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So let me introduce the concept of means

all
accounting which I think is really
fascinating for pricing.
And here's the example I want to give as I
mentioned it was
developed my Richard Thalor, who's a
professor at the University of Chicago.
And he proceeded people with the following
scenario.
Said, imagine an individual, let's call
him Mr. A,
and Mr. A has just won two tickets in
lotteries.
He's kind of a lucky guy, he won one
ticket for $50 and another ticket for 70
for $25.
So he's won two separate lotteries, valued
at $75 together.
Mr. B let's call him Mr. Brown, he also is
pretty lucky he won a ticket for $75.
So from a strictly economic point of view,
both of
these gentlemen have had their wealth go
up by $75.
So if we believe that people are
completely rational, then the
fact that both of these gentlemen
increased their wealth by $75.
And they
should be equally happy, but when he
presented
this to individuals like you and I in an
experiment and asked us to say, who do we
think is happier Mr. A or Mr. B?
We all think Mr. A is happier and the
reason we think that is when you get
good news like win four games, it's better
for that good news to be spread around
okay.
So think about if you had for your wife or
husband or someone else in your family
sons or daughters you
wanted to buy them gifts for Christmas.
And you bought them three gifts for
Christmas, would you wrap
them all in one big box or would you
separate them out?
I think we all know at least in western
culture
would rather separate them out so when
news is good.
You want to spread it all around, okay, so
let's continue with this example.
What about if news is bad?
So in this case, Mr. A in the experiment
received two unfortunate letters from two
different tax authorities.
The federal government of the United
States say, sorry
Mr. A, you owe an extra $100 on your
taxes.
The state of Pennsylvania also sent him a
letter saying, sir you owe $50 on
your taxes so the poor guy has to cough up
$150 to the tax authorities.
Now Mr. B also received some bad news, he
owes $150 in tax, but only to the federal
government.
So again we have two individuals who have
both been given the same
negative information they have to pay
$150.
But because, again Mr. A has received two
negative hits, people like you
and I in the experiment think that Mr. A
is going to be less happy.
So this is exactly the opposite inference.
When you've got bad news, you should lump
it all together.
Good news should be separated around.
So what does this mean for pricing?
Well imagine that your
a company and you charging customers a lot
of different things three or four
different things.
You might be better off trying to give
their price information
just as one overall price rather then
itemizing the entire thing.
And again if we think back to the
financial crisis
there was an interesting example of this
on a large scale.
You might remember that the federal
government of the United States bailed
out various banks and so on to the tune of
about $750 billion.
That's a lot of negative information
that's a big
hit, but I think people became especially
annoyed about this.
When they saw that 50 billion was going to
bank A, 100 billion to this bank.
And so listing things that are
negative creates a disproportionate
negative effect.
So if you've got bad news, what you
should do is you should integrate it all
together.
Now what about if news is mixed.
This is interesting things for pricing.
So again, imagine my friend,
Amy.
Here at the Wharton school she likes to
come to school by bike.
And, even though crime never happens in
Philadelphia, for the sake of
argument let's imagine that it does and
poor Amy's bike is stolen.
It's going to cost her $180 to replace it.
Chris as well again, perhaps its the same
thief who
knows, he has a bike slightly better bike
a $200 bike.
His bike is also stolen, but Chris, on the
way to
get his lunch in the cafe in Huntsman
Hall, he notices
on the ground a $20 bill.
So Amy is out $180, Chris is out $200, but
he found 20.
So he's also out $180.
Well, who's happier?
It turns out that Chris is actually
happier,
because of something called the silver
lining principle.
Here he got negative 200, but the plus 20
sort of makes him feel better.
So how would we translate this into
pricing?
Well, if I'm trying to sell you a car for
$20,000,
instead of charging you $20,000, I might
be better off
charging you $22,000, but let me give you
a $2000 rebate.
So I'm sure you can see how that principle
kind of works.
So now, I'm just going to spend a couple
of minutes introducing a very,
very important psychological theory called
Prospect
Theory that has interesting implications
for pricing.
I encourage you if you're more interested
in theory than
just beyond what we're talking about to
just have a have
a search for it on Google.
So, prospect theory was developed by two
psychologists.
The first of whom is professor Daniel
[INAUDIBLE] who still teaches at Princeton
University.
And has written a number of other
influential, things
in the area of human psychology and
decision making.
His co-author was Professor Amos Tversky
who, unfortunately
passed away, who was a professor at
Stanford University.
And the two of them received the Nobel
Prize for this idea.
So it's a pretty good idea.
Let's see how it applies to pricing.
So in standard economics, as you might
imagine, you and I are supposed to be
indifferent between outcomes that have the
same
expected value, what do I mean by that?
Let me give you a simple example.
So let's imagine my friend Amy offers to
give me a
$100 bill, says, okay, David, you can have
a $100 bill.
Or you can take the following gamble, and
the gamble is,
I'm going to toss a coin, a fair coin, if
the coin
comes up heads, I'm going to give you
$200, and
if it comes up tails, I'm going to give
you nothing.
So if I think about that, getting $100 for
sure, that's $100, the gamble also has an
expected value of $100, because 0.5 times
$200, plus 0.5 times zero is also 100.
So the expected gain I'm going to get from
these two things is exactly the same.
So if I complete if I'm a completely
rational calculating person, then I should
be
indifferent between these two options, but
maybe you
have a preference I would certainly have a
preference I would take the $100 for sure.
So what professors Conoman and Taversky
found is that when options were offered
as a sure thing and there was positive
options like receiving money for example.
People would rather have the sure thing
than the gamble even though the expected
value
was the same.
Counted toward what we would learn in
traditional economics.
So they developed a new theory called
Prospect Theory, that has three
really important points to it that are
missing from most other standard theories.
The first one is that, people have
an internal reference point where they
expect certain
things from a stimuli, like price, and
I'll
explain this with an example in a moment.
The second thing is, people respond
differently to deviations from the
reference
point, whether they are positive or
whether they are negative.
And then thirdly their is something called
diminishing sensitivity
that's a little more complex, I'll let you
a
those of you out there who are very
interested
in this theory to look that up on your
own.
But let me give an example of how it works
for pricing.
So imagine I go to my local Starbucks to
buy a
cup of coffee, and I'm expecting to pay $1
for the coffee.
That's my internal reference point.
When I get there, the coffee is selling
for
75 cents.
So I've just encountered a gain or
positive deviation from
the reference point, paying $0.75 is
better than paying a dollar.
So because of that gain of $0.75 on the X
axis here, my
happiness is going up by some amount I'm
happy from that gain of $0.75.
But what happened because of that
transaction, my reference
point has now shifted from a dollar to
$0.75
its being effected by the experience that
I've just had.
And now I go back to the Starbucks a day
later, expecting to
pay $0.75 but low and behold the price has
gone up to a dollar.
So now what I've what's happened from my
reference point of $0.75, I've encountered
a loss of $0.25, the loss is the same size
as the gain was before.
But the loss causes me to feel very, very
unhappy, so there's a
phenomenon called loss aversion that for
the same deviation $0.25 in either
direction.
The pain of the loss might be twice as
much
as the pleasure of the gain, again I'll
let you
go into this in more detail on your own,
but
the idea is if you promote your product
too often.
Then you try to raise it back to the
regular price, you've already driven
somebody's reference point down.
And then when you raise the price back to
the regular price your seating them a
loss that they will react negatively to
that's an important implication of this
theory.
Okay, so let me summarize what we've done
on this module about
pricing to value first and foremost the
thing to keep in mind.
Is the framework four inputs to the
pricing process, first of all what's my
marginal cost I do not want to plot price
below that that's the four.
Second of all what is the customer's
willingness
to pay as determined by their price
sensitivity.
That's the ceiling,
thirdly by how much would I have
to reduce the price because of competitive
pressures.
And fourthly how much will I have to raise
the final price to the consumer just to
give
my distributor or my partner some margin
to play
with those are the four things that
determine price.
That's the framework the second thing that
we spent a lot of time
on was the notion of customer price
sensitivity and how it could be measured.
And then finally pricing wouldn't be as
much fun or wouldn't be as complicated, or
as intricate without thinking about all of
the
aspects of human psychology that come into
play.
Things like prospect theory, things like
mental
accounting the endowment of fate and so
on.
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