The Psychology of Setting Prices
I interact with hundreds of companies in the course of my job, across 18 different verticals, from automotive, to food & agriculture, to security & compliance. All of them software companies. And just about all of them have one thing in common: “we’re validating our pricing model.”
I talk to a lot of people about how they’ve developed their pricing models, and most of the time they recognize they’re still very much in the experimental phases. Very rarely, however, when I chat with a company about their pricing, do I get this response: “I love pricing strategies and psychology.”
Pricing is something that just enough companies don’t think about, that it can become a competitive advantage. Most people think of their pricing strategy in one of three ways:
- Cost-plus pricing
- Comparison pricing
- Average willingness to pay
Nile Hatch, a professor of entrepreneurship at Brigham Young University, and a Ph.D. in Resource Economics from UC Berkeley delves into these a lot better than I can in the video below.
The key takeaway is this: pricing is a lot more complicated than you think. And it should be. If you think setting prices is easy, you’re probably not thinking about it hard enough.
Followers of the lean startup movement are obsessed with validating every assumption, testing every hypothesis, and iterating on the smallest detail of every MVP. But what about pricing? Enough people think of pricing as something they set, and not something they test.
The Psychology of SaaS Sales
When you think about SaaS sales, you have to understand the psychological context around what your customers expect. One CEO I spoke to, who has managed to build a multi-million dollar business without ever raising capital, explained that “even at the upper-market, pricing is game-changing. Even quoting a 4-figure price when they’re expecting a 6-figure price can ruin a deal.”
Again, and again, that same CEO has told the story of how his sales actually increased as he raised his prices. So am I saying the trick is find an industry where your customers are desperate to spend more money than they’re currently spending? Sure, if you can find it. But for those of us who do business in a capitalist reality, there’s something else at work here.
When asked about his advice for better understanding the psychology of your customers, this CEO I spoke with had this to say: “Go hire a firm, contact your lost leads, and do a study as to why they were lost.”
Too often sales are seen as a battleground, and when a lead is lost, you circle up, and dive into the next battle. But pricing theory can’t be won one battle at a time. Instead, it needs to be deeply understood, and even studied. Ask your customers why they didn’t buy at your price point the same way you would ask why they didn’t like a feature.
So what is the right pricing approach?
“We learned the hard way not to grandfather people into our product. We did a customer ROI analysis and had a cluster of 800 customers at the bottom. We reached out to ask them to raise their price. We realized that people, over time, become VERY price loyal. Not to your product or brand, but your pricing.”
As you start to think about your customer’s relationship with a price, it isn’t sheer sticker price. Pricing has as much of a UX as any product or feature. Understand the reaction your customers have to how they pay, when they pay, and what they pay.
Tomasz Tunguz at Redpoint broke down the ramifications of performance pricing in an article a while back, definitely worth reading. He explains performance pricing as “explicitly pricing a product in terms of the customers’ revenue gained or cost reduced from its use.”
But here was a key insight: “Performance pricing is a challenging go to market strategy for one key reason: it cedes the startup’s pricing power to the customer.”
When effectively taking psychology into account in pricing your product, you’re effectively adhering to lean startup principles. It has frequently been said that “plans rarely survive first contact with customers.” As the boxer Mike Tyson once said about his opponents’ prefight strategies: ‘Everybody has a plan until they get punched in the mouth.’”
What you have to ask about your pricing is how hard are you going to let your customers hit you? In less aggressive terms, how do you find the balance between getting customers to think about the value of your product while not thinking too much about having to pay for it?
The Anticlimactic Conclusion
In talking to another CEO whose product is specifically built around price determination, and maximization, he explained the relationship between complexity of purchase and retention. “Retention is lower when people are spending less because they don’t appreciate it as much, they haven’t thought about it as deeply.”
Dan Ariely talks about this in his book, Predictably Irrational. If someone is buying a toaster for $20 and they find out they could save $5 by driving 15 minutes to another store, most people would do it. But if they were buying a $1,000 TV, almost no one would travel the distance for that same $5 savings.
As you place your price in the customer’s context, think about not only the positive value-adds of your product, but of the negatives, the risks, the alternatives. One potential takeaway, think about this; behavioral economics says people make worse decisions when they have more options. Consider the impact a saturated market could have on customer churn. Suddenly, that psychological insight changes your perspective on communicating differentiation.
Place your prices in the context of your customer.
