If you follow behavioral economists like Dan Ariely, who I recently interviewed as part of the CMO 2.0 Influencer Conversations, you will know that there is such a thing as anchoring when it comes to pricing. Basically you can set an anchor for the value of a good and then have people judge all offerings within that space against that anchor. Anchoring is especially important for new product offerings – the ones for which people do not have an assigned value for – like the iPhone when it came out or the Amazon Kindle.

Let’s take a look at the differences between the product pricing strategies for those two products. The iPhone was introduced at $600, only to be reduced two months later to $400. Of course $400 looked like a great deal – when the anchor had been set at $600. And as Dan Ariely explains in a recent MIT Sloan Management Review interview $200 iPhones today look like an even better deal.

The Amazon Kindle on the other hand was announced with books at $9.95 – a subsidized price as Amazon is paying publishers more than that. But that set the anchor for the value of a book on Kindle in the mind of consumers. Now that they raised many books to $15 and up, it does not look like a good deal anymore – in fact it looks like it’s not worth switching to electronic versions of the book anymore. And the Amazon Kindle boards are full of protests by angry customers who are calling for boycotts.

Would Amazon have sold fewer Kindle’s if it had set the price of a book at $15 to start with, and tout some of the other benefits of reading on a Kindle – like searchability, note taking, etc.? It’s hard to prove of course, but I do believe that I would have bought the two Kindles that I bought so far with books at $15 and not feel as bad as I did when they increased their price. Subsidizing prices in a new product category is as bad a strategy as having free offerings to stimulate usage in a new category.

My CMO 2.0 Influencer Conversation with behavioral economist Dan Ariely, who is also the author of one of my favorite books, Predictably Irrational, was particularly insightful and instructive.

Dan started the conversation by talking about his past, and how a life changing event – having about 70% of his body burned by a magnesium bomb that detonated close to him – led him on a path of human experimentation.

We quickly moved to one of my favorite topics – how people make decisions either in a market framework or a social framework, and how mixing the two, which inevitably happens in the world of business, is not a good idea.

People are inherently social creatures, and when we talk about money we create a different set of expectations than the ones we have in our social world. The social world and the market world have different rules and regulations. What do you think would happen if instead of taking a bottle of wine to a dinner party you were to give the host cash so that she could buy her own bottle? It would no go over so well, would it?

In the business world we have no choice but to mix the two together, as we hire people in return for a salary, but also tap into social drivers that money cannot buy (i.e., an extreme example of that is firefighters putting their own life on the line, which could not be motivated by any amount of money). Too many companies try to put a monetary value on things where they would be better off leaving it in the social realm. They need to understand the trade-off between economic efficiency and social efficiency. Who would be more motivated to work overtime when you need it – the person who got a $1,000 cash reward for doing well or the one that was sent on a trip to the Bahamas worth $1,000? Research shows that it is the person getting the gift. The same is true for healthcare – why put a monetary value on the healthcare services that you provide to your employees? It does not buy you social efficiency which you could otherwise derive from providing them with that service as a social reward.

Next we talked about group dynamics, especially herding, and how that affects people’s buying behavior. People tend to herd – buy the music that got the most downloads, stand in line at the restaurant that has the longest line, etc. We also follow the herd of our own self, meaning that we buy things based on the way we bought before – even if that was based on a random act.

Dan also reviewed recent research that shows how we internalize the social. In an experiment he gave some people shirts with the term generous printed on it and others with the term stingy printed on it. After wearing the shirt in public for awhile people who had the generous shirts were behaving in a more generous way than those that had the stingy shirt. The interesting part of the experiment is that he got the same results when people were wearing shirts with the same terms printed on the inside of the shirt – so in a way that they were the only ones to know.

Another issue near and dear to many marketers is that of free trials. Free trials for products that are known quantities, i.e., Godiva chocolates, will not lead to the depreciation of value of those products in our mind. Free trials for products that we do not know, and do not assign value to, will diminish the value of that product so that when you start charging for it we will refuse to pay for it.

Other things that we talked about include:

• The dark side of social rewards
• How the feedback you get from focus groups can be very suspect because people have bad intuitions about their own behavior
• How ideation works best when other people can build on your ideas
• The importance of experimentation and business education in business
• How pricing is not determined by supply and demand and the importance of self-herding
• Behavioral economics and its impact on the economy and the stock market
• The honesty mindframe and its influence on cheating

As usual you can listen to the podcast on the CMO 2.0 Site and soon we will be putting up transcripts of this CMO 2.0 Influencer Conversation.

That is the question that MIT professor in behavioral economics Dan Ariely tries to make his readers think about in his new book, Predictably Irrational: The Hidden Forces That Shape Our Decisions, as he proves that most people are indeed predictably irrational.

Take the following experiment as an example. In the experiment, students were introduced to six products – two different wine bottles, a trackball, a wireless keyboard and mouse, a design book and a box of Belgian chocolates. Students were then given a form that listed all the items and asked to write the last two digits of their social security on top of the form and also next to each item in the form of a price. So, if someone’s last two digits was 23, they were asked to put $23 next to each item on the form. Next they were asked whether they would pay that price for that item with a simple yes or no. When the students finished that, they were asked how much they would be willing to bid for each item. Well guess what? The students with the highest-ending social security digits (from 80-99) bid highest, while those with the lowest-ending numbers (0-20) bid lowest. In the case of the cordless keyboard, the top 20 percent bid an average of $56, while the bottom 20% were willing to pay an average of $16. Overall the top 20% were willing to pay prices that were 216 to 346 percent higher than those of the students with social security numbers ending in the lowest 20%.

And that is just one of the many examples given in Prof. Ariely’s book.

So what does this all mean? As an economist, Ariely believes that fundamental economic principles like the one where supply and demand determine pricing, or the claim that free markets and free trade benefit everyone involved in those transactions, may in fact be bogus. The first one is based on the assumption that the supply and demand forces are independent from one another. The second is based on the assumption that all players in the market know the value of what they have and the value of the things they are considering getting from the trade. But if our choices are affected by random initial anchor prices as demonstrated in the experiment above as well as other experiments listed in the book, then the price that I am willing to pay (demand) can be heavily influenced by the supply side through MRSP (manufacturers suggested retail price), promotions, discounts, etc. So it is not the consumers’ willingness to pay that influences the market price, but instead the market prices themselves that influence the consumers’ willingness to pay. And for the same reason, the choices and trades we make in free markets may not at all reflect the true benefit that we would derive from the things we trade.

So what does that mean from a marketing perspective? For starters, and as it relates to pricing, it means that marketers may in fact have more control over buying behavior than they are currently given credit for. Additional research described in the book as well as on Ariely’s web site and blog, indicates that marketers may in fact be able to influence much more than the price a consumer is willing to pay for something, but also influence their general buying preferences.

In the end, the consumer may not be as much in charge as you think…