What We Can Learn About Pricing From Menu Engineers

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.