Metered Price Discrimination, Customer Margin or in the Vernacular of Social Media – Freemium

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.

Behind Crest White Strips Multi-Version Strategy

P&G practically created the teeth whitening white Strips category. Introduced under the powerful Crest brand it helped create new revenue stream  after all  it is not easy to grow 10% YoY when each brand bring in $1 billion revenue. The part that interests and impresses me the most is their multi-version pricing for the White Strips category. While I expressed concern about P&G’s other brand Downy’s horizontal product line extensions, Crest White Strips serve as an example of effective pricing  strategy, tactics and execution.

Take a look at the Crest White Strips page from P&G and here are some insights on their versioning strategy:

Side bar – Value Tag: For brand managers from Colgate-Palmolive and Unilever this article is worth $9999 to you.

  1. If one price is good two are better and four are even better if designed and positioned correctly. Crest offers four different versions of the product, offering increasing benefits from low to high end version.  This is vertical product line extension.
  2. Versions are designed in such a way that customers self-select  themselves to the right one (Second degree price discrimination).
  3. The lowest priced version is the Classic at $24.99 and the super premium version ($44.99) is the Crest Advanced Seal, introduced in early 2009.  That is a $20 price differential between the lowest and highest product creating great profit opportunity from up-selling.
  4. The price jump is non linear and reflects customer’s diminishing utility. From Classic to Premium it is a $10 jump indicating customers assign most value in this upgrade. Between other versions it is $5 jump indicating customer utility flattens out or grows slowly as they move up the versions.
  5. Note that the listings are benefits and not product features. Customers care about benefits  and not about the features – compare this to many of the technology offerings that simply list feature differences across versions.
  6. Look at  the images showing the packages. These are designed to visibly show that not only are these versions different but also  help “tangibilize the intangible” (Ted Levitt).
  7. In behavioral economics, the effect of  presence of high priced versions has been extensively studied. The netof those findings is that while these may not sell much, the  presence of high priced versions help improve customer willingness to pay for the other versions. But that is not the case with Crest Advanced Seal. I make this claim based on the number of reviews and rating for this product.
    Versions Reviews Rating (on a scale of 5)
    Classic 58 4
    Premium 34 3.75
    Pro Effects 17 3.5
    Advanced Seal 77 4

    If we use the number of reviews as a stand-in for the market share, Advanced Seal, despite being the super premium version, is their most popular seller. The ratings also indicate that customers are happier with their super premium version. At $20 price premium and arguably not much cost difference this is a big contribution to their profits.

  8. Their Pro Effects, scored the least both in terms of number of reviews and rating. Until P&G introduced Advanced Seal an year ago, this was their most expensive version. We can hypothesize that it served then as the expensive decoy but did not add as much value to the customers and hence did not get market share. Going forward we should expect to see P&G allocating fewer marketing resources to this version and keeping its price levels.
  9. All their prices end in 99, as seen again in behavioral pricing literature this is a good tactic. It is easy for everyone to have prices end with 99 but it takes marketing strategy and a clear understanding of customers to maximize profits.

Overall Crest White Strips serve as a great example of marketing strategy, versioning and pricing for profit maximization done right!

Good and Bad Price Discrimination

Note to new readers: Do check out my other articles on versioning and price discrimination. It would help me greatly if readers coming from Rutgers or New Jersey let me know how they found this article.

Discrimination has a bad connotation to it, it is safe to say that any kind of discrimination is not only disapproved by most democratic societies and but also is unethical.

Does that spill over to price discrimination? If general discrimination is treating different people differently based on demographic or psychographic characteristics, price discrimination is charging different prices to different people based on value they get and their willingness to pay.

However it is not possible to find what everyone’s true WTP is and consumers revolt marketers take the short cut – treating the demographic and psychographic variables as a stand in for value difference and implement third degree price discrimination.

The alternative is second degree price discrimination – offering multiple versions at different price points so that consumers self-select themselves to the right version.

I am starting to collect and list pairs of bad and good price discrimination. Do add yours in comments and I will add here.

Bad: A supermarket charging higher prices in low income neighborhoods, where there are fewer alternatives.

Good: Merchants in touristy places charging exorbitant prices.

Bad: Charging different prices for women and men for haircut.

Good: Charging different prices based on length of hair and on stylist level.

Bad: A restaurant charging people different prices because of their ethnicity.

Good: Offering many different menu items that appeal to different pallets at different price points.

Bad: Charging different prices for checkin at airports based on passenger’s skill set.

Good: Charging additional price for agent assistance for checkin and giving automated checkin for free.

Aligining Price With Value – Metering Vs. Versioning

In any  all you can eat pricing model, be it a lunch buffet or at&t iPhone subscription pricing, as long as the  total revenue  exceeds total costs, the business will make a profit  regardless of whether they lose money on any one customer.  There will always be a distribution of customers based on value they receive and price they pay

  1. Some customers get more value than what they pay
  2. Some don’t get as much value as they paid for

The problem occurs  when  the first segment uses a higher proportion of the service and risk completely starving the second segment.

AT&T says,

the heaviest data users, saying that 40 percent of AT&T’s data traffic came from just 3 percent of its smartphone customers

To provide appropriate level of service to the second segment AT&T needs to size their services so the big appetite of the first segment is served. Facing customer backlash from slowness, AT&T is trying to reduce data usage by the heavy iPhone users – this implies they are either working on introducing metered pricing or a multi-version pricing.

Either of these plans require that their subscribers understand the value they get from the current unlimited plan. If the customers do not know  how much value they have been receiving they will balk at any changes to current pricing. AT&T has a leg up on this, they have been itemizing  data plan usage minutes (page after page if you received paper bill) even though the plan is supposed to be unlimited. It is arguable how many customers look at paper bill but the auditing does provide a way for AT&T to make a case with its customers when they introduce new pricing plan.

For example,

“Dear customer, do you know, on the average, you used 100 minutes of data service for 1GBytes download in the past 12 months. That’s $50 in value per month and $30 more than what other customers like you receive. To better serve your needs and those of all our customers like yourself we are introducing a new pricing plan …”

Which one will it be? Will it be metering, charging per minute or megabyte of download of data usage? Will it be a set of new data plan versions offering a combination of minutes and download? Which has better chances of succeeding?

I do not believe it will be usage based pricing. It does not align with the current minutes plan and the  problem it introduces with customers constantly worrying about using the data service.  AT&T already has a track record in executing a successful multi version pricing plan for its wireline high speed service (see figure left). Modeled after this we should expect to see three to six different data plans at different price points, each offering a combination of minutes and download (GBytes).

Versioning is about offering multiple versions at different price points so the customers self select- in this case it also helps to better align the value customers have been receiving with the price they pay.

Why are the Raspberry and Strawberry Yogurts Priced the Same?

You are walking along the dairy aisle, picking up Yoplait yogurts. You prefer the 99% fat free version, so you load up on some strawberry, some raspberry and some vanilla. The price? All of them priced exactly the same,  59 cents. (Let us ignore the one time promotions they run on one flavor to clear out the stock). After picking a dozen or so 99% fat free version you look up and find Yoplait Whips and it also has almost the same line up of flavors. Price? 79 cents.

  1. Why does the price vary across the types of Yogurt (let us call this vertical product line) but not across the flavors within a product line?
  2. Does it cost the manufacturer the same to make raspberry and strawberry yogurt? Should the cost difference be reflected in pricing?
  3. Do customers value the different flavors differently?
  4. Why does the price vary across product lines?
  5. Does a marketer stand to gain more profit by doing vertical line extension or by increasing variety within a product line?
  6. Can the marketer increase market share by increasing variety within product lines?

In their paper published in Marketing Science( Spring 2006, Vol. 25 Issue 2, p164-174) Stanford GSB professor Michaela Draganska and Kelloggs’ Dipak Jain asked just these questions and found the answers for the rest of us marketers.

We find that consumers value line attributes more than flavor attributes. Given that consumers value line attributes more than flavor attributes,  firms have a lot to gain by pricing their product lines differently whereas they have little to lose from pricing all flavors within a line the same. We also find that the value of a product line is not merely a function of the number of  flavors it includes: The calculated inclusive values indicate that more flavors do not always result in increased utility for consumers and hence higher market shares.

Firms’ profits would not significantly increase if they were to price  flavors within a product line differently. Therefore, the current pricing policy of setting different prices for product lines but uniform prices for all flavors within a line appears to be on target.

What does this mean to marketers? This tells what true versioning means, it is not just changing colors or toppings. Do not chase market share by making minor tweaks, this does not result in  profit increase. Strategy is about making choices. When in doubt about where to invest your R&D and marketing dollars, instead of expanding variety within a product line (horizontal versioning)  go for product line extensions (vertical versioning).

The Danger of Throwing in a Freebie

Southwest steadfastly refuses to charge for bags (at least the first two bags). Their marketing campaign, “Bags Fly Free”, says it all. In the short run they are missing out on the profit from baggage fees. The total airline industry profit from baggage fee for last year was around $536 million. Southwest is betting on increasing capacity utilization by attracting and keeping customers who are fed up with all the extras while other airlines are training the customers to pay for the extras.

Before airlines started to unbundle their services customers viewed the service as a monolith as opposed to a “bundle”. My monolith, I mean, a product service that is marketed and perceived as one entity even thought it is made up of different components. A bundle, on the other hand, is put together from several components, is marketed as a sum of its parts and is perceived by customers as such.  Unbundling has changed the perception of airline travel from a monolith to a bundle – a bundle consisting of:

  1. the main component – the ticket
  2. convenience of paper ticket
  3. convenience of seat selection
  4. ease of boarding
  5. check-in bags
  6. and in one extreme case – use bathrooms

So what Southwest sells with its “Fees Don’t fly with us” is a bundle in which every component of the bundle except the ticket is marketed as free. What is the danger of throwing in freebies with bundles? According to consumer behavior researchers from three universities, who published their results in Journal of Consumer Research, April 2009,  it is the long term erosion in customer willingness to pay for individual components.

Authors Michael A. Kamins (Stony Brook University-SUNY), Valerie S. Folkes (University of Southern California), and Alexander Fedorikhin (Indiana University) found that describing a bundled item as free decreases the amount consumers are willing to pay for each product when sold individually. They call this the “freebie devaluation” effect.

Why does a freebie decrease the price consumers are willing to pay for each individual product? Our research shows that consumers tend to make inferences about why they are getting such a great deal that detract from perceptions of product quality,” the authors explain. “For example, consumers figure the companies can’t sell the product without this marketing gimmick.” [quote Source].

In the case of Southwest’s bundle in which everything but the ticket is free, the research implies that customers will expect lower ticket prices if they want only parts of the bundle. A customer who is not checking in bags, in essence, is purchasing only one component of the bundle but is paying for the entire bundle. The “freebie devaluation” effect will push down customer’s willingness to pay for tickets when they do not need to check in bags.

What does it mean for Southwest? Unless their customer travel indicate that most customers check in bags they run the risk of lower ticket price expectations from their customers, further depressing their profits.

What does it mean to other marketers who throw in freebie? The same research provides the answer – there is no difference in customer willingness to pay for the bundle whether or not one or more of its components are marketed as freebies. So resist the temptation to increase sales by either throwing in freebies. If you are offering a bundle – you might as well price it same as the sum of the prices of the components.