Why You Shouldn’t Use the Traditional Microeconomic Theory for Your Pricing Strategies
Pricing strategies can be tricky. We’ve seen demand curves where you have a price on the Y-axis and demand or sales volume on the X-axis, and it’s a straight line and sometimes a slightly bent line as the graph explains the relationship between price and sales volume. Let me tell you, they are wrong.
So why are they wrong? Who am I to challenge the traditional microeconomic theory that has been taught in universities for ages past and present? For one reason, I have helped hundreds of companies drive higher sales volume at higher prices by using value-based pricing for the pricing methods these companies use – completely negating the "truth" of traditional microeconomic theory.
These traditional theories are a vast simplification of the very complex process of making a buying decision. That complicated process has been examined ever since the late 1800s and for the last 70–80 years in an academic field called behavioral economics - generating three Nobel prize winners in that time. What was discovered is that these simplistic demand curves have nothing to do with actual reality.
So why are these curves done so simply, and why are they so wrong? They are designed using several assumptions, and all these assumptions are entirely false. Understanding these assumptions will help you develop your pricing strategies and a method that works.
Assumptions 1 thru 7 to Help You Understand Your Pricing Strategies
Assumption 1 - This assumes that all buyers make their choices among commoditized products or services. Products or services that are complete substitutes for each other, i.e., they are identical but also available from different sellers. That will never happen.
Assumption 2 - This assumes that all buyers have the same access to funds, which is a business-to-business case, which often means available budget, and that will never happen.
Assumption 3 - This assumes that all buyers make their decision solely based on price, which will never happen.
Assumption 4 - This will assume that all buyers are making rational decisions. Also, that will never happen because we are humans and not robots, and therefore, we are not making rational buying decisions.
Assumption 5 - This assumes all buyers are in the same circumstance and have the same needs and urgency, which is completely unrealistic.
Assumption 6 - This assumes that price elasticity (also called elasticity of demand) is equal at all price points. However, it is not.
Assumption 7 - This assumes that the price of a product or service does not message its quality and benefits, which means the cheaper, the better, with no limitations - another false claim.
So let’s examine these assumptions a little deeper to help you understand how to use the right pricing strategies in the future.
Assumption 1
The first assumption is that all products or services are identical, which is ludicrous because they are not. To some extent, if the vendor chooses to make it identical to everybody else’s product, yes, it may be identical. But there’s much more going on here. The brand and with its brand associations of the seller in question will not be the same as other sellers. Even the detail of the brand name and the logo makes a difference. Maybe not always a lot, but always something differs, however minute, and thus, it will affect what their customers are willing to pay, which leads to different prices for a product or service. For example, think about how the gas companies are spending oodles of dollars trying to convince you that just their additive to gas is worth another $0.25 a gallon, etc. They are trying to differentiate their product to make sense to the buyer. And obviously, some buyers prefer one additive versus another company’s additive. Some buyers prefer gas without any additives at all, etc. Some just have a better "feeling" about one brand of gas versus another brand of gas. So even for a total commodity like gas, how each company goes to market leads to differences in willingness to pay and buy for their customers, both actual and prospective.
Assumptions 2–4
The second assumption that all buyers have the same access to funds is quite false. A single mom working two jobs and a CEO of a $100M-worth company, both buying pasta sauce for dinner preparation, have vastly different access to funds. Therefore, their willingness to pay will be different, and their ability to make choices is very different, too. Likewise, an HR employee deciding to hire a business coach to a mid-level manager is likely to have a very different budget and purchase considerations compared to a VP level person, several levels above the manager, even if the coaching is for the same person.
The third assumption is that buyers make their purchase decisions solely based on price. This would be true if all products or services were identical and the buyer had access to funds, and the circumstance around the purchase was the same. So, neither of these is true.
The fourth assumption is that we make rational purchase decisions. Well, ask yourself, did you always make a rational purchase decision? Did you ever just buy something on a whim or because you felt emotionally attached to the product or service? You are very unusual indeed if you say yes to either of these two questions. Probably a martian as opposed to an earth-born human. Or Spock. We are not robots, but we are influenced in our decision-making by a legion of attributes, internal heuristics (prior experience, what other people say, feelings we have during the purchase occasion), and external influences (advertising, product or service reviews, how pricing is presented, branding, salespeople’s arguments, and much more).
Assumptions 5–6
In the fifth assumption, we talk about the circumstance of the buyer also affecting the prices that people can charge. And I’m often using the allegory of somebody is taking a sick child to the emergency room at the local hospital. If you’re running low on gas at that point, your willingness to pay is probably much higher than, say, and I’m sorry to say this, if you’re on the way to the in-laws on a Sunday afternoon. In the first example, you will probably fill up whenever it is most convenient and closest. In the second example, you may want to drive around for several miles more until you find the gas station where you have a loyalty card or where the price fits your budget. So the circumstances of buying gas in these two different circumstances change purely based on the circumstance of the purchase made.
Number six assumes that the elasticity of the demand is identical at all price levels. This is also not true. Just think about it. And this is common sense again. For instance, if the prices of a product or service are "low," it will appeal to price-sensitive customers who are likely to change their buying behavior significantly if there are price changes. On the other hand, if the prices are "high," whatever is sold will appeal to buyers who buy for other reasons than just a low price. Thus, at a low price, the elasticity of demand will be highly elastic, while at higher prices, it will be less elastic.
Assumption 7
Finally, we are at assumption #7. The price itself has nothing to do with how the buyer expects the quality and benefits of the product or service, but this is not true. The price is, in fact, the most powerful message of the benefits it will provide to the buyer. Means that a high price becomes a message of high quality and benefits, and a low price becomes a message of low quality and benefits. Trust me. I’m not making this up. We have all been there. Looking at a product, holding it in our hands, and then saying, "This is so cheap it cannot be any good." So what happens? We don't buy it for that very reason.
So, I hope I’ve convinced you that the traditional microeconomic theory is all wrong, and instead, there is a better way forward. It is still based on demand curves, just that these curves are very different from the traditional ones. Curves that are anything but smooth and straight but jagged and discontinuous.
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