one banking day. With dozens of new entities set to join the network this year, the way people pay for goods and services is changing fast, in what is being hailed as a revolution in personal payment.

Moves like these are having an impact on how consumers perceive the value of their purchases. These perceptions are being confounded by complex pricing promotions, rewards programs and loyalty schemes, enticing consumers to earn points, win perks and receive discounts on products.

Lying at the intersection of these trends are companies, which need firm foundations, based on sound behavioral economics principles, to craft sustainable business strategies.

In this article, I will describe several core concepts for understanding promotions and how people make spending decisions, based on research I have done related to consumer psychology around money. In doing so, I will highlight some caveats for companies engaging in promotional activities. In the end, the biggest payoffs come when companies are transparent about their offers and seek to build trust with their customers.

Perception Is Everything

Before we delve into the plethora of schemes that populate an ever more crowded payment environment, we first need to grasp two fundamental principles from behavioral economics: reference points and prospect theory/loss aversion. Both of these concepts are helpful starting points for devising marketing strategies, as well as for framing your offer, bearing in mind how consumers' perceptions of value may be affected.

REFERENCE POINTS. Pretend you are on a plane, browsing the duty-free catalog. You see a bottle of cognac on offer, which comes with a promotional gift of a high-quality fountain pen. Up until that moment, you had estimated such a pen to be worth around $100. Now, however, because the pen is offered as a freebie, your expectation of the production cost of the pen is suddenly affected, as well as your perception of the profit margins around it. Your "reference point" for the pen will be diminished, as will the maximum amount you would be willing to pay for such a pen in the future. This recalibration will occur even though price information around the pen was not explicitly provided.

This illustrates the variability of a price reference point -- the internal price that a consumer expects a product to have. This reference point may be based on past purchasing behavior or on a contextual view, such as when a merchant provides information at the point of sale, offering an attractive price that gives consumers the impression they are paying less than what they could be paying. A reference point may also be determined by what you believe is a fair price.

Many of the ways in which consumers' reference points are set are obvious, but some are more subtle. Think about cosmetic companies in department stores. Often, these companies will offer a bundle of free goods with a given purchase of a certain amount. These promotions are usually held a few times a year to boost sales. Yet sometimes they can seem unrealistic, such as "buy $35 of a product and get a goodie bag valued at $122." When consumers see offers of this type, their perception of the value of the individual products in the bag is diminished. Consequently, the reference points upon which they will base future spending decisions will also decline. Many customers who would have paid $25 for a lipstick, for example, will be less willing to do so once they receive it free as part of the goodie bag.

. Next, imagine you are shopping for a plane ticket and your reference point is $2,000. If you find a ticket for $1,500, you'll be very happy. But what if the opposite occurs? What if the only ticket you can find costs $2,500? The pain of spending $500 more than your reference point will be felt more acutely than the pleasure you experienced at having found the ticket for $500 less.

This is an example of prospect theory, also known as loss aversion. The basic idea is that margins of utility diminish in the domain of gains with respect to a reference point, while in the loss domain, disutility is steeper. In other words, a customer's pain of paying more than expected will have a stronger impact on future spending decisions than the satisfaction felt after having paid less than expected.

Now suppose that you bought the ticket for $1,500 and were satisfied with this price. At that moment, your reference point has changed. The next time you go shopping for a similar ticket, this will be the price you will expect to pay. If you subsequently find the ticket at your original expectation price of $2,000, you will find yourself in the domain of disutility. This time, the additional pain you feel for having to shell out an extra $500 will feel even greater than the pleasure of finding the ticket at your original reference price. This, in turn, will lower the likelihood of purchasing in the future to a much greater extent than a discount would increase the likelihood of purchase.

The Effects of Promotions

It is important to understand these psychological behavior patterns before talking about promotions and their effects on consumers.

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This article is based on:  To Get People to Pay, Understand How They Think
Publisher:  IESE
Year:  2017
Language:  English