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Note: This post goes deeper into the fundamentals of pricing and will be of most interest to pricing practitioners.

Looking for immediate advice? Try posts in our How to Price series …

One of Ibbaka’s projects for 2021 is an open-source tool for diagnosing pricing problems. This will be added to our growing collection of offline (and soon online) tools. As part of this work, we are looking into the many different types of pricing problems and how they are solved.

Pricing problems are often a symptom of some deeper problem with value creation, communication or delivery. Price is where all of the different marketing disciplines come together and, as a result, problems that may have been swept under the carpet tend to show up in conversations around price.

It is too expensive.

Can you give me a discount?

I don’t want to pay for all that.

Can I also get …?

Why do I have to pay that way?

Most of us encounter these questions, or objections, several times a week. They all come under the general rubric ‘pricing problem’ but the root causes are often quite different. Understanding the root causes and how to diagnose them is a critical part of pricing work.

Many companies look to value-based pricing as a solution. Value-based pricing is defined in different ways. Some people try to reduce it to a willingness to pay (WTP). Others get deeper into what shapes value for different market segments. Some people worry about this loose definition of value-based pricing, but one can see also see this as a de facto strength. Loose definitions are common with design problems and are one of the things that open up space for creative solutions.

What makes a pricing challenge a design problem rather than say an optimization or execution problem?

Design process guru Nigel Cross has spent a good part of his career researching this.

Design problems are part of the general class of ‘ill-defined’ problems. An ill-defined problem is any problem in which either the starting position, the allowable operations, or the goal state is not clearly specified, or a unique solution cannot be shown to exist.

Pricing problems tend to be ill-defined because …

1. They exist within complex adaptive systems, where a pricing move by one player leads to a response by customers and competitors. Pricing plays out over a series of moves by multiple parties, each with different goals.

2. There can be multiple goals that are often contradictory (“I want to optimize for volume and revenue.”) Clarifying and reconciling goals is an important part of pricing consulting. Achieving one goal often reveals the next goal, there is no ‘pricing is now done.’

3. There are many ways to solve pricing problems, from adding value to changing the connection between the value metric (the unit of consumption by which the buyer gets value) and the pricing metric (the unit of consumption for which the buyer is charged) to modifying packages and adjusting pricing levels or discounting policy.

Ill-defined does not mean there is no reliable approach to finding a solution. Finding solutions to ill-defined problems is what designers do, and this is why so many pricing problems are best approached as design problems.

In his research, Nigel Cross has identified a general structure to how designers approach problems. There is an underlying tension between the problem goals and the solution criteria. This tension is resolved by matching the problem frame to the solution concept. The solution concept must be tested against the solution criteria. All of this is built on a deep understanding of the relevant first principles.

What are the first principles for solving pricing problems?

This is an area where practitioners have taken a rather narrow view. The starting point has been the basic economics of supply and demand. We know that this is not enough. The market forces that set the prices for commodities in markets where there is perfect, symmetrical, information does not help us to ask the right questions when it comes to pricing.

The solution to the shortfall of basic economics has come under the general rubric of value-based pricing. There are the basic principles of value-based pricing:

1. Value is relative to an alternative

2. Value has economic, emotional, and community components

3. It is the differential value (the value that alternatives do not provide) that gives pricing power

4. Differential value differs across segments

5. Value-based pricing connects the value the customer receives to the price paid

This is a good start, but to develop deep expertise we have to ask pricing designers to go deeper.

One area that has been getting a lot of attention over the past few years is behavioral economics and its offshoot behavioral pricing. This approach applies the lessons from behavioral economics and prospect theory to pricing design. It gives us ways to think about …

• Framing and anchoring effects (What will the price be compared to?)

• Loss aversion, or the preference of many people to reduce risk rather than maximize profit (of course there is a segment of the population that shows the inverse behavior)

• Present bias, most of us would rather get rewards now than later

Behavioral pricing gets us beyond value-based pricing to apply the frame of how people make decisions to pricing design.

This is not enough though. To really go deep into the first principles for pricing design one needs to understand pricing in a larger context. The first way to do this is by thinking about pricing as a complex adaptive system (CAS).

A complex adaptive system is a system that is complex in that it is a dynamic network of interactions, but the behavior of the ensemble may not be predictable according to the behavior of the components.

Thinking about pricing, at a high level the components of the system are the buyer, the seller, and the competitor or alternative. In many industries, such as healthcare, regulators are also part of the system. The market mechanisms, by which buyer and seller find each other, and in some cases through which prices are set, can also be part of the system. Pricing design takes place in this context.

This does not go deep enough though. Each of the functions generating value, the value drivers expressing that value (economic, emotional, and community), the packages assembled for different market segments, the fences that direct buyers to a package, and the value and pricing metrics, can all be understood as a system of interacting parts. We need to understand these interactions in order to price effectively.

Of course, people are complex and understanding those complexities is where behavioral economics (really a part of psychology) and game theory (one of the foundations of cognitive psychology) come in. Pricing design goes a lot better when we can pull ideas and frameworks from these disciplines, We discussed this a bit above for behavioral economics. Some of the insights from game theory are that

• Rewards depend on the actions other people take

• The best strategies are very different for open-ended games, where players will interact many times, and single-play games (most B2B pricing is open-ended)

• There are ways to shift pricing from being a zero-sum game (where one person wins the other must lose) to positive sum games (where both players win)

We have written a bit about pricing and game theory here.

As we all know. Pricing is not ‘once and done.’ Pricing is something that changes over time in response to competitive conditions and market needs. It has many of the characteristics of an evolutionary system. Not much work has yet been done on applying concepts from evolutionary theory to pricing, but this is a rich area to explore. Pricing can be a frozen accident ( a term from evolutionary theory) where a sub-optimal solution is adopted and then kept over many generations. Successful pricing models need to be able to compete against themselves, indeed, one way of understanding a mature market is when the successful pricing models have chased the alternatives into small niches and are primarily competing with similar offers and pricing.

Pricing as a design problem

Designers are solution-driven. Our job, after all, is to come up with solutions. We use solutions as a way to clarify problems (that good designers use solutions, rather than theory, as a key way to clarify ill-defined problems is one of the most important findings from Nigel Cross’ research). Pricing solutions generally go well beyond the simple setting of a number. They are based on understanding the market segmentation and customer journey, they include the package and offer design and value communication, and then the core design goals of connecting the value metric (the unit of consumption by which the buyer gets value) to the pricing metric (the unit of consumption for which the buyer pays).

Many of the key processes for design are relevant to pricing work and pricing consultants need to be able to work with them. Some of these have been mentioned above.

• Customer journey maps are valuable tools in pricing design, so long as value delivery, communication, documentation, and capture are layered in

• The design thinking process of empathizing, defining, iterating, prototyping, and testing is relevant to pricing design

• Patterns are important, and understanding the key pricing design patterns and being able to combine and evolve them is part of the work

Design involves new skill sets for many pricing consultants. But they are skills we all need to cultivate. Ibbaka’s research on pricing practices will help bring the design-erly way of pricing into clearer focus.