The psychology of a discount

October is upon us — ushering in that enchanting season when we find ourselves ensnared by an incessant siren call: sales! Whether you're strolling by shops, navigating the labyrinth of online retail, or succumbing to the gravitational pull of TikTok's scrolling vortex, price-based promotions are inescapable at this time of year. Discounts are a ubiquitous marketing tool, applied across all types of products and industries.

The allure is clear, even to the casual observer: consumers have a soft spot for a bargain. On the surface, the equation is simple: lower the price, and a stampede consumers will surely follow. It's the capitalist dream, isn't it? More sales = more money. But of course we know when prices dip too low, they start circling the drain toward zero. So while discounts may seem like a foolproof strategy to grab a larger slice of the market, most businesses harbor a faint hope of turning a profit at some point.

This begs the question: what is the optimal discount? Furthermore, how does price influence a customer's decision to buy, and how does it stack up against other motivating forces? To solve this riddle, marketers must turn to consumer psychology and behavioral economics.

The three types of prices

First, it’s important to define price in the context of discounts and promotions. There are three important types of prices that contribute to a consumer's purchase decision: reference price, reservation price, and asking price.

Reference price

This is a nebulous benchmark occupying your customers' minds as they consider a product. Some items have a specific reference price, while others summon a more generalized or vague idea.

Imagine, for example, the coffee you order every morning from the same café. You might have a strong reference price based on your past experience.  You might also have a strong reference price when evaluating products you’ve researched extensively - such as cars, appliances, and houses.

But when you buy produce at the grocery store, however, your reference price may be more vague—a bag of clementines usually ranges between $1 and $1.50 per pound. If you see But when you buy produce at the grocery store, however, your reference price may be more vague—a bag of clementines usually ranges between $1 and $1.50 per pound. If you see clementines listed at $2.20 per pound, you might feel that they’re overpriced.

If you see clementines are listed at $0.25 per pound, you might have the thought that clementines are a great deal this week. Reference price is the lodestar by which consumers navigate their purchasing journeys. Yet, it can be problematic - derived from imperfect knowledge, incomplete information or misapplied context. Your past coffee orders have sculpted a firm reference price - you know that coffee shouldn’t cost any more than $2-$3 per cup.

'But then you find yourself at a specialty coffee store or chain, lured in by your desire to see if the pumpkin spice latte is actually worth the hype. Upon ordering your dairy delight, this misapplied reference price plunges you into a realm of sticker shock and may cause you to change course.

Five strategies to address consumer reference price when framing your discount:

• Show the original price when offering a discount.
• Include one very expensive item of the same category alongside more popular, reasonably priced items
• Include the price of similar products from more-expensive competitors
• Order items from highest price to lowest (e.g., on a menu board)
• Display the price near a larger number for perspective.

Reservation price

Reservation price is defined as the maximum amount a customer is willing to pay for a product or service. When a reservation price is well-known, it often converges with the reference price.

But reservation prices are influenced by many factors. That’s because consumers don't make purchase decisions based on price alone, but rather on their perception of the utility of the purchase. Utility is driven by the customers budget (the reservation price), expectations (the reference price), and cost (the actual or asking price, discussed next). But utility is also defined by the total value extracted from the purchase. This can be hard to quantify.

Additionally, there are other factors — convenience, desire, craving, available energy, and processing capacity among them — that might cause a customer to accept an asking price that is above their preconceived reference and reservation prices.

Because this is dependent on so many factors, increasing it is difficult — but here are some additional strategies to navigate around it

• Emphasize the quality of the product or service
• Differentiate the product or service with a compelling unique selling or value proposition
• Bundled items, features, or services to add additional value to the purchase
• Use social proof messages to increase the amount of satisfaction a customer expects
• Increase perceived urgency by making the product scarce or limiting the time a discount will be available

Asking price

As we already mentioned, the third type of price is the actual asking price. This is the price that the business demands for the product or service. Obviously, this is the price that marketers have the most control over. However, constantly lowering the asking price will eventually lead to a product priced at or below margin. Lowering the asking price has several other undesirable effects on consumer attitudes and behaviors towards the product and the brand.

The important thing to keep in mind in the context of promotions, is that how you price your products communicates volumes to your customers.  A product that is priced below all other competitors sends a signal that it may be cheaper, but is likely of lower quality.

A product that is perennially discounted will ultimately change your customer’s reference prices for the product. A common product that is more expensive than competitors without a clear unique selling proposition will seem overpriced. However, shift the value proposition and all of the sudden, your price may suddenly seem reasonable and appropriate.

None of these effects are inherently bad. Rather, they simply illustrate the influence price has on consumer perceptions and the importance of determining price and planning your promotions with intention.

What behavioral economics says about discounts & consumer behavior

So by now you know the 3 types of prices: reference price, reservation price, and asking price. Based on these definitions, it’s clear that a customer's perception plays a critical influence on their understanding of price, value and therefore, willingness to purchase.

There are a ton of academic studies on this evolving dance - all driven by behavioral economics. Behavioral economics is a field that combines insights from psychology and economics to understand how people make decisions - including buying decisions. There are many principles Anchoring suggests people often rely on the first piece of information they receive when making decisions.

When setting discounts, the reference price (anchor) can heavily influence your audiences’ perception of value. For example, showing a higher original price before displaying the discounted price can make the discount appear more significant.

Loss aversion: People tend to weigh potential losses more heavily than equivalent gains. When offering discounts, framing the discount as a way to avoid losing money or missing out on a deal can be more effective than framing them as gains. For instance, "Save $50" can be less persuasive than "Don't miss out on a $50 discount."

Scarcity and urgency: A psychological cousin to loss aversion! Creating a sense of scarcity or urgency can prompt customers to take action. Limited-time offers, countdown timers, or statements like "Limited stock available" can tap into this principle. Customers may feel compelled to buy sooner to avoid missing out.  

‍Endowment effect: People tend to overvalue items they already own. Offering a discount can make customers feel like they are "gaining" something, even if they are just paying less for it. Emphasizing the potential ownership or use of the product can capitalize on this principle.  Probably the most iconic example of the endowment effect at play is the mattress industry’s broad application of offering 100-night free trials to new customers. By the time the trial ends, customers feel an attachment to the product, making them more likely to keep their purchase.

Social proof: People often look to the behavior of others to guide their own decisions. Highlighting customer reviews, testimonials, or the popularity of a product can influence potential buyers, particularly when faced with many items to choose from. Leveraging social proof can be as simple as relying on influencer-generated content for social media ads, as seen in the below example. Another tactic that draws on this principle would be featuring "Best Selling" items or "Customer Favorites." For higher priced items, using social proof effectively can also raise a customer’s pre-conceived reference price.

Decision fatigue and choice overload: If you offer too many choices, customers will become overwhelmed and are mostly likely to not purchase anything at all. Combat this by offering a limited number of well-structured discount options to reduce decision fatigue and make it easier for customers to choose.

‍Processing fluency is distantly related to choice overload. This principle says when it is easy for people to understand and interpret information, it makes them feel better about the product they are considering. In the context of promotions, this means that discounts that are easy to understand (and mentally calculate!) leads to happier prospects that are more likely to purchase.  Some common tactics for this include ordering prices such that the lowest are on the left and the highest are on the right to make the series easier to read. Using color or text effects to support easy comparisons, and increasing the size or visual salience of important information to make it stand out.

‍Bundling: Combining products or services together and offering a discount for the bundle can make the overall purchase more appealing. This approach leverages the principle of perceived value and can encourage customers to buy more.

Gamification: Adding elements of gamification, such as loyalty programs, rewards points, or referral bonuses, can encourage repeat purchases and customer engagement. These strategies tap into the pleasure customers get from achieving goals and earning rewards.

‍The battle between dollars and percentages

‍We know that how a discount is presented can significantly impact its perceived value. A common question is whether price promotions should be presented as an absolute discount (e.g., "$2 off") or a proportional discount (e.g., "20% off").

Framing discounts in terms of percentages can make them seem larger and more attractive. Research has found that both of these approaches increase sales. Getting into the nuances of the studies reveals that discounts expressed as percentages may be more effective overall, but dollar-based promotions have more sway over discount-hungry customer segments. Ultimately, this is something you should test heavily among different customer cohorts and across different types of promotions before concluding one way or another.

The path forward‍

Look at any online purchase journey and you'll immediately note that there are often many behavioral economics principles at play at the same time. Applying the optimal combination of behavioral economics principles requires further research and disciplined testing to understand what motivates different sets of customers to make a purchase.

It's important to note that the effectiveness of the application of these principles can vary depending on the specific context, audience, and product. We always recommend testing and analyzing the impact of different behavioral economics principles through A/B testing, customer research and feedback to refine your approach over time. In the end, discounts are a powerful tool when wielded effectively, but their impact goes beyond just lowering prices.

It's about shaping consumer perceptions, influencing purchase decisions, and ultimately, building lasting relationships with customers. As peak season beckons, marketers that have a deep understanding of customer behavior, have planned carefully, and have a library of experiment data to inform their discount strategy will be better equipped to thrive in the competitive holiday season.