Book Review: Price of Everything

The book is The Price of Everything: A Parable of Possibility and Prosperity by Russell Roberts. A very well written book with a storyline, set in Berkeley and Bay area. That alone gets stars from me. If you are exposed to economics or a practitioner you will be bored especially with the  parables trying to teach you. On the other hand, if you find it hard to explain to your friends and colleagues market economy, price discrimination and dynamic pricing this book will give you pithy stories to tell.

The book starts with what most people and media would call as price gouging. The scene is aftermath of a mild earthquake when there is a sudden spike in demand for flashlights, candles and baby formulas.  The story’s protagonist Ramon was shopping for flashlights. The local Home Depot was completely sold out but another retailer had supplies – at twice the regular price. Is this price gouging? How dare a retailer profit from an emergency and squeeze their customers when they most need the supplies?

This leads to a series of events, later on in the book the question is put back to the readers, “Would you rather shop at a store that charges the same price all the time and runs out of stock in emergencies or shop at a store that has differential pricing and does not run out of essentials when demand spikes?”

This I think is a great way of teaching (that is if you are a reader looking for learning from the book) – set up the problem, the context and also toss in  conventional wisdom (which not only not wisdom but down right wrong),  let the reader toy with the problem and enable them to form their version of solution before giving an alternative explanation.

The question that was not asked by the author is – If what Big Box did was price gouging, would it be okay if someone picked up all the flashlights from the Home Depot and sold them right outside Big Box for a price just below  twice the regular price Big Box was charging?

There is also the famous story of the pencil – how no one single person knows how to make a pencil.  The core principle is how price and price alone serves as all the information that is needed to orchestrate the complex and distributed ecosystem that has no central authority and no other channels of information. I liked the version described in the book Free to Choose: A Personal Statement by Milton Friedman and Rose Friedman.

Price is Everything does not ask or explain why some are willing to pay $4 per pencil when Target and Walmart sell a box of two dozen pencils for 25 cents. What is missing is that while price alone serves as the signal, it is not something decided purely by supply and demand equilibrium. A marketer has control over the price they charge and  improving customer willingness to pay.

The book also touches on several other economics topics like  game theoretic thinking and choosing a dominating strategy.

Overall I recommend this book, even if the concepts are  not new to you there is value in learning from Russell Roberts how to tell a good story and how to create teachable moments.

Back to Basics

For any marketer, the goal should be to maximize profits and take actions (legal and ethical)necessary to achieve that.  The key to profit maximization is knowing your customers and serving them better than your competitors do. About six months back I published on  Slideshare a simple tutorial on Conjoint analysis. Despite the esoteric name and the statistical analysis involved behind this, the premise is very basic – Segmentation and Targeting. I want to go back to my previous quote from Mr. A.G. Lafley’s book Game Changer,

As you work to better understand the WHO, you’ll discover that people use your product for different reasons. They may have different occasions for when and how to use it; differences about what they think is a good value, and what they are willing to pay. One size does not fit all.

Marketing is about finding those reasons, occasions, usage scenarios and hence what the customer is willing to pay for. If there is no congruence between what the customers value vs. what a marketer charges for and how much do the customers value the offering vs. the price a marketer charges,  they end up missing out on profits. The loss comes from:

  1. Foregone profit from lost sales – because the marketer is charging for the wrong factors or simply pricing it wrongly
  2. Forgone profit despite large sales because the marketer is not charging for things that customers value

There is nothing more fundamental and relevant than segmentation and targeting. But this message is getting lost in the noise created by fads like   “Free”, “freeconomics”, “economics of abundance vs scarcity”. It does not matter what market you operate in, what services you provide and what your marginal costs are, the basics of marketing remain the same.

Lose sight of your “WHO” and their reasons you lose.

Cloudy With a Chance of Free Business Model

There is a children book called Cloudy With A  Chance of Meatballs which is  a great story about a town where food was in abundance, because it rained food three times a day. It rained breakfast, lunch and dinner. In this scenario, there is such thing called free lunch. In fact the town hired sanitation crew just to cleanup the excess food from the streets and keep them clear. I bet no one in the town went hungry and there was no need to save food for the rainy day (pun intended). There is a page in the book that shows a restaurant with people eating inside. One notable aspect about that restaurant is there was no roof. Waiters simply caught “the rain” and served their customers. The marginal cost of food is zero for the restaurant.

That brings us to free as a business model that Mr. Chris Anderson talks about. Mr. Anderson says how free is the future for digital goods and services because their marginal cost approaches $0.  The meatballs book  applies Mr. Anderson’s argument about marginal cost to physical goods. Abundance of one component simply makes it irrelevant in pricing because a marketer cannot make a value proposition based on that component. The business model shifts to other components that deliver value.

  1. Since the marginal cost of food is zero, should the restaurant serve its customers for free?: No. The marginal cost is irrelevant. The restaurant should charge the customers for the convenience  (someone else catching the raining and serving) and experience. The fact that marginal cost is $0 for food only changes the product/service that is being sold.
  2. If the restaurant simply serves the rain that people can do it for themselves, why would anyone go to any restaurant?: Same answer as above.
  3. How would one restaurant differentiate itself from others?: Better service, live entertainment,  complements like wine that is not part of the rain.
  4. What role do chefs have to play in such a town? If the food from the rain is bland or flavorless then chefs role could be to improve its flavor. They could also specialize in plating the dishes in an attractive manner.

Pricing is about capturing a share of that delivered value. Since  “free” does not capture value it cannot be a business model.

Relevant Cost – Do Not Ignore Opportunity Costs

In a talk  at Haas Alumni Luncheon Mr. Chris Anderson, the  author of The Long Tail and Free, talked about his new book Free. First few minutes into the talk he talked about his previous work, The Long Tail, and how the marginal cost of shelf space.  He said how physical goods (what he calls atoms) have a marginal cost to produce, store and sell and how information goods (what he calls bits) have declining marginal cost that approaches zero.

I will set aside my previous arguments on why costs do not matter with pricing and focus  on just what is marginal cost.  According to  Mr. Anderson, the definition of marginal cost is simply the cost to produce, store and sell one widget. That is the right definition if there are no opportunity costs. In his example he talks about how there is a marginal shelf cost to selling physical goods through Wal Mart. Why is there a charge? Because Wal Mart is looking at opportunity cost of storing your wares vs. someone else wares. If you look closely all shelf costs are sunk for Wal Mart, but still it charges a marketer a fee because of this opportunity cost.

Marginal cost is not about the widget you sell, it is the “relevant cost of serving one additional customer”. It is the higher of either the cost to produce/store/sell the widget and the opportunity cost of serving that additional customer.  The definition is easy to see for physical goods. For digital goods, for example music, the marginal cost is not zero (as Mr.Anderson says regarding digital music just because there are no CDs) but the revenue lost by selling this music vs. another or the future revenue lost by setting a very low reference price in the minds of customers.

Once you consider the opportunity costs you can see the deficiency in the definition and argument based on marginal cost being zero.

Death by million posts

How difficult is it to produce that one more blog post?

Could the last post you and I wrote be the last one we would ever write?

Is there a pricing model from Miroeconomics we can apply to blogging?

Is your blog meant for transactional readers or relationship readers?

The New York Times talks about the difficulties in driving users and hence generating revenue from blog posts. With no barriers to entry, infinite supply, zero switching costs and customer loyalty, and limited number of reader-hours blogging is taking its toll on those who blog for money.

The very fact that reader volume is unpredictable and determined by when the post hits the blogosphere relative to other posts points to world of “transactional readers” and not “relationship readers”. The latter is also known as subscribers to the RSS feed. Blogging for the transactional readers is unproductive, the marginal cost of producing one more post is way more than the marginal traffic (revenue) from that post. Since the probability that any single post can generate positive revenue is zero, the marginal revenue is zero as well.

If it is anything Microeconomics teaches us worthwhile, it is the concept of marginal costs and revenue. It is unpardonable to produce at marginal cost higher than marginal revenue.

On the other hand, going after relationship readers is a different game. The marginal revenue from one additional post is not the additional traffic and Ad clicks it generates but how much it adds to your credibility as an expert which gives a justification to your current subscribers for subscribing to your feed and for the transactional readers to become your subscribers. Note however that in relationship model, the marginal revenue is sill zero. But you are not producing and selling one post at a time. You are selling your expertise as a whole and it is irrelevant whether or not a single post brings in readers.

Once you realize this, there is no more pressure to produce in volume or beat others to break a news. There is no need for “toiling under great physical and emotional stress created by the around-the-clock Internet economy that demands a constant stream of news and comment” (NYTimes).

The other way to look at relationship blogging is to see it as an output of the work you did to gain and improve your expertise. This means that blogging is all fixed cost and zero marginal costs. Since the marginal cost and the marginal revenue are equal (of course, they are both zero) this is the right profit maximizing point to be.

But how do you recover your fixed cost when marginal revenue is zero? The pricing scheme that models the relationship blogging is Two-Part-Tariff. When the readers subscribe to your blog they pay the one time entry cost. You earned your revenue by gaining a share of their mind, time and space in the RSS reader. By charging this fixed price and a unit price of zero you have captured all you can from any single reader.

It is not difficult to see which model is better to pursue.