The reference price effect is one of the nine psychological determinants of price sensitivity1. It states that “Buyers are more price sensitive the higher the products price is relative to that of their perceived alternative.” What that means is when customers are looking to make a purchase, they judge your prices in relative terms, not in absolutes.
Reference price is what the customer is used to paying and what they expect to pay. Several factors affect reference prices – recollection of prices previously paid, comparison to competitive prices, comparison to products in your own product portfolio, pre-sale prices, manufacturer’s suggested prices, marked prices before discounts, etc. It’s important to note that perception is what matters. It’s the comparison with perceived alternatives that establish price frames in customers’ minds.
Customers develop reference prices, which become the benchmark against which prices get compared to. Prices above the reference price appear to be “high,” whereas prices below the reference price are perceived as “low.” Retailers often try to take advantage of the latter effect and generate short-term demand by offering discounts and running price promotions. An unintended consequence of doing this is that discounts and price promotions decrease consumers’ price references in the long run, and hence lowers their willingness to buy the product at higher prices in the future. This should be an important consideration when thinking about long-term implications of your pricing strategy.
Another approach companies often believe works for them is to use lower prices to acquire customers and then increase prices later on and generate higher profits. That strategy rarely works, because the customer’s price reference will make them resist any price increase. In order to increase prices, the most important task is once again breaking free from the pull of reference price.
Organizations rarely get to influence customer price frames. So it’s extremely important to leverage the opportunities like new product launches to achieve this. When new products are introduced to the market, customers are anchored on the first price that is presented to them and from then on that price becomes the anchor for what we are willing to pay for that product. Every other price is now evaluated with reference to the anchor price. Their first perception lingers in their mind, affecting later perceptions and decisions. Apple launched the original iPhone at $600. 74 days after launch, it dropped the price to $400. Not cheap for a cell phone, but when looked at with reference price of $600, it seemed reasonable. Another option is to present customers with multiple versions of a product that offer marginally higher value at higher price points. This is critical to ensure customers build price references within your own product portfolio.
1 Nagle and Holden – The Strategy and Tactics of Pricing, 3rd edition