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Most people are uncomfortable buying either the cheapest or most expensive item available, usually preferring something in-between. Companies take advantage of this "compromise effect" by manipulating their product lines to increase sales of their most profitable items.

Lets say you sell widgets. You have a basic model that sells for $50, and you have a top-of-the-line model that sells for $200. People would feel the most comfortable buying a midrange model that sells for around $100. The idea is that the basic model is seen as cheap, while the top-of-the-line model is percieved to have only a small benefit over the midrange model (for a hefty fee).

Companies take advantage of this by inventing an arbitrarily higher-priced top-of-the-line model, thus forcing a comfortable midrange price on their customers. One well known example is attributed to Williams-Sonoma; they were able to increase sales of its $275 breadmaker by introducing a second, slightly larger model at a price of just over $400. Xerox was able to boost sales of its high-volume copier to large corporations only because it introduced a higher-priced model with a few extra bells and whistles. Xerox succeeded because they released a model that purchasing managers could feel good about rejecting.

Most salesman operate along similar lines. When they start out by suggesting a ridiculously high price, its not because they think they can get it, but rather to establish the highest possible reference point in the mind of the customer. They know they will be more successful by starting high and lowering their prices.

People who fall victim to the compromise effect are essentially tricked into thinking they got a good deal. This isn't to say that the product is worthless or that the customer is foolish for purchasing the item. Its just another way of making people feel good about spending their money.
sources:
http://www.washingtonpost.com/ac2/wp-dyn?pagename=article&node=&contentId=A41329-2002Jan26¬Found=true
http://www.disenchanted.com/

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