From Behavioral to Cognitive Pricing

Below is an article by Leigh published in INsights magazine. The magazine published by the Neuromarketing Science & Business Association. See the article in its full glory here or just the text below.

Behavioral pricing has been used for many years but is essentially based on changing customers' behavior without creating new value. Cognitive pricing is a new paradigm in which the customer's positive mental experience can be given a monetary value.

The ability of companies to earn premium prices for their products and services is under threat. The rise of the Internet in general, and price comparison websites in particular, makes it easier for consumers to compare products, harder for brands to stand out from the competition, and risks turning many categories of product into commodities. And being commoditized usually means lower profits and less innovation. The emergence of behavioral economics gave marketers a new set of tools to maintain an edge: the techniques of behavioral pricing [1], [2]. This toolbox included leveraging judgment heuristics like anchoring, Goldilocks pricing, the left-digit effect, decoy effect and many other clever tricks. Most of these operate by influencing how customers perceive or estimate the monetary value of the products they buy. Anchoring, for example, can be used to compare the price of what you're buying with some higher reference price – so that you are willing to pay more. Behavioral pricing still works well, but it is becoming less powerful than in the past.

In some areas, regulators are limiting the scope of the techniques that can be used. The UK's Financial Conduct Authority is acting to stop insurance companies and others from using dual pricing – offering their services cheaper to new customers than to customers who renew for a second or third year. The Competition and Markets Authority already limits the use of reference pricing by retailers. And the European Commission regulates how prices of travel tickets are presented to consumers, for example insisting that all taxes are included and no mandatory surcharges are added.

In other areas, intermediaries make it harder to apply behavioral techniques. A supermarket might produce labels showing the price per 100ml or price per kg of all products, making it easy for consumers to compare the deal they are getting from competitive brands. And price comparison sites usually rank products from cheapest to dearest, making some techniques like Goldilocks pricing less successful.

However, two basic rules of economics still apply even today:

1. customers are willing to pay a price for a product that reflects the value it gives them, not just the underlying cost (although of course they are happy to pay less if they can get away with it).
    
2. if a company can apportion its fixed costs differently across different customers – for example, charging rich business people more for a last-minute plane ticket than careful tourists who book in advance – they will use resources more efficiently, and satisfy more customers, than if they charge the same price to everyone.

A world of price comparison and commoditized pricing risks destroying the business model of some companies. Although consumers might feel unhappy about some of the prices they pay today, they would be worse off if Ryanair, France Telecom and AXA Insurance went out of business altogether.

Recent discoveries in neuroscience research are at the basis of a new approach that better aligns the interests of consumers and companies: cognitive pricing. The basis of cognitive pricing is the insight that people gain value from their own state of mind. My beliefs, my mood, my identity and self-image, my affiliation with organizations, the stories I tell myself, my dreams and plans for the future – all of these can make me happier and provide real value to my life.

None of my beliefs, values, or aspirations are material products or services that I can acquire, but they do matter to me – and I would be willing to pay for them, at least indirectly. These mental states are studied by the newly emerging field of cognitive economics, and they are called cognitive goods.

Cognitive pricing is a method for packaging up these cognitive goods along with the products and services we buy. The cognitive goods themselves provide extra value that customers are willing to pay for – and they differentiate the products from competitors, so that the product is less at risk of being commoditized.

Traditional "rational" economic decisions based on price are made primarily in the prefrontal cortex using "System 2" reasoning, which is good at following mathematical rules. Behavioral pricing mainly operates at the "System 1" level, accessing the limbic and sensory brain's capacities for pattern recognition, pairwise comparison and emotion. But decisions based on cognitive pricing, based on valuing complex mental objects, do not fit comfortably into either “System 1” or “System 2.” Some authors [3], [4], [5], [6] have proposed that there might be a third mental system, representing a different level of cognition. This level might represent the human imagination, found to take place mainly in the striata and default mode network, and/or a process in the vmPFC and anterior cingulate cortex that monitors and controls the other two systems.

There is some tradition in both psychology and economics of understanding how people consume and benefit from intangible value. Thomas Schelling's 1984 article, "The Mind as a Consuming Organ" [7], explored how we gain pleasure from fictional objects, and Ainslie's Picoeconomics [8] (1992) followed this up with a model of "self-reward". Rory Sutherland's classic TED talk [9] has some excellent and amusing examples from the commercial world; Ariely and Norton (2009) developed a theory of conceptual consumption [10] and Kimball explored cognitive economics in a 2015 article [11]. The practice of cognitive pricing builds on these insights, to show companies how to capture some of that intangible value by putting a price on it.

Examples of cognitive pricing:

Coca-Cola
A can of Coca-Cola bundles together a lot of different benefits – some tangible and material, others only inside the consumer's head. All of the material benefits – with the possible exception of taste – can be provided easily by other, cheap alternatives. The cognitive goods, however, are mostly unique to Coke. These goods are what enables Coca-Cola to charge a premium.

British Airways (or KLM, Lufthansa or Air France)
Think specifically about the short-haul services of these airlines. The material experience is very similar to that of a budget airline: the seats are a similar size, the flight takes the same length of time, and (in economy class) you don't even get free food. One of the only concrete benefits may be the chance to fly from a more convenient airport, though even that isn't always the case. Yet many people are willing to pay much more for a British Airways flight even when a cheaper Easyjet flight is available.

Why?
The cognitive benefits of a British Airways trip explain this. They include:

• The implicit association with the airline's long-haul offerings: the dream of travel to an exotic location, in flatbed luxury, is still somehow in the air on your one hour flight to Munich for a meeting.

• The status game: you collect tier points or miles towards the elusive Silver or Gold status that will set you apart, psychologically as well as physically, from the rest of the passengers

• The gamble of an upgrade: you always have a chance of an upgrade to business class. Even though on a European flight that still doesn't provide much extra material benefit, it feels special.

These benefits are often wrapped up in the general label "brand", but there is a lot more to learn by analyzing the specific differences between the two offerings. You can apply psychology or neuroscience research to understand the additional value each component might attract. The "upgrade lottery" can be valued using decision-making experiments on probability based gambles, and the worth of the implicit "long-haul luxury" association can be measured with implicit market research tools.

Good Energy
This is an energy company that provides electricity to the consumer's house, in exactly the same form, voltage, etc. as any other company, but commits to generate it only from renewable solar sources.

The electricity is the same as any other, but by buying from Good Energy you get to believe in a positive story about yourself and the future of the environment. The word "story" is a tricky one in this context: I do not mean to imply that the story is untrue. Most probably it is an accurate story. But the direct material impact your purchase makes on the environment is unmeasurable in terms of your own personal future. In reality, it is your participation in a mass movement of individuals that has
a chance of making a difference, and that participation is yet another cognitive good that you are buying with your energy contract.

How much are cognitive goods worth?
We might enjoy the story or belief that comes bundled with a product, but does it really influence the price? Perhaps it helps sway the decision between two equally-priced cans of cola or electricity providers, but can it really earn a price premium?

The general answer is yes. Coca-Cola is typically priced at two to five times what a supermarket cola costs. British Airways tickets are often 50-100% more than Easyjet for the same cities and dates. Green electricity deals don't always cost more, but this is partly because they have benefitted from government subsidies on renewable energy generation.

Not all suppliers have successfully created a story that can earn a premium like Coca-Cola’s, but the possibility is always there. In some categories the cognitive premium will be smaller than in others, because of the market structure or the nature of the decision-making context. But in most industries there are great opportunities.

In most categories there is room for a more environmentally friendly option, a more "authentic" product (or several, depending on the story you tell about authenticity), a version that is targeted at a younger audience, and many others. Each of these is associated with a cognitive good that you plant inside the customer's mind. When they buy or use your product, that cognitive good is activated and replayed, creating more reward and pleasure for the customer.

The best way to find the cognitive goods associated with your product or brand is to identify the stories that are available in your category, and those that are not yet being told by your competitors. You can do this by exploring your customer's imagination – their "System 3" – measuring how much cognitive reward is generated by their different beliefs, identities and dreams. Then, start telling those stories – and you'll find out how much more your customers will pay to play a part in them.


References

1. Liu, M. W., & Soman, D. (2012). Behavioral pricing. In Handbook of consumer psychology (pp. 656-678). Psychology Press.
2. Caldwell, L. (2012). Psychology of Price: How to use price to increase demand, profit and customer satisfaction. Crimson Publishing.
3. Stanovich, K. E. (2009) "Distinguishing the reflective, algorithmic and autonomous minds: is it time for a triprocess theory?" in Evans & Frankish In two minds: Dual processes and beyond (2019), Oxford University Press.
4. Evans, J. St B. T. Evans (2009) "How many dual-process theories do we need? One, two, or many?" in Evans & Frankish In two minds: Dual processes and beyond (2019), Oxford University Press.
5. Houdé, Olivier (2019) 3-System Theory of the Cognitive Brain, Routledge.
6. Caldwell, L. (2018) "Introducing System 3: How we use our imagination to make choices", GreenBook. https://greenbookblog.org/2018/04/24/introducing-system-3-how-we-use-our-imagination-to-make-choices/
7.  Schelling, T. C. (1987). The mind as a consuming organ. The multiple self, 177-96.
8. Ainslie, G. (1992). Picoeconomics: The strategic interaction of successive motivational states within the person. Cambridge University Press.
9. https://www.ted.com/talks/rory_sutherland_life_ lessons_from_an_ad_man?language=en
10. Ariely, D., & Norton, M. I. (2009). Conceptual consumption. Annual review of psychology, 60, 475-499.
11. Kimball, M. (2015). Cognitive economics. The Japanese Economic Review, 66(2), 167-181.