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Summary:

Let’s say that you’re an entrepreneur or general manager about to take a new product to market. How do you price it? Traditional economic theory tells us that the market clearing price is the point at which supply and demand meet, and that consumers always know the […]

menu_engineerLet’s say that you’re an entrepreneur or general manager about to take a new product to market. How do you price it? Traditional economic theory tells us that the market clearing price is the point at which supply and demand meet, and that consumers always know the utility of any given purchase. So surely pricing your product shouldn’t be that hard, right?

Just as most of us must rely on relative pitch to discriminate amongst various tones, so too must the vast majority of consumers rely on relative price cues in order to determine what they’re willing to pay. What this means, according to behavioral economist Dan Ariely, is that the price of everything is “up in the air.” That’s where menu engineering comes in.

Gregg Rapp, Menu Engineer

Have you ever gone to a restaurant and found some ridiculously priced item on the menu? Of course you didn’t buy it — you’re no sucker. Or are you? This Today Show piece on Gregg Rapp may surprise you.

Rapp is a menu engineer. He helps restaurants maximize revenue by hacking common flaws in human decision-making. For example, by simply removing “$” signs from prices, people are less intimidated by them. And he advises against listing items from least to most expensive, because that focuses the consumer on price. Instead he mixes up items, making it hard to find their price — thereby encouraging the customer to emotionally commit to something before finding out what it costs. But my favorite strategy of his is that of putting some absurdly expensive item on the menu. Rapp doesn’t expect many consumers to buy it, but having it there makes expensive items appear cheap by comparison. Think about it: How many times have you ordered a bottle of wine in the middle of the price range?

Let’s give the strategy a try. We’ll assume that two companies are offering the same product to the same customer, but are using two different price lists to do so.

Company A: Silicon Valley Pricing Model

Widget — Basic : $10,000

Widget — Premium: $20,000

Company B: Menu Engineer Pricing Model

Widget — Silver: 10,000

Widget — Gold: 20,000

Widget — Platinum: 50,000

See the difference? My hunch is that most companies could increase revenue by simply adding a very high-end offering, even if they never sell a single one of those expensive units.

Arbitrary Coherence

Ariely also talks about something he calls arbitrary coherence. He argues that pricing is, at least at first, arbitrary — that we don’t all have some notion of “absolute price” when it comes to the utility we’ll get from every potential transaction. That’s the arbitrary side of his term. He goes on to argue that once we anchor ourselves to the price of something, our expectations with respect to price going forward is relative to our first impression — that’s the coherence bit.

In a seemingly absurd experiment, he showed that simply asking students if they would pay the last two digits of their Social Security number for various things significantly impacted what they were ultimately willing to pay for them:

“Did the digits from the Social Security numbers serve as anchors? Remarkably, they did: The students with the highest-ending Social Security digits bid highest, while those with the lowest-ending numbers bid lowest…. In the end, students with Social Security numbers ending in the upper 20 percent placed bids that were 216 to 346 percent higher than those of the students with Social Security numbers ending in the lowest 20 percent.”

This explains why having high MSRPs is so important. Conventional wisdom is that high list prices allow sales organizations to engage in price discrimination through discounting. There’s definitely some truth to this assumption, but there’s more to it than that. High list prices can actually increase perceived value — even in businesses in which the marginal cost of production is low.

Of all the levers a business has at its disposal, price is often the most powerful. The vast majority of revenue gains from higher prices result in profits (whereas selling more units often carries a commensurate increase in expenses). And the assumption that higher prices will erode loyalty or decrease demand is often just plain wrong. I’ve never seen a business that’s put too much thought into pricing, but I’ve met plenty that haven’t thought about it enough.

Mike Speiser is a Managing Director at Sutter Hill Ventures. His thoughts on technology, economics and entrepreneurship will appear at this time every week.

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By Mike Speiser
  1. Excellent post, Mike. From my own experience as a consumer – very true! :)

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    1. Thanks. Was at the Left Bank Brasserie last night and noticed that they followed all of the rules… Oracle has also managed to put these ideas to work for years in enterprise software…

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  2. Straight out from ‘Predictable Irrationality’

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    1. Yeah, from both “Predictably irrational” by Dan Ariely and “The science of fear” by Daniel Gardner

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      1. Haven’t heard of the Science of Fear — will check it out. I do mention and link to Dan Ariely twice (author of Predictably Irrational).

        http://www.predictablyirrational.com/

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  3. [...] What We Can Learn About Pricing From Menu Engineers (GigaOM) [...]

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  4. Good analogy.

    Would also point to ‘ladder pricing’ where each new step on the ladder gives you an additional relevant feature for a few dollars (or it’s multiple) more. Hosting providers & a lot of SAAS vendors use this technique where people tend to use the last step which has everything for a “slightly” more price than the previous one.

    Cheers!

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    1. Thanks Indus. You make a great point. This is a function rich with opportunity. Yet companies with 4000 software engineers and 1000 sales professionals often have <1 person working on pricing. Crazy, really…

      Thanks again for a great comment.

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  5. [...] What to learn about pricing from menu engineers (GigaOM) [...]

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  6. [...] all the levers a business has at its disposal, price is often the most powerful.”  (GigaOM via The Reformed [...]

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  7. I recall reading (years ago) that Sears used this principle since the early 20th century. For each product, they had a Good, Better, Best option. About 10% of sales are in the “Good,” and about 5% were in “Best,” with all the remainder at “Better.”

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    1. Very interesting. Didn’t know about that Glen. Thanks for pointing it out.

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  8. Great post Mike but I’d add another behavioral behavior to the mix here: Studies have shown that people often use price as a cue to quality (of course Ariely has been involved in these as well). http://www.carlsonschool.umn.edu/Assets/71779.doc
    In your example, I’m willing to bet that some companies will buy the Platinum version because of a corporate culture of being/investing in the best or out of fear that they’ll expose themselves to some future unknown risk by not getting the best.
    However, all of these points to a trend that I believe is a negative for corporate innovation. I personally rather that most companies spend time on innovating and creating value. Menu engineering is not an activity that increases value, it is essentially a form of psychological manipulation. I’m actually a fan of Umair Haque in this regard in that types of “innovations” create “thin” value as opposed to “thick” value. http://blogs.harvardbusiness.org/haque/2009/07/the_value_every_business_needs.html While pricing manipulation can provide some hacks for optimizing a company’s potential cash flow, I believe that consumers will trend away from these companies in the long-run. As consumers become exhausted through this type of activity, they will revert to products that leave some of the pricing on the table to ensure the customer experiences value over time. I know that I personally seek alternatives to vendors that rely on manipulating the buying experience rather than delivering great product at a great price.

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    1. Great comments Jake. On innovation — I don’t think innovation suffers because of smart business moves. In fact, more cash flow can lead to more innovation (as Google demonstrates). Having said that, a company that innovates on business model alone is not interesting — which, I believe, is the risk that you are pointing out?

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      1. If by business model you mean employing psychological and behavioral tricks to manipulate the buying process, then yes, I think innovations based on these types of advances promote hollow value for the consumer. I’d like to think that consumers see through this type of activity but the reality is that they are very successful tactics. I’ve often argued that the strongest secular trend at work in the market today is the decline in the average consumer’s critical thinking capabilities. And a true market approach argues that if it’s exploitable, it should be exploited. Hence, the housing bubble.
        I believe that these types of strategies can be very effective at transferring wealth from consumer to producer, but they don’t provide much of a transfer of utilization value from producer to consumer. If this is the case, then I believe what happens is that at some point, consumption can become discontinuous. If the market sees a compelling new alternative, it quickly migrates away from the behaviorally engineered value towards the alternative with higher core value (i.e. CDs > iTunes).
        I’m a believer that start-ups should focus on creating alternatives with much higher core value. Existing market leaders will rely on “menu engineering” to perpetuate their existence based on their inability to perform real innovation. As a VC, I would think you could use these tactics to help you find good start-ups but probably not in the way you imply: it seems to me that industries where market leaders are relying on “menu engineering” will be the areas that are ripe for start-up disruption!

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      2. You made an impassioned argument, but I don’t think you addressed my point. Because a restaurant takes the “$” off the menu doesn’t mean the food sucks.

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    2. Excellent point, Jake, and I tend to agree with you. However, there’s a fine line between strategy and manipulation. Consumers may eventually get tired of these specific activities, but the underlying principles will guide all future activities.

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    3. This is what I call “cargo cult” mentality. I see a lot of it in third world countries where I do my stock buying. The idea is that if you produce a cardboard cutout of a product or service, you can then charge a huge amount of money for the concept of it…without necessarily having to produce the goods. This sort of thinking works quite well in industries like tourism and hospitality where there is a high turnover of one-time-only customers

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  9. Great article, Mike. The Economist did a similar thing when they rolled out online access to their magazine – they had one price for online-only access and a second, higher price, for the print version. The “menu engineering” they engaged in was to have a print+online bundle at the same price as the print version. Predictably, they sold most of the bundle, thereby enabling online access without taking a huge hit. I wonder if it’s still working for them?

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  10. I think the folks at Microsoft were listening to this type of advice when they created Vista Ultimate.

    The lesson here is that the expensive item ‘on the menu’ needs to deliver the goods not just be expensive.

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