Applying Behavioral Economics To Retail

Recently, the McKinsey Quarterly published a brief article titled “A marketer’s guide to behavioral economics“. The author recommends four strategies for marketers, all inspired by research in behavioral economics.

Behavioral economics is, of course, a large and established field of academic research, complete with a Nobel Laureate (Daniel Kahneman). The academic work has been popularized in a number of books (examples: Nudge, The Winner’s Curse) over the past decade.

In my previous work at ProfitLogic/Oracle as well as my current consulting work with retailers, I have been on the lookout for opportunities to help my clients exploit these findings. Sadly, I have not come up with anything that isn’t already well-known or already being applied.

Against this backdrop, I was curious if the McKinsey article had new insights to offer; something that I could make Monday Morning useful for retailers.

Let’s take a look at the four recommendations from McKinsey.

1. Make a product’s cost less painful

In almost every purchasing decision, consumers have the option to do nothing: they can always save their money for another day. That’s why the marketer’s task is not just to beat competitors but also to persuade shoppers to part with their money in the first place.

Retailers know that allowing consumers to delay payment can dramatically increase their willingness to buy.

Even small delays in payment can soften the immediate sting of parting with your money and remove an important barrier to purchase.

Useful, yes. Novel, no. This is well-known to retailers as indicated by layaway plans, “no payments for 6 months” etc.

2. Harness the power of a default option

The evidence is overwhelming that presenting one option as a default increases the chance it will be chosen. Defaults—what you get if you don’t actively make a choice—work partly by instilling a perception of ownership before any purchase takes place, because the pleasure we derive from gains is less intense than the pain from equivalent losses.

An Italian telecom company, for example, increased the acceptance rate of an offer made to customers when they called to cancel their service. Originally, a script informed them that they would receive 100 free calls if they kept their plan. The script was reworded to say, “We have already credited your account with 100 calls—how could you use those?” Many customers did not want to give up free talk time they felt they already owned.

This is interesting and useful for some industries but I couldn’t think of a way for a retailer to act on it. If you have any ideas, do let me know.

3. Don’t overwhelm consumers with choice

When a default option isn’t possible, marketers must be wary of generating “choice overload,” which makes consumers less likely to purchase.

Large in-store assortments work against marketers in at least two ways. First, these choices make consumers work harder to find their preferred option, a potential barrier to purchase. Second, large assortments increase the likelihood that each choice will become imbued with a “negative halo”—a heightened awareness that every option requires you to forgo desirable features available in some other product. Reducing the number of options makes people likelier not only to reach a decision but also to feel more satisfied with their choice.

This is well-known and is the so-called “assortment breadth” problem.

Retailers will be the first to agree that

  • if you have too few choices, consumers won’t even notice the product
  • if you have too many, consumers may turn away from buying the product
  • there’s an optimal zone somewhere in the middle

To make it Monday Morning useful, we need to systematically quantify what the optimal number of choices is, for each product category. But this is not easy due to the number of confounding factors.

Seasonal variations in demand, inventory stockouts, store-to-store variations in demand, and the effects of price cuts and promotions all affect consumer behavior and it is very difficult to isolate the effect of just the assortment breadth on demand so that the retailer can act on it.

4. Position your preferred option carefully

Economists assume that everything has a price: your willingness to pay may be higher than mine, but each of us has a maximum price we’d be willing to pay. How marketers position a product, though, can change the equation.

… marketers sometimes benefit from offering a few clearly inferior options. Even if they don’t sell, they may increase sales of slightly better products the store really wants to move.

… many restaurants find that the second-most-expensive bottle of wine is very popular—and so is the second-cheapest. Customers who buy the former feel they are getting something special but not going over the top. Those who buy the latter feel they are getting a bargain but not being cheap. Sony found the same thing with headphones: consumers buy them at a given price if there is a more expensive option—but not if they are the most expensive option on offer.

This is not widely practiced and hence potentially useful. Making it Monday Morning useful doesn’t seem that hard either: when planning a product range, many retailers follow what’s known as a “good-better-best” pricing strategy: an entry-level, affordable item, a moderately-priced, sensible item and a high-quality, expensive item. To this, they can add an item that’s (say) 50% higher in price but only slightly better in quality/features than the current highest-price product.

After reading this section, I searched for academic work on the topic and stumbled on a real gem: a paper titled “The Effect of Product Assortment on Buyer Preferences” by Stanford Professor Itamar Simonson.

I highly recommend the paper if you can get your hands on it (unfortunately, it is behind a paywall). It is fascinating and a really fun read. Prof. Simonson describes numerous neat examples – here’s one:

Williams-Sonoma, a mail-order and retail business located in San Francisco, used to offer one home bread maker priced at $275. Later, a second home bread maker was added, which had similar features except for its larger size. The new item was priced more than 50% higher than the original bread maker. Williams-Sonoma did not sell many units of the new (relatively overpriced) item, but the sales of the less expensive bread maker almost doubled.

Overall, I got something useful from the McKinsey article and the Simonson paper. Next step: run it by my clients and see what they think. I will keep you posted.


20 thoughts on “Applying Behavioral Economics To Retail”

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  4. Hey Rama,

    Here is an example from a jetlite (the jetairways low cost carrier, was sahara before) flight I was on a couple of days back. They sell various skymallish items onboard using an auction mechanism. In addition, they also have a “lottery” for various items that you “win” using a sccratch card. You pay a flat Rs. 599 for any item you win and pick it up at a counter at the airport after you deplane. These items are regularly priced according to the brochures at upwards of 1-2K Rs. Of course, every scratch card wins something!. Something must be working as I saw people queue up at the counter to pick up their winnings after the flight.


  5. Re: the default option — restocking fees charged by some retailers (eg. electronics/computer parts) when a customer returns an item, seems to have a similar effect. They are usually willing to waive the restocking fees when the customer purchases another item of same or greater value. Obviously the original intention of this fees was to offset costs in getting the returned item back on the shelf.

  6. On Amaresh’s point … the balance is between intrusiveness & entitlement. I’d hate to get a free credit card since I am not sure what the fine print is – and credit card companies are not charitable by any means!!!

  7. This is actually practiced in “stealth” as opposed to explicitly by some Indian Retailers (at least that’s my interpretation – so you correct me if not) – where you give the customer a sense of entitlement (who does not want to be “entitled” right?

    Say someone buys the 2nd best trouser (the 4th point is amazing & true – use to apply to me when I wanted to look like I have made it “materially”!) … and walks to bill – you tell him at the counter that he is already got a custom handkerchief set and whether he would like a custom cufflink for x $

    Or you buy a Refrigerator and when setting the bill are told that you have been credited with a Rs.200 Voucher to get “custom vegetable bins” – and then lead them on?

    Have I got this correctly?

    I would believe that the best use of this will be in the entertainment, travel & hospitality industry OR wherever there is “re-usable” inventory and repeated compulsory contact between the customer and the seller. So the phone credits example is quite default

  8. Satish,
    Thanks for your comment.

    The idea of looking for inspiration in the bazaars of the world certainly makes sense and I agree it is only a matter of time before electronic tags become commonplace.

    While “global price visibility” would be very useful for consumers, I suspect that sellers will be reluctant to supply their prices to you since it directly commoditizes their products and may hurt their brand image. The exception to this may be the lowest-cost players (e.g., Wal-Mart) who are likely to win the price-comparison contest.

  9. Your note on behavioral economics and your summarization of the McKinsey were a great read!

    To look for something “new” or “untapped”, it may be worthwhile to draw inspiration from the fish markets and the bazaars of the world where competition is red-hot! I have also had the opportunity to participate in a mock trading session at the pits of the Chicago Merc. The place resembles a fish market with its open outcry system and a lot of visual indicators of competitive behavior and buyer behavior.

    So, where can we draw some parallels and look for “untapped” potential in retail using this analogy? What if I, as a mall anchor store operator, have a camera eye view of my competitor’s shelves (and vice-versa)? What if I, as a consumer deciding to go between two mall anchor stores, can get a real-time view of store-specific prices (not the online prices!) for certain comparable items across multiple anchor stores, especially when the price can vary from minute to minute. This may not be immediately applicable because retail prices at the store don’t change that dramatically on a real-time basis due to tagging issues. However, given the advancements taking place in electronic price tags, I see this happening really soon!

  10. @Amaresh: Thanks.

    The credit card example is a good one, particularly since it doesn’t cost the bank anything UPFRONT. I’d love to find an analogue for retail. I will check out the white paper.

  11. @vibhu:
    Thanks for the comment. I feel that conditional coupons (e.g. $20 off any spend of $50 or more) are not really an example of the “default option” strategy since shoppers benefit only if they spend. I feel that an offer has to be no-strings-attached for it to harness the power of the default option. Pure $x gift coupons are certainly a good example but they are used very infrequently due to the expense.

    I fully agree with your observation about the ad hoc nature of how these promotions are designed. “Coupon design” would be a valuable service. I am less worried about the optimization compared to the difficulty of predicting the response for a creatively designed coupon. I suspect that experiments will be needed to assess the response since historical data typically won’t have enough variation to build a good model on.

  12. Re: 2. Harness the power of a default option

    First of all – this is great blog Rama. You can probably see from the number of readers 9int his small niche of a field) you have that you’re def doing something right!

    A quick thought on ‘default option’ as summarized above. A way to action this is what Retailers are already doing – promos/discounts in the form of a $$ gift certificate. So instead of a x% discount promotion – a Retailer could provide $Y gift coupons – which some already do. I see folks going to the store to ‘cash their coupon’ more than they would if the store just offered x% off.

    The analytics action item here would be to:
    + Measure lift due to such coupons and compare to measured/computed lift due to other type of discount like markdown or promotion. you can then compare all sorts of metric associated with this type of promo.

    + Another – potentially more complex option – is to offer ‘coupon design’ as a service. One could optimize several ‘conditions’ that apply to the $$ coupon – merchandise/location, discount $$, customer type etc. The complexity could come from – how many attributes can actually be measured & how to optimize/restrict the potentially large search space.

    Retailers already offer promos like “$20 gift coupon for any T-Shirt purchase” to certain loyalty customers. It appears that the design is currently done ad-hoc or intuitively. If one can add analytics to it & show potential impact/measure results – it would be a great value add service for promotions – which already form a bulk of retailers incentive $$.

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