[MUSIC] So let me introduce the concept of mental accounting which I think is really fascinating for pricing. And here's the example I want to give. As I mentioned, was developed by Richard Thaylor who's the Professor at the University of Chicago. And he perceived that people with the following scenario. So I mentioned 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 1 ticket for $50 and another ticket for for 25. So he's won 2 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 increase their wealth by $75, they should be equally happy. But when he presented this to individuals like you and I and 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 when the fall gains, it's better for that good news to be spread around. 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, again, at least in Western culture, we would rather separate them out. So when news is good, you want to spread it all around. 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 in the United States says, 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've 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 you're a company and you're charging customers a lot of different things, three or four different things. You might be better off trying to give that price information just as one overall price rather than 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 in 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 sold $50 billion was going to bank A, $100 billion to this bank and so listing things that are negative creates a disproportionate 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 mention that it does, unfortunately his bike is stolen. It's going to cost her $180 to replace it. Chris as well, again, perhaps has the same fee, who knows. He has a bike slightly bit a black a $200 bike, his bike is also stolen but Chris, on the way to get his lunch from the cafe in Huntsman's 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. Yeah, he got negative 200 but the plus 20 sort of makes him feel better. So how can we translate this into pricing? Well, If I'm trying to sell you a car for $20,000, instead charging your $20,000, I might be better of charging you $22,000 but let me give you a $2,000 rebate. So I'm sure you can see how that principle kind of works. So now, just going to spend a couple of minutes introducing a very, very important psychological theory called Prospect Theory. It has interesting implications in pricing. I encourage you if you're more interested in theory than just beyond what we're talking about, then just have a search on Google. So Prospect Theory was developed by two psychologists, the first his name is Professor Daniel Kahneman, 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 $100 bill. She says, David you can have $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 it, getting $100 for sure that's $100, the gamble also has an expected value of a $100 because 0.5 times 200 plus 0.5 times 0 is also 100 so the expected gain I'm going to get from these 2 things is exactly the same. So 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'd take $100 for sure. So what Professors Kahneman and Tversky found is when options were offered as a sure thing and that were 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. Counter to 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 the 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're positive, or whether they're negative. And then, thirdly, there's something called diminishing sensitivity, that's a little bit more complex. I'll let you, 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 a dollar 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 a positive deviation from the reference point. Paying 75 cents is better than paying $1. So because of that gain of 75 cents on the x-axis here, my happiness is going up by some amount. I'm happy from that gain of 75 cents. But what's happened because of that transaction, my reference point is now shifted from $1 to 75 cents as being affected by the experience that I just had, and then I go back to the Starbucks a day later, expected to pay 75 cents, but lo and behold, the price has gone up to $1. So now what's happened from our reference point of 75 cents, I've encountered a loss of 25 cents. 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, 25 cents 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 here 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, you'll seeing then a loss that they will react negatively too, that's an important application of this theory. So let me summarize what we've done in this module about pricing the value. First and foremost, I think to keep in my mind is the framework, four inputs to the pricing process. First of all, what's my marginal cost? I do not want a price below that, that's the floor. 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 will I have to reduce the price because of competitive pressures? And fourthly, by how much will I have to raise the final price to the consumer just to give my distributer 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 spend 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 this much fun. It wouldn't be as complicated and it's 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 affect and so on. [MUSIC]
