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How Online Reviews Affect Willingness to Pay

Imagine you are planning a trip to see a movie. You mention it to one of your friends, who immediately tells you they have already seen it and it stinks – they advise you not to waste your money.

How likely would you be to still go and see the movie?

In our last post, we offered an in-depth guide to the concept of Willingness to Pay (WTP). We explained that WTP is an essential notion for anyone in sales and marketing to grasp because it describes how customers, far from being passive agents happy to pay whatever a vendor asks for a particular product or service, have usually already made up their mind about what is and is not an acceptable price.

Indeed, the entire act of buying can be explained in terms of consumers deciding there is value in the purchase, the perception of value leading to willingness to pay. But what people see as good value is influenced by a wide range of factors, including the product or service in question, perceptions of quality, personal values and preferences, prior experiences, knowledge, preconceptions and expectations.

Put simply, if a business wants to get its pricing strategies right, it has to understand what its customers are willing to pay.

In discussing the different factors that influence WTP in our last blog, we left one important topic out for further consideration in its own right – what other people have to say about a product we are thinking about buying.

Going back to our movie example – for most of us, our friend’s negative review would be enough to make us think twice about spending our money at the cinema. To put it in the academic terms used to explain WTP phenomena, we would wonder about the transactional utility of buying a ticket – if the movie really is awful, then we are unlikely to get any pleasure from watching it, which would defeat the point of spending our money.

The reason why the views of other people are so important to WTP is that we obviously don’t know whether a purchase, whether it is a cinema ticket, a meal at a restaurant or a new pair of trainers, will feel ‘worth it’ until we actually spend the money. As many of us don’t like taking these kinds of risks with our hard-earned cash, we look to what other people are saying to give us a clue.

There’s even a school of thought which suggests that we prefer to make decisions based on what other people say rather than making a judgement for ourselves. Dan Gilbert from Harvard University says that most of us are not very good predicting how different experiences will affect us as we fail to consider too many of the details. But what we are good at is using other people’s experiences to make a judgement about our own feelings – perhaps because we are instinctively empathetic creatures, we are good at ‘measuring’ the happiness other people describe and applying it to our own decisions.

All of this goes some way to explain the rise of online reviews. To recap, when we spend money on anything, we want to be sure we will get some level of satisfaction out of it, whether it be a pleasurable experience or a sense of value. As we’re not always great at judging whether we’ll be happy with a purchase by ourselves, we like to listen to what other people have to say. And nowadays, of course, we no longer have to rely on just talking to family, friends and acquaintances. We can read all the opinions we like courtesy of online reviews.

Online Review

Just how important are online reviews?

Whether you look up a product, service or experience on Google or Amazon, or go to a dedicated site like Yelp, user reviews are everywhere these days. Nine out of 10 consumers say they read online reviews before visiting a business, while 88% say they trust online reviews as much as they do personal recommendations from friends and family.

Moreover, online reviews are having a direct impact on people’s spending behaviour. According to one survey by Podium, 93% of consumers say reviews influence their purchasing decisions, with 82% acknowledging that they have made up their mind to buy based on what a review says. Looking at product reviews on social media in particular, it has been suggested that a single positive review can boost conversions by 10%, while 100 positive reviews will result in a 37% conversion uplift.

We can further refine all of this to say that online reviews have a direct bearing on what people are prepared to pay for products and services. The same Podium study found that more than two thirds of customers (68%) are prepared to pay up to 15% more for a product if they feel reassured by a positive review that they will get a good experience.

Other sources suggest that customers will spend up to 31% more for any product and service rated “excellent”, while a one-star increase in customer ratings on Yelp has been linked to an average 5 – 9% increase in business revenue. In the travel industry, three quarters of people say they are willing to pay more for a hotel that has good reviews from previous visitors.

The flipside of all of this is that 86% of people say they will hesitate to buy from a business that has negative online reviews. A single negative review is estimated to cost a business an average of 30 customers.

So the picture is clear – online reviews play a critical role in customer purchasing decisions, positive reviews encourage people to spend more, and quality of reviews therefore has a direct impact on a business’s turnover. The question is, what can businesses do to make online reviews work better for them?

Learning from reviews

As well as our apparently natural tendency to take our cues from other people when it comes to making decisions about unknowns, there is another key reason why online reviews have such an impact on buying behaviour which businesses absolutely have to understand – trust.

Consumers trust reviews from other customers almost 12 times more than they trust descriptions and comments made by vendors. And it is not difficult to understand why – when we read branding messages from companies, modern consumers are smart enough to understand that they are trying to sell us something, and not everything they say can be taken at face value. With customer reviews, however, there is an expectation that what is said will be objective, honest and dispassionate, with no ulterior motives for praising a product. When there are lots of reviews for the same product, consumers also get a chance to compare opinions, good and bad.

On the one hand, this is an extremely powerful and cost effective marketing tool for brands and businesses to harness. Instead of spending vast amounts on expensive advertising campaigns to convince customers how great you are, you can sit back and let them convince each other – for no expense on your part whatsoever.

The problems occur when businesses don’t get the positive reviews they want. This is where the temptation to game the system starts to creep in – to either start writing your own fabricated reviews to make your product sound better, or to pay ‘brand ambassadors’ or ‘influencers’ to do it for you. In the long term, however, this is counterproductive. Once the seeds of doubt start to creep into customers’ minds that the reviews they are reading might not be genuine, that all important element of trust is broken. That’s when reviews will cease to have the same level of impact on purchasing decisions and WTP.

Finally, while businesses can’t write customer reviews for themselves, they can do more to encourage customers to leave feedback. This appears to be something the majority of businesses are not yet very good at – just 13% are proactive in asking customers to leave a review after they make a purchase. This is a missed opportunity, because while some people will leave feedback or comment on what they have bought on social media, the overwhelming majority are still unlikely to even think about it unless asked. We have seen the difference that larger numbers of reviews can make to conversion rates.

Key takeaways

  • Online reviews are now widely used by the majority of people when researching products and making purchasing decisions.
  • Reviews appeal to consumers because they help them decide whether or not they will get the satisfaction they are looking for from a purchase. People also trust that they are getting an honest, objective opinion when they read what other customers have to say.
  • Positive reviews have a powerful impact on the choices consumers make, on conversion rates, and also on how much they are willing to pay. Good reviews are also a great marketing tool for businesses, helping to attract more customers. In short, good reviews can be linked directly to better business performance.
  • Conversely, negative reviews will put people off making a purchase and drive away custom.
  • That doesn’t mean businesses should fear poor reviews, however. As an honest and direct record of what customers think about their products and services, reviews give businesses some of the best insights they are likely to get into what their customers think about them. The only appropriate response to a poor review is to take it on board and respond to the issues raised, in the hope of earning more positive reviews further down the line.
  • While businesses cannot dictate what customers write in reviews, and can only focus on delivering great experiences, they can be more proactive in encouraging people to leave reviews, and therefore get the benefits of more positive feedback.

th!nkpricing is a brand of Smart Pricer. We enable a better way to sell more by offering a platform to understand, optimize, and measure your pricing in a unique way.
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The Ultimate Guide to Willingness to Pay

The great Roman statesman and philosopher Seneca the Younger once wrote: “We no longer wonder what things are, but how much they cost”. He coined this line a little under two thousand years ago, but the words remain impressively relevant to our own modern world of commerce and consumption, where we seem to look at all things through the lens of cost and value.

Businesses can set whatever price they like for the goods and services they sell, but if that price is at odds with what their customers are prepared to pay, they are unlikely to make many sales. That is why Willingness To Pay (WTP) is one of the most important factors any business should consider when devising a pricing strategy. Put simply, it is not enough to consider your own margins when setting a price. You must also consider the perceived value of the product from the customer’s perspective, and weigh up the likely impact your pricing will have on demand – a subject we have addressed in depth in this previous blog.

If you want to go directly to the essentials of how WTP works, you can click here for the summary. Else, keep reading to get the whole picture and understand the ins and outs of WTP.

Willingness to Pay

There is no magic formula every business can use to calculate WTP. It is far from an exact science. Consumers judge value in different ways for different products and services. For example, if someone is buying a new fridge-freezer or TV, there will be a different matrix of value judgements involved – different weightings given for reliability versus aesthetic appeal, quality of build versus quality of the experience and so on. When we book a hotel room, we balance practical considerations like number of beds and location against our willingness to pay extra for little luxuries, whereas for a concert ticket to see our favourite performer, it’s all about the value we put on the experience.

So there is very little consistency in how WTP works across industry verticals, or even from one product or service to the next. Cultural, social and personal factors also dictate that consumers from different countries or demographics are also likely to exhibit different WTP for the same goods. Evaluating WTP is therefore part and parcel of a business understanding its customer base and making pricing decisions that are as compatible as possible with the perceptions of their most important target demographics.

As Ibbaka puts it, “The goal is to capture as many customers as possible at as high a price as possible.” The highest possible price is that which corresponds with the WTP of enough of your customer base to make your venture most profitable. With a luxury brand like Rolex, for example, it might seem that their exceptionally high prices are well above what the majority of people are prepared to pay for a watch. However, they still find enough customers prepared to pay a premium for the quality and brand identity that Rolex represents – and the margins on their products are so high – that they are still able to make a considerable profit from a relatively low turnover.

We dig deeper into how different pricing strategies look to balance margins and demand to maximise profitability in this blog. But underpinning all pricing strategies is the ability to set prices that you know enough of your customers will be prepared to pay, and that requires understanding how value decisions are made by consumers at an individual level. That’s where we’ll focus our attention in the rest of this guide.

Willingness to Pay in Theory and Practice

The formal definition of WTP is the maximum price a customer is prepared to pay for any given product or service.

It is important to understand that an individual’s willingness to pay for a certain product or service is not fixed – the maximum they are prepared to spend can and often does vary. This is largely influenced by personal factors such as current cash flow, other outgoings, how much they have spent on the same shopping excursion, how necessary the purchase is at that present time and so on.

However, it is also widely accepted that there are ways that brands and retailers can influence WTP with the aim of encouraging customers to spend more. Several models have been developed to explain how this can be put into practice, one of them being transactional utility theory.

Transactional utility theory argues that every time a customer goes to buy a particular product or service, as well as having a maximum price they are willing to spend in their head, they also have a reference price in mind. The reference price is what they are actually expecting to spend, and might be influenced by previous experiences buying the same or similar products, research they have done ahead of the purchase, advertising and so on.

WTP and reference price might sometimes work against each other. For example, if your favourite music artist announced a concert in your town and tickets were priced at €50, you might on the one hand be happy to pay that for the experience. But on the other hand, you might, as a point of reference, consider that the last time you went to a concert you only paid €20, or that you could have a much cheaper night out at the cinema. Reference price can therefore drag down WTP.

Transactional utility theory argues that reference price and WTP can both be used by vendors to increase the likelihood that an individual will buy. In short, it is all about managing the satisfaction of the purchaser. WTP is largely based around a person’s judgement of the satisfaction they will get from a purchase after the fact. So taking the concert ticket example, if you judge that the pleasure you will get from seeing your favourite artist is worth more than €50 (and perhaps outweighs any negative financial consequences), you are likely to buy a ticket regardless of other considerations.

Customer satisfaction

But consumers can also get a sense of satisfaction from the perceived value of a purchase itself, and this usually revolves around the reference price – if something is priced lower than you were expecting, the attraction of the bargain is itself a big incentive to buy. This is where special offers and discounts come into their own – you might be undecided about whether you should spend €50 on a ticket to see your favourite band, but when you see they are available for an early bird 20% discount, your mind is made up by the pleasurable feeling of getting a good deal.

The aim for businesses, then, is to know their customer base well enough to be able to price lower than their WTP. But as that can be a difficult judgement call to make, a more practical approach is to use reference price as a benchmark – either beating the prices competitors set for similar goods and services, or using special offers to increase the likelihood of a customer feeling they are getting a good deal. The payback for brands and retailers is that studies have shown a link between increased customer satisfaction and higher WTP – so, over time, the happier you can make your customers in their purchases, the more you can afford to charge them. That partly explains how luxury brands like Rolex can set prices so high – their customers get a great deal of satisfaction from buying their products, so are prepared to pay more.

Factors that Influence Willingness to Pay

Encouraging customers to increase their WTP for a product or service is clearly a very attractive idea to businesses, which is what makes the theory of transactional utility so interesting. But the conversation doesn’t stop at “Let’s make our customers feel satisfied that they are getting good value for their money.” Because the obvious question then is – how exactly do individuals decide what is and is not good value?

This is where things get tricky, because there are a lot of different factors at play in how individuals judge value. As well as characteristics of the product or service itself such as quality and general market value, personal and demographic factors such as age, gender, nationality, ethnicity, religion, income and lifestyle all influence people’s purchasing decisions.

What is more, these factors can change considerably over time – sometimes quite quickly. For example, manufacturers and vendors of plastic goods may well have seen WTP – or even willingness to buy at all – take a sharp hit amongst certain groups of consumers in just the past couple of years because of concerns over climate change and pollution.

Understanding how all of these different factors interact to determine a person’s WTP for any given product is far from easy. However, as a general rule of thumb, we can break things down into three general areas:

1. Characteristics of the product

In any given commercial sector, you can expect to find goods and services priced at a variety of different points. This is an acknowledgement of the fact that different people will have different WTPs for very similar products, and a way of the market catering for all budgets. But when you compare two such products directly, what makes some people willing to pay more for one rather than the other?

Quality is the most obvious factor – we have already mentioned Rolex a couple of times, and another good example of a brand that enjoys high WTP from its customers on the back of a reputation for quality is Apple.

Another factor that makes consumers willing to pay more for a product is what is known as the unique value effect. This is the idea that a unique selling point – something one product offers that others do not – will not only influence customers to choose that product over others, it will also make them willing to pay more for it.

To carry on the smartphone example, the big manufacturers have long been locked in a battle to add unique value to each new release in the form of clever new features in order to justify pushing up the prices. Apple, Samsung, Huawei and others focus much of their marketing around tech and specifications, whether it is a triple rear camera or 5G connectivity, because they know that successfully selling the unique value of their handsets will encourage customers to pay more.

2. Personal and social characteristics

Coffee personal characteristic

Of course, even if you take two broadly similar products with very different credentials when it comes to quality and/or unique value propositions, there will always be people who are unwilling to pay the extra for the ‘better’ product. This is critical to how brands position themselves in the market and plays a key role in the pricing strategies they adopt. The opportunities that exist for budget and discount brands exist because there are plenty of consumers who are unable or unwilling to pay top prices.

The flipside of this is that personal values and social trends can also intersect to push up what some individuals are prepared to pay for certain products. A good example of this is ethical and sustainable consumerism, where some people are prepared to pay a premium for their organic milk or Fair Trade coffee.

3. Consumer savviness

Finally, a simple assumption that has far-reaching consequences for pricing strategy – modern consumers are well-informed and smart, arguably more so now than they have ever been, and are prepared to play the pricing game to get themselves the best possible deal. In practice, this often boils down to biding their time before making a purchase. The reference price a customer has in mind when they are considering buying a product often includes the calculation that, at some point, any given product or service will probably be put on promotion by one vendor or another. If a customer is willing to wait a while, they are likely to get themselves a better deal.

A good example of this is the way that smartphone manufacturers use a strategy known as price skimming following a new release. At first, they price handsets very high on the understanding that a certain group of early adopters will always be prepared to pay a premium for the unique value they see in the latest cutting edge gadgets. The likes of Samsung and other smartphone companies appreciate that this is a relatively small demographic, however, so after a certain period of time they will cut their recommended retail price (RRP’s) to target a different group of would-be customers. Savvy consumers have got wise to this and will hold off for the price cuts, making them something of a self-fulfilling prophecy.

Sometimes, however, vendors can flip this around and make it work for them. Ticket sellers, for example, covering everything from airline fares to concerts, have become very adept at making early bird prices work in their favour. Here, the expectation is that prices will rise, so consumers rush to buy early in a bid to get the best possible deal. Clever vendors can use this to push up WTP even for apparently ‘discounted’ tickets – by setting a high ‘door price’, they can make any kind of early bird reduction feel like good value.

Key Takeaways

Let’s recap the key points we’ve covered about WTP:

  • What customers are willing to pay for a particular product or service is an essential factor to consider when adopting a pricing strategy.
  • Getting a handle on what your customers are willing to pay is far from easy because there are so many influencing factors involved. But getting it wrong can have very negative consequences for your business. Price above the typical WTP of your core customer base, and you will see demand fall, with a knock-on effect on your turnover.
  • Despite the difficulties, accurately evaluating what your customers are willing to pay for your goods and services will help you to maximise your profits by pricing at the optimum point on the demand curve – i.e. the point where price and turnover gives the best possible margins.
  • It therefore pays to invest time, effort and money in really understanding your customers and their attitudes to pricing and value. Use your customer data to analyse the buying trends that will help you to estimate WTP more accurately.
  • WTP is not fixed and it is possible to encourage your customers to raise what they are willing to pay by focusing on factors like satisfaction, quality, unique value, personal beliefs and social trends. Customers will also change what they are willing to pay over time and brands should be prepared to regularly re-evaluate their assumptions, as well as recognise the impact that changing prices and discounting can have on consumer perceptions of value.

One other important area we have not fully touched upon in this blog is how the experiences of other consumers influence WTP and the reference prices shoppers carry in their heads when they consider a purchase. This will be the subject of our next post – and in particular, how the modern trend for writing online reviews and sharing experiences on social media is influencing willingness to pay.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.
Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog posts.

Which Pricing Strategy Should You Choose?

Finding the right price for your product or service is tough. Just simply calculate your costs and add a markup is not enough anymore.

 

Quote Pricing Strategy

 

Whether you are a total beginner or already advanced in pricing, this blog will introduce you the five main models for pricing strategy to help you get a better feeling about what to choose for your business to get paid for the value your customers perceive.

The 5 most common pricing strategies

In previous posts, we have spoken in general terms about the importance of pricing strategy and why, out of all the other factors which impact on profitability, pricing has the biggest effect. We have also looked at the relationship between pricing and demand, explaining the role of demand curves in identifying an optimum unit price for a product.

Depending on the literature you read, the number of defined pricing strategies out there easily runs into double figures. But most analysts agree that these can be boiled down to five main categories which we will now share with you.

1. High price

Also known as premium or luxury pricing, this approach is commonly adopted by brands that want to build and maintain their identity around quality and exclusivity.

It is based on the reasoning that certain customers would prefer to pay higher prices in return for a brand with an exceptional image and credentials

– price in itself becomes a key differentiator.

Because unit prices are kept high, margins are also extremely healthy. The calculated risk is knowing you have the kind of brand equity, as well as the quality of products, that will keep demand and sales strong.

There are high profile examples of brands that thrive on premium pricing strategies right across the world. It is often the choice in commerce business, from luxury motor car marques like Bentley and Rolls Royce to watchmaker Rolex. For these brands, paying more than you would have to pay for similar products from other vendors is part of the appeal for customers. It’s like buying your way into an exclusive club.

A pricing phenomena we see in fashion at the moment are exclusive “Drops”. By using this tactic, brands release very limited runs of a new garment and charge exceptionally high prices for them.

Widely credited to have been masterminded by New York streetwear brand Supreme, it is an approach that has been adopted successfully by the likes of Gucci, Adidas, Nike and Louis Vuitton in recent years. Besides enjoying high profit margins, this approach has another goal. “Drops” are also enabling fashion marques to get the most out of their own direct-to-consumer online channels, attracting consumers away from mainstream retail channels to their own websites with the promise of cutting edge, limited edition runs.

 

Rolex Premium Pricing

Brands like Rolex use high pricing as part of broader strategy to maintain a reputation based on exclusivity and premium quality.

2. Mid-price

Although the likes of Nike and Adidas have become well known for their premium-priced ‘drops’, the majority of their business is built on what might be called a mid-price model

– an everyman, all-things-to-all-people approach.

A mid-price strategy can be seen as trying to strike a balance between a reputation for quality and good value. Unlike premium pricing models, the aim is not to target people who like to spend big, but rather to appeal to the mass market and therefore gain deeper penetration. At the same time, many brands are also conscious of pushing prices too low, as they don’t want customers to start questioning if the quality stands up and start thinking of them as a discount brand.

Mid-range pricing strategies are the most common type you see in mass market goods because they seek to find a middle-ground compromise between all competing factors – costs versus revenues, quality versus value, demand versus competition.

3. Low price

Low or economy pricing is arguably the strategy that takes the principle of the demand curve most literally – that if you drop your prices, demand will increase. That’s great if you want to boost your sales volumes, but the flipside is that lower unit prices mean lower margins.

Economy pricing is widely employed by specialist discount or value brands that seek to

– make high demand profitable by cutting back costs as far as possible.

Most supermarkets engage in economy pricing on the core grocery lines they sell, using their buying power and economies of scale to drive down wholesale costs. Most also now produce their own ‘no frills’ product lines, pushing down costs further still with minimal branding and marketing expenditure.

 

Supermarket pricing

Supermarkets routinely adopt economy pricing models with a wide range of high volume, low margin grocery items.

 

Budget airlines like Ryan Air are also renowned for their low price strategy. They are focusing on offering the cheapest price in the market and bring you from A to B on time. No more, no less.

4. Price skimming

Price skimming can be seen as an attempt to straddle the divide between premium and mid-range pricing strategies.

What it typically involves is brands rolling out new products at a high price point, banking on creating a lot of hype around the launch and the fact that early adopters are often prepared to pay whatever it takes to get first look. After this early shot for profits, prices will be scaled back to more of a mid-range point, seeking to broaden the appeal and keep sales volumes high.

Skimming is very common in electronic device markets such as smartphones and games consoles. Brands like Apple, Samsung and Sony are renowned for skimming – the Playstation 3, for example, originally retailed in the US for $599, but was reduced over a period of a couple of years to just a third of that original price.

– Skimming aims to segment consumer markets into different bands:

● Early adopters who show inelastic demand however high the price is
● Mainstream shoppers
● More value-conscious buyers

By treating each segment as separate, and drawing a different demand curve for each, brands determine a series of optimum price points that they can adjust to over time, trying at each stage to minimise the consumer surplus – the difference between what people are prepared to pay for a product, and what they actually pay. In other words, price skimming tries to find the optimum price for different groups at different times.

This strategy works well for brands that exert a near-monopolistic influence over a market – Apple, for example, at various stages has known that the main obstacle to people buying its iPods, iPads and then iPhones is price, rather than competition. Adjust the price, and you can hoover up everybody. But once competition increases and rivals are prepared to undercut a brand’s price on launch, skimming becomes much harder.

5. Penetration

Finally, penetration price strategies can be seen as working in the opposite direction as skimming.

They see products launched at a budget price point, and then gradually increase towards the middle ground. This is the classic “special introductory price” strategy, and

– the goal is to rapidly grab market share, rather than aim for profitability.

Penetration pricing is the model often adopted by disruptors looking to enter an already crowded market and attract customers away from incumbent brands. It works most effectively when markets are highly saturated with little product differentiation – someone coming along and offering a better price is then enough of a point of difference to attract custom.

To follow on from the consumer gadgets example used above, smartphone vendors like Samsung and, later, Huawei adopted penetration pricing as a way to grab market share from Apple, which dominated smartphone sales at first. Both companies were highly successful, and now boast a bigger share of the global smartphone market than their Californian rival.

Plus, in classic penetration pricing style, both Samsung and Huawei have gradually moved away from aiming to undercut the market to now providing products at a wide range of price points – including the premium end Apple deals in.

 

Samsung pricing

Samsung, now the world’s biggest smartphone vendor, started out undercutting Apple’s iPhone prices, before moving to higher price points once it has established market share – a classis penetration pricing approach.

 

Unlike economy pricing, penetration pricing is not about squeezing every last drop of margin out of low prices through aggressive cost cutting. It is about deferring profitability until you have the market muscle to either gradually raise prices, or start to up-sell more profitable products.

A classic example here is Uber. Widely regarded as one of the greatest disrupters of the digital age – a ride-sharing app that changed the private vehicle hire market the world over – Uber spread like wildfire on the back of a ground-breaking, uber-convenient app-based purchasing model and lower prices than most standard taxi firms. It grabbed market share ok, but profitability has remained stubbornly elusive.

Ironically, Uber is now the target of dozens of new entrants all over the world looking to grab its market share with lower prices – DiDi in China and south-east Asia, DiDi-backed Lyft in the US, Bolt in northern and eastern Europe. That makes it virtually impossible for Uber to get to where it wants to be, raising prices in a market it thought it had snatched control of.

Pricing is a Process

Considering everything that goes into an effective pricing strategy can easily make your head spin: labor, material costs, logistics, demand, competition … the list is endless. Thankfully, you don’t have to master everything at once.

 

Breaking down Pricing

 

Simply sit down, look at your current sales data and see how effective your pricing is today. Start with playing around with your prices and consider the impact on your sales volume. This will help you pinpoint the right kind of pricing strategy to use.

More than anything, though, remember pricing is an ongoing process. It’s highly unlikely that you’ll set the right prices right away — be assured that it often takes a trial and error approach until you find the right prices for your business, and that’s OK.

 

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog posts.

 

Why to Consider a Pricing Software?

You want to determine the right pricing strategy for your business objectives, and then implement those strategies in the right way to maximise profits? As you may have already realized that requires you to be in command of a complex web of competing factors and considerations.

The solution: by bringing a variety of financial and market data together in one place, pricing software products provide users with the tools they need to understand their pricing requirements, evaluate different pricing models and adjust policies flexibly in response to changes in demand, competition and other market forces for optimum impact.

Pricing is fundamentally important to business success. But it is far from an easy thing to get right.

A recap of the basics of pricing

A few blog posts ago, we outlined the basics of why pricing is crucial to every company. Compared to other factors like cost control and increasing sales volumes, pricing has a proportionally bigger impact on profitability than any other financial variable at a company’s disposal.

But while higher prices can lead to higher profits, they also tend to have a detrimental impact on demand. The law of supply and demand teaches us that, as prices go up, fewer and fewer consumers are willing to buy. The precise relationship between rising prices and falling demand varies from product to product, market to market and brand to brand.

Businesses use mathematical models known as demand curves to forecast projected sales at different price points, and therefore work out the optimum ‘sweet spot’ where price and volume will return the highest revenues. Increase price any further past this point and the continued fall in sales will start to have a negative impact on profits.

 

demand curve for milk

Figure 1: The demand curve for milk

 

Even then, we’re still only dealing with the bare bones of pricing. Demand curves are not stable and to maintain the ‘sweet spot’, companies have to account for a host of variable factors that influence the relationship between price and demand, such as consumer tastes and habits, competitor behaviour, seasonal fluctuations and so on.

It is also common for businesses to work with several different demand curves simultaneously, for different markets, demographics and channels, trying to juggle a variety of different optimum price points which are all liable to change over time while still maintaining consistency.

And then, finally, we get onto the issue of pricing strategies, or the use of pricing to achieve specific business and marketing objectives. Vendors looking to grab market share, for example, may delay concerns about profitability and adopt a discounting strategy to attract customers, adjusting prices upwards at a later date when they have an established foothold in the market.

Pricing also has a strong influence on brand identity and reputation. Some brands purposefully stick to high price points in full knowledge that they put off the majority of consumers. The intention is to tap into demand for exclusive, high quality, aspirational products. You might only attract 10% of the market, but that 10% is prepared to pay enough per item to support very high margins.

On the flipside, discount brands rely on a reputation for value to drive high sales volumes, but at the expense of very low margins per item.

Pricing Software combines the complexity with considerable benefits

Given that brief overview of pricing, it’s clear that it is not a straightforward thing to get right. Choosing the right strategy, forecasting demand, accounting for external market variables which will impact on sales volumes, revenue and profitability — this all requires commercial businesses to have their finger on the pulse of various sources of data and intelligence, many of which are liable to fluctuate considerably over time. It is this complexity, and the considerable benefits of taking a truly dynamic approach to pricing optimisation, that recommend pricing software platforms to any business looking to get the most from pricing.

 

Variable factors affecting pricing

Figure 2: Variable factors affecting pricing

 

Pricing in the cloud

In the digital age, the world has become more agile and dynamic. Consumers are used to the convenience of having dozens and dozens of purchasing options literally at their fingertips. It doesn’t take much for someone to switch from one brand or one retailer to another — a negative customer service experience, a recommendation from a friend on social media, spotting a better price through Amazon or Google.

Similarly, with so many channels available to reach target markets, commercial operators have never had so many opportunities to reach new audiences and make grabs for share with creative pricing and service offers. Competition has accordingly never been so fierce.

In this fast-paced environment, businesses have to be increasingly agile and dynamic about pricing, too. That is why pricing software which can process and interrogate vast quantities of available data efficiently, making accurate predictions and adjusting according to fluctuating variables in rapid time, is becoming more and more popular. Instead of having to wait for signs that a pricing strategy is no longer working and reacting once ground has already been lost, pricing platforms allow businesses to proactively stay ahead of the curve.

The emergence of pricing products stems from the revenue management solutions that evolved in industries like hospitality and aviation. For these two sectors, the internet represented a major disruption of decades-old business models. Instead of controlling sales of flights and hotel rooms through a few carefully selected and managed retail partners, ecommerce suddenly meant that there were dozens of different places to buy seats and rooms available online, often through sources not controlled by the airline or hotel chain, and with a variety of different price points.

The response of the smartest airline operators and hoteliers was to apply careful analysis of sales at different price points to determine who bought at what prices and when, based on the understanding that the elasticity of demand (how prepared people are to pay more for a product) changes as availability drops. Armed with these insights, revenue managers at airlines and hotel operators were able to develop variable pricing strategies which maximise yield by adjusting price over time in line with changing availability, and targeting different demographics each time.

 

cloud-based pricing

 

This kind of approach therefore represents a way of optimising revenue/profitability through data analytics and flexible pricing. This is central to how th!nkpricing works. But the key difference is that our software is being designed to model a variety of different pricing strategies so you can come up with the best possible approach for your different product lines. It therefore works at a level above revenue management, applying in-depth analysis and modelling to pricing strategy as well as to the pricing policies you implement over time.

The accessibility and flexibility of a cloud-based pricing platform has many benefits for businesses, but the main ones include:

  • It helps businesses to fully appreciate the impact of pricing on their performance with clear statistical visualisations and simulations based on real business data.
  • It allows brands to dig deep into the effectiveness of their pricing and easily find alternative solutions that deliver a greater impact, capitalising on opportunities they may otherwise have missed.
  • It delivers definitive comparisons between different pricing strategies based on robust business intelligence.
  • It supports the kind of speed and agility in pricing decisions that companies increasingly need in ultra-competitive, fast-paced markets, helping them to respond quickly to changing conditions.
  • It provides a bedrock for businesses to continually assess and improve their pricing strategies over time, with robust real-time monitoring supported by visual reporting that helps to identify and analyse patterns over times that can inform beneficial adjustments.

 . . .

We will be digging deeper into how to use these tools to take advantage of pricing opportunities and build a long term pricing strategy in future blog posts.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog posts.

The Demand Curve and its Role in Pricing Decisions

In the last post, we introduced you the concept of the Law of Supply and Demand. We learned that the relationship between supply, demand and price can be represented as two curves on a graph. Now we deep dive and explain this impact on pricing decisions.

One of the properties analysts look at when they study demand curves is movement, or the way demand shifts along the line in tandem with price and vice versa. In particular, they look at how steep the movement curve or line is.

Take a look at Figure 1 and Figure 2, hypothetical demand curves for the price of oil and Netflix subscriptions respectively. Figure 1 shows a shallow line, which indicates that demand is elastic — changes in the price have a significant impact on demand. Figure 2, on the other hand, shows a steep line, which suggests that demand is inelastic, or changes relatively little in relation to price.

 

demand curve for oil

Figure 1: The demand curve for oil

 

demand curve for Netflix

Figure 2: The demand curve for Netflix subscriptions

 

Using Figure 2, Netflix could be confident that raising its subscription prices would have such a modest negative impact on demand that further increases would keep increasing revenues. At a €15 charge, it stands to make €1500m, considerably more than the €1025m it would make at €10 per subscription, despite having 2.5 million fewer subscribers.

For the oil industry, however, Figure 1 would caution strongly against price increases. In terms of turnover, the peak earnings here would be at €30 per barrel (€1900m), tailing off sharply after €50 per barrel.

In real world scenarios, the relationship between price and demand would rarely produce straight lines like these, which is why we talk about demand curves. Take a look at Figure 3 plotting the possible correspondence between price and demand for a litre of milk.

 

demand curve for milk

Figure 3: The demand curve for milk

 

This concave shape is considered the classic demand curve. It demonstrates both an elastic section (between €1 and €3) and an inelastic section (between €3 and €5). This kind of curve is typical of most products, where price increases from a floor value will quickly drive away a large proportion of customers, before the impact of further hikes gradually decelerates. The ‘sweet spot’ in this curve is actually €2 per litre, which would return the highest revenue based on demand. For a product like milk, you might imagine that the higher price points represent a premium product like organic, lactose-free or farm bought, where there remains a smaller but loyal customer base that are not put off by increased prices.

Less commonly, you might see a convex demand curve that slopes the other way (Figure 4). This type of curve would be typical of a product where there is a certain amount of tolerance for price increases in the market up to a certain point, meaning demand is inelastic. But after that tipping point, tolerance for further price increases is lost, demand becomes very elastic (shown by the curve shallowing out) and further price increases are likely to become counter-productive. It is probable that brands like Apple and Netflix work with these kinds of demand curve, adopting price increase policies up to the tipping point but no higher.

 

demand curve for IPhone

Figure 4: The demand curve for the latest IPhone

 

Applying the Demand Curve to Pricing Strategy

We will look more closely at specific pricing strategies in our next blog. But in general terms, a correctly calculated demand curve can help a brand determine two things:

  1. The optimum unit price for a product
  2. The type of pricing strategy that is likely to deliver best results going forward.

One thing to bear in mind about the accuracy of any demand curve calculations is that, once plotted, the graph assumes all other factors which could influence both price and demand are constant. But of course in the real world they are not, and many other variables — product supply, consumer demographics and habits, the price of substitute goods, levels of competition, innovation and disruption, seasonality — all play a part.

Accurate demand modelling needs to take all of these factors into account, allowing for what are known as shifts in the price-demand relationship. If something should happen to lower demand with price remaining constant, the demand curve will shift to the left; if demand increases with price constant, the curve shifts to the right. Businesses are often building their pricing strategies within a range of probabilities from the lowest to the highest shift away from the anticipated norm.

Businesses calculate unit price using the following formula:

Sales Revenue = Unit Demand x Unit Price

So in other words, to calculate sales revenue, you pick a point on your demand curve and multiply the values for demand and price. The point on the curve that gives you your highest revenue figure tells you the optimum unit price. However, it again has to be acknowledged that maximising sales revenues is not the only objective to consider with pricing.

Most businesses are more concerned with profit, and that also has to factor in unit costs. In some situations, the level of demand which gives the optimum sales revenue may not deliver the highest profits, as the cost of producing so many or so few units may eat into margins. This is where the strategic business objectives come into play and add another layer to pricing decisions. Aside from revenue and profit considerations, for example, vendors might weigh up the brand reputation and identity implications of pricing, keeping unit prices low if they want to be associated above all else with value, keeping them high if their brand is built around quality and prestige.

. . .

Next time, we will dive into the details of different pricing strategies brands and businesses might adopt, looking at how the science and art of pricing is a key part of marketing any product and how important it is to sustaining success in the long term.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog post.

An Introduction into the Law of Supply and Demand

In our last blog post Why Pricing is Crucial for You, Your Customer and Your Company, we have discussed why pricing is the number one profit driver of business and what you need to consider around pricing. Now we introduce you the concept of price-demand curves in a 2-part series. Let’s start with the basics, before diving in deeper next week.

One of the biggest secrets to success in business is knowing how to set prices. While pushing up prices can seem a great way to boost profits, increase them too much and you will drive away customers. Before deciding on a pricing strategy, business owners need to understand the relationship between price and demand, and how one affects the other. The Demand Curve, which models customer demand against price fluctuations, is one very useful tool for bringing this understanding into pricing decisions.

For certain companies in certain industries, price increases seem to have little impact on how much consumers want to buy their products. Apple, for example, has consistently pushed up the price of each new iPhone release, so much so that the latest handsets now top €1000. Despite only having a 12.1% share of global smartphone sales in 2016, Apple was still able to take 91% of the market profits.

 

apple market share

 

When Netflix hiked its subscription rates between 13% and 18% in January 2019, the company’s stock leapt 6.5%. No one expected even these considerable price increases to have any negative effect on the brand.

But these companies are the exception rather than the rule. Figures show that a tiny minority of companies — as few as 3% — manage to hit annual targets on price increases intended to bolster profits. In other words, 97% of planned price increases fail.

Why? Because, as a rule of thumb, when prices go up, sales volumes fall. Customers generally don’t like paying more for goods and services and are highly motivated by value when they make purchasing decisions.

This inverse relationship between price and demand is described by a model known as the demand curve. The demand curve is used to predict just how much of an impact raising or lowering prices is likely to have on demand, and is therefore a crucial tool in establishing pricing strategies.

If the impact of a price rise on demand is relatively low, businesses are still able to profit from them — this is what brands like Apple and Netflix, for a variety of factors, have been able to achieve. But if even a modest price increase is likely to lead to sharp decline in demand, it risks putting overall profitability at risk.

So what does the demand curve model actually describe? To fully understand its implications, we must look first at the economic principles which underpin it.

The Law of Supply and Demand

The concept of the demand curve has its origins in the law of supply and demand. One of the fundamental principles of market economics, this law states that, all other factors being constant, commodity prices will increase when supply is low and/or demand is high.

Flip this around and the law also shows that demand, or the quantity of a product bought, is a function of price. Assuming supply is stable/high, an increase in price will cause consumers to buy less of a product while, conversely, a fall in price will lead them to buy more.

What this law captures is consumer attitudes to value. If supply is low or demand outstrips supply, people are prepared to pay more for a product they want or need rather than not have it at all. But if supply remains good — which means consumers will be able to find equivalent goods or services elsewhere — they are less likely to be prepared to pay more because they see no value in doing so. Similarly, if prices go down while supply is constant, consumers respond to the better value on offer by buying more.

Demand Curves

The relationship between supply, demand and price can be represented as two curves on a graph — one curving upwards to plot the relationship between supply and price, one curving downwards to show the relationship between demand and price. For the purposes of this article, we will put supply to one side and consider only the relationship between demand and price.

demand curve

Figure 2: Typical demand curve

Demand curves are used to forecast how changes in price will impact on demand, and therefore to inform pricing strategy. They are drawn with price on the vertical axis and quantity on the horizontal axis. In almost all cases, the line/curve will slope down from left to right as this indicates the inverse relationship between price and demand. The exact shape of the line/curve will vary from market to market, product to product and brand to brand. Interpreting the shape and position of the curve gives businesses important insights into the impact pricing fluctuations may have on revenue and therefore on profitability.

. . .

In the next blog post, we will dive deeper into the topic of demand curves and explain its role for making pricing decisions.

th!nkpricing is a brand of Smart Pricer. We are making professional pricing accessible to everyone by offering a platform to understand, simulate, and optimize your pricing with machine learning-driven algorithms and advanced demand prediction.

Want to stay in the loop and become a #pricinghero? Subscribe to our thinkpricing newsletter to not miss any upcoming blog post.