Pricing When Cost To Serve Is $0

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:

  1. 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.
  2. 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).
  3. 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.

3 thoughts on “Pricing When Cost To Serve Is $0

  1. With airlines I was saying the marginal cost (even if it is non zero) is not the relevant cost, it is opportunity cost that is relevant. That said, costs do not matter for price setting.

    As I say in another post it makes perfect sense for any marketer to charge for extras to capture some of the value they add. They however need to be aware of reference price effects and first work to improve this before starting to charge for what used to be free.


  2. Amusement parks have a fixed capacity, but some parks have realized the value in restricting their capacity to a far lower number. Disney World has what are called e-nights ( see ). Tickets for this 3-hour period at the end of the night. They cost an extra $10-12 and they’re only available for people who are staying at Disney lodging. Admission is capped at around 5,000 people.

    People love these events! Read the comments on the website above. Some people call them the best thing in the world and the fave thing on their vacation. Someone can ride Space Mountain 5 times in an hour during an e-night; something you’d never ever be able to do during the day.

    These e-nights are a crucial part of the pricing for the entire Disney Orlando operation. Disney also has “magic mornings” where the park opens a couple of hours early to certain guests. If you want these deals, you must stay at the Disney hotels. That allows them to price their properties at a premium. By restricting admissions of a park to far less than the capacity of the park for 20-30 hours a month, Disney generates a huge positive impact on their bottom line

    Some airlines have free standby service; some do not. The most successful airline in the US, Southwest Airlines, only allows passengers with their “fly anytime” fare to fly standby on other flights. They require that any passenger flying on a cheaper fare pay the difference before they can fly standby.

    What impact does this have on their bottom line? See . Southwest prices their flights based on the demand for the time. If customers were allowed to abuse that peak pricing by regularly flying standby at the time they really wanted, that could have a huge impact on Southwest’s bottom line for those preferred flights.

    I think your logic is right for Hotels, baseball games, and theaters. They generally benefit from having a full house; the experience is enhanced for all. But it’s not necessarily the case for airlines and amusement parks.


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