Ok. It has been awhile since my last blog entry. I guess I don’t find interesting articles about pricing all that often. But I think this one, although not overtly about pricing, is terrific. The article, “Claiming a Large Slice of a Small Pie: Asymmetric Disconfirmation in Negotiation” was written by George Wu and Richard Larrick and a summary was published by Capital Ideas, Selected Papers on Decision Research by the University of Chicago Graduate School of Business. In short, Wu and Larrick show that in negotiations between two people, both sides consistently underestimate the amount of bargaining room that exists (small pie bias), and as a result, they overestimate how much of it they captured (large slice bias). The reasons for these errors, they argue, are: (1) it is difficult to accurately determine how far a counterpart will move and negotiators use flawed hypotheses to estimate that range; and (2) negotiators want to believe they have done a good job. A negotiation that looks like it resulted in the individual capturing most of the negotiating zone confirms to that individual that he/ she has done a good job, because he/ she doesn’t realize or have the incentive to realize that the negotiating zone was much larger.
According to Wu and Larrick, if we overestimate what we can get in a negotiation, our counter party has a strong interest in correcting our mistake. In fact, the counter parties often object rather aggressively to estimates of negotiating room that are too high. Those aggressive objections can lead us to over-compensate, and end up underestimating going forward. Conversely, if we underestimate that negotiating range, the other side has no incentive to correct our estimate. If our estimate is already acceptable, their incentive is to make a good deal relatively quickly and claim victory for themselves.
There are some obvious connections in the Wu, Larrick article and how I think about pricing. B2B pricing involves a bunch of negotiations. Sales people who face the challenges described by Wu and Larrick conduct those negotiations every day. Most sales reps have many (hundreds) of customers who buy hundreds or thousands of products. The amount each customer is willing to pay for a given product varies from customer to customer, which makes it nearly impossible for a single sales person to accurately assess how much each customer is willing to pay for a given product. In addition, most sales reps receive at least part of their compensation based on how much they sell. From a sales rep’s perspective, the risk of getting no sale (and therefore less commission) increases as the rep’s estimate of willingness to pay increases. So even though a sales rep probably would make more money by selling at a higher price, the difficulty of figuring out what a customer will pay and the risk of losing the entire sale offset that incentive to price higher. That means sales reps will tend to be more conservative in estimating how much negotiating room they have.
The other connection between my view of pricing and the Wu, Larrick article is a syndrome I refer to as “We can afford it”. In the article, the authors demonstrated that the amount by which individuals underestimate the negotiating range is greater for large zones than it is for small ones. What that means is it is more likely a sales rep will underestimate a customer’s willingness to pay if the product they are selling has an inherently high margin. If a sales rep is selling something that has an average margin of 60%, they are much more likely to think the price is high and at the outer edge of what a customer will pay than when the margin on the product is 10%. So many times in my career I have heard a sales person say they can’t possibly raise the price because “we are getting a 40% margin!” The corollary to that is when a customer asks for a lower price on a high margin product, and the sales rep agrees, because “We can afford it.” I don’t see that on products whose list price provides a low margin. The sales reps know they don’t have much room to move, so they assume the customer is not going to demand as big a bargain.
Perhaps none of this is news to you. Sales people have limited information to figure out how much a customer is willing to pay, they perceive greater risk in asking for too much than in asking for too little, and they underestimate even more when “we can afford it.” There is money to be made in helping sales people get past that and better estimate what customers are really willing to pay. It requires a combination of better processes and tools for reps to understand the ranges of prices available to them, a better understanding of the real risk/reward trade-offs, ( and perhaps better incentives), and better tools and processes to manage exceptions, so we don’t give away discounts just because we can afford it. And in a shameless plug, Strategic Pricing Solutions can show you how to do that.
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