Psychological pricing

Example of psychological pricing at a gas station

Psychological pricing (also price ending, charm pricing) is a pricing/marketing strategy based on the theory that certain prices have a psychological impact. Retail prices are often expressed as "odd prices": a little less than a round number, e.g. $19.99 or £2.98. Consumers tend to perceive “odd prices” as being significantly lower than they actually are, tending to round to the next lowest monetary unit.^[1] Thus, prices such as $1.99 are associated with spending $1 rather than $2. The theory that drives this is that lower pricing such as this institutes greater demand than if consumers were perfectly rational. Psychological pricing is one cause of price points.

Overview

According to a 1997 study published in the Marketing Bulletin, approximately 60% of prices in advertising material ended in the digit 9, 30% ended in the digit 5, 7% ended in the digit 0 and the remaining seven digits combined accounted for only slightly over 3% of prices evaluated.^[2] In the UK, before the withdrawal of the halfpenny coin in 1969, prices often ended in 11¹⁄₂d (elevenpence halfpenny: just under a shilling, which was 12d). This is still seen today in gasoline (petrol) pricing ending in ⁹⁄₁₀ of the local currency's smallest denomination; for example in the US the price of a gallon of gasoline almost always ends in US$0.009 (e.g. US$1.799).

Digit ending	Proportion in the 1997 Marketing Bulletin study
0	7.5%	7.5
1	0.3%	0.3
2	0.3%	0.3
3	0.8%	0.8
4	0.3%	0.3
5	28.6%	28.6
6	0.3%	0.3
7	0.4%	0.4
8	1.0%	1
9	60.7%	60.7

In a traditional cash transaction, fractional pricing imposes tangible costs on the vendor (printing fractional prices), the cashier (producing awkward change) and the customer (stowing the change). These factors have become less relevant with the increased use of checks, credit and debit cards and other forms of currency-free exchange; also, the addition of sales tax makes the pre-tax price less relevant to the amount of change (although in Europe the sales tax is generally included in the shelf price).

The psychological pricing theory is based on one or more of the following hypotheses:

The first theory that explains the rationale for odd pricing is prospect theory. This theory says that "consumers facing uncertainty in decision making, base the value of an alternative on gains or losses offered by the alternative, relative to some reference point, rather than on final absolute states of wealth or welfare". This theory is based on the fact that losses mean more than gains. So based on that criteria, one would think that something only a few cents under a whole dollar would actually be beneficial to the price. This theory works so well because of how the "reference price" is established by the consumer. The reference price for something that is $19.98 would be $20. This establishes the odd pricing as a better deal.
Judgments of numerical differences are anchored on left-most digits, a behavioral phenomenon referred to as the left-digit anchoring effect.^[3] This hypothesis suggests that people perceive the difference between 1.99 and 3.00 to be closer to 2.01 than to 1.01 because their judgments are anchored on the left-most digit.
Consumers ignore the least significant digits rather than do the proper rounding. Even though the cents are seen and not totally ignored, they may subconsciously be partially ignored. Keith Coulter, Associate Professor of Marketing at the Graduate School of Management, Clark University suggests that this effect may be enhanced when the cents are printed smaller (for example, $19⁹⁹).^[4]
Fractional prices suggest to consumers that goods are marked at the lowest possible price.
When items are listed in a way that is segregated into price bands (such as an online real estate search), price ending is used to keep an item in a lower band, to be seen by more potential purchasers.

The theory of psychological pricing is controversial. Some studies show that buyers, even young children, have a very sophisticated understanding of true cost and relative value and that, to the limits of the accuracy of the test, they behave rationally. Other researchers claim that this ignores the non-rational nature of the phenomenon and that acceptance of the theory requires belief in a subconscious level of thought processes, a belief that economic models tend to deny or ignore. Results from research using modern scanner data are mixed.

Now that many customers are used to odd pricing, some restaurants and high-end retailers psychologically-price in even numbers in an attempt to reinforce their brand image of quality and sophistication.^[5]

Research

Kaushik Basu used game theory in 1997 to argue that rational consumers value their own time and effort at calculation. Such consumers process the price from left to right and tend to mentally replace the last two digits of the price with an estimate of the mean "cent component" of all goods in the marketplace. In a sufficiently large marketplace, this implies that any individual seller can charge the largest possible "cent component" (99¢) without significantly affecting the average of cent components and without changing customer behavior.^[6] Ruffle and Shtudiner's (2006) laboratory test shows considerable support for Basu's 99-cent pricing equilibrium, particularly when other sellers' prices are observable.^[7]

The euro introduction in 2002, with its various exchange rates, distorted existing nominal price patterns while at the same time retaining real prices. A European wide study (el Sehity, Hoelzl and Kirchler, 2005) investigated consumer price digits before and after the euro introduction for price adjustments. The research showed a clear trend towards psychological pricing after the transition. Further, Benford's Law as a benchmark for the investigation of price digits was successfully introduced into the context of pricing. The importance of this benchmark for detecting irregularities in prices was demonstrated and with it a clear trend towards psychological pricing after the nominal shock of the euro introduction.^[8]

Another phenomenon noted by economists is that a price point for a product (such as $4.99) remains stable for a long period of time, with companies slowly reducing the quantity of product in the package until consumers begin to notice. At this time the price will increase marginally (to $5.05) and then within an exceptionally short time will increase to the next price point ($5.99, for example).^[9]

Benford’s law says that this should be the opposite due to the relative frequency of a specific digit a in the first place of a number is Fa = log10[(a + 1)/a] The digit 1 occurs with a relative frequency of about .30, the digit 2 with a relative frequency of about .18, and the digit 9 finally with about .05.

Research has also found psychological pricing relevant for the study of politics and public policy.^[10] For instance, a study of Danish municipal income taxes found evidence of "odd taxation" as tax rates with a nine-ending were found to be over-represented compared to other end-decimals.^[11]

Several studies have shown that when prices are presented to a prospect in descending order (versus ascending order) positive effects result, mainly a willingness to pay a higher price, higher perceptions of value, and higher probability of purchase. The reason for this is that when presented in the former, the higher price serves as a reference point, and the lower prices are perceived higher as a result.^[12]

Historical comments

Exactly how psychological pricing came into common use is not clear, though it is known the practice arose during the late 19th century. One source speculates it originated in a newspaper pricing competition. Melville E. Stone founded the Chicago Daily News in 1875, intending to price it at one cent to compete with the nickel papers of the day. The story claims that pennies were not common currency at the time, and so Stone colluded with advertisers to set whole dollar prices a cent lower—thus guaranteeing that customers would receive ample pennies in change.^[13]

Others have suggested that fractional pricing was first adopted as a control on employee theft. For cash transactions with a round price, there is a chance that a dishonest cashier will pocket the bill rather than record the sale. For cash transactions with an odd price, the cashier must make change for the customer. This generally means opening the cash register which creates a record of the sale in the register and reduces the risk of the cashier stealing from the store owner.^[14]

In the former Czechoslovakia, people called this pricing "baťovská cena" ("Baťa's price"), referring to Tomáš Baťa, a Czech manufacturer of footwear. He began to widely use this practice in 1920.^[15]

Price ending has also been used by retailers to highlight sale or clearance items for administrative purposes. A retailer might end all regular prices in 95 and all sale price in 50. This makes it easy for a buyer to identify which items are discounted when looking at a report.

In its 2005 United Kingdom general election manifesto, the Official Monster Raving Loony Party proposed the introduction of a 99-pence coin to "save on change".^[16]

A recent trend in some monetary systems is to eliminate the smallest denomination coin (typically 0.01 of the local currency). The total cost of purchased items is then rounded up/down to, for example, the nearest 0.05. This may have an effect on future "odd-number" pricing to maximize the rounding advantage for vendors by favoring 98 and 99 endings (rounded up) over 96 and 97 ending (rounded down) especially at small retail outlets where single item purchases are more common. Australia is a good example of this practice where 5 cents has been the smallest denomination coin since 1992, but pricing at .98/.99 on items under several hundred dollars is still almost universally applied (e.g.: $1.99 – $299.99) while goods on sale often price at .94 and its variations. It is also the case in Finland and The Netherlands, the only countries using the euro currency which do not use the 1 and 2 cent coins.

References

↑ Bizer, George Y.; Schindler, Robert M. (2005-10-01). "Direct evidence of ending-digit drop-off in price information processing". Psychology and Marketing 22 (10): 771–783. doi:10.1002/mar.20084. ISSN 1520-6793.
↑ The Widespread Use Of Odd Pricing In The Retail Sector, Marketing Bulletin, 1997, 8, Research Note 1, J Holdershaw, P Gendall and R Garland
↑ Thomas, Manoj; Morwitz, Vicki (June 2005). "Penny Wise and Pound Foolish: The Left‐Digit Effect in Price Cognition". Journal of Consumer Research 32 (1): 55–64. doi:10.1086/429600.
↑ "Keith Coulter" (PDF). Connect: News from the Gradiate School of Management at Clark University (Clark University). Winter 2012. p. 5.
↑ Schindler, Robert M.; Parsa, H. G.; Naipaul, Sandra (2011-11-01). "Hospitality Managers’ Price-Ending Beliefs A Survey and Applications". Cornell Hospitality Quarterly 52 (4): 421–428. doi:10.1177/1938965511421168. ISSN 1938-9655.
↑ Why Are So Many Goods Priced to End Nine? And Why This Practice Hurts Producers. Economic Letters, p. 41–44
↑ Ruffle, B. J.; Shtudiner, Z. (2006). "99: Are Retailers Best Responding to Rational Consumers?". Experimental Evidence. Managerial and Decision Economics 27 (6): 459–475. doi:10.1002/mde.1282.
↑ El Sehity, T.; Hoelzl, E.; Kirchler, E. (2005). "Price developments after a nominal shock: Benford's Law and psychological pricing after the euro introduction". International Journal of Research in Marketing 22 (4): 471–480. doi:10.1016/j.ijresmar.2005.09.002.
↑ Choice magazine, January 2009
↑ Ashworth, J.; Heyndels, B.; Smolders, C. (2003). "Psychological taxing in Flemish municipalities". Journal of Economic Psychology 24 (6): 741–762. doi:10.1016/j.joep.2003.06.002.
↑ Olsen, A. L. (2013). "The politics of digits: evidence of odd taxation". Public Choice 154 (1-2): 59–73. doi:10.1007/s11127-011-9807-x.
↑ Bennett, P., Brennan, M., Kearns, Z. (2003). Psychological aspects of price: An empirical test of order and range effects. Marketing Bulletin 2003; (14), Research note 1. pp. 1-2. PDF
↑ The Straight Dope: Why do prices end in .99?
↑ Landsburg, Steven E. (2012). The Armchair Economist: Economics & Everyday Life (Rev. ed.). New York: Free Press. ISBN 9781451651737.
↑ Social responsibility of the Bata Company, in Czech language
↑

Boyes, W. J.; Lynch, A. K.; Mounts, S. (2007). "Why odd pricing?". Journal of Applied Social Psychology 37: 1130–1140. doi:10.1111/j.1559-1816.2007.00203.x.

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