The engineering and science world has a wonderful concept called, ‘reasoning from first principles.’ In other words, you think about the core principles you know to be true and build from there.
We’re going to attempt to create a ‘first principles’ view of pricing based on core assumptions about human behavior and basic business concepts. If you want to dive deeper into the concept of first principles, Farnam Street Blog‘s article is a great overview.
The goal of this will be to provide a solid foundation of concepts we know to be true, and use them to create the myriad pricing strategies, tactics, and methodologies we use today. For those with an economics background, you may notice that there is a lot of overlap with microeconomic theory.
The four principles are:
- People make decisions to accomplish goals: While human decision making is often deeply flawed, people are still trying to make good decisions, often under constraints. Our irrational and rational side may have different opinions on what we should accomplish, we are always trying to move closer to some goal, scratch some itch, or simply to fill some need
- Buyer context matters: Buyer behavior even for the same person can vary by context. Buyers will sometimes make drastically different purchasing decisions based on their environment, mood, who they’re with, and how they feel. As a basic example, what is your willingness to pay for a beer when at a convenience store, a sports game, a restaurant, and a bar?
- Buyers are different: This is obvious but many businesses forget this when pricing their products. Two different people can value the same product very differently. When asking if your price is right, the first nuance to that question is – for whom?
- Market context matters: Our expectations change over time as a result of market context. Buyers think about value in the context of their alternatives and as a market evolves, pricing trends adapt and so will customers’ expectations.
Let’s expand upon each of these a bit:
1: People make decisions to accomplish goals
It would be difficult to argue with the premise that people make decisions to accomplish goals, improve their lives, and generally avoid negative stuff. These decisions are not only purchasing decisions, but they are also every day decisions ranging from whether to go for a walk, who to hang out with, and when to go to sleep.
Economists often use a convenient shorthand to represent the benefit a person gets from their decisions as ‘utility.’ For example, if you buy a pair of shoes for $60, you thought the utility you would get from that paid of shoes was greater than or equal to $60. The addition from the field of economics that makes pricing relevant is that people are trying to maximize utility under constraints.
Many of the historical economic models thought of people are ‘rational agents’ who make decisions that maximize their utility. Further, many readers may raise an eyebrow at the notion that people make decisions to improve things. However when thinking about decision making, we shouldn’t define these goals too narrowly. Even the most irrational decision accomplishes some type of goal: it may fill an immediate emotional need, or that person may have a flawed understanding of the cause and effect of their action. There are myriad reasons for confusing decisions and when thinking about pricing, it Is important not to overemphasize a buyer’s rational side at the exclusion of understanding their emotional, and often irrational side.
However, this isn’t a intractable problem. We can look at humans as broadly value maximizing, but also very susceptible to context, emotions, peer pressure, and bad information.
So what does this mean for pricing?
In a world of constraints, a buyer will examine the price of your product or service and all of its relevant factors, against alternative options. I deliberately used the phrase ‘alternate options’ instead of ‘competing products’ because buyers don’t always need to buy from your product category. Often not buying at all, or purchasing from a completely different product category can be sufficient.
2: Buyer context matters
Given that a buyer is going to make a decision of what they think is best, we then need to dive into what ‘best’ really is in that specific situation.
Let’s look at a common good: coffee
Coffee is one of the most popular beverages in the world and people have many options for consuming it.
For home consumption, you can purchase grounds at the super market and pay $0.10 to $0.50 for a cup. When deciding which brand to buy, some buyers may carefully compare prices, consider the taste of different products, and even check out which product has the most visually appealing packaging.
Alternatively, you can go to a Dunkin Donuts and coffee will cost between $1.50 and 2.30
You’re paying a premium in this context because they are making it for you, it’s likely faster, and more convenient.
On the higher end, you can visit Starbucks and pay $1.85 and upwards of $5. While the coffee is different, you’re also paying for a ‘coffee shop experience’ and for many, the identity and brand associations of Starbucks. If you drink Starbucks, you may get the benefit of being a ‘Starbucks person’ who has disposable income, appreciates calling a large coffee a ‘Venti Coffee,’ and may like hanging out working in a coffee shop.
Even higher, if you go to a specialty coffee shop, like Render in Boston, you’re now looking at $3 to $5.50+. You can shake off the corporate vibe of Starbucks, support smaller businesses, and get coffee beans that are perceived to be higher quality.
Now a single buyer may purchase from each type of establishment in different situations and pay very different prices for a similar core product. However, context matters: the buying situation, the environment, value added services, branding, and more.
3: Buyers are different
In many ways, each person is unique. Each person has a unique set of interests, experiences, beliefs, and buying behaviors. Since in most industries it’s impossible and or illegal to sell differently to every person, we often cluster buyers into segments to represent relevant, actionable themes of buying behavior.
Marketers have wisely invested a lot of time understanding how to segment their market, whether it’s by needs, demographics, psychographics, and plenty of other metrics.
This principle is obvious to many, however, it’s easy to lose sight of this when pricing your product. People often talk about THE price. However, we need to think about price more broadly and consider how we want to target our pricing to different segments of customers.
4: Market context matters
Markets are not stagnant. We live in a world of constant change. One company is one top on day and bankrupt another.
This also applies to buying behavior and market prices. To return to our coffee example, prior to Starbucks, many people didn’t associate coffee with the premium experience it is today.
Multiple trends impacted the price of coffee over time: First coffee prices dropped as coffee production became cheaper with new production capabilities. Next coffee retailers learned to engineer a premium coffee experience and prices went back up.
In other industries, the price of higher education has exploded while the price of TV’s have declined at a rate of 16% per year from 2000 to 2019.
While you don’t want to simply price off of your competitors, you want to know what prices your customers will compare your product to. Almost as important, as you plan your pricing strategy, it’s important to recognize how your market may evolve in the context of pricing and act accordingly.
Conclusion
If there is one key takeaway to wrap up this pricing first principles it’s this:
Different buyers make purchase decisions based on what they think is the best decision, for their specific situation and context, subject to the interesting idiosyncrasies of the human mind.
Of course, in our simple examples, we’ve left out of a lot of other scenarios and nuances. For example, different products vary in their competitiveness, the variability of how much consumers value their product over its costs, accessibility, and even how emotional the purchase is. However, if you always start with the buyer and try to understand how they are making their decision, their context, and the market context, you’ll be well on your way.
