No matter what size a retailer is, there’s no better way to annoy your customers than by raising your prices. Sometimes, however, you may find yourself needing (or wanting) to do just that. Figuring out how to tactfully increase your prices is tricky, but behavioral economics can help. The key point to emphasize is that consumers tend to be very sensitive to how fair they think a price is, and targeting that experience of a price being fair or unfair can help alleviate your customers’ frustration.
The idea of “price fairness” is a bit vague, but in general, it’s the relatable feeling that a price is about right for a product. When you walk past (or scroll past) a product and you immediately get the sense that it’s too expensive or that it’s surprisingly cheap, you’ve made a price fairness judgment. We usually think of this as an emotional response to price, and as a result, it is sensitive to customers’ existing emotions: customers in a good mood are more likely to think prices are fair.
Previously, I have discussed how to use a certain type of price fairness evaluation, namely the use of reference prices, to make deals look better to customers. This approach plays on the emotion of price fairness by giving customers something to base their gut-reactions on in order to get an immediate sense that “this is a good price!” or “this is not a good price!”
While this strategy can allow you to temporarily increase customers’ valuations of your products, what if you need to actually increase your prices? How do we address the negative emotion of unfairness?
A comprehensive look at price fairness perceptions comes courtesy of a 1986 paper by behavioral economic heavyweights Daniel Kahneman, Jack Knetsch, and Richard Thaler. The authors conducted a massive set of telephone surveys asking respondents about hypothetical situations dealing with issues like price increases or wage decreases in domains from groceries to photocopies to real estate. They had these people evaluate how fair or how acceptable these company behaviors would be, and one of their most surprising findings was that consumers were, on average, surprisingly sympathetic.
Remember how consumers think prices are more fair when they compare favorably to a reference price? It turns out that 75% of consumers feel that retailers are also entitled to similarly “fair” levels of profit. In other words, if a company was making $X of profit and their costs went up, consumers agree that it is fair for prices to increase so that the company could maintain its $X profit.
In fact, most consumers believed it would be fair for a firm experiencing losses to shift that loss completely onto their customers. As long as the firm was upfront and honest about why it had to raise prices (and those reasons were good), consumers indicated that price increases were entirely fair. Note that this does not necessarily mean they would still be willing to pay higher prices, but it does mean they would not develop a negative impression of the firm.
There are a few caveats to this idea of reference profit entitlement:
- Just because consumers agree that retailers are entitled to a reference profit does not mean they will agree on what that reference should be. If a firm is already making more money than a close competitor, consumers may instead select the competition’s profits as the most appropriate reference. In a sense, they are making a fairness judgment about how to make another fairness judgment, and successful and profitable companies will generally be seen as having less of an excuse to raise prices (consumers see profitable companies as about 3 times less justified in raising prices as compared to companies losing money).
- It is not fair to increase prices when the threat to profit is unrelated to the product at hand. For example, increased manufacturing costs may be a fair reason to raise prices on a product, but increased employee pay may be a less fair reason because it feels less directly related. If you want to increase the price of a product, emphasize that it is because of costs specific to that product.
- It is not fair for a firm to increase prices in anticipation of lost profit. For example, if you know that the wholesale cost of a product will increase at some point in the near future, 79% of consumers would say it is not justifiable to increase the price of your products in stock now. A company must be in a position where its profits are actively threatened in order to fairly raise their prices.
Interestingly, while consumers feel that it is fair for a firm to raise prices when their profits are threatened, they do not tend to think it is unfair if a firm does not pass on savings to their customers. In other words, if costs go up, then retailers are allowed to raise prices, but if costs go down, retailers are not expected to lower prices. Consumers are apparently much more retailer-friendly than we might have thought.
To quote the paper, “the cardinal rule of fair behavior is surely that one person should not achieve a gain by simply imposing an equivalent loss on another.” Consumers are much more forgiving of a price increase when they understand that there was a need for it, and explaining that need will generate more sympathy than ignoring the issue or trying to offer a small concession in conjunction with the price increase.
This also means that retailers must ensure that they never appear to be abusing their position within the market. In the most famous hypothetical from this paper, respondents are asked to imagine that there has just been a large snowstorm in their town, and in response, a hardware store increases the price of snow shovels. From an economic point of view, this is rational: consumers value snow shovels more, so the store is wise to raise the price. However, 82% of consumers see this as an abuse of market power, and even if they need and can afford the shovel, they are both less likely to buy it and certainly more likely to remember this unfair behavior in the future.
Nevertheless, overcoming this bias using explanation can be surprisingly effective. For example, Uber‘s surge pricing (in which multipliers are added to the price of a ride during periods of high demand) is a textbook example of an “unfair” pricing strategy. However, the brief explanation offered by the app that this multiplier is meant to “get more Ubers on the road” manages to diffuse much of the frustration. Lyft goes one step further and states explicitly that the extra fare goes directly to the driver, thus linking the need for the price increase with its source.
To make a price increase seem even more fair, you can mix the explanation strategy with a reference price strategy. For example, when Amazon Prime recently increased it’s annual cost from $79 to $99, not only did they attempt to explain that it was to cover rising fuel and transportation costs, but they also originally suggested that they might raise the price to $119, which makes the $99 price tag look more attractive.
What might be an example of a bad explanation? Just yesterday, Netflix announced that they would be raising prices, and their explanation was, ”these changes will enable us to acquire more content and deliver an even better streaming experience.” This explanation is vague and does not appeal to any underlying costs or losses that a price increase will address (even if there is one). Since it doesn’t do much to address the sense of unfairness that new customers will be feeling as they pay the higher prices, it will be interesting to see how consumers react once the price hikes take effect.
- Customers may be surprisingly understanding of the need to increase prices. They tend to believe that firms are entitled to their profits and are fully justified in protecting those profits.
- Explanations go a long way. Making your reasons for price increases clear, simple, and fair will go a long way towards making your customers accept your new prices.
Guest post by Stanford’s Alex DePaoli
Follow him @AlexDePaoli.