Consider these real life pricing scenarios that you see everyday:

  1. Six Flags Discovery kingdom sells its annual season pass for $49.99. According to its website, “Buy your Season Pass for $49.99, just $5 more than a one-day admission.”  Now why would they give away an unlimited entry annual pass for “just $5 more than a one-day admission”.
  2. Movie theaters charge extremely high prices, 4 to 5 times what we usually pay outside, for popcorn.
  3. Gas stations sell gas almost at cost and sometimes they even lose money due to credit card interchange

What is common in all these pricing scenarios? All these businesses are practicing what the economists would call as,  “Metered Price Discrimination“, or what marketers describe as, “Customer Margin“. There is nothing new, it starts with, “price discrimination” – charging different customers different prices.  Customers differ in the value they get from a product/service and in how much they are willing to pay for it.

Let us start with a simple case where the only way to monetize a customer is the price they pay. Let us keep it really simple and assume all costs are sunk and the marginal cost to serve a customer is $0.

For each price point you set, there will be different number of customers willing to pay that price. That is your demand curve. Your job is to find the price that maximizes profit – if you increase the price you will lose some customers but gain more from the remaining ones,  if you decrease the price you will gain new customers but lose revenue.

Total profit ∏1 = p times N ; price is the only lever you can control

Now consider the case where there are many different ways to monetize the customer (let us still keep costs as $0). For example, amusement parks charge parking, sell you lunch etc. Then you have several different levers to control,

Total profit ∏2 = p times N + R1 * n1 + R2 * n2 + ….

where R1, R2 etc are average revenue from each additional service you sell or ways you monetize the customer and n1, n2 are the subset of customers that generate that revenue stream. It is trivial to see that n1, n2 etc are directly a function of N.

Your goal now is find the entry price p that maximizes total profit and not just the profit from price paid. For example, movie theaters may set the ticket price lower such that they bring in lot more people but make up for it from the subset who are willing to pay higher price for popcorn. Similarly gas stations attract more customers with lower gas price and sell high priced snacks and drinks in their stores.

This is Metered Price Discrimination – some customers get away with paying the low “entry fee” while others pay more by consuming additional services at different prices.

Now consider the special case where the entry fee, p =$0. You have what is described as “Future of pricing”, freemium. You give up on monetizing entry fee and focus only on profit from other revenue sources.

Total profit ∏3 =   R1 * n1 + R2 * n2 + ….

There is nothing new, radical or futuristic about it.

If you have done the analysis, know your customers and find that ∏3 is better than ∏2, then by all means set the price to $0. You need to know ex ante, what the different revenue streams are going to be and how many customers will generate that. You cannot go in with a free model assuming that once you get customers in you  can monetize them later.

If all you have is hope, or promises of a marketing guru quoting some extreme examples that show higher ∏3, you have have your work cut out for you.