Pricing Strategy: Price Reductions vs. Free Gifts

 

Behavioral economics has found companies often rely on heuristics and fall prey to cognitive biases when making pricing decisions. Companies may anchor on competitors’ prices, assuming that “market price” is fixed and must be matched or beaten (Kahneman & Tversky, 1974). The herding bias may also negatively impact performance. The herding bias presents as the tendency to mimic competitors’ pricing actions despite a lack of evidence that this mimicry improves profit (Kienzler, 2018). These biases can lead companies to believe price discounting is the best tactic when value-based pricing is more likely to produce higher profit.

Price reductions can trigger negative price–quality inferences in consumers when the price reductions are uncommon in the industry, price reductions have not previously been offered, or the consumer has only basic industry knowledge. Customers may assume a lower price signals lower quality, reducing willingness to pay in the future. Repeated discounting can also train customers to wait for sales, undermining long-term price integrity (Raghubir & Corfman, 1999; Darke & Chung, 2005). In addition, discounts must exceed a psychological threshold before they meaningfully increase purchase intent in some customers. This can result in discounts that reduce margins without increasing volume (Inman, McAlister, & Hoyer, 1990).

An alternative to increase sales volume and/or retain customers is to offer a small gift with purchase while maintaining the price. The small gift can enhance perceived transaction value without reducing the product’s price anchor. Free gift with purchase promotions often increase positive affect and purchase intention more than equivalent price discounts (Diamond & Sanyal, 1990; Campbell & Diamond, 1990). Free gifts also leverage the “zero-price effect,” in which customers disproportionately value free items (Shampanier, Mazar, & Ariely, 2007). In sum, free gifts maintain the reference price of the core product, protect perceived quality, and provide customers with a memorable sense of added value.

The numerical effects of a price discount compared to a free-gift are below:

Example: A gym currently prices a yearly membership at $1200. They believe the cost to the gym is $960 per year to provide services to members. They have 100 members.

Profit = Revenue – Cost

Profit = ($1200 x 100 members) - ($960 x 100 members) = $24,000

The gym would like to increase revenue by offering a 10% discount in membership price. The new price would be $1080. If the membership remains at 100 and costs to the gym are the same:

Profit = ($1080 x 100 members) - ($960 x 100 members) = $12,000

Given the smaller profit margin per customer resulting from the 10% discount, the gym would need to have 200 members to reach the same level of profit:

Profit = $24,000 = ($1080 x Nmembers) - ($960 x Nmembers)

$24,000 = Nmembers ($1080 - $960)

Nmembers = $24,000 / ($1080 - $960) = 200

This increase in membership may be possible, but the larger membership would likely increase costs to the gym in the form of needing to hire more staff, purchase additional equipment, and repair expenses from increased use of the facilities.

An alternative would be to provide a gift to entice customers to retain their membership and encourage new customers to join.

Example: Rather than discount the membership price, the gym decides to give all members who renew a logo t-shirt. New members will also receive the free t-shirt. The t-shirt costs the gym $15 per t-shirt to design and manufacture. If only the current members renew:

Profit = ($1200 x 100 members) - ($960 x 100 members) – ($15 t-shirt cost x 100 members) = $22,500

Given the increased cost per customer from the $15 t-shirt, the gym would need to have 106.6 members to reach the same level of profit prior to the discount:

Profit = $24,000 = ($1200 x Nmembers) - ($960 x Nmembers) - ($15 T-shirt cost x Nmembers)

$24,000 = Nmembers ($1200 - $960 - $15)

Nmembers = $24,000 / ($1080 - $960 - $15) = 106.6

The question for the gym becomes whether they think a free t-shirt would retain current members and result in 7 new members. Gifts like the t-shirt also provide free advertising and could increase customer loyalty. Of course, the hope is the t-shirt would increase membership beyond 6.6 members. This increase in membership is feasible. It is almost certain the costs associated with 6.6 new members would be lower than an additional 100 members required under the 10% price discount.

Conclusion: Firms should strategically manage pricing decisions. Research has shown some instances in which price reductions could be beneficial. In most instances, discounts are a poor choice. Large increases in volume may be necessary to maintain the same level of profit following a discount. Offering a gift to your customers can increase volume at a lower cost to the firm. Offering a free gift can also increase customer loyalty and provide advertising for the firm. Ultimately, the company should conduct their own research to determine whether price reductions or free gifts result in greater profit. For the aforementioned reasons, it may be wiser to trial the free gift tactic prior to a price reduction.

References

Campbell, L., & Diamond, W. D. (1990). Framing and sales promotions: The characteristics of a “good deal.” Journal of Consumer Marketing, 7(4), 25–31.

Darke, P. R., & Chung, C. M. Y. (2005). Effects of pricing and promotion on consumer perceptions: It’s not just what you pay; it’s how you feel. Journal of Retailing, 81(1), 35–47.

Diamond, W. D., & Sanyal, A. (1990). The effect of framing on the choice of supermarket coupons. Journal of Retailing, 66(2), 145–160.

Inman, J. J., McAlister, L., & Hoyer, W. D. (1990). Promotion signal: Proxy for a price cut? Journal of Consumer Research, 17(1), 74–81.

Kahneman, D., & Tversky, A. (1974). Judgment under uncertainty: Heuristics and biases. Science, 185(4157), 1124–1131.

Kienzler M. (2018). Value-based pricing and cognitive biases: An overview for business markets. Industrial Marketing Management, 68(1). 86-94.

Raghubir, P., & Corfman, K. (1999). When do price promotions affect pretrial brand evaluations? Journal of Marketing Research, 36(2), 211–222.

Shampanier, K., Mazar, N., & Ariely, D. (2007). Zero as a special price: The true value of free products. Marketing Science, 26(6), 742–757.