Unlocking the Black Box of Retail Pricing

What do you get when you add together inflation, layoffs, rising household debt, and natural disaster coming soon to a neighborhood near you?

In social terms, you get widespread anxiety. In the retail context, that general angst translates into increasing numbers of price-sensitive consumers.

As a result, industry analysts, consultants, and technology companies are all hot on the quest to understand the complexities of pricing. But despite rapid advances in data-driven pricing models, pricing has remained a black box.

Current research by Saint Mary’s University professor Dr. Jason Ivanoff, funded by the David Sobey Centre, is revealing just why price optimization is so hard to achieve.

Data-driven price optimization not a magic solution

Dr. Ivanoff, who teaches psychology at SMU, studies cognition, the mental processes that drive human behavior. These days, he’s particularly interested in how we think about money and make purchasing decisions.

Conventional marketing wisdom tells us that consumer reactions to pricing are largely shaped by brand awareness and brand loyalty. This assumption leads many retailers to set prices based on experience, intuition, or algorithms based on sales data. Yet neither instinct nor sales numbers provide the full picture of how customers react to pricing in the moment. For example, sales data don’t include information about shoppers who browsed but decided not to buy.

To thoroughly understand the real relationship between prices and consumer decisions, we need to observe how the brain processes pricing data in real time. Right now, the only place we can do that is in a lab like the one Dr. Ivanoff runs, where his team investigates in real time the factors that encourage or discourage purchase decisions.

Brand loyalty may be overrated

Dr. Ivanoff and his research team designed an online psychology experiment that tested traditional assumptions about consumer responses to pricing, including the influence of brand loyalty.

At the beginning of the experiment, participants were asked to identify their favorite brand of a grocery-store item, such as a soft drink. They then viewed a series of screens, showing their favorite brand next to a fictional brand. On each screen, the pricing of the two items differed; in some instances, the two prices were close together while in others they were far apart.

When the two prices were similar, most participants chose their favorite brand. But when the price of the fictional brand dropped, many–but not all–participants opted for the cheaper product.

Dr. Ivanoff and his team were at first surprised by these results, which defied traditional pricing logic. That logic would predict a more uniform response to price changes, but the study’s participants seemed to act capriciously. Some were loyal to their preferred brand despite high costs; others readily switched to the fictitious brand with just a slight discount.

Such behaviour flies in the face of algorithmic approaches to pricing. But that’s because humans don’t tend to make decisions using algorithmic thinking. We’re more fickle than that.

Dr. Ivanoff’s study reminds us of what Daniel Kahneman explains in Thinking, Fast and Slow: few of the decisions we make rely on rational, logical thought processes. These take time and effort, so when we’re faced with a decision that doesn’t matter a lot, such as deciding which soft drink to buy,  we tend to default to speedy, non-conscious decision-making. That’s why a preference for a particular brand can be short-circuited by an inflated price.

As Dr. Ivanoff points out, if consumers didn’t make snap purchase decisions, shopping could overwhelm them. Imagine having to consciously evaluate the pros and cons of putting each item in your grocery cart. Is the quality of the chosen brand good enough for me and my family? Is it a good deal? Are there cheaper alternatives at another store? How much would it cost to travel to another store with less expensive options? Do I need this product now? You’d be exhausted before you made it to the end of the produce aisle!

Once you appreciate the cognitive processes driving consumer decisions, you see how complex a challenge pricing is, despite advances in data collection and analysis. Intuition, experience, customer surveys, and prior sales data continue to play a role in finding that optimal price. But at the end of the day, you’re not likely to find a perfect formula to predict consumer purchase decisions unless you also consider how consumers perceive pricing.

One consumer, many behaviors

Consumers behave less consistently than either marketers or economists would like to believe. For example, some behavioural economists assume that shoppers operate with a fixed upper limit for prices. When interviewed in a focus group or surveyed, a consumer may state there is a maximum price they’re willing to pay for a brand or product. Yet faced with a purchasing decision, they may or may not follow through on that intention.

“A customer doesn’t necessarily walk around with a fixed price threshold in mind,” says Dr. Ivanoff. “The price someone is willing to pay for an item depends on the situation.”

Consider the example of a working mother cruising the frozen food aisle on her weekly trip to the grocery store. One week, a frozen shepherd’s pie catches her eye, but she says to herself, “I’d never pay 15 dollars for that when I can make it myself in 20 minutes.”

Then the next week, when her son has the flu, her partner is out of town, and she’s facing a tight deadline at the office, she grabs the same item, barely looking at the price. Same consumer, same price, but a different response, and one that neither a survey nor an algorithm could have predicted.

Reframing pricing questions

As Dr. Ivanoff’s psychological research unlocks the black box of pricing, it also unleashes a Pandora’s box of new questions.

Current questions about pricing tend to center on the search for a silver bullet to optimize pricing. Marketers wonder how they can enhance the magic of brand power. Software Sales managers ask which new application or tool provides the greatest visibility into real-time consumer behavior.

These questions all help advance the evolving science of pricing, but insights from cognitive psychology show that no single discipline or single tool will solve pricing dilemmas on its own. Research such as Dr. Ivanoff’s also raises new questions for retailers to explore, such as:

• How can retailers establish a behaviourally-informed price for a new brand?
• When do consumers consider price increases to be fair?
• How do prices that are perceived as unfair influence purchase decisions?
• What situational factors might affect consumer attitudes toward price changes?
• How can we observe consumer decision-making in real time?

Pricing, as Dr. Ivanoff puts it, is a “multi-faceted” issue. In this era of price-sensitivity, it pays to expand beyond traditional methods of price-setting, drawing on both practical experience and the latest research.