Pay What You Can Is Not Price Discrimination

Update 1/2/2014: I am saddened to hear Sensorielle is now closed.

This has been my favorite pricing case study for the past ten months or so – Sensorielle spa in the city I love, Boulder, went to a Pay-what-you-can pricing model. The spa’s owner, Ms. Petteway made it clear that this is not “pay what you want” but a scheme to allow those loyal customers who were hurt by down economy to come back and pay only what they could afford.

A few months back I wrote about the partial results published by:

Ms.Petteway published results from her experience in the Boulder Net LinkedIn discussion board. She talks about how  few customers interpret the pricing plan as “pay what I want” and ask for high-end services even though they pay less than the posted prices. For any rational customer (Homo Economicus) whose goal is to maximize their utility, it makes sense to pay the minimum they can get away with.

I said then Pay-what-you-can  scheme despite its close resemblance to first order price discrimination is not really price discrimination. It does not stand on solid data ground or analysis and leaves the future profit uncertain. Better results could be achieved with segmentation and targeting.

Will this pricing scheme help the spa identify willingness to pay of different customers? No, because the reference price is set by the list price and is pushed down by the option for “pay-what-you-can”. There are other ways to get customers to reveal their true willingess to pay (see my article on Pricing for garage sale).

I do not have access to any sales data nor have I had this conversation with Ms.Petteway but I hypothesize that they found this pricing scheme yielded lower profit than previous years.  The spa is not standing still and is making  more pricing changes  for the coming year:

  1. The Pay-what-you-can is limited to just two days of the week. This is something they should have done to start with and that would have been a great way to sort customers based on their WTP.  This would also help reduce cost of operations for those days by staffing with junior staff and not offering their high margin services. I also would recommend offering no reservations or charge for reservation separately (unbundled pricing) for these pay-what-you-can days.
  2. They are increasing prices of some and decreasing prices of some. If they based it on customer survey then it makes perfect sense. When re-pricing  two version of the same service I would have recommended that they don’t reduce the price for both.
  3. Note how the text reads for price decrease and price increase. They say “price reduced” and “price changed” respectively. That is not a strategy but the right messaging – do not ever say price increase.

Small businesses can blame the economy and be swept by the recessionary wave or they can take control on their marketing strategy to drive higher profits. Lack of specific marketing skills is not an excuse anymore. Kudos to Ms.Petteway for experimenting with pricing and her willingness to adapt as she gained more data about consumer behavior.

Will The Customer With High Willingness To Pay Please Step Forward

Within any given customer segment, however  specifically defined it is, are individuals who ultimately are different from everyone else in the same segment. Demographics, psychographics, buying behavior  etc all go only so far. Every individual ultimately has unique preferences, interests and willingness to pay  – all of which are non-static and highly malleable. The challenge is in finding the exact willingness to pay of each customer at any given point in time but the opportunity for the marketer is to create product versions, promotions and messaging that nudges the customers with higher willingness to pay to step forward or those with lower willingness to pay to step backward. In either case the front row of customers will be those that are the  least price sensitive.

Here are three case studies of marketers nudging the higher willingness to pay customers to identify themselves:

  1. For their new animated movie Frog and the Princess, Disney is  holding two and half weeks’ worth of premium-priced screenings at single theaters in New York City and Los Angeles. Ticket prices? $20 to $50. Disney says it brought in $2.8 million in ticket sales from these premium priced tickets.
  2. Panera bread, a gourmet casual restaurant, introduced a premium priced sandwich for $16.99 while most of the menu items are priced at $10 or less.
  3. A coffee shop owner used to charge $1.60 for his regular cup of Joe. He introduced premium coffee  illy and serves it in white ceramic cup with illy logo (premium product and premium packaging) at a premium price of $3.00. Sales tripled after this move.

The net is, the marketer can either take the prices as exogenous, set by   competitors , dictated by costs etc. or take control of their pricing to maximize profit.

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.

Pricing For Richistan

Richistan is the name of the book by The Wall Street Journal columnist Robert Frank. The book is about the lives of the wealthy and high propensity to consume. Frank says in that book,

Pricing for Richistan is like pushing an unlocked door – no pressure

Through @pricingclub I saw the USA Today news on $4000 sunglasses by Oakley.

“I could have seen something like this selling three years ago,” says John Horan, publisher of Sporting Goods Intelligence newsletter. “But conspicuous consumption is out.”

Conspicuous consumption is not all out. While marketers (like LVMH) targeted Richistan there were a few other segments which self selected themselves. They had high willingness to pay but not the wherewithal to pay.  Only these segments are now out. Since the economic downturn we do not know the population of Richistan. Their ranks may have shrunk but as it does I hypothesize that those who are left in it have increasingly low price sensitivity and are willing to splurge lot more than. So it makes sense to introduce super and ultra premium products like the $4000 sunglasses.

Oakley is producing just 200 pairs, thus making it exclusive and its stated target segment is “the guy who doesn’t blink at spending $300,000 on a car”. This is super narrow targeting, males of Richistan that can buy expensive cars without a thought. Compared to $300K price tag the $4K is going to look relatively small.

Another reason why this will help Oakley is the presence of $4K per pair sunglasses helps to improve customer reference price and make their $200-$500 prices look like a great deal.

Great marketing strategy. But, what is surprising to me from that story is not the price but the argument for the high price based on the cost.

About 80 layers of costly carbon fiber — a material more common to the aerospace and motor sports industries — are pressed into the frame. The ultracostly material and design make the frames more flexible and comfortable for athletes, says Neil Ferrier, Oakley’s advanced product development chief.

Another reason for the high price tag, Ferrier says, is the number of worker hours devoted to them. About 90 hours of machine time go into crafting each pair, he estimates.

Costs do not matter to customers and making a cost based justification makes sense only if a marketer expects push back.    So why bother even mentioning cost to produce?

Segmentation Based On Purchase Occasion

It is relatively easier to target segments that are static with time – by that I mean, customers will stay in their “assigned segment” if not for their lifetime but for a much longer period. The extreme example is gender as segmentation variable.  A marketer can target the resources accordingly and can measure its effectiveness. But how can a marketer target  customers when at any given time the customer could be in any one of the segments?

I think the Danish word for this is  -Vaelg!  The English word is Versions.

Here is what Scandinavian Airlines does to target its customers,

Sometimes you want comfort, sometimes you want lowest prices and sometimes both. Fly our Business, Economy or Economy Extra – whatever fits your needs best. By the way Vaelg means choose in English

Please Self-select yourself!
Please Self-select yourself!

One last point – notice how they do not show any price in these options. This is applying consumer behavior principle of getting customers to commit emotionally before they see the price. This is a pricing tactic that works well with the chosen pricing strategy.

All in all a very good execution by SAS.

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.