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

The 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

It 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

The 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!

 

 

 

Pricing Flash Storage in Tablets – Don’t Call This As Markup

The New York Times Bits blog laments about the giant markup Apple and Amazon charge on flash storage. Bits blog not only complains about the price vs. cost difference but also caught on to the price difference between Kindle and iPad for the same storage.

Kindle: 16 gigabytes for $300 and 32GB for $370; to enjoy 16 extra gigabytes of storage, a customer pays $70 more. For its smaller 7-inch tablets, Amazon charges $50 more for an extra 16 gigabytes.

iPad: You can get a 16GB model for $500, a 32GB model for $600 or a 64GB one for $700. That’s $100 extra for that first 16GB bump, then a relatively cheap $100 to get from there to 64GB.

At the outset let me point out I have lamented on the same topic as well but mostly admired it and only lamented it a bit as a consumer. Let me point out how the flash storage prices vary even within Apple’s different product lines,

Yes both Kindle and iPad are able to extract lot more consumer surplus with their flash pricing. That is because they figured out their customers value the additional capacity lot more and are willing to pay the additional $100 (or $70) for doubling capacity. This is not markup and the fact that flash costs 50 cents per gigabyte should not matter.

Using words like markup comes from cost based pricing (add up all the costs then mark it up to get the price, hence markup), as is shown by this text in the same Bits blog post,

Of course, when you buy a new gadget, you’re not just paying for a slab of components. The maker of the product is trying to get you to cover the cost of research and development, manufacturing and advertising, and still rake in some profit.

Note how sure the author is – “Of course, you understand the price you pay is …”.

Let me do my own convincing and point out that – of course  customers are not concerned about your costs. They are not paying the price to defray your costs. Besides R&D, Manufacturing and Advertising costs are sunk and are not attributed on a per unit basis.

Customers pay for what they value and marketers charge for that value. If marketers figured out a way to deliver the value at  the lowest possible price it does not mean they have to pass on the savings as lower prices unless they are forced (by market forces) to do so.

Call this effective pricing and don’t call it as markup.

As a customer do I lament alongside Bits blog? I do. But as a product guy I admire their pricing.

For extra credit see my articles on

1. Nexus 7 flash pricing
2. Second degree price discrimination infographic
3. Why Apple does not include earphones with iPad?

Waging the right price war – The $65,000 Mistake

I believe “price war” may be a misnomer if both sides do not live to fight many rounds. We only see price battles or skirmishes that go for 1-2 rounds before one side throws in the towel or runs out of cash. There are two kinds of companies when it comes to price wars.

Category 1: There are just handful of companies that can wage incessant price war  by consistently keeping their prices low

Category 2: Even fewer that can withstand such low price attacks by their competitors.

Amazon.com and Walmart fall into the first category. Apple is in the second category.

In fact if the two players know that the other has the will, reserve and wherewithal to keep up the fight without ever letting up they most likely will choose not to enter price war in the first place. This is very much like nuclear deterrent  — mutually assured destruction.

BestBuy does not fall in either of the categories but was tempted to take on Wal-Mart with its iPhone 5 pricing. The result? BestBuy lost $65,000 in a single day.

Let alone the price war dynamics this is simply the wrong fight to pick. A tactical blunder.

First the product is not yours and the customer has many alternatives. Most are willing to pay full price at Apple stores. Customers do not think where they buy is important when it comes to iPhone (a qualifier is some insist they buy only after standing in line in front of Apple stores).

Second Walmart did not cut the price uniformly across all stores and did not make available unlimited quantities. Agreeing to match the price on such promotional tactic is simply wrong. It appears smart deal-seekers, instead of running from one Walmart store to another, simply walked into to neighborhood BestBuy and asked for the low price match. How convenient.

Finally, the low price was not attached to any other product sales and not designed as a loss leader that would help maximize customer margin.

And the result? Deal-seekers walked in, probably for the first time in many months, bought the $127 iPhone 5 and walked out without buying anything else. That is the $65,000 loss in a day.

Other readings:

See here for Waging Effective Price Wars.

See here for Effective Pricing

 

 

From Effective Pricing to Egregious Pricing – Starbucks

In the past I have only written praiseworthy things about Starbucks pricing. I always admired how they set prices for their drinks, decide to raise prices when everyone else was running price promotions and how they communicated their price increases. This time I think they have crossed over from effective pricing to egregious pricing.

First time I wrote about Starbucks pricing it was on their decision to increase prices when the global economy was going into recession

In the case of Starbucks, how did they arrive at price increase, going against the flow? The simplest calculation here is, when price conscious customers moved out all they are left with are price insensitive customers who prefer their products. Hence it makes sense to charge more for them as long as the loss in profit from further drop in customers is less than the increase in profit from higher price. (Here is an attempt at formal proof on why increasing prices yields better profits).

Later on it was on their price communication,

As you read this multiple times you will find all kinds of reasons except, “We cater to a somewhat higher-income customer and we price our products based on customer willingness to pay. Besides we don’t expect any push back from these high income segment”.

A key attribute of those practicing value based pricing is never explicitly saying that they are practicing value based pricing. There are always other reasons and you never say pricing at customer willingness to pay. A key part of practicing effective pricing is effective pricing communication and managing customer perception.

Even when they announced $7 lattes I only had good things to say. After all they likely have more data on their customers and buying behaviors than any of us do. They likely found a segment willing to pay $7 for lattes and are simply targeting them with a product version at a price those customers are willing to pay (second degree price discrimination).

Even if there is no such segment, a $7 price tag helps to improve the reference price in the minds of rest of their customers and hence will provide Starbucks with a way to increase prices of their other drinks.

All these are effective pricing. No doubt. But now I think they crossed over from effective to egregious, launching a contemptuous attack on their customer’s intelligence.

Starbucks recently introduced its new Steel gift card that is sold only through Gilt.com and costs you $450 but buys you only $400 worth lattes.

If we leave out the last phrase “$400 worth”, everything else about this product is indeed effective.

1. They chose the right customer segment and set a price specific to that segment
2. Set a hard limit on number of units they wanted to sell – a result of their understanding of the size of the segment and a tactic to create artificial scarcity
3. Designed the product to be distinctive (Steel over Plastic) – making it a conspicuous consumption. Imagine flashing this card in your local Starbucks, the baristas and the rest of us mere mortals have no option but submit to your opulence (Disclosure: I go to Starbucks only when someone else is buying)
4. Selling it only through luxury goods website Gilt.com and not at every Starbucks outlet – thereby not only reaching customers with high reference price, high willingness to pay and high wherewithal to pay but also not targeting rest of their customers
5. Guaranteeing profit from a high value gift card that locks up future sales and the possibility to add 10-15% of face value as profit from breakage (customers not using full value of the card)

Had they stopped right there, a $450 card worth $450 lattes, that would’ve been effective pricing. Then they took it one step further.  They decided to extract even more profit by setting the value of the gift card to only $450. And as they were wont to do with giving cost reasons they said,

One reason the card is so pricy is because it isn’t made of plastic — but specially etched steel. That guarantees the heavy metal wedge with the familiar Starbucks logo will stand out in your wallet and at the cash register.

The Starbucks card costs $50 to make,

Even if it is true, why should the cost matter in this case? This is not a true product. This is like the US Treasury asking you to pay $550 in change for a $500 bill because it costs them $50 to print that bill.  While it made perfect sense to use cost argument to push through price increases, cost has no relevance to take away value of the gift card.

What they have demonstrated here is utter disregard for the customer. They probably think, if these customers were willing to pay $5000 for a luxury product that costs $50 make why not take $450 cash from them for $400 worth lattes.

The sad part is they may be right and they likely will sell out all 5000 of their limited edition steel gift card. After all don’t we all pay $100 more for 16GB additional flash that only costs pennies? May be the steel gift card is laser etched and designed to fit so perfectly in your palm and that alone is worth $50 for some.

My outrage is probably misplaced and egregious pricing is likely the new effective pricing.

How are you going to react when you see that startup founder flashing the steel card at Starbucks, especially when his product is free?

Second Degree Price Discrimination and iPad Mini

There are enough news media reports, may be they all came from the  same source, about the imminent iPad Mini (a smaller and cheaper version of iPad to compete against Kindle Fire and Nexus). AllThingsD is convinced Apple has ordered 8-10 million units.

First there were “confirmed rumors” about invites going out on October 10th. Now they have retreated to another “confirmed rumor” about October 23rd event.

It is possible all these sources are true and Apple will go on to release a iPad Mini. But I find it still difficult to see a scenario where the lower priced iPad Mini can deliver incremental (net new) profit.

An analyst on CNBC said,

It could be big for investors, said Sterne Agee’s Shaw Wu.

“Like other products, lower price points tend to drive sales. An iPad Mini we think would likely drive incremental iPad buyers,” Wu said in a phone interview with TheStreet. “There’s going to be some cannibalism of iPad sales, but we think it makes a lot of sense.”

I am not sure if Wu followed Apple’s pricing strategy so far. Besides he seems to miss the point that lower price points also kill profits. Apple, however, never chased market share. Shaw Wu is not alone on this, there are many stock analysts and others who seem to think “some cannibalism is not bad”.

Exactly how bad is the cannibalism? Well for starters it is not about sales volume or revenue, it is about profits. Contribution margin on iPad is 42%-50%. That is, $210 to $250.  Given that we are hearing (from analysts) either $199 or $299 price point for iPad mini and that we know from Amazon that they are selling KIndle Fire at cost, it is highly likely contribution margin from iPad mini is in the range $10-$100.

I cannot see a scenario Apple selling anything at cost.

So for each unit of $499 iPad cannibalized, Apple has to sell 2 to 25 iPad minis. If we assume average, that is 13.5 iPad Mini for every iPad sales lost. Is that doable? Let us look at recent market research numbers on customer preference for iPad in the presence of cheaper iPad mini (second degree price discrimination)

35% of iPad owners surveyed by deal aggregator TechBargains.com say they’d trade in their old model for the smaller tablet

However, only 18% of all respondents in the TechBargains survey say they want the new gadget,

These are not good numbers. Presence of lower priced iPad, packed with value, will cause more than one third of current iPad customers to trade down. This can be compensated only if the 18% of the total addressable market for iPad mini (those who will not buy $499 iPad) is greater than 35% of iPad market.

One way for Apple to reduce the magnitude of this trade down is to what railways did in the past with their third class cars. For railways there was a big market of low price travelers (and they had excess capacity). They wanted to attract these low price travelers but did not want to lose the high contribution margin from those second class (or first class) travellers trading down to cheaper third class.  So to ensure those who can afford will continue to choose the second or first class the railways removed roof from their third class cars.

Apple could do something similar and cripple their iPad mini such that only the most cost sensitive segment will self-select to this version while the higher willingness to pay segment will continue to prefer the full iPad. But that is complicated by the presence of really good alternatives at these lower price points.

Even for those who would buy an iPad mini, there are many options at the $199-$299 price points.

The $199 price point is crowded with feature rich tablets and there are two others delivering great value at $269 and $299 price point. Not to mention the $399 iPad2 which offers better value than a $299 iPad mini.  Apple cannot cripple its iPad mini and expect to win against these value packed alternatives.

The cannibalization does not end with just iPad. It also extends to iPad Touch.

At $199 and $299 price points Apple will compete with its other product line – iPod Touch. Since the 7″-8″ tablet will deliver lot more value than iPod Touch for the same price more will switch from these high contribution margin units.

Considering Apple’s practice of effective pricing (note the fact that they did not introduce a $199 new iPod Touch) and effective use of product versions at multiple different price points I do not see Apple entering this field. Even if they did, it is only 10-30% chance this new product will result in net new profits.

 

Pricing Strategy Vs. Pricing Parlor Tricks

A research paper published in Journal of Consumer Research, Jan 2012, found that how we present pricing affects perception

Presenting item quantity information before price (70 songs for $29) may  make the deal appear much more appealing than if the price were presented first ($29 for  70 songs).

There are many similar peer reviewed research reports that found behaviors like,

Customers are more likely to prefer prices ending with digit 9

Customers are immune to higher prices when you don’t show the $ sign

Customers pay higher prices when you write the price in words instead of numbers

Customers succumb to decoy pricing (present three options but one is asymmetrically dominated by other and hence a decoy)

Through books and TED talks these  academic reports seep into popular media and are presented as pricing lessons for businesses small and large, especially for startups. After all, these are peer reviewed research reports based on controlled experiments that found statistically significant difference, published in reputable journals and hence worthy of our trust?

May be these are true, but what do they tell us about the customers and their needs? What job is your customer hiring your product for when they pay this cleverly presented price?

The problem is these behavioral pricing tactics may just be statistical anomalies. Let me point you to a xkcd  comic that so nicely makes the point I am about to make . After what xkcd has to say, anything I say below is redundant.

Let us take the first research I quoted, “70 songs for $29 vs. $29 for 70 songs”. What could be wrong here?  Well, why specifically 70 and 29?  What other combinations did the researchers test and what are the outcomes? What about 60 for 25, 50 for 20 etc etc.

Is it possible that they had tested 20 different combinations and found that just this one produced statistically significant difference? (Like the green jelly beans in xkcd comic?). Did the researchers stash away all the experiments that produced no results and published  the one that produced this interesting result?

An opinion piece in Business Strategy Review, published by London School of Economics, pretty much says this is the case with most research we read.

The problem is that if you have collected a whole bunch of data and you don’t find anything or at least nothing really interesting and new, no journal is going to publish it.

Because journals will only publish novel, interesting findings – and therefore researchers only bother to write up seemingly intriguing counterintuitive findings – the chance that what they eventually are publishing is BS unwittingly is vast.

Pretty much we cannot trust any of the research we read.

What are likely statistical flukes get published as interesting findings on pricing and find their way into books, TED talks and blogs. The rest don’t even leave researcher’s desk. Let alone academic journal, try writing a blog post that reports, “found no statistically significant difference”. Who will read that?

What we are seeing is publication bias that is worse than any sampling bias or analysis bias and a prevalence of pricing parlor tricks presented as authoritative lessons in pricing for businesses.

When it comes to pricing your product, be it pricing cupcakes or a webapp, you would do well to look past these parlor tricks and start with the basics.

Pricing strategy starts with customer segments and their needs. You cannot serve all segments, you need to make choices. Choose the segments you can target and deliver them a product at a price they are willing to pay.

As boring and dull as it may sound, that is pricing strategy. Your business will do well to start with the most boring and dull than chasing the latest parlor trick based on selective reporting.

Everything else is distraction. May be these fine tunings have some effect but not before strategy. After you get your foundation right, then you can worry about what font to use in the sign board.

How do you set your pricing?

Other Readings:

1. Segment-Version Fit
2. Five Ways Startups Get Pricing Wrong
3. Small Business Pricing
4. Three Components of Effective Pricing
5. Approximate Guide to Pricing Webapps  (buy access for 99 cents, pun intended )