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    « Are Relationships a Competitive Advantage? | Main | Case Study: Escaping Commoditization »

    May 23, 2006

    The Reference Price Effect

    A buyer needs to have a method to compare alternatives. If it is a strategic purchase (a “consultative” sale) there will be a fairly complex method of comparing alternatives and choosing the right solution. If it is a commodity purchase (a “transactional” sale) the buyer looks at two things: price and convenience.

    What is price? Price can be misleading. A buyer of a commodity uses price to compare alternatives. The buyer is not always taking into consideration the total cost of his purchase. He wants to believe he is making a smart decision. In pricing strategy there is phenomenon called “The Reference Price Effect”. This states that buyer will be more price sensitive the higher the product's price relative the the to the prices of the buyers' perceived alternatives.  In other words, if the buyer believes that there are many others who can deliver the same service he will focus much more on price.  Another key point is it is the buyers "perceived alternatives".  It doesn't matter what the reality is, it matters what the perception is.  If it is a transactional purchase the buyer will make a relatively quick decision and will go with what he perceives is the best price.  He assumes that all suppliers provide the same product and service and price is the only differentiating factor. This is frustrating for those who don’t want to see their business reduced to a cut throat price, but if that is your market you must accept it. You can work on moving to a consultative model with customers who appreciate more value added services, but in the mean time you have to compete.

    The perceived prices the buyer is comparing are not always the actual price. Some of the reference prices include pickup and delivery charges and others don’t. Some prices require a separate split delivery charge and others don’t. Buyers or reprographics services focus on price per square foot because that is the means by which they compare providers of that service. At least if they perceive the service as a commodity. 

    If you include everything in your price and charge a higher than market price you will exclude certain customers. Those customers are not necessarily cheap.  They believe they are making an economical decision. They may also be accustomed to paying additional fees for additional services. If your market makes decisions based on price you need to make sure your pricing model fits your market, not the converse.

    We all deal with this as consumers. I deal with this phenomenon when I travel. I will often go to Expedia to book a flight. I will enter WAS, for all Washington airports and my arrival city and Expedia will return a list of flights sorted by price. Every so often I will book a flight because it was a couple hundred dollars cheaper only to find myself stuck in traffic and paying expensive parking fees to park at Dulles Airport or BWI Airport.

    I live 10 miles from Washington National airport. It is a $15 cab ride to the $2 metro which takes me right to the terminal. I am over 40 miles away from both Dulles and BWI.  Washington National is not always the cheapest, but when you add up the costs (including my time) I don’t away make the smartest decision. It feels right at the time I book it, when I am comparing prices side by side.

    Most airlines are charging additional fees for meal in coach class. If I am hungry I will buy a meal, but I can’t honestly tell you if the meals are more expensive on US Airways or Delta. I will choose the most reasonable flight based on the price of the ticket on Expedia. The price of the flight is the “reference price”. That is the price that I will use to choose my flight. The airlines and airports have plenty of opportunities to make money off me traveling to the airport and when I’m on that flight.

    You may say "I don't want to have to deal with getting into that level of detail with the pricing".  If your business is moving quickly to a consultative model then you will not have to pay that much attention to those details.  If you are still primarily in a transactional model you must pay attention to these details.

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