What do amusement parks, airlines, hotels, baseball games, and theaters all have in common? Two things, first their capacity cannot be stored for future use and second the cost to serve one additional customer (marginal cost) is $0. Once a plane takes off, all the empty seats in the plane expire, generating no revenue for the airline. How should a business price its service that falls in this category? Just because the marginal cost is $0 and the lost revenue opportunity should the excess capacity be sold at the lowest possible price?
There is a renewed focus (in the echo chamber of blogosphere), almost an obsession, with marginal costs and the fact that it is “spiraling to $0” for digital goods. Wired magazine editor, Mr.Chris Anderson, has been talking and writing about this and has a book coming in July. Before we go further I would like to reiterate that what it costs to produce a product/service does not matter in how it is priced and higher capacity utilization is not a valid reason for lowering prices.
The answer to the pricing question lie in:
- Opportunity Costs: The cost to consider is not the marginal cost but the opportunity cost of admitting one additional customer – that is what is the lost revenue opportunity from selling one airline seat now at a lower price. Only airlines excel in implementing this pricing strategy that is based on yield management.
- Value: That said, the business should look at the value created for the customer using the service. It is common sense that a business makes profit not just by creating value but by capturing some of it. Note that the value created is different for different segments (technically it is different for each consumer but it is hard to quantify).
- Reference Price: Businesses must consider the impact of low (or zero) price now on future profits due to the reference price effects. Once an airline sets a very low price or allows a customer to travel free because the cost is $0, then it risks setting a very low reference price in the minds of customers. In the future, such customers will despise paying regular prices and may even be up in arms. The effect of reference price cannot be understated, despite the value added to consumers the reference price prevents the business from capturing a fair share of the value added.
Do you know your opportunity costs, value created and the reference price? Please use trackbacks to comment on this.