This is your brain on shopping…
Chris Cortner

This is your brain on shopping…

Chris Cortner December 20, 2017 Posted in: General

Holiday shopping season is here, and so are all the deals. Psychological pricing strategies are implemented in transactions running the gamut from consumer goods to real estate and insurance. Buyers’ perceptions of value can be affected simply by the way a price or discount is presented. Here are a few examples of the sometimes peculiar things our brains do while we accumulate “stuff.”

One of the most common pricing strategies is known as charm pricing, where a price will end with a 9, be it $7.99 or $49. Magnitude is a measure of the perceived “size” of a given price. It’s a way the brain encodes a price. Think of it in analog terms as a point on a line running from cheap to expensive. The left-most digit may weigh heavily in this perception, as the digits to the right are ignored to some degree. For example, the perceived magnitude difference between $3.00 and $4.00 compared with that between $3.00 and $3.99 would be discerned as being significantly larger due to this mental anchoring at the left-most digit. For some, the difference from $3.99 to $5.00 might register as about $2.00 rather than the more accurate estimate of $1.00 by considering the difference of $5.00 from $4.00.

Ander and Simester studied the effect on demand by manipulating the end digit in prices. They found that prices ending in nine increased demand. In seemingly irrational cases, an increase in price from $44 to $49, for example, increased sales. One hypothesis for this behavior is the perception that the last digit tells the buyer something about the market value of the item. Prices ending in nine are often associated with discounts, so this may indicate to the buyer that he or she is realizing a better value.

Through his research, marketing professor Jonah Berger has devised the Rule of 100. The idea is that buyers’ perceptions of the value of discounts vary with size. A discount can either be shown as a percentage or as a dollar amount. The Rule of 100 says that when the price of an item is under $100, discounts are more attractive when displayed as a percentage, and when an item is over $100, the dollar discount display is favored. For example, when the bottom line price is $30, indicating 25% off of a $40 shirt is preferred over the identical $10 off. The preference is reversed for higher-priced items. I completed a quote on a major insurer’s website and was shown at the end that my discounts would be $271. I will admit that this does have a better ring to it than saving 13.7%. 

In testing, humans are able to more accurately and quickly discriminate between numbers among which the difference is large. This is known as the numerical distance effect. Many buyers will endure Black Friday, searching for deals to save tens of dollars, but only about half of homebuyers shop around for mortgages where differences in interest rates seems small when looking at fractions of percentages but the difference over time can be tens of thousands of dollars.

Strategic pricing is very common in real estate. Asking prices can be set at round numbers, precise numbers or “just below” a round number. Respective examples are $400,000; $407,932; and $399,000. Beracha and Seiler examined over 300,000 real estate sales. Over a third had prices ending in $9,000 and 14% had prices ending in $0,000. Homes priced “just below” a round number yielded higher sale prices relative to the value of the home. The listing prices of “just below” priced homes were higher than those of round-number priced homes given the same home value.  It was found that while greater discounts off listing prices were realized, they were outweighed by this initial overpricing of “just below” homes. Circling back to left-most digit anchoring, these initially-higher prices don’t seem to dissuade buyers from making offers and ultimately negotiating discounted sales on these homes, as the “just under” pricing appears to keep the price in the buyer’s range, or at a point where the buyer believes he/she can move the ultimate price into the range. The satisfaction of getting that perceived discount likely doesn’t hurt either.

Psychological considerations are not part of the actuarial Ratemaking Statement of Principles. When pricing insurance, actuaries must be concerned with a sound estimate of the expected value of all future costs associated with individual risk transfer. And we must assure rates are not excessive or inadequate and not unfairly discriminatory. However, it is clear the psychology of pricing is not lost on insurance marketing departments. In insurance, customers like to receive discounts. Common themes in insurance advertising are humor, peace of mind and saving money. For example, “You can save 15% or more by switching,” “Discount Double Check,” “Cash back for safe drivers” and “Safe Home discounts.” Rather than bad-driver and single-policy auto insurance surcharges, we see good-driver and multi-policy discounts. The way discounts are presented via marketing may affect a buyer’s perception of their value.

Psychological pricing is implemented in many fields on target audiences and our cognitive biases. If you have any last-minute shopping or will be braving the post-holiday shopping crowds, you might notice some of these strategies put to work around you.

Chris Cortner is an Associate Actuary with Pinnacle Actuarial Resources, Inc. in the San Francisco, California office. He holds Bachelors of Science degrees in Economics and Biology from the University of California, Los Angeles. Mr. Cortner has considerable experience in the industry working on assignments involving loss reserving, ratemaking, rate filings, financial reporting, competitive analysis, captives, reinsurance and commutations.
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