In line with recent blog posts about competitor pricing and customer buying psychology, here's another interesting observation, from a study entitled: The Effects of Consumers' Price Expectations on Sellers' Dynamic Pricing Strategies. In this research paper in the American Marketing Association's Journal of Marketing Research, authors Hong Yuan (University of Illinois-Champaign Urbana) and Song Han (Renmin University of China) posit and prove that consumers search less when prices are lower than the last period.
The concept was that, based on what the customer expected the price to be (based on previous prices paid), customers choose how much effort to put into searching for alternatives, and how price influenced this decision.
The authors proposed and supported the proposition that: “The higher the buyers’ observed price in the current period, the more they went on to search; the lower the buyers’ expected price, the less they search.”
That is to say, Customers have a price they expect to pay or the price they think is fair, called the reference price. If your price is BELOW their reference price, they will likely just make the purchase without searching further. However, if your price is higher than the reference price they have in mind, they are likely to put more effort into shopping and comparison.
One way that customers may set a reference price is to base it on your previous price. That is to say, customers who buy the same item again and again may remember the previous price they paid, and they will likely make that their reference price.
So raising your price, i.e. setting your price above your customers’ reference price, is equivalent to encouraging your customers to search for alternative prices.
If you are able to maintain or lower your prices, your customers are less likely to shop around; so don’t raise your prices (unless you can’t avoid it). Costs don’t always support our ability to lower prices or maintain them, but as pricers we should be aware of this psychology of pricing to manage our customers’ reference prices.
Based on these findings, I would say when retailers see an increase in costs, the tendency is to raise prices, but do this only once if possible. When retailers raise prices, we are inducing our customers to search for alternatives, which we’d obviously rather not do. So if we have to do it, let’s do it only once. As costs come down, we could lower our prices immediately and get the benefit of our customers not shopping around. However, it seems more beneficial that if we lower our prices slowly, we also encourage our customers to not shop around. Raise prices quickly when costs go up so we only induce search once rather than several times in gradations. Likewise, lower prices slowly when costs go down to deter search multiple times.
When your price is below your customers’ expectations they are more likely to purchase and not expend the effort to search around. When your price is above their expectations they are more likely to search for alternatives. Raising price induces search; lowering price reduces search. As pricers and as marketers, we must manage our customer’s reference price, the price they expect to pay.
With concern for "reference pricing," you can understand the obvious need for daily pricing intelligence to be ever-aware of what your competition is doing about competitive pricing.
The main purpose of this study was to examine the effect of price expectations on consumers’ adaptive search behavior and sellers’ pricing strategies … the study showed that price information collected throughout the entire purchase history (not just the prices paid in the last period) has an important role in price expectation formations. In turn, these expected prices affect search behavior because consumers decide whether to continue searching by comparing their price expectations and observed current period prices.