Pricing & Usage of Service
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Pricing ·
Mar 31, 2010 | 0 Comments
HBS has an old but great interview about the impact of pricing & usage of service.
HBS has an old but great interview about the impact of pricing & usage of service.
Lots of gems including:
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We find that people are more likely to consume a product when they feel "out of pocket." When the price paid for a product is very salient, they want to "get their money's worth," so to speak. The net result is that consumers are more likely to consume when a price is vivid and fresh than when it is obscured or distant. In the case of a health club, this means that members are more likely to go to the gym right after having made payments than later on in their memberships. Similarly, people are more likely to go to a ball game when they have purchased tickets to a single game than when they purchased tickets to multiple games. In the first case, the cost of that game is quite salient. In the second case, the cost of any one game is bundled with the costs of all the other games.
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I have investigated how the unbundling of price into routine payments affects the decision to purchase. The classic example is the "pennies-a-day" effect. Chicago's NPR station asks people to donate by joining their dollar-a-day club. Framed in that manner, the donation seems quite reasonable—about the cost of a cup of coffee. Contrast that with what would happen if they asked people to join their "$365 a year club. Suddenly, we're talking big bucks in the minds of most consumers. We see similar efforts by magazines that advertise their low per-issue prices or insurance companies that break the cost of their premiums down to a low, per-day cost. All these efforts are attempting to take the very same cost and make it seem trivial.
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Sunk costs are a curious bit of psychology. Economists say that attending to sunk costs is not rational—when considering whether to go to a play or attend a football game, the amount of money you spent on the tickets should be irrelevant to the decision to go. The only things that should matter are the costs not yet incurred, such as cost and hassle of driving, and the benefits to be consumed, such as the enjoyment of the game. At the same time, almost everyone pays attention to sunk costs. We go to plays or concerts that, in retrospect, we'd rather not go to simply because we have a $50 ticket in the pocket.
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Similarly, one of my colleagues describes a person who pays $300 to join a tennis club, only to come down with tennis elbow. Nevertheless, he continues to play in spite of the pain, reasoning, "I don't want to let my $300 go to waste." And some people even count on their own irrationality and buy season tickets to a play or symphony series, knowing that it will force them to get out of the house.
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The same concept can be applied to health care. In its current form, most of us pay for blanket health care coverage that entitles us to a number of periodic services such as checkups, shots, mammograms, etc. The problem is that the costs of these benefits are not particularly clear. I don't know what that annual checkup is costing me, so I don't perceive it as a cost. If health care providers could make the costs of these procedures more salient—perhaps by sending me periodic reminders that these procedures are costing me, say, $50 each regardless of whether I use them—they would be able to tap into the sunk cost effect. Patients would be more likely to say, "I'm paying for it, I shouldn't let it go to waste."
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Take your average health club. It faces two tasks: getting people to join and getting people to renew. (The churn at health clubs can exceed 50 percent.) Knowing that members are going to be more likely to renew in year two if they feel that they have "gotten their money's worth" in year one, a club should look to encourage attendance. One way to do this is through the timing of payments. Many clubs demand payment in full at the start of a year-long membership. The result is that people work out a lot in the first month or two, while that payment is still fresh in their minds, but gradually stop going as the payment fades from memory. In this case, the sunk cost effect weakens the further one is from that initial payment. Now consider the member who makes payments monthly. For him or her, the cost of membership will always be vivid and they will feel obliged to work out on an ongoing basis. At the end of the year, who is more likely to renew? Clearly, the person who worked out regularly will have a higher likelihood of renewing his or her membership.
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At another level, the decision of when and how to bill for a product depends on the underlying demand for a product. Managers who offer a scarce resource, such as a private golf course, face a constant battle between maximizing the number of paying customers (in this case, club members) and minimizing congestion (in this case, the inability to get a tee time). For such managers, if every paying customer showed up at one time, the system would break down. One way to assure this is to bill in a lump sum as opposed to in installments. In the case of the country club, in particular, I might advise that dues be billed in the middle of the winter, when the ability and desire to play golf is low. By the time the summer months roll around, most members will no longer feel the pain of having made payment and will feel less of a need to "get their money's worth" by playing often. The net result is that demand to play golf on any given day will decrease, allowing the club to increase the number of memberships it offers.
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I think that price-optimization software is very good at the objective part of pricing—the questions of "What price should I charge?" and "How does demand change as I change price by 5 percent up or 5 percent down?" However, this assumes that all else is held constant—that the same terms and conditions apply.
In reality, these other factors, these terms and conditions, might have a dramatic effect on the optimal price. For instance, while price-optimization software might tell the manager of a health club that he can increase revenues or increase profits by raising membership fees from $600 to $700, it may not be able to tell him anything about the effect on revenues and profits by moving from an annual payment scheme to a monthly payment scheme.
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When buying or leasing a car, research has shown that consumers are much more sensitive to the size of the monthly payments than they are to the number of months over which they have to make those payments. As a result, potential buyers may have a bigger negative reaction to an increase from $300 per month to $350 per month than from an increase in number of months from 36 to 48. This is tough for price-optimization software to pick up. The behavioral aspects of pricing are things that optimization software has difficultly picking up.
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