Risk-based Pricing Model: The Role of Loss Aversion in Pricing
What has risk-based pricing model got to do with loss aversion?
If you were to choose between losing and gaining $5, which one would you choose? According to latest research, you’re more likely to defend and protect your money and opt for not losing $5. In fact, research finds that people in general are 2 times more likely to choose avoiding risk (in this case $5) than they are winning ($5).
To put it simply, people are naturally risk averse and think it is better to not lose than to win.
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So, what does this teach us about pricing? Well, just ask yourself: Why do people keep going to casinos though the risk of losing is higher than winning? How do insurance companies use a risk-based pricing model to motivate people to save and buy insurance policies? Why do businesses sometimes invest in business and pricing strategies that are bad for business – even when the data tells them not too?
The answer is loss aversion. But where does risk-based pricing model come in, in terms of loss aversion?
In this article, we will translate loss aversion in pricing using a risk-based pricing model example. Because a price really brings out feelings of loss; and there’s nothing better than loss aversion to get us all making irrational pricing and buying decisions.
To demonstrate these points, we’ll discuss the role of loss aversion in a risk-based pricing model. We will also provide some pricing examples, human/gambling examples and some broader business examples of loss aversion.
We believe loss aversion is an important element of a risk-based pricing model because when you know about the power of loss aversion, you can:
- Implement a risk-based pricing model to drive earnings growth
- Set prices that factor in customer risk factors
- Articulate to customer why your prices help them prevent loss more than your competitors
By the end of this article, you’ll learn what loss aversion in risk based pricing is and, more importantly, what you can do to control your loss aversion instinct to make better pricing strategies and risk-based pricing models.
Why do people resort to loss aversion?
Humans make bad decision because of loss which in turn impact their ability to see value and understand what is a good price from a bad price. People tend to care more about losses than wins. Meaning, the pain of losing outweighs the pleasure of winning.
Let’s go about with three examples of loss aversion such as gambling, pricing and the business. Let’s discover how each of them relate to loss aversion.
Risk-based pricing model examples on loss aversion:
1. Gambling
How does gambling business exploit loss aversion to make money with pricing?
Let’s take casino gambling for instance. Regrettably, there’s not a lot of patterns to outline the behaviour and why people go to casinos. Although, casino is a typical example for loss aversion. People who lose money on a bet will not just give up and go home. They will put more bets in hopes of coming out on top. The driving factor is the pain and regret of the lost money.
How do casinos encourage people to play games wherein the probability of losing than winning is higher?
Everyday, casinos are in the business of overcoming loss aversion. They win by abstracting the loss. How? Casinos let the gamblers play using chips or debit cards (which don’t feel as valuable) instead of with currency (perceived as valuable). As players lose this “fake” money over a period of time, the casino will provide “rewards” to lessen the sense of loss. They offer them like free drinks, T-shirts, free stays in the hotel and other benefits. Therefore, losing becomes “no big deal,” so gamblers continue to play. Consequently, losing money night after night.
In general, casinos serve two main customers segments – 1) routine gamblers that keep on gambling to avoid the pain of loss and 2) one-off gamblers who gamble once or twice but then stop even when probability says they’d be likely to win if they’d keep going.
Both customer groups are avoiding loss but to varying degrees and more interesting show different behavioural patterns in response to price, loss and risk.
There’s a reputable theory that provides many features of actual gambling behaviour. It’s called the prospect theory. Prospect theory can explain a wide range of experimental evidence. This includes attitudes to risk.
Prospect Theory explained
Loss aversion theory is founded on Kahneman and Tversky’s prospect theory. The theory asserts that people hate losses and go to great efforts to avoid them.
Prospect theory explains that people hate losses much more than they like wins.
For example, if we had a choice to make 20 or avoid losing 10 dollars most people would say avoid losing it – as to them, its more tangible – they have the money now.
Feeling the pain of something you have now, outweighs the pleasure of the gaining something you don’t have. Even if the path to making that gain or money is clear and you’ve very likely to get it.
This is because loss aversion influences decision-making. Loss aversion is emotional. When we make decisions mostly, then we are not using our logic brain.
If we were to look at the scenario logically, we would make the 20 dollars. As the probability of making that 20 dollars is the same as losing it. What’s more, there’s a 100% upside potential.
This indicates people will work harder to avoid a loss than to win.
Why? Because they actively try to avoid losses at all costs, and make decisions based on this cognitive bias.
The riskier the context, the harder loss aversion plays upon our decision-making.
2. Pricing
Customers feel loss when they receive a price rise letter. They either switch to alternative suppliers or demand discounts or credit notes to compensate for the pain they felt from their financial loss.
Consumers feel loss when they see prices of fuel change and act in erratic ways. However, there four ways in which customers can cope with consumer sticker shock as a result of higher gas prices:
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- downgrade from premium to regular;
- take fewer trips by car or switch to public transportation;
- reduce the miles driven per trip, like getting a holiday closer to home;
- to improve miles per gallon, drive more economically and less aggressively; in addition, buying a specific dollar amount of gas rather than filling up every time is also helpful
Price increases – people interpret this as a personal loss. Thus, we oftentimes see emotional reactions resulting in lost business. One strategy is to only increase prices on new customers – but again you need to be careful with calculating the price increase for new business. There’s no point in penalising new customers before they’ve even experienced your business. Loss breeds bad word of mouth, and sign ups to loyalty programmes and referrals will be low.
Reference prices
Everyone has a reference price in their head when they are going to buy something. A reference point is basically what your customers think the price should be or expect to pay. If it is above that reference price, people feel the pain of loss more. Even if they are wrong in their price and the item or service they are buying is more valuable that the reference price they have associated with the item. Which means you need to know whether the person you are selling to is an informed buyer. More informed buyers are likely to pay more than uninformed buyers.
Existing customers’ reference price is often the last price that they paid for. However, for new customers, you can influence or set their reference price. Oftentimes, we see retailers showing MSRP and then a marked down price. This is one way of influencing the reference price. Alternatively, you may want to compare your product to a more expensive one to increase the customer’s reference price.
Mark up to mark down strategies
Customers feel loss when they buy something at full price and then it’s discounted. Especially when the business is supposed to be using a premium strategy and then ends up eroding brand and customer value using cheap shot mark down strategies. Think fast-fashion retailing. Even the luxury brands do this now. The new generation of consumers say they are okay with fake luxury goods, as long as they are good i.e., look like the real thing. And many do, this is why luxury brands are facing big pricing issues at the moment. Gone are the days consumers value quality, provenance and brand authenticity. Now they want luxury fashion to be fast fashion. They are will to compromise on quality to a certain extent and don’t really care about provenance.
Customer feel pain if they missed out on a time based promotion. But only when they really wanted the product or service. They don’t see it as a loss if they don’t need or want it.
Some businesses provide “limited time offers”. For example, in Macy’s. Why wouldn’t they sell a jacket for 50% on a Monday that was on sale on a Sunday? The answer is loss aversion. If you’re reluctant in getting a new jacket, you are more likely to buy it while it’s on sale. If you go back on a Monday, the sale is over and you have lost the opportunity. You don’t have the extra incentive to go buy on Sunday if Macy’s doesn’t stop the sale on Monday. Loss aversion is a driving factor for the success of sales.
Buying ‘risky’ investments in a higher price band that also have the potential of financially penalising them down the line is also likely to create higher feelings of loss – i.e., life assurance, shares
Studies indicate, for example, that wealthier people as a group are less likely to own term-life insurance and more likely to own whole-life insurance because it serves as a partial savings instrument. These individuals also hold a higher level of wealth than others, suggesting that they tend to save more (presumably for precautionary motives), all other things being equal. The study also found that all groups regardless of personal wealth tended to overestimate the actual cost of life insurance by a large margin.
This finding support prospect theory which postulates that rational consumers may view pure protection insurance, such as term-life insurance, as a risky investment because the insured may lose premiums if a bad event does not occur within the pre-specified term. Hence, those who are fairly sensitive to the potential loss choose not to buy term-life insurance. Instead, they may choose a more safe option to prepare for uncertain future events by increasing precautionary saving.
3. Business
Leadership decisions to invest in bad business and pricing strategies is another example of loss aversion in action. In particular, businesses natural bias for investing in their bad pricing decisions and blind spots because they do want to avoid the pain of a bad decision.
For example, HMV is a business that failed miserably because of loss aversion. They in fact, doubled down on bad strategy because they denied they made very bad business and pricing decisions.
HMV held on too long to a strategy that was once successful. They ignored online retailers, supermarket discounting and downloadable music. Even saying that it’s just a fad. Still, HMV opened a digital music store in 2010, by then, it was already too late. In January 2013, it went into receivership. The outcome of investing in loss aversion as a business.
Likewise, Nokia is another example of doubling down on a bad strategy because of loss aversion. In fact, the pain of loss caused by the company’s continued investment in its own proprietary operating system even though it was working for them. Though Android and iOS were dominating the market, Nokia suffered deep financial losses and sold mobile division to Microsoft to prevent further negative financial figures.
GM also is another example of a business strategy suffering at the hands of loss aversion. In 1998, for example, GM killed the EV1, a battery-operated car, just before a breakthrough in battery technology occurred. GM CEO Rick Wagner opined in 2005 as the GM’s biggest strategic blunder.
What comes through from all these examples is that price, ideas, products and buying situations make people feel a whole range of gains and losses.
What is constant however, is that people value the avoidance of pain much more than the pleasure of gain. Which means how people are likely to value each of these gains and losses is a tough but key question for pricing departments to crack.
An important aspect of this theory then is understanding your customers reference point. As it is the reference point that defines gains and losses. And it is the reference point which is the one of the main causal drivers to different price response behaviours and price elasticity analyses.
A key aspect to focus on as a pricing manager is understanding your consumers or customers reference points when they buy from you. References points are a tricky concept to measure but they are essential to track. They exist entirely in your customers’ mind, yet they control their price responses and buying decisions (i.e., to buy or not to buy at that price).
A complicating factor, however, is that a reference point can change quickly – it is not necessarily fixed. Such a change is referred to as a reference point shift. Mere reflection of a purchase, a price and buying cycle can change the buyers reference point.
For example, when a product’s price is less than a customer’s internal reference point (IRP), the consumer is likely to perceive then product’s price as a loss and a gain. What’s more, when the customer recognises that the product’s price is not the same as their IRP, their reference point might shift from the repurchase state to their IRP. The extent to which this new reference point exceeds the product’s price would then be perceived as a gain, which could be termed as a perceived discount.
A concluding point in discussion then is, motivating people to buy at a certain price based on their feeling of loss.
From all of these examples, it is clear that penalty frames have more of an impact on a customer’s reference point than reward frames. This is because penalty frames have more impact than reward frames – as the basic principle of loss aversion purports. However, at the same time, penalty frames are the same as penalty charges. People don’t like penalty fees as they see that as a great loss to them. Rather, customer prefer to know that the price they are paying is removing their pain points. Only then, will they pay more than their reference point.
Implications
- The value of loss is two times the value of reward.
- Because of the behaviour of the customer’s reference point, a price may also be perceived as two losses, a loss and a gain, and even a gain forgone.
- People and companies prefer to stick to an existing course of action, no matter how irrational – because they are driven by loss aversion.
- Pricing managers can re-set prices using risk-based pricing models only when they understand the effect of loss aversion and other biases on decision-making in their industry
- Feelings of loss are present in all buying situations – however different groups experience loss differently when they buy or when they respond to changes in price
- Decision-makers should be mindful of some of the tricks that psychology plays on them when they develop a business strategy or decide to invest in a failing one.
Tips to help you control your feeling of loss when you buy or make business decisions
Think carefully about how you frame your offers and prices. Framing prices in terms of loss makes people take action.
Framing alternatives to buying from you as a loss will likely outperform the other approaches. Also, demonstrating why the customer is at risk when they don’t buy from you is likely to outperform other approaches.
Make logical decisions – have guidelines to prevent loss aversion influencing your decisions.
Research has identified a number of mutually reinforcing biases. These explain why people’s decision may be influenced by a prior commitment to a course of action.
The most important biases to look out for are:
- The sunk cost fallacy
This is a bias resulting from an ongoing commitment. A simple example is when, a person orders too much food and then overeat just to “get their money’s worth”.
- The illusion of control
It is the tendency for people to overestimate their ability to control events. It occurs when someone feels a sense of control over outcomes that they apparently do not influence.
- Preference for completion
It suggests that people have an innate bias toward finishing a task. May it be simply finishing a food or seeing a project through.
- Pluralistic ignorance
This is also explained as “no one believes, but everyone thinks that everyone believes”. It is a situation in which people go along with a norm or guideline just because they assume incorrectly that most accept it. However, they privately reject it in the first place.
- Personal identification
People’s identities and social status are tied to their commitments. This is what research in both psychology and sociology say. Therefore, backing out from a commitment may result in loss of status or a threat to one’s identity. Surely, no leaders will admit that they made a wrong decision. As a matter of fact, making smart decisions is what defines a good leader.
These are the biases that lead companies’ decision makers to disregard signals that their strategy is no longer effective. Karl Weick, of the University of Michigan, calls it consensual neglect: “the tendency of organizational decision makers to tacitly ignore events that undermine their current strategy and double down on the initial decision in order to justify their prior actions.”
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Conclusion
We explained the risk-based pricing model and the role of loss aversion to pricing. We discussed the prospect theory. Also, we have provided examples of loss aversion on gambling, pricing and business strategy. We conclude that customers can feel a range of difference feelings of loss and gain when they see a price.
A key implication of research and cited case examples then is customers are willing to pay much more to remove the pain of risk than the pleasure of a gain. Many companies assume the opposite when they set price.
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