Suppose You Made Pricing Decisions Based On Your Marginal Cost

Let us suppose you made pricing decisions based on your marginal cost. One of the examples quoted in Mr. Chris Anderson’s series on “free” is digital music. Mr. Anderson says, since the cost to produce, store, distribute digital music is $0 (or approaches $0) it makes sense to give it away and find other ways to make money, like concert tours and other paraphernalia. Let us take the marginal cost argument to the extreme and apply to the concert itself.

The marginal cost to admit one additional person into the concert arena is, you guessed it, $0. Once you decide to put on a concert, pay for marketing, stage, security etc it does not cost anything additional to allow one more person for  free into the concert arena. So why not do that?  Because the marginal cost is relevant only up to the point whether or not you can breakeven on your initial investment and is always irrelevant to your pricing decision as long as you do not charge below your marginal cost.

Before you put on a concert , you add up all your costs of what it would take to do it. Then you look at what is your “average price” below which you cannot breakeven and hence makes no sense to do your concert. This is the floor for the average price. Then you determine the multiple customer segments and their willingness to pay for the tickets and design a multi-version pricing scheme that appeals to those segments. You design your pricing and product mix such that those with higher willingess to pay will self-select themselves to the higher priced version (because of closer seat etc). Then you determine the total profit  and see if this is net positive over the total cost of your concert. At no point you are deciding based on the marginal cost.

Why is this any different when you cho0se to distribute your music digitally?  I am not saying do not make your digital music free, by all means do it if that is the best among all available options in terms of total profits delivered. Make your business decisions because you have done the analysis and evaluated all options and not based on “everyone else is doing it” or “free is the law”.

But the problem with writing a book that says, make it free when it drives maximum profit through other means, charge for it when that delivers maximum profit,  is you are seen as hedging your bets. As Professor Dan Ariely points out, people trust confidence more than expertise. Prof. Ariely says, “We’re Swayed by Confidence More than Expertise“. You can sell more books with confident assertions.

Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want.  Maybe this is why so many pundits on TV for example exaggerate their certainty?

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