Pricing is one of the most puzzling aspects of product management. How do you price the product right? The van Westendorp pricing model can help you with this question. Here’s how:

Why ‘pricing’ is difficult?

Pricing is one of the four Ps of the marketing mix. Pricing is extremely difficult. Other aspects of marketing are driven by well set out rules and approaches. Other the other hand pricing is difficult. Firstly, it is not easy to understand what people are ready to pay for your product. Secondly, there is no correct answer to this question. A price that is suitable for one person may not be suitable for another. Thirdly, it needs to be dynamically adjusted to internal and external factors. For instance, these factors may change the minimum price for breaking even.

Here is the pricing dilemma :

1. If you price the product too low, you tend to lose potential revenue. In fact, you can run into losses. This can happen if you are not able to cover the cost of the goods sold. At the very least you tend to lose revenue.
2. If you price the product too high, you tend to lose customers. Also, sometimes, the market is a monopoly. In these cases, people may be forced to buy your product. However, they will have a dissent against the product. These customers may defect at the first opportunity.

This is where the van Westendorp pricing model comes handy. However, let us first look at the classical model. Secondly, we shall see what are the limitations of this model.

Classic economic model (and its limitation)

We have studied the elasticity graph in our Economic 101 course. It tells us that as the price increases, there is a drop in demand. Let us briefly have a look at the graph. Thereafter, let us understand how this method is inadequate for managers.

The classic elasticity of demand curve models the change in the quantity demanded per unit change in price. It’s formula is:

Some limitations are:

• It cannot be used to determine the price for products that are needed in single or less quantity.
• It does not track the nature of change accurately. PED over the price changes as it is non-linear as seen in the graph.
• It does not tell us a range where pricing should give us maximum sales.

van Westendorp pricing model

Peter van Westendorp was a Dutch economist. He came up with the model for finding the desired range of pricing for the products. It looks like an economic model. However, it finds usage in market research. The model is also known as the Price Sensitivity Model or PSM. It is a direct and robust method for pricing.

Some assumptions of this model:

• People have an understanding of the value of the product.
• Pricing is a distinctly important feature. That is we do not focus on changes in the valuation of a product as the feature set changes.

Overview of this model

Although the approach seems too mathematical, it is easy. There are only three simple steps. If you follow these steps, you will get the results.

van Westendorp pricing model survey

These are the four questions. Firstly, we ask them that at what price they would start questioning the legitimacy of the product. For instance, let us say they are used to buying a bottle of shampoo for $18. If a company sells the product for $12 it may excite the customer. However, if the price is $6 they may question the quality.

Secondly, we ask people about the best price. Let us call this the bargain price. For example, the customer may be delighted to buy a new brand of comaprable shampoo for $12. This is the bargain price.

Thirdly, we also set out to see the upper bounds for the price window. The customers start thinking that the price is expensive at some price point. It is important to keep the prices less than or equal to this.

Fourthly, the final question is about the highest price that the customer is willing to pay. It is important to capture this price point becuase of few reasons:

1. Customers may not be truthful about the expensive price point. This extra data gives us more flexibility of interpretation.
2. In a low competition situation it may help to price the product higher to get more revenue from the product.
3. The point of ‘too expensive’ can be quite useful for luxury products. Customers that want luxury products may have higher satisfaction paying close to this price point.

Four core questions of the Price Sensitivity Meter

1. At what price do you think the product/service is priced so low that it makes you question its quality? (minimum price)
2. At what price do you think the product/service is a bargain? (bargain price)
3. At what price do you think the product/service begins to seem expensive? (expensive price)
4. At what price do you think the product/service is too expensive? (very expensive price)

van Westendorp pricing model example: pricing for electric cars

Now let us consider a real-life example. We will refer to the research paper published in a top tier academic journal. Larson et. al., (2014) published a paper on pricing for electric vehicles. They wanted to study attitude about electric vehicles between different groups of people. The cumulative frequency plot represents the response for experienced users.

An interpretation of this chart

• The optimum price range would be $22,000–27,500
• People do not expect the electric cars too be too cheap. It is evident from the solid black line in the graph.
• People are somewhat ready to pay a higher price too. This is evident from the plot of dotted black line.

FAQs

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What is Autonomous Consumption?

Autonomous consumption definition

The consumption that is independent of the level of income is called autonomous consumption(AC). It is also known as exogenous consumption. Apart from the bare necessity for survival, it may also include payments towards loans and other obligations.

The counter to this type of consumption is induced consumption(IC) which signifies an expense that is dependent on the earning.

Moreover, there is another interesting term associated with AC: dissaving. In the condition that a person earning a salary per month. The person ideally spends money less than earning. The difference is accumulated as ‘savings’. The opposite of saving is called ‘dissaving’

In other words, dissaving is tapping into external sources of money when income is less than expenses. Generally dissaving is done by tapping into savings. However, in extreme cases, people arrange for money by selling off assets, goods, etc or by borrowing money, food, or services from others.

Autonomous Spending

Autonomous spending is a concept of macroeconomics. It is essentially automatic spending that is the bare minimum for a living person to exist. The expenses that are related to survival like food and shelter come under this category. An unemployed person needs these basic items to stay alive and would have it no matter how badly the economy functions.

On a larger level, the term autonomous expenditure signifies the necessary expenses made out by the government of a country.

Autonomous consumption formula

Firstly, we have defined AC to be the minimum expense a person makes irrespective of the income. Now if we consider a general case of consumption. In that case, the consumption will have two components: IC and AC.

Secondly, since we have already defined IC as the consumption which is dependent on the income, the IC will have a component that varies from person to person. Let us call this variation as c_m which signifies the unit change in consumption for change in the income. This gives us the net IC as c_m*Y_d.

This gives us the formula for total consumption (TC) as

TC= AC+ IC

or

TC = c_a+c_mY_d

Autonomous consumption graph

Autonomous consumption example

Some of the common examples of AC have been discussed earlier in this article. The common autonomous consumption example includes house rent, mortgages, loan EMI, groceries, clothes, etc.

However the specific examples can change from person to person. For instance, older people may require medicines for their survival while younger people may not need them.

Covid19 and Autonomous consumption

Covid19 came slowly, like a surreptitious predator. We were oblivious of ‘some virus in some Chinese province’ and kept on with our daily lives. Over the course of two months, the virus spread all over the globe. The panic came soon after. The first shock was for the aviation companies which are now struggling to keep afloat. Secondly to the tourism industry worldwide. Finally, all major economies are now at war against this virus.

The leaders of all kinds of firms now have a daunting task. There is a need to reassess the situation, restructure the supply chain, identify and fix the money leaks. However, the biggest challenge in these times is to understand the disillusioned, impoverish, and highly skeptical consumer. The business in times of recession is tough; business in the times of depression is tougher.

Managing through crisis

Firms need to be cognizant of the economic situation. This is the first time since the Great Depression that economies are expected to nosedive worldwide. We cannot predict the actual damage. In the best-case scenario, it would still be worse than the 2008 recession.

1. Reduce inventory – one of the key challenges is to manage the inventories. The economic shock has sent ripples across the supply chains. Managing inventory for AC goods like foodgrains is paramount.
2. Accumulate assets – firms that are not depleted of cash can take advantage of this situation. The assets are cheaper to procure in these times.
3. Autonomous Consumption: consumer expenses would be primarily directed towards essential goods and services. Improve your product offering by providing necessary and budget-friendly options.
4. Self-reliant offerings – firms that sell DIY kits will make money. Also, gardening, farming, and other self-reliance products will sell.
5. Downsize – downsizing is the key to saving money. Firms can reduce production of non-essential goods. Alternatively, expand the portfolio into essential goods may help.

Read our Covid-19 resources by clicking here.

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There are various schools of thought in economics and neoclassical economics is one of the major ones. Schools of thought are a broad classification of ideology that come under a similar set of assumptions, notions, and methodology. Neoclassical Economists believe that individual decision making can be modeled on their need to maximize their personal utility.

What is Neoclassical Economics?

Neoclassical economics has its roots in the “neoclassical” era which spanned between 1870 and 1933. There is no cutoff date. However, strong consensus puts the neoclassical era origins somewhere around the early 1900s. In the NE school, mathematical inquiry became a mainstream methodology.

Neoclassical economics definition

NE is an umbrella term for a set of theories that have a common set of underlying explanatory predictors and outcomes; mostly using supply and demand to predict the production and consumption patterns. It was preceded by classical economics. Thorstein Veblen coined the term NE and he was quite critical of the concept. We shall discuss this, subsequently, later in this article.

Neoclassical economics theory

At its core, NE has two essential principles: methodological individualism & rational choice(Boland, 1998). The first philosophy posits that economics can be looked as sets of choices made by individuals. The second philosophy is that of ‘rational choice’. These two principles have been the foundations of many of the modern economic theories.

The NE model

One of the most common models in NE builds upon the utility maximization principle. Under the assumption of a competitive and free market, it can be used to determine the price for a commodity.

Let us consider a product, say a bar of soap. Let us say that there are 1000 people who would buy(demand for the soap is 1000 pieces) it at the market price of $10. As the price of soap decreases, to $9 more people should buy it. Thereby, the demand shoots up to 1200 pieces. This nature of demand is called elasticity which means that it changes with respect to price. It is evident from the graph below. The red color line shows the ‘demand function’ or graph for demand.

Likewise, for the same soap, let us say there are 5 producers who are ready to sell the product at $10. As a result of a price drops to $9, some of the producers will not be willing to sell it because it would either cause them a loss(if the cost of producing the soap) or they are not ready to sell it lower price point. For instance, there may be only 4 producers of soap at $9. This is called the elasticity of supply. In the graph below you can see the blue line which represents the supply. As the price of the product increase, there are more and more sellers ready to sell it.

Consequently, this means is that if there is a demand for some good, then it must be balanced by the supply. There will be a point where the supply and demand requirements meet. This common point is called equilibrium and it dictates the market economics.

This is the most basic represenation of the supply-demand equilibrium model. You can refer to textbooks in economics for more advanced discussion of topics

Example of NE

The artificial price of natural diamond

One of the classical(no pun intended) and controversial(no uproar in comment section intended) of NE is the diamond industry. Diamonds are plentiful in nature and quite cheap to mass-produce. Therefore, they have very low intrinsic value, however, they are sold for a premium price. The basic business model of De Beers, a monopolistic company that operates most of the diamond industry is based on the NE model. It has an elaborate set of measures to ensure control over the ‘supply’ side of the market. They ensure that there are as few as possible diamonds released to the markets which makes the prices sky-rocket.
In addition to that, the company is also known for one of the most inflationary campaigns in American consumer history. It created a campaign in the form of radio and print ads where it proclaimed that any man who loves a woman should spend two months of his salary in a diamond ring for her.

In conclusion, government controls are needed for the regulation of such practices. Regulatory measures can lead to the curbing of rampant looting of innocent consumers. Decartelization and lawsuits helped reduce the market share of De Beers from about 90% in 1987 to about 37% in 2018.

Assumptions of NE

One of the differences is that while classical economists looked at economics from a producer’s perspective while the NE looks at economics from the consumer’s perspective. As a result, the first assumption of NE is that utility rather than ‘cost of production’ drives the market prices of goods and services. Consequently, the value of produce is not only governed by the cost of production but may have a premium beyond the cost of production due to the perceived utility a consumer derives from it. This leads to an implicit assumption that the key purpose of a firm is to maximize profits.

Moreover, the second common but sometimes implicit assumption is that of the ‘rational behavior’ of an individual. NE theories posit that the primary concern of an individual is to maximize their personal satisfaction from any action. Thereby, they try to act selfishly in their own interest. This means that for every resource they have, they would like to make a decision that results in the highest satisfaction for them.

Classical vs Neoclassical

This debate is based on the premise of the economic model. Firstly, as the name suggests, Classical Economics(CE) came before Neoclassical economics. However, there is no cut-off date delineating them. It is merely a school of thought or idealogy and both form the part of mainstream economics today. One of the simplest comparisons of the same is provided below:

Neoclassical economics and Behavioral Economics

We have discussed that one of the assumptions of NE is rationality. Behavioral economics breaks that assumption. Behavioral economics(BE) is based on a set of theories that model human behavior. One of the keystone theory is the tendency of individuals for ‘loss aversion’, published in the seminal paper of Kahneman and Tversky in 1979. This theory states that people are more loss-averse than they are gain seeking: a loss of $1000 hurts more than a gain of $1000!

BE models the actual behavioral responses to situations where individuals act in a manner that at times may contradict the strictest ‘economic sense.’ This also breaks the second assumption of ‘utility maximization,’ where individuals may but an overly expensive iPhone over a Samsung Galaxy that offers imperceptibly similar performance at half or lower the price(a subjective statement to give an example).

In fact, Nobel laureate economist Richard Thaler also claims that the irrational individual would be ‘dumber and nicer’ than what neoclassical economists would believe. On the other hand, Paul Ormerod has said that modern economists must have some understanding of behavioral economics too, irrespective of their school of thought.

Criticism

Economics enjoys its own share of fandom as well as criticism. Some of the common complaints against economics, in general, are that it has deeply rooted assumptions, unrealistic focus on the prediction of the models and more importantly, failure of models altogether.

The first criticism stems from the assumption that the consumers are rational decision-makers. Contemporary economists converge towards a more realistic situation where the behavioral aspects of the decision making are also considered. Humans are prone to mistakes, emotional swings, irrational beliefs, and random fluctuations also. The dissent against mainstream economics which also includes NE is that over a period of time, the models became detached from reality and convoluted in mathematical equations that are highly speculative in nature.

Finally, there is also growing descent against the classical and neoclassical economists. The public perception of economists resembles these types of economists who focus on economic growth and wealth creation. If a firm follows the neoclassical model, then it can theoretically derive as much value from the consumer as much as they possibly can. This is especially true in ‘branded’ commodities like Starbucks Coffee or Fuji drinking water which is sold as massive margins just because people would pay for it. This is part of the capitalist culture which is looked down upon by some of the critics. Their rational is that neoclassical economics is focused on the transactional aspects of the production while neglecting the labor. A more nuanced development in the economic model should ideally include the human aspects as well.

Veblen was also critical of the fact that neoclassical economics stressed on profit maximization. According to him, this makes NE not any different from the CE.

Contemporary thoughts

The change in attitude towards the orthodox or neoclassical economics has lead to the creation of new streams of study. One of the prominent aspects of NE being questioned are:

• Rational individuals
• Rational firms
• Invisible hands
• Profit maximization
• Maximizing shareholder’s wealth

The heterodox economists are ones who are more critical of the NE. They have lesser trust in the aspects of NE like giving free hand to the firms without government intervention or belief in rational individuals who take perfect decisions. In “The changing face of economics, ” the authors state that the tenets of NE has always been the “holy trinity of rationality, greed, and equilibrium” and is being replaced by the trinity of “purposeful behavior, enlightened self-interest, and sustainability.” These changes present a refreshing look at how we envision our organizations, how we design public policies and how we ensure that the scarce natural resources are not depleted in a generation or two.

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