CEO of a automobile company, or a freelance graphic designer, one of the most critical

business decisions you'll have to make is what price to ask for your goods or services.

Charge too much and you lose customers, but charge too little and you lose money.

You might remember this graph from your high school Economics class. It suggests that as

the price of a product increases, the supply (the number of people who want to sell it)

goes up, but the demand (the number of people who want to buy it) goes down. Supposedly

there's a magic number where these two lines meet that's high enough to keep sellers

sellin' but low enough to keep buyers buyin'.

It's called the equilibrium price, and it's a useful theoretical concept, but it's not

much help to Ruth here, who's about to launch a line of homemade bath soaps on Etsy. Even

with a lot of expensive market research, it would be very difficult for her to predict

how much people would be willing to pay for her Lavender Lemongrass Facial Scrub.

She can, however, calculate her costs--in other words, how much time and money she has

to spend to make one bar. Assuming that her costs stay the same, the more she charges

above that, the more her profit margin will increase... but the more her sales will decrease.

That is, if this graph is an accurate representation of how customers behave.

But this graph doesn't take into account one crucial fact: that humans aren't robots,

and our financial behavior doesn't track neatly along a straight line.

Just ask Louis Vuitton if raising prices always lowers demand.

In 2007, a group of researchers tried to get into customers' heads… literally. Using

an MRI machine, they found that just looking at prices activated the areas of the brain

associated with physical pain. Funny enough, that response was less when they took away

the dollar sign, even less without the decimals, and least of all when written out. Now you

know how fancy restaurants get away with $40 dollar chicken.

That painful feeling of losing something (like money) is known in economics as negative utility.

Conversely, positive utility is the satisfaction we get from gaining or consuming something.

And that doesn't necessarily mean a physical benefit. The sense of status one gets from

buying a $5,000 designer handbag is positive utility. So is the peace of mind of having

a $20 fire extinguisher under your sink even if you never use it. It's all about emotion.

Every customer wants to walk away from every transaction with net positive utility, meaning

they want to feel like they gained more than they lost. But how do customers know whether

something is over- or under-priced? Short answer: they don't. Not really. I mean,

do you know how much it costs to manufacture a computer? Or a candy bar? Without that information,

consumers are forced to guess at a product's value, and they do that through comparisons.

In study after study, when presented with multiple brands at varying price-points, most

consumers tend to gravitate towards the median price. That is, they assume the most expensive

option is probably over-priced, but they're also wary that the cheapest might be an inferior

product, so the the one right in the middle is their best estimation of the product's

true value.

This is sometimes referred to as the “magic of the middle,” and understanding it is

essential to attracting customers. Sarah is a freelance graphic designer and she's asked

to bid on a job she really wants. But she's relatively new to the industry and not sure

how much she should quote. She asks other professionals in the field what they typically

charge, and even cold calls some design companies pretending to be a client--not very honest,

but revealing--and finds out that graphic design rates in her area run from $50-150

dollars per hour.

Sarah really wants this job, so she might be tempted to offer a rock-bottom rate of

$25 an hour, but to many potential clients, that could be a red flag. They might assume

that someone offering substandard prices will deliver substandard work. She decides to quote

just under the median price: $80 an hour, and thanks to her strong portfolio, she lands

the job!

In other words, price is often interpreted as an indicator of quality. This should be

very relevant to someone like Ruth, whose customers will only buy her fancy bath soaps

if they believe they're fancy. Her potential buyers might enjoy saving money on socks or

toilet paper, but they're not looking to skimp on Mother's Day gifts. How powerful

is the effect of price on psychology? One medical study found that placebos were more

effective if the patients receiving them believed they cost more.

The fact is that it's very difficult to make low prices a successful business strategy.

Partly because they are often interpreted as an indicator of poor quality, but it's

also because average profit margins are much smaller than people assume. A survey found

that American consumers believed the average profit margin in the U.S. to be 46%. That

is, they assumed that for every dollar a company takes in, it will keep 46 cents in profit.

The actual number? Closer to 5%.

To understand how sensitive profit margins are to pricing, take the theoretical example

of Martin, who owns and operates a couple food trucks selling Cuban sandwiches. Martin

sells about 100 sandwiches a day at $8 a sandwich, with a total yearly revenue of around $300,000.

After subtracting all of his food, labor and operating costs, he's left with about $45,000

in profits a year, for a respectable profit margin of 15%.

But Martin wonders if he could attract more business by lowering his prices. After all,

the pizza place next door sells two slices for $7… If he knocked just 75 cents off

the sandwich price, maybe he could poach some of their customers. He does the math and is

shocked to discover that even at that modest price decrease, his yearly profits would be

slashed to under $20,000. He'd have to sell more than twice as many sandwiches as he

is now… just to break even. And how many more customers could he realistically expect

to gain from such a small discount?

This can be even more disastrous for an entrepreneur like Gabe, who sells men's razors online.

If he offers a steep discount for a limited time, he could indeed see a jump in sales…

but those might just be his regular customers taking advantage of the sale to stockpile--people

who would've eventually bought the razors anyway at the regular price.

This is what happened to General Motors in 2005, when they announced an unprecedented

price cut in their cars. Sales skyrocketed for a couple months, and then plummeted. Essentially,

they were poaching customers from future quarters. They ended up losing billions.

If you want to try to beat the competition with low prices, you'll have to make it

a part of your business plan from the get-go. That means scrupulously keeping costs and

wages as low as possible, while constantly communicating to your customers that your

product is reliable.

Or, you could focus instead on just making a great product, ask a price that you genuinely

think it's worth, and be ready to adjust to feedback from your market.

And that's our two cents!

If you'd like to dig deeper into the thrilling world of prices, you can check out “Confessions

of the Pricing Man” by Hermann Simon.

If you've ever sold anything or started a small business, how did you decide on a price?

Let us know in the comments.