Walk away, don’t play chicken with Amazon

I do not know why businesses refuse to learn from the past and why they insist they are different from all others who came before them. Admit it now, it is okay, no business can take on Mr. Bezos and Amazon on price leadership at the low end. Don’t get into the ring. Don’t wage a war. It won’t be a war, it will be quick skirmish in which  you will be thoroughly destroyed and forced to issue statements like,

“it was an experiment and we achieved what we set out to achieve”

This time the brave new knight to get into price war with Amazon is OverStock.com. They announced a daring campaign – a promise to sell books 10% below Amazon. Not just match prices, which would have been a signal to Amazon to not drop prices but sell 10% below. And what did Amazon do? GigaOm reports

Amazon is quietly slashing its own prices on print books. In a special report over the weekend, trade publication Shelf Awareness noted that Amazon has begun “discounting many best-selling hardcover titles between 50 percent and 65 percent, levels we’ve never seen in the history of Amazon or in the bricks-and-mortar price wars of the past.”

These are far greater than the usual 40-50% discount Amazon usually does. Where does that leave OverStock.com? Is it ready to sell below the 65% discount Amazon offers?

When it comes to price setting there are two kinds of companies – Price Setters and Price Takers. Apple is a Price Setter at the high end. Amazon is the undisputed Price Setter at the low end. A rational low end Price Setter may look at cost advantages to maintain leadership. But Amazon is no rational player. At least that is what they want all of the market to think.

Amazon has adopted a deliberate irrational strategy, signaling others they are not going to play by someone’s rational expectations.  You should be careful in waging price wars with such irrational players.

if you are playing a game of chicken in cars, if you were to break the steering wheel and toss it out the window in front of your opponent then he knows you are not going to swerve. (source: Art and Science of Negotiation). That is strategic irrationality.

In the game of chicken played in retail prices, Amazon is such a strategically irrational player. Mr.Bezos has signaled to all other players that he has thrown away his steering-wheel and placed a brick on his gas pedal. They are not going to let up on lowering prices and they can keep at it as long as they can because they have the full trust of their shareholders.

Even this morning CNBC’s David Faber was talking about Amazon stock prices and investor behavior. Even after Amazon reported a loss its stock did not suffer much. Faber quipped, “may be Amazon should have reported larger loss so its stock could have gone  higher”.

In 1999 Barron’s magazine warned investors about Amazon. Then its market cap was $19B, now it is $141B.  Amazon practices strategic irrationality while investors seem to be equally irrational, strategic or not.  There is no expectation what so ever from investors on profit.

Let me repeat my advice. Don’t bother. Don’t get into price war with Amazon. Walk away. You are not going to dismantle Amazon as Price Setter at low end. Instead focus on customer segmentation, product mix and differentiation. You have far better chance of succeeding there because your competitors there are far more likely to be rational.

Finally, let me predict something for Google Nexus 7 – the next Kindl Fire is going to force it to slash prices.

Amazon Price Discrimination Done Well

I wrote a while back about price discrimination and its bad rep. It is actually not all bad. My attempt to rebrand it as price harmonization did not catch on. The right kind of price discrimination is offering multiple versions at different price points so customers will self-select themselves to the version they want to pay.

Like you pick retina display with MacBook Pro or SSD disk over HDD. This is second degree price discrimination. With price discrimination, as long as you do not restrict customers from choosing certain versions and let them choose any of your versions then it is perfectly acceptable.

The success of second degree discrimination also depends on packaging and pricing the cheapest version such that it helps bring-in low-end of the market without being attractive to those who would gladly pick the higher priced version had there not been the cheaper version.

Amazon has a product that very nicely executes second degree price discrimination, while also capturing a little bit extra consumer surplus from one of the genders. (Yes, pure gender based price discrimination is bad but I will show you why in this case it is not the case.)

Take a look at the 3 versions of the same model of GPS watch.

The first version

base-gpsThe base model without heart rate monitor costs you $147.35 (at a discount of $52.64). If you want heart rate monitor to go with the black model, it is sold separately for $45, bringing the total to $192.35.

Now the second version

red-gpsIt is the red model with included heart rate monitor, priced at $184.91. That is $7 cheaper than black base model plus heart rate monitor add-on.

Why is the drab base model priced such that its combo price is more than buying bundled red model? Because they are targeting the base model  at low-end customers with lower willingness to pay.  And if some of those insist on heart rate monitor with that color they likely value it more hence have higher willingness to pay and should pay $7 extra over the bundled red model.

Also note the list prices of the base and red models – $199.99 vs. $229.99 – a difference of $30. But how they are discounted is much different from the $30 difference. You would expect discounted price of red model to be just $30 over black base model. Instead it is $37.56 over base model. In other words the amount Amazon has to discount to make the sale goes down as they move up the model.

That is $7.56 in profit from effective pricing.

Finally, the pink one

pink-gpsThe pink model, arguably a choice targeted only at women, is $1.22 more than the red model. But still cheaper than black combo.   Nothing prevents men from buying it so the pink model pricing is not at all a gender based price discrimination. But helps to capture additional consumer surplus from women who most likely will buy it. (I am succumbing to stereotype here! Sorry!)

So is $1.22 a big deal? For the razor thin per-product margin Amazon operates at and the volume it does, it most likely does. The $1.22 flows directly to their net-income.

Overall a very fine management of pricing.

But don’t attempt this at your business – most businesses, especially small businesses and startups do not have the volume, data and computational wherewithal to fine tune pricing to this level. Worse, most are not even in the right zipcode to attempt any such fine tuning.

Ask me what your business should do instead!

 

 

 

Waging Price Matching War

In game theory they talk about deciding your move based on what rational opponents would react. A variant of that strategy is to convince your opponent that you are no where near rational so they better not expect you to do the rational reaction to your action.

For example if you are playing a game of chicken in cars, if you were to break the steering wheel and toss it out the window in front of your opponent then he knows you are not going to swerve. (source: Art and Science of Negotiation). That is strategic irrationality.

In the game of chicken played in retail prices, Amazon is such a strategically irrational player. A recent BusinessWeek article screams

Amazon’s Jeff Bezos Doesn’t Care About Profit Margins

Mr.Bezos has signaled to all other players that he has thrown away his steering-wheel and placed a brick on his gas pedal. They are not going to let up on lowering prices and they can keep at it as long as they can because they have the full trust of their shareholders.

The right move in this game is not to do exactly the same and agreeing to match prices. But other retailers don’t seem to get it.

Target is the latest retailer who decided to play the price matching game not realizing their opponent’s stated irrationality. Target announced they will match all Amazon prices if customers can show proof.At least, unlike BestBuy’s mistake of making it easy for customers to get the price match, Target has added manual steps for customers. But that isn’t enough to stop the bleeding – either customers will do that additional work or simply go to Amazon.

If one player in a market says they will match any lowest price in the market the rational move for others is not to lower their prices because they get no advantage from it and only erode their margins. But Target is not dealing with rational player.

Fundamentally, by agreeing to match Amazon prices, they are saying their store provides no unique products, no unique value and  is undifferentiated from an online store. The right strategic move would be to ask,

“what unique value the store provides to its target customers and what is the right product mix that makes the customers buy from them”.

Even if this would result in severe revenue reduction – because they end up eliminating many products from their shelves – in the long run it would help make Target a profitable venture.

Instead they chose to play the game of chicken with with an opponent who has given up on steering.

This isn’t going to end well for Target. Circuit City here we come.

Price Setters and Price Takers Revisited

Let us recap.

If you can set the price and defend it against competition you are a price setter. Premium price or bargain price does not matter. As long as you can defend it because of your product’s (perceived) differentiation (among your target segment) or because of your cost advantage you are a price setter.

If your pricing is a reaction to an existing competitor then you are a price taker.

In the tablet space, big or mini, Apple and Amazon are price setters but Google is a price taker.

In my September article in GigaOm I analyzed the profit implications of iPad mini for Apple. Making a case against $199 lower-end iPad mini I wrote this about price setting:

If Apple is the price setter in the premium tablet category, Amazon is the price setter in the low end. Entering this segment would mean becoming the price taker or making an effort to become a price setter with a different price point.

By design, Apple has never been a price taker. In any market, the price setter gets to control its  own profit while a price taker is at the mercy of market forces. Trying to become a price setter when there already is one requires Apple to either go low or just a bit higher. Either way, Amazon has set the price anchoring. The most likely scenario is a $299 price point for the iPad Mini.

The real pricing came in at $329. In other words Apple chose not to be player in the low end market because it realized Amazon as the unshakeable price setter in that category and chose a segment where it can be the price setter.

Price Setters will thrive and go on to create significant value over long term.

Price Takers will be relegated to the footnotes of history.

Moving from Free to Fee: Follow-up to End of Freemium

You gave away your product for free, betting on other ways of monetizing your users. Sooner or later you realize that the promise of other revenue streams do not materialize. Your free users remain freeloaders. The success stories reported in tech blogs turn out to be the lucky ones and even among those it is highly likely they succeeded despite freemium not because of freemium. Like I wrote in my last article in GigaOm you too recognize freemium has run its course.

You decide to charge for what you used to give away for free. How can your free product make the successful transition to fee, overcoming user backlash?

First let us look at categories of free. One, products that we have come to expect to be free and feel entitled to getting these free. Two, products that we used to pay for but became free or products we see as optional.

 Free as mom’s love: Entitlement Category

Probably entitlement is the wrong word to use given the political times but examples will make it clear. To see a classic example of this let us go back 70 years and revisit a service that was started during World War II.

During World War II, the Red Cross had comfort stations for soldiers overseas, with free coffee and free doughnuts. Then, in 1942, the Red Cross started charging for the doughnuts.

Charging for coffee and doughnuts touched a nerve in soldiers and made them hold a grudge against Red Cross that lasts even today (among veterans). It did not matter that the Red Cross was forced to charge for free coffee by the Government or that repealed the policy soon. The ill-will and grudge continued.

Present day examples in the entitlement category are email, twitter and facebook. Charging for these is very much like your mom charging you for Thanks Giving dinner. Placing a price tag on these will bring significant long-lasting backlash  as American Red Cross found by charging veterans for doughnuts. According to Uri Simonsohn, professor at Wharton School of business,

we expect this category of products to be free like mom’s love is.

In a recent GigaOm article, Mathew Ingram explored the question of for-pay version of twitter. What makes a for-pay twitter unthinkable and impractical is how the users have grown accustomed to see it as entitlement. Even enterprise customers who do not think twice to pay $15 per user for Chatter Plus, will not accept a for-pay twitter.

The best solution for getting out of entitlement trap is not to get into one in the first place. This requires constant reminder to your users about the dollar value of the product or service they get it for free. Perfect example of this avoidance is Amazon’s free shipping for orders worth $25 or more. Amazon by default selects the for-pay option making customers explicitly change to free shipping. In addition Amazon always adds the shipping charge then subtracts it from the total to show the dollar value of the service they deliver.

If your product is firmly stuck in the entitlement category you have only one option to move to for-pay model – target a different segment, preferably the one with budget to pay. For instance, secure, reliable email service for businesses vs. just plain old email for personal use.

Returning to Mathew’s for-pay twitter example, the service as it exists today, serving general population, does not have a path from free to fee.

Free as in free lunch

Fortunately, the second category is the most common one for news sites and webapps we now get for free. If these products need not have been free but were made free due to various reasons (mainly the failure to understand customer segment, needs and the value add).

The challenge is the user backlash from being asked to pay for something they did not have to. We have seen such outcries when airlines decided to charge baggage fee, when Ning decided to move to for-pay model and when Times erected pay wall. The good news is this is not as insurmountable as the entitlement trap.

Four years ago I was knee-deep in unbundled pricing. I was looking for ways to unlock value by charging for extras and do so as a strategy without being seen as nickel and diming the customers. The answer I found then was what economists call as reference price.  It is the price we used to pay for a product regardless of the value we get. Any increase over reference price causes us pain and any decrease is seen as a gain.  The added challenge with free is the reference price of $0. Since the users did not pay even a token amount the move from $0 takes extra work.

As it turns out, reference price is not a fixed number etched in our minds. It is malleable and yields well to behavioral nudges. One such nudge is introducing a super-premium version at even higher price when you move from free to fee. Another nudge is using cost argument to justify the move.

If your startup is stuck in free and want to move to for-pay version, make sure the free was never seen as entitlement and start with moving the reference price. The best option is not to start with free at all if your product indeed adds compelling value to your customers.

There are two kinds of companies – Price Setters and Price Takers

When Amazon introduced its Kindle Fire it positioned it as a direct competition to Apple’s expensive iPad. In a letter published in its landing page, Mr. Bezos drew a clear distinction between Apple’s pricing strategy and Amazon’s pricing strategy. Apple was not explicitly named in the letter, but not hard for all to see who Mr. Bezos was talking about.

The two kinds of companies, according to Mr. Bezos, are those that focus on charging more vs. those that focus on charging less. While that is a pricing distinction Mr. Bezos want to drive for Kindle Fire positioning, there is another way to classify companies – based on the level of control they have in pricing their products. In fact I should say, the level of control they are willing to exercise and follow through in pricing their products.

There are indeed two types of companies; those that work hard to set prices (Price Setters) and those that just tag along, take market prices and work hard to stay alive (Price Takers). Be it charging for perceived value to customers (Apple’s pricing) or charging to reach the mass market and keep out the competition (Amazon), they both have a well defined strategy and work hard to implement it.

When Mr. Jobs was Apple’s CEO he used to say (some version of it)

If we knew how to make cheaper products that we are not ashamed of putting it in your hands, we would have made it

When Mr. Bezos talks about pricing (as recently as last week in Times) he seems to be saying (paraphrased)

We are not thinking short term, we can keep our prices low for a long long time, longer than our competitors can stay solvent

The core strategy and their commitment to follow through on it come through clearly in such statements. Apple and Amazon are Price Setters. They are not going to let the market set their prices.

Apple and Amazon are not alone in this class, Wal Mart , Whole Foods, lulu lemon, Wall Street Journal, REI, and most luxury brands (across all categories) are also  Price Setters. But this is small class of companies.

Price Takers are a large class of companies. They have no pricing strategy or if they have one they lack the will and wherewithal to follow through. They react. They let the markets decide their prices. You can go back and look at recent price drops of many products and see for yourselves who belong to this class.

Mr. Bezos wrote in his letter, companies that charge more and those that charge less can both thrive. Unfortunately that is not the case when it comes to Price Setters and Price Takers.

Price Setters will thrive and go on to create significant value over long term.

Price Takers will be relegated to the footnotes of history.