Is It Time to Raise Prices?

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Of course, you can't make smart pricing decisions without taking your costs, competitors, customers, and salespeople into account. But nearly all experts agree that making any of those factors the primary basis for your decision is a big mistake. Instead, the right price for a product or service should rest on one thing -- the value that a product or service provides.

When determining your prices, says John Gourville, a marketing professor at Harvard University who studies pricing, the first question to ask is this: How much would a rational consumer be willing to pay for your product, assuming the consumer had a perfect understanding of its actual worth? It sounds easy. But while most business owners spend a good chunk of their time touting the benefits of their products and services, "they haven't tried to monetize those benefits," says Brent Lippman. The first step toward creating a pricing strategy, then, is to do just that -- think through the benefits of your product and make a rough calculation of what you think they're worth in dollar terms.

Marc Cenedella went through this process in 2003, when he was setting subscription rates for his start-up, TheLadders.com, an electronic job-search service that lists only positions paying more than $100,000. Most career sites allow job seekers to search for free and make money by charging employers. Cenedella's strategy is different: He charges job seekers and lets employers list their six-figure positions for free. After many meetings with "way too much pizza," Cenedella and his team arrived at their value figure: somewhere between $10,000 and $40,000. Their assumption was that a job seeker who used their site would find a position at least one month faster than one who didn't. Since that job would pay $100,000 or more, the value of the company's service translated to roughly one month's take-home pay, or somewhere between $10,000 and $40,000, depending on the job.

Fair enough. Of course, it's hard to imagine anyone coughing up tens of thousands of dollars for a weekly e-mail newsletter. And indeed, you'd be hard-pressed to find a pricing expert who would suggest that as an appropriate price.

That's because there are two kinds of value: objective value and perceived value. The former is what Cenedella came up with: the price of a product or service assuming the customer has a perfect understanding of its value -- and understands it in the same way the seller does. Think of objective value as the most that you could rationally charge for a product. At the other end of the spectrum, the least you could rationally charge for a product would be the incremental cost of producing it -- a breakeven price. Somewhere between the two lies what is known as the perceived value of your product -- that is, what a person actually is willing to spend. In a perfect world, your customer would see the value of your offering and be willing to fork over the full amount. But in many circumstances, there's a disconnect, and what people are willing to pay is very different from your product's objective value. (In those cases, you'll have to use marketing and other tricks to try to change your customer's perception of value. But more on that later.)

How do you determine what people are willing to pay? Study after study has demonstrated that when it comes to purchasing decisions, people are irrational. In one classic study, researchers asked consumers whether they would be willing to travel an additional 20 minutes to save $5 on a calculator that costs $15. Most said yes. Then they were asked the same question about a $125 jacket. Most answered no. Now, rationally, $5 is $5, whether you're buying a calculator or a jacket. But it's seldom that simple, according to Richard H. Thaler, a professor at the Graduate School of Business at the University of Chicago and author of "Mental Accounting Matters," an article published in 1999 in the Journal of Behavioral Decision Making. "People make [purchasing] decisions piecemeal, influenced by the context of the choice," writes Thaler, who won a Nobel Prize for his work in behavioral economics.

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