Impact Pricing Podcast

Ep168: Behavioral Economics: The Psychological Side of Pricing, the Secret Sauce to More Sales with Gerald Smith

Gerald Smith is a Professor of Marketing at Boston College. He’s been a Pricing Consultant with Strategic Pricing Group and Monitor Group since 1987. Gerald is the author of a relatively new book, “Getting Price Right: The Behavioral Economics of Profitable Pricing”.

In this episode, Gerald discusses the power psychology holds in pricing in relation to behavioral economics as he talks about the soft side of pricing alongside the importance of framing.

Why you have to check out today’s podcast:

  • Find out what the hard side and soft side of pricing are all about, and why the behavioral side of pricing is more powerful than the logical side
  • Understand why companies do framing, as well as why a frame of reference is important in pricing
  • Discover why there’s power in psychology when talking about behavioral economics

“Ask yourself and ask your pricing team, what do customers get and what do they pay for what they get? And say, is everybody in the industry doing it the same way?” 

Gerald Smith

           

Topics Covered:

01:39 – The start of Gerald’s pricing journey with Thomas Nagle and Reed Holden

03:08 – Gerald talks about his dissertation in relation to his new book, Getting Price Right

04:33 – The behavioral/soft side as potentially more powerful than the logical side

06:39 – The main point of Getting Price Right – the psychology of the sellers, the people that really set price

09:11 – Talking about the dominant pricing bias of salespeople giving discounts all the time

13:07 – Pricing strategy vs. pricing orientation

15:15 – Framing as one of the foundational theories of economics

18:09 – Discussion about Apple’s pricing slogan and the company having huge margins

22:45 – The power of behavioral economics – psychology; analysis vs. gut

24:12 – Talking about frame of references and setting price metrics

27:45 – Gerald’s piece of pricing advice for today’s listeners

Key Takeaways: 

“We always think of pricing as a hard skill, as a quantitative skill. My students say to me, ‘Professor, tell me the formula for setting price.’ And I say, ‘No, no, no, folks.’ I mean, pricing is a soft skill that also brings in hard skills, for sure, so there are both skill sets.” – Gerald Smith

“Sellers are also psychological and absolutely driven by psychology.” – Gerald Smith

“One of the very dominant biases in pricing is that people have a tendency to discount price all the time. It’s very irrational, and it, in fact, violates the principles of both psychology but especially economics, because economics says that people should rationally maximize the profits of the outcomes that are before them. And in the case of many people that apply this kind of discounting bias, they don’t focus on the profits; they focus on the sales, and sales are not profits.” – Gerald Smith

“Salespeople that work for somebody else are more likely to discount, but salespeople that do their own thing are less likely to discount. When they’re selling their own place, they want to make sure that they maximize their profits if they can, but if they’re selling for somebody else, they’re happy to take that deal. That’s because they get paid a commission on the deal. It is endemic to the world of pricing that people do this.” – Gerald Smith

“Psychology is powerful. Analysis is terrific, but psychology is absolutely vital.” – Gerald Smith

“Consumers or buyers give, but they also get. And so, if I can change what they get and what they give, then that can be very powerful.” – Gerald Smith

People / Resources Mentioned:

Connect with Gerald Smith:

Connect with Mark Stiving:   

Full Interview Transcript

(Note: This transcript was created with an AI transcription service. Please forgive any transcription or grammatical errors. We probably sounded better in real life.)

Gerald Smith

Ask yourself and ask your pricing team, what do customers get and what do they pay for what they get? And say, is everybody in the industry doing it the same way?

[Intro]

Mark Stiving

Today’s podcast is sponsored by Jennings Executive Search. I had a great conversation with John Jennings about the skills needed in different pricing roles. He and I think a lot alike.

If you’re looking for a new pricing role or if you’re trying to hire just the right pricing person, I strongly suggest you reach out to Jennings Executive Search. They specialize in placing pricing people. Say that three times fast.

Mark Stiving

Welcome to the Impact Pricing podcast, the podcast where we discuss pricing, value, and the irrational relationship between them.

I’m Mark Stiving. Today, our guest is Gerald or Gerry Smith, and here are three things you’d want to learn about Gerry before we start.

He is a Professor of Marketing at Boston College, and I’d like to say pricing, but we’ll see what he says. He’s been a Pricing Consultant with Strategic Pricing Group, Monitor Group since 1987, which means he got to work with Thomas Nagle; I’m jealous. And he’s the author of a relatively new book, “Getting Price Right: The Behavioral Economics of Profitable Pricing”.

Welcome, Gerry.

Gerald Smith

Thank you, Mark. Good to be with you.

Mark Stiving

It’s going to be fun.

So, how did you get into pricing?

Gerald Smith

I got into pricing when I entered a PhD program in 1987, and it turned out that I started working with a person there – as you mentioned, Thom Nagle – and Thom Nagle was in that program, Reed Holden was, as well, so I’ve known Reed Holden and Thom Nagle very well for many years. And I got very interested in pricing at that time, so for my dissertation, for my PhD, I focused on the psychology of pricing. So, Thom Nagle and others had focused on the economic side of pricing, and I did my work on the psychology of pricing. So, that’s how I got into it. Got involved in consulting work during that time, and continue to sort of keep one foot in consulting and one foot in the academic side, and doing research and so forth. So, both sides.

Mark Stiving

Nice. So, you and Thom and Reed were all students at the same time? Or was Thom a professor there?

Gerald Smith

Thom was a professor. Thom had just come to Boston University from the University of Chicago. And so, the group of us were there, they were kind of a team of four, that we’re all involved in pricing – teaching pricing – as well as researching pricing. So, Thom was involved in all of our dissertations.

Mark Stiving

Nice.

So, here’s the hard question for now. Can you describe your dissertation to non academics? What did you do?

Gerald Smith

Well, actually, you’re right. Part of the reason that I kept one foot in both worlds was that I thought it was important, in fact, to be able to translate the great research that happens in the academic setting, to translate it for people that are actually applying it in practice. And so, I have spent a lifetime doing that.

The book that I wrote and just was published last October, “Getting Price Right: The Behavioral Economics of Profitable Pricing”, is actually all about this whole idea of the psychology of pricing, and it is hugely practical. Essentially, it is about the soft side of pricing. We always think of pricing as a hard skill, as a quantitative skill. My students say to me, “Professor, tell me the formula for setting price.” And I say, “No, no, no, folks.” I mean, pricing is a soft skill that also brings in hard skills, for sure, so there are both skill sets. So, the book, and in fact, a large focus of my career has been on the soft side of pricing, as well as the hard side of pricing. And the soft side is very psychological.

Mark Stiving

Yeah. So, by the way, I agree 100% with that.

I often think – and I’d love to hear your thoughts about this – that I can break pricing- you say hard side and soft side. I’ll break it up into rational and irrational or logical and psychological. They all feel really similar to me when I describe them in those ways. And so, I spend most of my time and energy on the logical or the rational side, the economic side as you described it, and so I tend to think of that as more important, but I think the behavioral side is more fun. What do you think?

Gerald Smith

I think that the behavioral side is potentially more powerful.

For example, Steve Jobs saw a lot of pricing in the music business when people used to sell CDs and record albums, and they would sell for $20, essentially, packages of music, so many songs on a CD and so forth, and the whole industry was sort of oriented around that. I call it in my book a dominant frame of reference. And Jobs said, “You know what? All of these music executives, they’re really beset by status quo bias. They like the status quo. They’re making a lot of money the way it is.” And he said, “I think I want to break that.” So, he started selling songs for 99 cents each, right? Totally reframed price.

He introduced something called iTunes. That was sort of, you know, kind of a throwaway at the time, but actually, iTunes became the largest music reseller on the planet, and that is because Jobs reframed the price, and framing is very much a soft skill.

So, it is powerful. I mean, I think that that’s a good example of where making that simple change, and we take for granted that that’s a change. No, no, that is reframing, the way the market is willing to pay for something. And it was a brilliant strategy, you know.

Mark Stiving

Okay. So, I can’t disagree with anything you said, with one possible exception, and that is that when I think of behavioral economics, I think of it as the consumers being psychological, not the suppliers being psychological. And what you described was the supplier’s side.

Gerald Smith

That’s the whole point of the book. It’s that sellers are also psychological and absolutely driven by psychology.

For example, I described in the book a couple that owned a property in the West, in the Western United States. It was actually in the state of Utah. It was a 15 acre ranch. They went to sell it, and they asked the real estate agent, “Tell me what we should offer this for.” And the real estate agent said, whatever it was, “Sell this ranch with a house…” – they had a house on it – “and a nice piece of property for $15,000 or for $1 million.” It was $1 million. And they said, “Well, it doesn’t make sense, because there is another property right next to this that just sold for $500,000 and it doesn’t have a house on it. Are you saying that this thing is only- that the house side of this property is only worth $500,000?” And so, they said, “Go back and look at it again, and maybe we should even think about breaking this up.” He said, “No, it wouldn’t make a difference.” He said, “There’s only one way to look at that, and that is as a house, and a ranch with a house.”

So, we went to another real estate agent and said we want to break this into two properties and sell it as two properties – one as a buildable estate and the other as a ranch house. And by golly, they made another kind of 40 or 50% than they would have over the old guy. But the original real estate agent couldn’t get beyond his status quo bias. He is already investment. He said, “I kind of know how this is.” Well, he didn’t know how it was.

So, you see this all the time. You see it very much with people. And that’s the whole point. That’s the focus of my work. It’s not on consumers and the psychology of consumers. Everybody’s written about that and they know it very well. Mine is about the psychology of the sellers, the people that really set price.

Mark Stiving

Okay, I didn’t expect this. This is going to be fascinating. Thanks.

Gerald Smith

Here’s another example.

One of the very dominant biases in pricing is that people have a tendency to discount price all the time, right? Now, is that rational? People actually think that it’s rational, but in fact, it is irrational, and so, because they never consider that they would offer a higher price, or if they do, they quickly set that aside. And so, Reed Holden calls this the crack cocaine of discounting, right? So, it’s a very apt statement; it really is. But it’s very irrational, and it, in fact, violates the principles of both psychology but especially economics, because economics says that people should rationally maximize the profits of the outcomes that are before them. And in the case of many people that apply this kind of discounting bias, they don’t focus on the profits; they focus on the sales, and sales are not profits. So, it’s a big misnomer.

Mark Stiving

Yeah. So, I certainly agree that sales people are very irrational, and they tend to discount way too much.

Gerald Smith

Right. Yeah.

Mark Stiving

Relative to where they should be in terms of what’s the expected value of the sale.

Gerald Smith

They don’t ask that. They don’t ask that question.

Mark Stiving

They certainly don’t, but we would, as economists, as logical, statistical beings.

Gerald Smith

Right. Here’s a- Go ahead.

Mark Stiving

I was going to say, do you have evidence? Do you have stories of salespeople discounting too much?

Gerald Smith

Oh, yes. I’ll give you examples of discounting, and it’s actually a good example also of something called ownership bias.

So, salespeople that work for somebody else are more likely to discount, but salespeople that do their own thing are less likely to discount. Now, they still discount, but they’re less likely to.

There is a good example of real estate agents in Chicago, and this is actually quantified study, okay? So, they really followed the data on real estate transactions for 300,000, I think it was, and they found out that when a real estate agent was selling a home for somebody else, they would frequently recommend that they discount the price and sell the property faster. They would say, “You’re not likely to get a better price, so I would go ahead and take the lower offer.” But when they were selling their own house, they kept it on the market an additional 10 days, so 10 days longer, and they got a better price. Interesting.

When they’re selling their own place, they want to make sure that they maximize their profits if they can, but if they’re selling for somebody else, they’re happy to take that deal, okay? That’s because they get paid a commission on the deal, right? So, absolutely. And it is endemic to the world of pricing that people do this.

Mark Stiving

Yeah. So that story, by the way, is in the first Freakonomics book.

Gerald Smith

It is. Yeah. It’s great.

Mark Stiving

Yeah, it’s a great book. It’s a great story, and I added that story to my new book that’s coming out called “Selling Value”, and what I try to use that as an example of is why we, as companies, should be compensating our salespeople more on margin – although I really hate giving salespeople cost information – but we should be compensating more on margin than on revenue, because it more aligns the salespersons’ incentives with the company’s incentives.

Gerald Smith

Well, I agree with that, and I think that incentives are important.

So, that’s actually the psychological part of pricing. And by psychological, meaning, in my world, I talked about pricing orientation. So, we’re familiar with the idea of pricing strategy, right? Pricing strategy is what our prices should be, and we organize our company around that to set those prices as they should be, like, a value-based price is a good example of that, right? But pricing orientation asks a different question. It says, how does pricing get done around here? How does pricing get done? Who’s involved? What kind of influence do they have?

So, for example, if we have people that come from what I call “sales nation”, like from the nation of salespeople, and they speak their own language, they have their own ideas about how to set price or how to go about business, you’ll see very distinct biases, that bias the pricing in favor of what the customer is willing to pay, and that’s usually price discounting.

On the other hand, if you have somebody from finance that is highly influential in pricing, they have their own set of biases; or somebody from accounting, they have another set of biases. And so, you therefore often tend to see a great focus on margins, as you’re talking about, but in fact, margins aren’t the end-all and be-all, and neither is sales volume. It is maximizing incremental profit contribution, and that may include a combination of low prices in lots of volume, or high prices in less volume; either way. And it may be a combination of several different products that have different margins, loss leaders that drive the profit contribution of other items in the basket.

So, that’s the kind of thinking I think. Did that make sense?

Mark Stiving

Oh, absolutely. I think it does make a ton of sense when we think about how we’re going to compensate salespeople, and especially how we’re going to create our own strategies.

Gerald Smith

Okay.

Mark Stiving

I want to go back to what you started the conversation out with, and those are examples of people or companies changing industries. And I’ve always thought of changing industries more as changing the pricing metric. And by that, I mean, what do we charge for? The example that I always think of when I think of this is Netflix vs. Blockbuster, right? And they changed what we charge where we stopped renting by the night and paying late fees to paying a monthly subscription fee. How does that fit into the way you think about this?

Gerald Smith

So, in behavioral economics, it goes about this question of saying, how do people make decisions? How do they view the problem that is in front of them? And one of the foundational theories of behavioral economics is framing. What is the frame of reference that people use for making a decision? Okay? And so, I can see two options in front of me, and both are identical, except that one is framed differently than the other. Okay?

I’ll use the example in the talk that I’m giving at PPS coming up. I show two packages of ground beef, and one is framed as 85% lean, and the other is framed as 15% fat. Which would you prefer? Not only which would you prefer, but which are customers likely to pay more for? Very interesting, isn’t it? Same content, but framed slightly differently.

And so, you’re right. Companies can frame prices in very different ways, and it is a very powerful thing. Adobe used to sell software by the package, right?

Mark Stiving

Yep.

Gerald Smith

You pay $700 for Photoshop, but then Adobe decided to change in 2012 and sell Adobe Photoshop and a couple of other programs and bundled them into Adobe Creative Cloud for $74 a month. Why would you pay $74 a month? Wow. Well, that’s a lot less than $700 a year, but you’re paying it forever, right?

What was interesting about that, and this is ‘how does pricing get done around here?’ Adobe didn’t just lean on the finance people for this or the marketing people or the salespeople. They brought them all together and did this transition over a period of five years, from 2012 to 2017, and it was hugely powerful and changed the company. And today, it’s a hugely valuable company because of it.

Mark Stiving

Yeah, absolutely.

Gerald Smith

So that’s absolutely framing.

Mark Stiving

Okay. Can I ask you- I’m going to ask you the hardest question I ever asked anybody who talks about behavioral economics.

Gerald Smith

Okay.

Mark Stiving

And you seem really smart, so I’m really looking forward to the answer to this.

I often think behavioral economics is ‘how do we trick people into making decisions?’ And how would you address that? Because that just doesn’t feel right to me.

Gerald Smith

No, it’s not that at all. Behavioral economics. Economics says that people behave rationally.

Mark Stiving

Yep.

Gerald Smith

And therefore, we should all behave as economically-rational human beings, right? But behavioral economics says, “Well, you’re right. People do behave rationally, but sometimes, they don’t behave rationally as defined by economic theory.” Right? And so, in that case, you say, “Well, how do they behave? And does that make sense with how they behave?”

For example, Steve Jobs – another Steve Jobs example. This is Apple, actually. Just Apple, overall, used to have – and I think they still do – a slogan that they use for pricing. It was “55 or die”. Do you know what it meant?

Mark Stiving

I do not. Never heard that.

Gerald Smith

55% gross margins for all of our products. 55 or die. So, if you ever wondered and you were coming out with a new product, and you said, “What is our price going to be?” Well, it’s certainly going to have a margin of 55%. Wow. Okay.

Now, that is pure behavioral economics. Is it rational to have a pricing goal like that? Sure, it’s a rational pricing goal, isn’t it? On the other hand, 55 or die is pure cost-based pricing. It is taking my costs and adding a margin of 55% or having achieved a margin of 55% on the price that we sell it for. So, it was 55 or die.

Even the iPhone. I mean, Steve Jobs did a masterful job of describing his pricing logic for that. Guess what his gross margin was. The original iPhone.

Mark Stiving

Probably 55.

Gerald Smith

56%. Isn’t that interesting? Now, he never said that, but if you looked at the numbers, and I did, I looked at the numbers and it was 56%. Today, the iPhone – and I think this is still true – has margins of up around 75-80%. Huge margins.

Now, I think they still have that rule of thumb. Is that a good rule of thumb? It’s full of bias, because it’s cost-based pricing. On the other hand, it has enabled Apple to always have higher prices to justify their very good products and services. And Wall Street loves them; absolutely loves them. And today, they’re a $2 trillion company.

Mark Stiving

Yeah. So, you could think of 55 or die as “I am setting our margin floor at 55%. Your job as a company is to build products that can achieve at least that, if not way more than that.”

Gerald Smith

Right.

Mark Stiving

And so, that doesn’t feel- I often think that margin floor isn’t cost plus pricing, unless, of course, everybody works to the margin floor, and then it becomes cost plus pricing.

Gerald Smith

Well, it assumes that 55% is at least the true margin – at least the true margin – but that may not be true. I mean, Jobs started out with a 55% margin, but two or three months after that, he cut the price by $100.

Mark Stiving

Yep.

Gerald Smith

Or $200.

Mark Stiving

That was $200.

Gerald Smith

$200. He cut the price by $200, and he apologized in an ad. He apologized to the people that have already purchased iPhones, that he cut the price.

Now, why did he cut the price? Because he saw a huge opportunity in the Holiday Market coming up to drive volume with a lower price. And my point in this is that his goal was to maximize profit contribution, not margin, but overall contribution, which is a combination of volume and margin, and not short term, not just for the holidays, but long term because he thought he could establish a much better beachhead in the market. And that’s what happened.

Mark Stiving

Yep. Absolutely.

Gerald Smith

I’ve given you lots of Apple examples, but they do good pricing.

Mark Stiving

Yeah, it’s fun. But I want to go back to the question, because I don’t think you answered my question yet, and I’m going to use one of your examples to say it.

What if by writing on my package it’s 85% lean, I can convince you to make a decision that’s not good for you?

Gerald Smith

You’re right. That would be not ethical. Unethical, for sure. Yeah. And what you’re doing is you’re pointing out the power of behavioral economics, because psychology is powerful. So, analysis is terrific, but psychology is absolutely vital.

Bill Belichick, who was the coach of the New England Patriots, his philosophy was, “I always look at the analysis that my scouting team gives me and that my analysts give me.” When they look at players or when they look at teams, they say, “I always look at the analysis.” But he said, “In the end, I go with my gut.” And the gut is the psychology thing. And Jeff Basil says the same thing. He said, “You always have to rely on analysis,” but he said in the end, “The big decisions that you make in life, you go with your gut.” Isn’t that interesting?

And so, I do think that that’s true, and I think we have the ability in setting prices, as you say, to trick people, for sure. And there is an ethical part of that.

Mark Stiving

Okay. And by the way, I get it. I struggle with thinking about it. That’s all. Because I use behavioral economics all the time; we have to. If we’re going to present a price to somebody, you don’t present it in its worst light; you present it in its best light.

Gerald Smith

Absolute true. A suggested retail price is a frame of reference.

Mark Stiving

Yep.

Gerald Smith

It’s extremely important. And you set the price here, the suggested retail price here.

Here I am at Boston College University, and the suggested retail price for a year is, say $75,000. It’s a lot of money, isn’t it? But a lot of students don’t pay that.

Mark Stiving

Right.

Gerald Smith

Now, why is it that they don’t pay that? Well, because of need, because of scholarship, because of their abilities, and they come here, and so, there are prices that are all over the board, and by the way, those prices are never disclosed. Isn’t that interesting? We don’t have a menu where you can sort of pick different prices. The university sets different prices for each one, for each person, right? Is that ethical? Wow. It’s a good question. But it is certainly a powerful way of getting the job done.

Mark Stiving

Yeah. So, that is a great example of price segmentation.

Gerald Smith

It is.

Mark Stiving

At the same time, we’re signaling the quality of the education as we’re $75,000 a year.

Gerald Smith

Exactly. That’s exactly right. And so that’s why that’s vital that we do have that frame of reference, and the frame of reference might be defined in prices per package, or it might be defined in prices per month, right?

Mark Stiving

Yep.

Gerald Smith

I mean, it’s exactly that. By the way, those are, you know, if you have an industry that is all kind of barreling down one dominant frame of reference, if somebody can successfully change the frame of reference, as Jobs did with music, that can be hugely powerful and successful.

Mark Stiving

Yeah. I mentioned that I often think of those as pricing metrics – what do we charge for a fact? I could argue that that’s what Jobs did. He changed. Instead of selling an album, he sold a song. If we can change pricing metrics in our industry, we can often change industries.

Gerald Smith

Well, I think you have to think of it not just in terms of changing price, but changing the value proposition, which includes both the get and the give, right?

Mark Stiving

Yup.

Gerald Smith

Consumers or buyers give, but they also get. And so, if I can change what they get and what they give, then that can be very powerful. T Mobile is very successful today, because they reframed and they changed the metric on price, essentially, for buying an iPhone or whatever kind of phone you have. So, yeah. So, both of those, I think, are key.

Mark Stiving

Yeah, absolutely. And when I think of setting a price – we’re going to agree completely on this – but when I think of setting a pricing metric or determining a pricing metric, it’s always about how is it that my customers receive or perceive value from my products? And the closer I can come to creating a metric that’s aligned with the way they perceive value, the better chance I have at capturing more of their value, right? Of their willingness to pay.

Gerald Smith

That’s exactly right. Yeah, that’s exactly right.

Mark Stiving

Gerry, I think I could talk to you for days, and in fact, I promise, I’m going to go buy your book now, because it’s definitely different than anything I’ve heard about, but I got one last question for you.

What’s one piece of pricing advice you would give our listeners that you think could have a big impact on their business?

Gerald Smith

I would say, I’ve talked about this idea of framing, and it’s a soft skill, and I would pay attention to framing. Ask yourself and ask your pricing team. What do customers get and what do they pay for what they get? And say, “Is everybody in the industry doing it the same way?”

For example, with one client that I worked with, they’ve wrestled with the question of what should they charge for freight? Right? Freight. And it turns out that they are the largest in the industry, they’re the number one, and they charge for freight on a per square foot basis. Everybody else is charging for freight on a drop basis, meaning, you drop it, you pay a fixed fee, right? They said to me, “Don’t you think we should do it like everybody else?” What do you think I said? Of course not. You have a unique frame of reference, and it means it’s difficult for those other competitors to compare to you, and your customers, they say, wow, I mean, okay. It’s hugely important.

So, ask yourself, how do we charge? What do customers get and what do customers pay for what they get? And should it be different in any way? And when I say should it be different, meaning you might want to change the frame of reference, not for everybody, but for a segment of the market, and try that and see how that goes. It’s a very powerful concept. So, it’s chapter two in the book. It’s a good one.

Mark Stiving

Nice. Well, I’ll let you know what I think about it after I read it.

Gerald Smith

Okay, I love that. Okay.

Mark Stiving

Alright. Jerry, thank you so much for your time today. If anybody wants to contact you, how can they do that?

Gerald Smith

Boston College. gerald.smith@bc.edu

Mark Stiving

Perfect.

Episode 168 is all done. Thank you for listening.

If you enjoyed this, would you please leave us a rating and a review? Those are extremely valuable to us. And finally, our goal is to help you win more business at higher prices, so if you have any questions or comments about the podcast or pricing in general, feel free to email me mark@impactpricing.com.

Now, go make an impact.

Mark Stiving

Thanks again to Jennings Executive Search for sponsoring our podcast.

If you’re looking to hire someone in pricing, I suggest you contact someone who knows pricing people. Contact Jennings Executive Search.

Tags: Accelerate Your Subscription Business, ask a pricing expert, pricing metrics, pricing strategy

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