You are right. Pricing is mostly psychology. There is a lot of sophisitcated math and analysis that goes on, but that's mostly a sideshow. The real action is in the psychodrama that goes on between "cost plus" and "whatever we can get away with" (which is more politely termed "what the market will bear") which are the floor and ceiling of "minimum to make it worthwhile for me" and "laugh all the way to the bank."

You can do the math on the limit points, but the range is usually so wide that the interior is the fun part.

Things like the well-known $X.99 effect are just the tip of the iceberg of pricing psychology.

In the early days of a new product, it's all psychology because there's no good data on expected volume, but for products that can't scale smoothly, you HAVE to assume a volume to develop your infrastructure. This usually goes wrong in one direction or the other. The Segway famously undershot its projected volumes by an order of magnitude.

In later days, the incumbency effects of the initial pricing persist. We don't realize this because overpriced and underpriced products/services tend to go out of business, or redefine/rebrand themselves off our radar, so the accidentally right-priced survive, creating a survivorship bias in favor of rational pricing. Once you mature into a right-price range, you can further optimize your margins, but hitting "roughly right" in the first place is a matter of inspired guesswork (helped along by psychology) coupled with luck.


You see the impact of pricing irrationality when structural changes happen. For example, books are pretty much the most weirdly priced objects in existence, because of two forces: the returns model, and the huge variances in volumes sold. Yet, whether it sells 1000,000 or 10,000, two business books will end up being priced around $20 - $30 hardcover. Probably $24.99 or $29.99. So margins are all over the place, and when a disruption like the Kindle hits, everybody complains about the new $9.99 price.

I've seen this process from the inside. When we published a book at our last company, we looked for pricing data, and we did our volume simulations and our "cost plus" and "what the market will bear" estimates. No use. We ended up debating the different psychological perceptions of $8.99 vs. $14.99 and so forth.

The biggest reason this happens is that when you start, you simply have no idea how to price your product/service because you don't know how big you can get, and when you'll be able to trigger different economy-of-scale changes. Cost structure changes like a downward staircase, as you do focused, diminishing costdowns (this is called "driving down the cost curve" but it is more of a staircase, with each step taking serious creativity). But volumes (and therefore revenues) change erratically and if they are growing at all, you can only estimate the very noisy growth rate with averaging over several weeks or months.

So given this uncertainty, you set a very conservative cost-plus price that imitates a comparable product (you pick a comparison point that at least meets your cost-plus lower limit and design your marketing around that price positioning). Then you scramble to adjust prices and lower cost structures. Cost structures can be driven down based on your creativity and industry fundamentals. Price reductions are set by industry expectations. If you are peddling electronic hardware, you'd better plan on driving your price down in accordance with Moore's law, no matter what you are selling, because the market expects that.

Temporary pricing control strategies, such as "introductory offer" pricing can help you estimate the demand curve coarsely in the early days, but you usually need the "final" price to run the offers psychologically speaking. Saying "introductory offer, 70% off list price" is far more effective than "introductory price, $10, price will go up dramatically in 3 months, so get it now." One way to get around this is to make the nominal list price ridiculously over the "what market will bear" price, and then just permanently live on the discount curve. That's what infomercials appear to do.

Things can get irrational in consumer goods, but you have to get to truly expensive enterprise and government products to see "insane" in pricing. Every major fighter aircraft project in the history of the USAF is an exercise in pricing madness. The program starts with a planning number for aircraft to be built, and the design is optimized around the economics of that fleet size. Then of course, politicians gradually reduce the order number, and move the design out of its economical range, and you get small numbers of ridiculously overpriced and over-engineered aircraft...