Effect of Reference Price On Future Price Discrimination

I do not know how many times I quoted “If one price is good, two are better”.  Instead of reading all my posts on this topic, it serves you well to read this article from The Economist on pricing for music downloads. A very clear explanation of basic pricing concepts and the need for  pricing discrimination.

The core idea of multi-version pricing is to define versions that meet the needs of different segments and deliver them at prices they are willing to pay. The versions differ in features and hence the value they provide.  It is not enough to have versions, it is essential to position these correctly so customers will self-select themselves to the right version.

In the music downloads business 99 cents has been the price for very long time. Multi-version pricing here would mean producing musics that appeal to different segments and pricing them accordingly.  The Economist article quotes a music downloads pricing study from Wharton researchers that found

this would increase profits by a mere 3%. Part of the problem was that people who valued one song highly also tended to place a high value on others. This implies that person-specific, and not song-specific, pricing would be more efficient.

willingness to pay for music downloads does not vary across music types but only across customers

If only types of music were the segmentation variable it would have been easier to identify the segments. If this holds true for the rest of the population, certain segments just have higher willingess to pay for all kinds of music and vice versa. It is non-trivial to determine which segment a customer belongs to and  price discrimination for the same song will be perceived unfair.

The question is if this type of consumer behavior existed before Apple iTunes introduced 99 cent price for all music downloads or it is a direct result of that. For the segment that simply has higher willingness to pay for all songs Apple’s pricing is not the reason for their behavior. But for the second segment, it is conceivable that they would have valued different music differently. But the 99 cent price set a hard reference price that neutralized this difference. The net result is a segment that is willing to pay just one price for all the songs.

Once again we see unrecognized profits due to reference price effect, in this case set and controlled by a dominant player in the value chain.

Next up are lost profit from $9.99 price for e-Books set by Amazon, Barnes and Noble and Sony and  $8.99 reference price for hardcover books set by Wal Mart.