Pricing Digital Goods – (Hint: Not Free)

The problem with digital goods is it is easy to get confused by its economics, the marginal cost is $0, selling a unit to customer does not make it unavailable to another and there are challenges in restricting use. This has led to supposedly new branch of economics, “economics of free and abundance”, led by Mr. Chris Anderson and has built a large following.

I have written several articles on the need to sell the value and not focus on the marginal cost. In the digital world matching price to value is more difficult than it is in physical world.  Economist Brad DeLong from UC Berkeley (my alma mater) writes in his 1999 paper titled, Speculative Microeconomics for Tomorrow’s economy,

In many information-based sectors of the next economy, the purchase of a good will no longer be transparent. The invisible hand theory assumes that purchasers know what they want and what they are buying so that they can effectively take advantage of competition and comparison-shop. If purchasers need first to figure out what they want and what they are buying, there is no good reason to assume that their willingness to pay corresponds to its true value to them.

When customers do not exactly know what they want and the value they get, the marketer will find it hard to make a value proposition and charge a price that captures that value. Difficult does not make it a good reason to give up on charging for digital goods and give it away for free.

In a Nov 1998 article in Harvard Business Review, economists Hal Varian  (also from Berkeley now at Google) and Carl Shapiro wrote (Harvard Business Review, 00178012, Nov/Dec98, Vol. 76, Issue 6)

But there is a practical way to set different prices for basically the same information without incurring high costs or offending customers. You do it by offering the information in different versions designed to appeal to different types of customers. With this strategy, which we call versioning, customers in effect segment themselves. The version they choose reveals the value they place on the information and the price they’re willing to pay for it.

It takes us back to what Ted Levitt said about customers buying holes and later what Clayton Christensen said about, “what job is your customer hiring your product for?”. The difficulty in value calculation comes from focusing on the “drill” and not on the “hole”. If marketers focus on what the customers really want and what job they are hiring the digital information for it becomes easier to tease out the value to customers and how it differs across segments. Then the marketer can target the segments with specific versions and position it appropriately to capture a share of the the value through effective pricing.

Proposals to give away your offering (Mr. Chris Anderson in Free/Freemium) or let the customer decide what they want to pay may capture your imagination but as Hal Varian (who was described by Mr. Chris Anderson as someone who taught him more about economics than any of his professors) said in 1998 (full ten years before these new models):

Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data.

The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.

First Order Controls and Fine Tuning In Pricing

I have only been to a handful of major league baseball games. Every time I went,  someone else was paying for it.  But for every seat that was occupied in the stadium there was someone who paid for it, be it purchased individually or as a bundle. Every seat in the stadium whether or not occupied has an expected value for its profit. The profit comes from the price paid for the ticket and additional margin from what the fan spends in the stadium.

The notion of expected value means there is a probability associated with whether or not a given seat will be sold. In fact it is not a single value, it is a probability distribution for different price points. The distribution is not only different for different teams but also is  different for  different opponents, different game in the season, weather etc.  Even more complicated is the fact the probability distribution is dynamic for the same game, it changes from the time the game schedule is announced to just before the Umpire calls  Play Ball. After that the expected value falls to zero, at lest after first two innings.

But most if not all ballparks do not go to this level of pricing. They practice multi-version pricing, but pricing is static or fixed. That is not true however for the secondary market where the price fluctuates and is determined by customer’s willingness to pay. One company is making it easier for ballparks and other event managers with limited capacity that is not inventoriable (that is it expires after certain period). That company is, QCue,

Qcue is the world’s only dynamic pricing engine for live entertainment events. Using a scientific approach to pricing, Qcue combines computational analysis and external data sources to allow organizations to adjust pricing multiple times per day.

Solutions like the one from QCue break down the barriers to adopting complex probabilistic models and multiple regression based predictive models in pricing. But I still want to point out that application of analytics in pricing is still a fine-tuning knob, the one you employ after you have achieved larger first order control.

The  first order controls involve the basic tenets of marketing – segmentation and targeting. Marketing strategy is about understanding the different customer segments, the value to the different segments and producing multiple versions that add value to them at price points that maximize your profit. If your first order controls are not correct or optimized, any additional benefit you achieve through other optimization scheme will only result in sub-optimal profits.

You stand to gain lot more profit from analytics engines like QCue, but only if your marketing strategy is correct to start with.

Do we know value when we see it?

In past few articles I wrote about the price consumers pay and the price marketers get to charge. Those explanations depended on the value consumers get from buying the product. In B2B segments and in some  utilitarian product categories (like a light bulb) it is fairly easy to calculate economic value to the consumers.  But how can a marketer find the value added for the rest of the products? Do the consumers even know the value they get? I would like to remind you here that there is no magic value reader that is available.

I was looking at a JCPenney survey that asked, “Did you get value from your purchase?”. If customers do not know the value how can they answer this? Even if they did, this question does not help find what that value was.

There is one advanced analytical method, it is called by an esoteric and not so relevant name – conjoint analysis. Stated in simple terms the method is about

  1. Consumers do not know the absolute value of products they buy but we can deduce that from their preferences and likelihood of purchase. Instead of asking  consumes for how much they value ask them about how likely are they to purchase a given product on a scale of 1 to 100. This is called “Utility” in conjoint analysis. Note that the use of the term Utility does not imply that the product is  utilitarian.
  2. Any product can be modeled as a sum of its components, not just utilitarian features (like price and screen size of a TV) but hedonistic features like 1080 dpi and conspicuous features like diamond studded TV. The price should always be a component in your modeling.
  3. Show consumes a series of products with different feature set and ask for their rating. From these ratings we can deduce not only the  utility values  of different products but also the relative weights they assign to the components.

This explanation barely scratches the surface, you can find more information on this in a SlideShare presentation I published.  The net is that there are analytical methods that can be employed to get consumers to reveal the values and what components go into that value equation.

With this setup and my previous classification of consumption I will try to model consumer behavior with respect to  utilitarian, hedonistic and conspicuous consumptions and the shift in consumer buying patterns from luxury product categories to “premium” or  utilitarian categories.

Pricing Direction For Recessionary Times – Higher

Marketers are usually obsessed with market share and top line growth. In the recessionary times when customers are feeling the pinch and switching to private labels one would expect a price war among the major CPG labels for market share. But exactly the opposite is happening. There are four news stories from  recent Wall Street Journal issues:

  1. Heinz Profit Rises 11% Amid Price Increases

  2. Higher Prices Fuel Nestlé’s Profit

  3. Higher Prices Propel Unilever Earnings

  4. P&G, Others Are Confident Higher Prices Will Stick

Of course this increase in profit with increase in price point to pricing inefficiencies until now, marketers have been pricing it below their profit maximizing price, probably focused on market share.

So why will the prices go up with profit despite drop in revenues? With recession, as some customers shift to private labels those who are left and prefer these brands have a higher willingness to pay and are loyal to the brands despite the price. Until now the CPG companies were going after the wider market with lower price. Now they know that they can’t get the price sensitive segment and hence it makes no sense to leave their loyal customers with higher consumer surplus. Hence the increase in price.

But how can profit go up when revenues go down?  The price increase is pure profit but when marketers lose sales volume the loss in revenue is not all profit. As long as the marginal profit from increase in price  is more than the loss of profit from lost sales, the marketer will gain from the price increase despite loss in revenue.

So the strong brands are increasing prices not decreasing and they are reporting increasing profits despite drop in revenues for some. If you are a investor are you worried about drop in revenues or happy to get increase in profit?

Varian Makes a Case for Private Investments

Hal Varian, Economics professor at UC Berkeley and Google’s Chief economist wrote an Op-Ed in WSJ stating private investments as the cure for economic downturn. This comes from the aggregate demand function that describes national income

National income = Consumer spending + Private Investments + Government spending + Net exports

Increase net exports is a problem when US  is continuing to import oil and cheap products from China and the dollar continuing to be a strong currency. Consumers are tightening belts. The Government spending when done right will work except that it may run into problems related to who will buy the new debts. Varian says private investment is the solution.

Funding Fiscal Stimulus without China’s help

China a major buyer of US treasuries is reported to be losing its interest in buying more US debts. For the US economy which has exhausted all options and now looking at deficit spending as the last hope this could spell more trouble.  First a brief background.

President Elect Obama announced that the US deficit could reach $1 trillion for years to come. He has said that he will be passing multi-billion dollar fiscal stimulus packages to stop the free fall of the US economy. Fiscal policy is now the only available lever to pull given that the only other major lever, Monetary policy has been exhausted.  The Fed had already reduced the target interest rate to  0-0.25%, there is no further room for the monetary policy. Even now the lax monetary policy did not stop the fall and is proving to be impotent. The only hope is fiscal stimulus.

But with any fiscal spending the first question to ask is, “How is the Government going to fund the spending?”. In other words, what gives? The only revenue source to the Government is the Tax collection. When the Government spendings exactly match the tax revenues collected we will have a balanced budget. Otherwise we get surpluses or deficits.

The Government does deficit spending by issuing debts, in the form of US treasuries. Any individual, institution or Sovereign funds from around the world can buy these. Until now a biggest buyer of US debt has been China. But with its slowing economy and its posed $1 trillion fiscal stimulus it is losing interest in buying US debt.

What does this mean?

The US Government has to find other buyers from locally or from EU. It may have to spice up the bonds issue by increasing the rate it offers on these bonds, but this means the interest rate for all US credits will go up. For an economy struggling under credit crisis, this will further staunch credit available to businesses and individuals and the effects may negate the positive effect from Government spending.

The net is, without a buyer for US debts at current rates, getting out of the economic crisis through deficit spending is not going to work.