Guest Post: My kingdom for a horse – your literary introduction to the psychology of pricing

Think, just for a moment, exactly like a client.

You asked me to provide you with a quote for a particular legal service – one that you are relatively unfamiliar with. You have just received a copy of the firm’s terms of engagement and a fee quote that tells you that the work will cost £10,000 and is payable within 28 days of the final bill being issued, which is estimated to be in two months’ time.

Do you have any questions for me?

‘A horse, a horse! My kingdom for a horse!’

Richard III, Act V, Scene IV – William Shakespeare

How does one successfully value a kingdom? It all depends on the context. Perhaps the only time a horse could be valued more than a kingdom would be when the horse represents the difference between living and dying. Of course, some kings would rather die than give up their kingdoms in exchange for their lives, which takes us neatly into the heart of the pricing debate. How much anything, whether a product or a service, is worth, essentially depends on what someone is willing to pay for it at a given moment in time. While the numbers are important, understanding the psychology of pricing can make the difference in achieving the best outcome.

What do we mean by the psychology of pricing? Take a coffee shop loyalty card as an example. Coffee shop A offers one free coffee for every ten stamps collected. On the first purchase, the first stamp is collected, leaving just nine more until the free coffee. Coffee shop B offers one free coffee for every 12 stamps collected. On the first visit, just because it’s the first visit, the first three stamps are collected, leaving just nine more until the free coffee. There is no significant difference between the taste and cost of the two coffees or the location or environment in either shop. In both cases, the customer needs to purchase nine more coffees to receive a free coffee. However, when they look at both cards in their hand the next day, they perceive that they are only 10% of the way to the free coffee at shop A, but 25% of the way there at shop B – ‘3 out of 12′ looks like greater progress than ‘1 out of 10′. In most cases, the customer decides to return to shop B, simply because they perceive that they are closer to the final goal.

As a brief follow on to the example, some coffee shops realised that it was quicker to pre-stamp their cards so that they could just be handed over on the first visit. However, personally stamping the card in front of each individual customer (especially when explaining that they were giving the customer three stamps because it was their first visit) further increased the likelihood that the customer would return to that shop, simply because of the psychological ‘reward’ that they experienced on that visit.

‘Have you figured out what you’re going to say to your board when they realise you paid me $30m more than others were offering?’

Thomas Crown – The Thomas Crown Affair (1999)

In 1867, America bought Alaska from Russia for the sum of $7.2m. Was this a good price to pay? Given the size of Alaska, this sizable sum worked out at just two cents per acre. Significantly at the time, Russia was glad to sell it (they thought they may lose it in future wars anyway) and most Americas were generally positive about the purchase. Of course, the cost of maintaining and policing the land was likely to far exceed the purchase price, but this was an ongoing cost, rather than a lump sum. Time has shown than perhaps America got the better of the deal, since the oil and minerals subsequently discovered under the land have proven to be incredibly valuable, but then again. Then again, maybe Russia didn’t exactly lose out, because they received $7.2m for land they may otherwise have lost for nothing (or more accurately, lost while incurring the costs of trying to defend it).

Staying with the US for a second tale, in 1626, Dutch Colonists bought Manhattan for 60 guilders (roughly $1,000). If that sum had been invested for the 390 years since at an interest rate of 4%, that would equate to $3.75bn today. Although a large sum in isolation, it is far less than Manhattan would be worth today. That does not mean that the seller necessarily had a bad bargain, since at the time of sale, the land was completely undeveloped. However, if the purchaser could have got an interest rate of 6% over the 390 years, the 60 guilders would now be worth around $6trn, suggesting the seller would have got the better of the deal.

An early example of value-pricing saw Christopher Columbus agree with Queen Isabella of Spain that he would be entitled to 10% of all revenues from all lands that he discovered. Unfortunately for the explorer, the Queen subsequently failed to honour this part of their agreement, but had she done so, his personal return would have been far greater than under almost any other pricing strategy he could have proposed.

‘Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result: happiness. Annual income twenty pounds, annual expenditure twenty pounds nought and six, result: misery.’

David Copperfield, Chapter 12 – Charles Dickens

Cost-based pricing (understanding what it costs to produce a product or service and then pricing the product or service to achieve more than this in return) is an important part of pricing. It is not surprising that the prevalent method of pricing legal services is based around cost-based pricing derived from the billable hour. However, cost-based pricing should be just part of the overall pricing picture. The following example is overly simplistic, but should serve the purpose:

Imagine a piece of complex tax advice that the partner estimates will take 75 hours of fee earner time to complete. The work will be split between four fee earners (a trainee solicitor, a junior associate, a senior associate, and the partner) at an aggregate fee earner rate of £300 per hour. Therefore, it will cost the firm £22,500 to do the work. The partner wants to achieve a profit margin of 40% on the work. Accordingly, the partner values the work at £31,500, which the client agrees to pay.

Assuming the fee earners complete the work on time, they will generate £9,000 in profit (ie the 40% profit margin). However, if the complex tax advice saves the client £10m, would it not make more sense to charge the client 1% of the amount saved? In this case, the firm would receive £100,000 for the work, which would deliver profit of £77,500 (a profit margin of 344%). Paying £100,000 for just 75 hours of work might seem like a lot, but paying just £100,000 to save £9.9m sounds like a great deal.

Is this not overcharging? We can fall into the trap of thinking this, particularly when we compare the potential £100,000 against either the cost of doing the work (£21,500) or the value of the work at a 40% margin (£31,500). However, what really matters are the rules, which for the UK are contained in The Solicitors (Non-Contentious Business) Remuneration Order 2009 and Civil Procedure Rule 44.4 and in the US are contained in the American Bar Association Model Rule 1.5. Without going into the detail, these rules essentially indicate that firms should take into account a range of factors when pricing their services. In addition to the cost of doing the work, such factors may also include: the importance of the work to the client, the complexity of the work, the urgency in which the work needs to be completed, and the results achieved.

‘To create value for your business, you need to create value for your clients. To sustainably create value for your clients, you need to create value for your business.’

Value Proposition Design, Chapter 2 – Alex Osterwalder (et al)

In the legal services market, where the use of the correct terminology (or indeed, even a misplaced comma) can make a huge difference, it is perhaps unfortunate that economists use the term ‘price discrimination’ for a concept that is inherently valuable to legal businesses and the clients they serve.

An example of price discrimination involves setting different prices for related services based on what different groups of clients are willing to pay. The simplest example is a flight to New York. A student may wish to make the trip during their vacation and be willing to pay up to £500 to travel in economy. An executive may need to take the same flight for a business meeting and be willing to pay more than three times to travel in business class. A successful businessman may prefer to pay even more again for the luxury of first class travel. In all three cases, the individuals will leave the UK at the same time and arrive in the US at the same time but have chosen to pay very different prices for the same flight. Where does Premium Economy fit in? Premium Economy was the most recent class of air travel to be created, based on an analysis of price discrimination that revealed that a number of passengers were willing to pay more than economy prices for a more comfortable flight, but unwilling to pay for all of the benefits of flying in business class.

‘Highly irrational, but highly predictable’

Validatum – Richard Burcher

Pricing involves decision-making on behalf of the firm (what to offer) and on behalf of the client (what to accept). While most people believe that they take decisions rationally, most are also unaware of the hidden traps in decision-making that can lead them to take completely irrational, but highly predictable, decisions.

The following are just examples of some of the psychological elements to consider when setting (or indeed accepting) a price. Each element can be considered in isolation, but should also be considered in combination with the other elements.

Anchoring – In a non-commoditised business (which still covers a significant proportion of legal services), clients generally do not know what a particular service is worth and it can be difficult for them to compare the value of one service to another. The first price that a client hears essentially provides an anchor against which they compare all subsequent offers. If a client receives an initial quote for £2,000 for a piece of work, it will be a challenge (although not necessarily an insurmountable one) for another firm to win the work with a quote of £10,000. The second firm may have greater experience in that area, a stronger reputation, similar clients willing to give testimonials, more favourable payment terms … the list could go on. The simple fact remains that if the anchor is considerably lower than the price that the second firm offers, it will take them greater effort to win the pitch than if they had pitched first.

Framing – The value that clients place on a product or service is subjective and can be influenced by context. Understanding different alternatives and framing the price in relation to those can be a useful technique. A mug of Twinings tea may be priced at £2.50 in a local coffee shop. While a consumer could purchase a box of 40 tea bags from the local convenience store for the same price, they could not enjoy a single hot cup of tea until arriving back home. In addition to the time element, the menu frames the price of the tea against the price of the other hot drinks on offer, such as coffees range from £1.80 for an espresso through to £3.80 for a latte macchiato.

Perception – One decision-making element that plays in favour of pricing higher is that higher prices are generally perceived as signifying greater value. If one were to see a designer bag advertised for £20, an automatic assumption would be that it was a fake. By comparison, seeing the same bag advertised as a limited edition for £1,000 may compel some people to buy it, even in preference of a very similar (but regular) edition of the same item priced at £500.

Decoys – Offering a client a choice between three prices not only helps the client to pre-commit to paying the price they agree on (based on the psychological factor of them having personal involvement in ruling out two of the three options), but also enables the firm to subtly direct the client towards one of the options. A simple ratio is 3:4:8. Imagine a matter that it is difficult to value price. Based on the billable-hour and 40% margin, the price will be £3,000. The second price on offer could be £4,000. The extra value might be explained by offering an additional meeting to explain the details, a quick review of a related topic for the client, or another ‘value add’ option. (The firm could even offer the client the choice of which one of the three additional benefits they wanted.) The third offer is then the premium priced at £8,000. This additional cost should be justified in some way (perhaps by offering all of the additional services that the client could choose between under the second option). All of the additions need to be achievable should the client choose this option, but the real reason for proposing the £8,000 is that it makes the £4,000 price more appealing than the £3,000 price. If the only two options proposed were the £3,000 and the £4,000, most clients would go for the cheaper option – the more expensive option of the two is not obviously the more valuable). However, when the decoy £8,000 option is also offered, four times out of five, the client will chose the £4,000 over the £3,000.

Time – Time can be a useful point of leverage both in terms of the delivery of the product or service (you need only think of the delivery date options on Amazon), but also in respect of payment terms. Time-based delivery only works if the firm can be certain of delivering the product or service on time or provides the client with a form of guarantee in case the firm fails to deliver on time. Alternative payment terms (eg offering a lower fee if the client pays up front for the work) can be useful for reframing the pricing discussion without focusing on discounts or premiums based on the service delivered. Depending on the firm’s financial terms, alternative payment terms may even represent a discount to the client while being of net benefit to the firm.

‘The purpose of psychology is to give us a completely different idea of the things we know best’

Paul Valery

The above introduction to the psychology of pricing is no more than a brief introduction. There are a wider range of different pricing models than any one person may first think of, from the most obvious (fixed fee, completely bespoke, and percentage of value generated) through to those less common in the legal sector (freemium, bundled packages, and advance commitment) and many more besides. While cost-based pricing based on the billable hour can be a starting point, placing too great a reliance on the billable hour will leave significant value on the table to the detriment of the firm and the firm’s clients.

Think, just for a moment, exactly like a client.

You asked me to provide you with a quote for a particular legal service – one that you are relatively unfamiliar with. You have just received a copy of the firm’s terms of engagement and a fee quote that tells you that the work will cost £10,000 and is payable within 28 days of the final bill being issued, which is estimated to be in two months’ time.

Do you have any questions for me?

Richard Hinwood is the head of strategy & chief of staff at Withers. This article initially appeared on Adam Smith Esq