The problem with digital goods is it is easy to get confused by its economics, the marginal cost is $0, selling a unit to customer does not make it unavailable to another and there are challenges in restricting use. This has led to supposedly new branch of economics, “economics of free and abundance”, led by Mr. Chris Anderson and has built a large following.
I have written several articles on the need to sell the value and not focus on the marginal cost. In the digital world matching price to value is more difficult than it is in physical world. Economist Brad DeLong from UC Berkeley (my alma mater) writes in his 1999 paper titled, Speculative Microeconomics for Tomorrow’s economy,
In many information-based sectors of the next economy, the purchase of a good will no longer be transparent. The invisible hand theory assumes that purchasers know what they want and what they are buying so that they can effectively take advantage of competition and comparison-shop. If purchasers need first to figure out what they want and what they are buying, there is no good reason to assume that their willingness to pay corresponds to its true value to them.
When customers do not exactly know what they want and the value they get, the marketer will find it hard to make a value proposition and charge a price that captures that value. Difficult does not make it a good reason to give up on charging for digital goods and give it away for free.
In a Nov 1998 article in Harvard Business Review, economists Hal Varian (also from Berkeley now at Google) and Carl Shapiro wrote (Harvard Business Review, 00178012, Nov/Dec98, Vol. 76, Issue 6)
But there is a practical way to set different prices for basically the same information without incurring high costs or offending customers. You do it by offering the information in different versions designed to appeal to different types of customers. With this strategy, which we call versioning, customers in effect segment themselves. The version they choose reveals the value they place on the information and the price they’re willing to pay for it.
It takes us back to what Ted Levitt said about customers buying holes and later what Clayton Christensen said about, “what job is your customer hiring your product for?”. The difficulty in value calculation comes from focusing on the “drill” and not on the “hole”. If marketers focus on what the customers really want and what job they are hiring the digital information for it becomes easier to tease out the value to customers and how it differs across segments. Then the marketer can target the segments with specific versions and position it appropriately to capture a share of the the value through effective pricing.
Fads like freemium, freeconomics and economics of abundance can help to sell books or speaking engagements but as Hal Varian (who was described by Mr. Chris Anderson as someone who taught him more about economics than any of his professors) said in 1998 (full ten years before the fads):
Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data.
Probably Mr. Anderson missed this class.
The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.
In the Alfred Hitchcock film 39 Steps, the opening scene features a stand-up act by a man introduced to us as Mr.Memory. People paid money to come to this show. He was someone who had committed at least 50 facts per day into his memory and could answer any audience question. The questions range from the distance between Winnipeg to Manitoba to baseball statistics. Today we do not need Mr.Memory nor do we appreciate committing facts into memory. We have Google, or bing or the next big search engine.
If you look closely at Mr.Memory’s act it was still an entertainment act. If it was a rote regurgitation of facts the audience would not have paid good money to get there. He was witty and the audience was laughing. Mr.Memory would have bombed if the audience were bored or laughing at him instead of at his jokes.
Google or not, data, information and facts have always been available to those sought them. Data might not have been free or there were transaction costs but was available. People protected data as if the value is intrinsic to the data. Value is not intrinsic to data. Value is created from the insights one derives from these to serve a market and gain upper hand over the competition.
There is a quote that was attributed to Sam Walton (I cannot verify the authenticity): “I am not so much afraid of someone stealing my data as someone can make better decisions with it than I can”. Whether or not Sam Walton said this the statement holds true.
Mr. Memory may not have job today but he knew then that his advantage came from doing something different with the information – delivering entertainment that competed for customer wallet share against other forms of entertainment.
Do you, as a decision maker, just seek data for its own sake or create actionable insights that deliver profits?
From big businesses to home based businesses there is an uncontrollable desire to allocate a share of the total cost to every unit of product sold. It is actually surprising that some of the small businesses do elaborate calculations just so they can allocate a share of the mortgage, insurance, delivery vehicle etc. This is from the NYTimes story on new entrepreneurial craze – Cupcake stores:
For each cupcake she sells, Ms. Lovely figures she spends 60 cents on ingredients, 57 cents on mortgage payments and utilities, 48 cents on labor, 18 cents on packaging and merchant fees, 16 cents on loan repayment, 24 cents for marketing, 18 cents for miscellaneous expenses and 4 cents for insurance. That totals $2.45, leaving a potential profit of 55 cents on each $3 cupcake.
It is not difficult to see that Ms.Lovely’s elaborate calculations are based on volume sold, so any changes in number of cupcakes sold will affect her cost allocations. Only the ingredients and labor costs are true marginal costs (you could argue even those don’t count as MC). For a cupcake priced at $3, that gives a contribution margin of $1.92 which all add up to defray the fixed costs of mortgage, insurance taxes etc.
So when volume drops and the margin drops below 55 cents will Ms.Lovely increase price of her cupcakes? Will the market pay for it?
Padding marginal costs with cost allocation combined with the percentage margin obsession will lead to incorrect pricing that is unrelated to what the market is willing to pay and lost profits or even the end of your business.
I saw a notice posted on the external doors of an ice rink that said,
Please close the doors behind you otherwise the rink will fog up
I did not stand around to measure how many followed the advice and whether this number was better than what it would have been if the sign had simply asked “Please close the door behind you”. But other people have done such studies.
In the book Influence: The Psychology of Persuasion (Collins Business Essentials) author Robert B. Cialdini narrates the work done by Harvard Social Psychologist Ellen Langer on the power of the word “because”.
People simply like to have reasons for what they do.
It does not matter how relevant or meaningful the reason is. The word “because” made the difference in people accepting your request. This isn’t to say that giving reasons for requests works universally but it does help to reduce resistance.
Take the case of price increases. When a marketer pushes through price increases without extending any reason customers resist those increases and perceive the price increase as unfair. But if the price increase were justified with a reason, a greater number of customers will accept it. In their paper titled, Perceptions of Price Fairness, researchers Gielissen, Dutilh,and Graafland validated the hypothesis that price increases justified with cost arguments were perceived to be fair by customers.
Ellen Langer’s and Cialdini’s work point to another possible reason for customer acceptance of higher prices – it is not the justification itself but the mere presence of one. This opens up opportunities for both B2C and B2B marketers to re-price their offering or capture greater value without turning away customers – just give a reason.
We see that in the earnings results of CPG brands that used commodity price increase in 2008 to push through their price increases.
Another case is for two-part pricing – asking customers to pay an upfront fee and then a per unit price. Examples are mobile phone activation fee or registration fee charged by services. These upfront fees are nothing but pure profit for the marketer and find customer acceptance when justified with reasons, however trivial, like processing fee or registration fee. For B2B case, a marketer can charge additional upfront price with reasons like customizations or order processing.
Just give a reason! – “We are increasing prices otherwise we will go out of business”
I should note that this is a pricing tactic and not a strategy – if your strategy is wrong, any number of fine tuning tactics, even with reasons, are not going to help.
Footnote: It is a good idea to A/B test your reasons even though Cialdini and Langer say the specific reason is immaterial.
The question of, “Why all movie tickets are priced the same?” have been studied at length*. Economists express surprise at how primitive movie pricing is and how sub-optimal it is to charge the same price for all the movies. Marketers are surprised by the absence of basic tenet of marketing – segmentation and targeting, positioning the product and capturing value. Movie ticket pricing are indeed a greenfield for practicing price discrimination offering large un-captured consumer surpluses and value from price sensitive moviegoers.
Most pricing recommendations for movie theaters ask for
- Higher pricing for weekends
- Higher pricing based on mega budget films with stars
- Higher pricing in the opening weeks and then reduced pricing (like Hardcover, softcover books pricing)
These methods were usually pushed aside because of the logistics of implementing them ( Movie Mystery. By: Hessel, Evan, Forbes, 00156914, 1/29/2007, Vol. 179, Issue 2) or complexity in estimating weekend box office sales. Others offered conventions as the reason for not adopting variable pricing at movies.
To be fair, movie theaters do practice price discrimination. They sell the morning shows at a discount bringing price sensitive customers who are willing to make the trade-off (Second degree). They give discount to students (Third degree). They sell discount tickets through supermarkets that can be used after the first two weeks (Second degree).
But the basic question remains, when everything else is held constant except for the movie itself, why are the tickets for two different movies priced the same? For example, at an AMC multiplex the 4PM screening of two new animated movies, Planet 51 and Fantastic Mr. Fox, are priced exactly the same $10.75. Fantastic Mr. Fox is based on a book by renowned children author Roald Dahl (a very good book if you have not read alrady) and Planet 51 is a slapstick comedy of reverse ET. Why can’t these be priced differently? Why cannot movie theaters practice price discrimination across movie titles?
The answer, I believe, lies in utility customer gets from different movies. Movie theaters can charge different prices for different movies only if the customer utility and hence their willingness to pay varies across different movies. Stripped to the barebones, all movies are perceived as the same by customers – these are all entertainment. In other words different movies are simple horizontal product line extensions.
Based on the marketing study that found horizontal product lines are perceived identical by customers and hence have no difference in customer willingness to pay I hypothesize that customers will not accept pricing that varies across movies.
While pricing different movies differently is not possible, movie theaters can and do charge different prices when the movie varies in format or experience like 3D and IMAX 3D. For example, AMC charges $11.75 and $12.75 for 3D and IMAX 3D shows of Disney’s Christmas Carol. This is possible because the 3D shows are vertically differentiated and the perceived value to the customers vary from the baseline version.
The net is movie theaters cannot increase profits by pricing different movies differently but can do so by offering vertical differentiation in the form of 3D movies (of course this is not under the control of theaters but the studios), better seating (practiced in most other entertainment venues) or better experience (specific auditoriums with better speakers).
Footnote: Other movie ticket pricing references
- Movie Mystery. By: Hessel, Evan, Forbes, 00156914, 1/29/2007, Vol. 179, Issue 2
- Why Popcorn Costs So Much at the Movies: And Other Pricing Puzzles by Richard B. McKenzie (p157-163) (My review of this book here)
- Why are all movies the same price? – Marginal revolution
- Antitrust and Pricing in the Motion Picture Industry. Yale Journal on Regulation Summer2004, Vol. 21 Issue 2, p317-367, 51p
- The Wisdom of Crowds by James Surowiecki (p98-102)
Hormel Chili reported increase in profit despite drop in revenues. Unlike all previous CPG cases we saw last quarter, Hormel’s profit came exclusively from cost reduction. In fact they failed to capture larger profit because of the price cuts.
Their revenue declined 10% on a volume decline of 3%. This means their prices dropped on the average by 7.2%. That is pure profit given away in he form of promotions and lower prices while the customers really were not looking for it. Their frozen food line saw 8% price erosion (revenue fell 9% on a 1% volume drop).
The good news is Hormel knows it and definitely is going to fix it. Hormel Chairman and Chief Executive Jeffrey M. Ettinger said,
Although we are pleased with our earnings, we experienced disappointing sales in the fourth quarter,” he said, citing in part lower pricing for its pork and turkey products and planned production reductions at its Jennie-O Turkey business, which is in the middle of a turnaround.
They can only go so far with cost reduction, but their current lower price offers bigger headroom for profit growth. If Hormel improved its prices by 5% and if their volume fell by about the same amount, their revenue may not grow as much but their profits will increase by $64 million, that is 60% net income growth from 5% price improvement!
If the stock market really follows profits over market share, we should expect Hormel stock to heat up.
Much will be said and written about the reported news that Mr. Murdoch is close to signing a deal with Microsoft (source NPR), disallowing Google from searching and indexing his company’s content and getting paid by Microsoft for the search access. We will hear more about how content is free or wants to be free, how it is commoditized and how people can get free content from somewhere else. The most vocal proponent of them all, Mr. Jeff Jarvis, described WSJ’s move as, “it is suicidal”. At the other extreme, Mr. Murdoch described Google as, “stealing my content”.
The truth, however, lies somewhere in between.
On the content wants to be free argument: This is an extreme position treating all contents as the same and treating all customers the same. The value of content is in the minds of the customers and it varies across segments. For instance, my WTP for WSJ opinion pieces is $0. There are news articles that add no unique value and hence by definition are commoditized. While other articles, even thought they have high value, fail to capture value because of alternative free means of accessing these articles (WSJ articles can be accessed for free through Google searches).
On customers don’t want to pay for content: It is a widely accepted notion that customers do not want to pay for access to content. There is no basis to these and any marketing research studies done are not rigorous enough. This is the very definition of Conventional Wisdom, and going against it will be seen as disastrous move.
On “it is suicidal”: It definitely is not. WSJ still makes a great portion of its revenue from paid subscriptions. It takes a lot more Ads and CPM to get the same amount of revenue. For someone running one of the top sources of business information we should give WSJ the benefit of doubt that they did the revenue models and calculated loss of revenue from Google traffic. If they were not monetizing much of current traffic, it is not a devastating loss and it offers future revenue potential from subscriptions.
On the stealing argument: This is another extreme claim. What is true is Google can and does monetize search results with search Ads and it does not share those revenues with WSJ or with any other source. One thing Google or other search engines do is lowering customer’s reference price for the articles, preventing WSJ and others from capturing value. It is not that far off for Murdoch to get recover some of that by asking Google and Microsoft to pay for indexing access.
On charging for content: Charging for content starts with value, communicating that value, and protecting that value through reference prices. How can you credibly communicate value of a newspaper or a Journal? WSJ is taking the approach of showing what is possible from reading, sometimes even drawing suspect causations based on correlations. Another example is Elsevier, which is communicating value of its online journals articles through by making (again somewhat suspect) causation arguments showing new research grant. Both WSJ and Elsevier may be using causation argument when none exist but they are trying and spending resources on creating the value proposition while most others do not even know how to communicate theirs.
This is not a battle between Murdoch and Google or other search engines, this is the beginning of the efforts by content producers, those who create value, to capture their fair share.
Ann Taylor reported their Q3-2009 went up despite drop in sales. Their gross margin went up by $7.7 million while their sales fell by $64.8 compared to same Q3-2008. Kay Krill, President and Chief Executive Officer, commented,
Our results for the quarter were a direct result of our strategy to maximize gross margin performance by tightly managing inventories, focusing on full-price selling and controlling costs. I am pleased that our performance also reflects the cumulative benefits of our ongoing restructuring program initiatives.
I have been writing all along about the need to cut promotions, focus on protecting pricing and practice effective price management to deliver profit growth. But I am not fully convinced that price increase contributed to Ann Taylor’s profit growth. In fact they may have lost more than they gained from price realization and any profit growth was a result of their cost cutting. I will focus on the gross margin number when I say profit in this discussion.
Ann Taylor cut down on promotions and focused on charging full-price with the net result of increase in average prices. Another measure is inventory control. Total inventory per square foot at the end of the third quarter of 2009 was down 20.7% versus year-ago. If we assume (see note below) that this reduction can be equated with drop in volume of the same level, from the revenue change and volume change assumption we can compute that the average price increased by 10.6% (See end of this post). In other words 1% increase in price resulted in 2% drop in volume (price elasticity 2).
Their percentage gross margin was 48.8% the previous year.
Loss of profit from drop in volume (due to increase in prices) = 20.7%*48.8% = 10.1% of Q3-2008 revenue
Increase in profit from 10.6% price increase = (100%-20.7%)*10.6% = 8.4% of Q3-2008 revenue
This is a net loss due to drop in volume. Since their profit in Q3 2009 increased YoY, the profit increase is entirely due to cost control and other effectiveness measures in merchandising.
So did Ann Taylor make the right decision to improve prices? Could they have delivered higher profit by keeping their promotions and price levels? Unless there is a strategic reason to preserve brand premium and long term profit, this price increase was not a profit maximization move.
Footnotes:
On the volume drop assumption, this could be wrong because sales volume is a flow metric while inventory was a point metric. But this is inventory per square foot of store, so it is a good stand in for volume. Another possibility is that a portion of the 20% reduction is to respond to volume that is already lost due to recession (demand curve shift). If the price elasticity drops to 1 or low, then yes the price increase makes perfect sense.
Calculating price increase :
R = P * Q; (P2/P1) = (R2/R1)*(Q1/Q2) (R2=$527, R1=$462, Q2 = (100%-20.7%)*Q1)
Price: $98
Price: $119
WSJ is now selling bike jerseys. More than the design what is interesting is their decision to offer two versions at two different price points. Short sleeve at $98 and long sleeve at $119. This is an effective versioning strategy, recognizing that different customers have different needs and willingness to pay. They created two versions at two different price points to match the segment’s needs and capture value. If one price is good, two are better.
This type of versioning is what I describe as vertical product line extension. Another option for WSJ would’ve been to introduce multiple different designs (say with different “news stories on the jerseys”). That is horizontal versioning.
Marketing studies show customers’ willingness to pay varies along the vertical dimension and does not vary along the horizontal dimension.
What does it mean to a marketer?
Versioning can translate into multi-price points and higher profits only if the value to the customers varies across them. Simply creating multiple colors is not versioning. Each customer has different willingness to pay but a marketer cannot capitalize on that through horizontal versioning.
When decision makers, people, press, stock analysts and armchair analysts (I will include myself here) are all used to seeing decisions being made one way, any time they are asked to make or see a decision being made the other way their immediate reaction is to describe it as risky, wrong or crazy.
It is crazy to raise prices in recession: Almost everyone wrote off Starbucks for increasing prices now.
It is risky to cut on inventories: NYTimes described the move by luxury retailers to cut inventories as risky.
It is stupid to give up market share: Almost all stock analysts ding companies that give up market share to maintain price premium.
If it does not fit the conventional wisdom it must be wrong.
In his book The Affluent Society, Galbarith first introduced the concept of Conventional Wisdom. He wrote,
In the never ending competition between what is right vs. what is merely acceptable, even though strategic advantage lies with the former all tactical advantage is with the latter. Acceptance comes from convenience, because finding what is right is hard and not convenient. Ideas that are familiar are easy to accept because everyone does it and end up having great stability.
Decision making is not a popularity contest. If it is just about following what is accepted, familiar and convenient where is the competitive advantage? I want to quote again from the NyTimes Magazine story,
“The numbers either refute my thinking or support my thinking,” he says, “and when there’s any question, I trust the numbers. The numbers don’t lie.” Even when the numbers agree with his intuitions, they have an effect.
“It’s a subtle difference, but it has big implications. If you have an intuition of something but no hard evidence to back it up, you might kind of sort of go about putting that intuition into practice, because there’s still some uncertainty if it’s right or wrong.”
Knowing the odds, [redacted] can pursue an inherently uncertain strategy with total certainty. He can devote himself to a process and disregard the outcome of any given encounter.
Do you trust data over convenience and gut feel for decision making?
When the pricing per unit is not uniform across all units and varies with quantity purchased, it is called non-linear pricing in economics. There are two main reasons a marketer will practice non-linear pricing:
- Customers have decreasing marginal utility with every additional unit and the price must change to reflect the reduced value. So if you are a maker of bottled water, you price your single bottle at one price and multi-pack at different price.
- Another reason is to reflect your decreased cost to serve the customer who buys high volume. Suppose you made and sold physical components, like the glass pane for LCD panels any customer buying high volume helps to defray many different costs and contribute to large proportion of your revenue and profits so you give a discount
Should you always decrease the price with volume? Non-linear does not mean prices will only decrease with quantities purchased, price per unit can increase as well. There are three primary reasons for this:
- The value to customer increases non-linearly with the quantities they buy. For example, a $10 Mbps Internet connection enables new services that are of higher value than that is possible with a 7Mbps connection.
- The cost to serve the customer increases non-linearly after certain limit. For example, there is need for new investments or new costs that need to be passed along to the customer.
- Allowing the customer to consume high quantities comes at higher opportunity cost in the form of lost sales.
The third reason is exactly the case with cellphone providers. In a NYTimes article on Cellphone pricing plans, economists (surprisingly) described this as “weird”
“The whole pricing thing is weird,” said Barry Nalebuff, an economics professor at the Yale School of Management. “You pay $60 to make your first phone call. Your next 1,000 minutes are free. Then the minute after that costs 35 cents.
”To economists, it simply doesn’t make sense to make chatterboxes pay that penalty. After all, most businesses tend to give discounts to customers who buy more.
It is not weird if you look at how cellphone networks are provisioned. The way said cellphone pricing plans are structured is called three-part tariffs. At any given coverage area, served by one Radio Base Station, there is limited capacity. At any given time only so many users (voice or data) can be supported. With all pre-paid subscribers a cellphone provider can size their system accordingly knowing how many total users they can support and based on call model how many simultaneous calls they can support.
Admitting a user to consume radio capacity beyond their allocated minutes will come at the expense of not providing service to other paid customers. Charging a higher unit price per minute will discourage those heavy users and nudges them to upgrade to next subscription level. When more such customers upgrade the cell phone provider can make additional investments in capacity.
There is nothing weird in not rewarding your high volume buyers. Cost reasons aside, if the value to the customer increases non-linearly your price should increase non-linearly as well, to capture a fair share of that value.
This is my recommendation:
- Hard Facts, Dangerous Half-Truths And Total Nonsense: Profiting From Evidence-Based Management by Jeffrey Pfeffer and Robert I. Sutton
- Marketing Imagination, New, Expanded Edition by Theodore M. Levitt
- The Strategy and Tactics of Pricing: A Guide to Growing More Profitably by Thomas T. Nagle and John Hogan
- The Affluent Society by John Kenneth Galbraith (if you can’t read the whole book just read the chapter on Conventional Wisdom )
In a seminal work titled “How the questions shape the answers” published in American Psychologist (1999), Norbert Schwarz describes how responses are influenced by question wordings, format and context. Schwarz writes,
“Self reports a fallible source of data and minor changes in question wording, question format or question context can result in major changes in the obtained results”
This is especially a more pronounced problem when it comes to survey questions that ask customers for their willingness to pay (WTP) for a product. When you directly ask a customer questions like:
- will you buy this product at 10?
- how much will you pay for product? a) $4 b) $8 c) $10 d) $10 e) $12
- will you buy this product if this were not offered free any more?
The researcher run the risk of getting answers that are not in any way a true representation of what the customers will actually do. These kinds of questions assume that customers know how much they value the service and customers are willing to disclose it. Another flaw in WTP studies is treating customer WTP as a fixed number in the minds of customers while it has been shown to be malleable (Thomas and Menon, Journal of Martket Research, 2006).
I saw a report from Forrester research on US customer WTP for online newpapers. I admit I have not read the report but only their promotional blog post about it. The report claims 80% are not willing to pay for content From what I read I am not satisfied with study or its methods. The survey question was:
If the Web sites for the newspapers and magazines you read were no longer free, how would to prefer to pay for that content?
- Wouldn’t access them if I have to pay
- Subscription access to access all online content
- Subscription that combined print, web, and mobile device access
- Individual payment for each article read
The biggest flaw I find is anchoring – the question clearly reminds that the content has been free. The question was too generic, asking about newspapers and magazines you read and not about a specific newspaper or magazine. The respondents could be thinking of all newspapers, even those they read occasionally while answering this question. There were no questions reminding respondents of value they get or to rank the online news sources by importance. If the question had been,
If your most favorite newspaper cannot financially support the free online access, would you be willing to pay in one of the following ways?
- Subscription access to access all online content
- Subscription that combined print, web, and mobile device access
- Individual payment for each article read
- Wouldn’t access them if I have to pay
… the results would have completely different.
Based on their survey, Forrester recommends:
- Publishers should continue to offer free, ad-supported products to the 80% of consumers who won’t pay for content online; and
- Publishers should offer consumers a choice of multichannel subscriptions, single-channel subscriptions, and micropayments for premium product access.
I do not agree. Even if we assume the 80% number is correct, does providing free provide higher profit than charging? Do newspapers rally want higher reach (because of the Ad revenue)?
If a newspaper publisher really wants to find customer willingness to pay for content they need to do more targeted study of their readers, use methods like Conjoint analysis to tease out the segments, how much customers in each value the product and focus on methods that help improve customer reference price before charging for content.
The net is the results are unreliable and Forrester’s recommendations are plain wrong.
