Waging Price Matching War

In game theory they talk about deciding your move based on what rational opponents would react. A variant of that strategy is to convince your opponent that you are no where near rational so they better not expect you to do the rational reaction to your action.

For example if you are playing a game of chicken in cars, if you were to break the steering wheel and toss it out the window in front of your opponent then he knows you are not going to swerve. (source: Art and Science of Negotiation). That is strategic irrationality.

In the game of chicken played in retail prices, Amazon is such a strategically irrational player. A recent BusinessWeek article screams

Amazon’s Jeff Bezos Doesn’t Care About Profit Margins

Mr.Bezos has signaled to all other players that he has thrown away his steering-wheel and placed a brick on his gas pedal. They are not going to let up on lowering prices and they can keep at it as long as they can because they have the full trust of their shareholders.

The right move in this game is not to do exactly the same and agreeing to match prices. But other retailers don’t seem to get it.

Target is the latest retailer who decided to play the price matching game not realizing their opponent’s stated irrationality. Target announced they will match all Amazon prices if customers can show proof.At least, unlike BestBuy’s mistake of making it easy for customers to get the price match, Target has added manual steps for customers. But that isn’t enough to stop the bleeding – either customers will do that additional work or simply go to Amazon.

If one player in a market says they will match any lowest price in the market the rational move for others is not to lower their prices because they get no advantage from it and only erode their margins. But Target is not dealing with rational player.

Fundamentally, by agreeing to match Amazon prices, they are saying their store provides no unique products, no unique value and  is undifferentiated from an online store. The right strategic move would be to ask,

“what unique value the store provides to its target customers and what is the right product mix that makes the customers buy from them”.

Even if this would result in severe revenue reduction – because they end up eliminating many products from their shelves – in the long run it would help make Target a profitable venture.

Instead they chose to play the game of chicken with with an opponent who has given up on steering.

This isn’t going to end well for Target. Circuit City here we come.

Waging an Effective Price War

First it was the $9.99 (the $8.99, $8.98) hardcover books, now it is $9.99 DVDs. Wal-Mart’s started the price war with a very low price on pre-orders for hardcover books and DVDs. Almost immediately Amazon.com was forced to match Wal-Mart’s price and so did Target. When the three retailers wage this war, customers stand to benefit while shareholders will see value destruction.

The value lost is not uniform for all three retailers. According to WSJ that quotes a JP Morgan analyst, Wal-Mart makes less than 1% of its revenues from its online channel WalMart.com while Amazon.com it is 100%. Online revenue from books and DVDs is even smaller portion of the total revenue. I do not have numbers for Walmart.com but Amazon.com makes 58%  of its total revenue from media sales ($11 billion annual, granted that includes music CDs as well).

The all new low price is offered only on 10 new titles, so their share of total online revenue is low but even a fraction of the 58% is a larger share of total revenue than that of 1%. Wal-Mart may not gain much from this price war but stands to hurt Amazon.com a whole lot more. That is an effective price war.

It is effective not because it added to Wal-Mart’s profit but it forced Amazon.com to respond. There really was no reason for them to match the price.  Let us do back of the envelop math. Let us assume the low price was offered only for a quarter,  the new books and DVDs constitute 10% of the media sales and the margin for Amazon.com is 10%. The price cut is about 30% of their total price, all of which is lost profit. That is a total loss of $82.5 million (11*(1/4)*10%*30%)

Even if we assumed the worst so that Amazon.com’s new book and DVD sales would be completely wiped out had they not matched Wal-Mart’s  price cut, their loss would total to just $27.5 million (11*(1/4)*10%*10%). Clearly, retaliating is not a profitable option for Amazon.com and by doing so they only helped make Wal-Mart’s initial attack effective.

Meanwhile Wal-Mart is only happy to reap the benefits of free publicity from its low cost price war that hardly puts a dent on their profits while damaging their competitor’s profits.

Free To Fee

Sooner or later businesses are going to realize the difficulties in running a high fixed cost business and free business model. Specifically newspapers that have been giving away their online version for free.  The free online version not only cannibalizes print sales but also sets a low reference price that makes moving from free to fee difficult if not downright impossible. For any neswpaper the simplified revenue model can be written as:

Revenue =  Subscription revenue + Single copy revenue + Ad Revenue

In the past, newspapers made the assumption that Ad Revenues are going to grow and drive total revenue, hence they did everything they can to increase “eyeballs” and number of page views. What they failed to see is what they are giving up and whether the increase in Ad Revenue is better than loss from subscription revenue.

The question is ,

Is ↑Δ Ad Revenue  > ↓Δ Subscription revenue?  Or is this an assumption they used to make the newspapers free.

As the assumptions turned out to be false, they are starting to look at subscription revenue (online and paper versions). There are two challenges to this reversal to pay-to-read scheme:

The first problem is the reference price. Readers have been getting it for free and will be reluctant to pay for what used to be free despite the value they get. Any price increase that does not first focus on improving the reference price in the minds of customers will fail.

The second problem is making sure the newspapers offer unique and differentiated content that is not available for free elsewhere. Editor of Financial Times, which charges for complete  access to its online version FT.com, has  this to say

“If they feel it’s distinctive enough … you’ve got to be different” … “it’s the people in the mediocre middle that are going to be the meat in the sandwich”.

Let us look at these problems with The New York Times as our case study.

Recently The New York Times is polling its readers for their willingness to pay. They asked their website readers if they are willing to pay $2.50 to $5 per month for access.  Instead of asking their readers for their willingness to pay for a monthly fee, NYTimes should focus on improving the reference price for access to the web version.

One way is to have a “value meter” that is running prominently in each page and showing how much a reader saved from the free version. This is similar to what Amazon.com does with free shipping.  There are many other ways to improve reference price. ( I admire Amazon.com for its strategy and decision making based on analytics rather than on fads and gut feels).

Regarding unique and differentiated content, it is a hard task. One way could be is to create scarcity. For instance they could make available only the current day edition free and charge for access to all archives including the previous day version. If the article is adds value to readers even after a day, week, month or year then they should be willing to pay for it.

Going from free to fee is an uphill battle. Unfortunately all these could have been avoided if the newspapers have did the analysis and scenario planning before they made their online versions free.

Pricing Kindle Books

Sometime back I wrote this model for pricing a book

Price of a book  = Content   + Consumption  + Convenience

To be correct it should read

Value of book = Content    + Convenience

Content is the information content and Convenience is ease of access of to the content based on your usage scenarios. The Consumption component is really folded into Convenience. This equation is for a given format of the book.

then we can write  price for any given format  as

Price =  F(value)   +  G(price of all other formats)

The function G() boils down to reference price. Note that this is a recursive function but its base case is the price for the current most common format, the hardcover book. The sign of G() is usually negative, in other words it prevents the publisher from capturing the full value of the book.

So how should the Kindle book be priced? Amazon wants to price most books at $9.99 but the publishers are against such flat pricing. They saw what Apple’s 99 cents pricing did to music labels and want to have better control over their pricing. Recently one publisher declined to have their book available on Kindle at the same time as their hardcover book. Other books like Dan Brown’s upcoming book may not be available in eBook format for a long time.

If $9.99 is not the price, how should the eBooks in Kindle and other formats should be priced?

Sony executive, Steve Heber used cost argument to justify the lower price tag:

Steve Haber, president of Sony Corp.’s digital reading business, says it is logical to expect that digital books should cost less, because of the lower production costs, such as for paper. “There should be significant savings” for consumers, he said.

It is quite possible Mr.Heber is using this cost argument more towards publishers to put pressure on them to reduce their  prices to Sony than as a blanket statement on pricing based on cost. Cost is irrelevant to pricing a book  or anything else and Mr. Haber knows that as well since this part of Sony’s DNA, judging from pricing  for other digital content from Sony.

A Forrester analyst, Sarah Rotman Epps,  said,

“What we’ve seen in other industries and in the evolution of digital content is that consumers are not willing to pay as much for content that is separated from its physical medium.”

I am not sure if Ms. Epps has looked at data on consumer behavior with respect to pricing for digital content. But I disagree with her assessment.  First, the low price expectation for digital books comes not because of separation of content from physical medium but due to low reference prices set by other free digital books. Second the new medium, eBook reader, is not net negative it adds several convenient factors that increase the value to the consumers.  Customers are willing to pay for convenience and willing to pay for it.

Now questions arise, whether the value added by eBook format comes from the format, the distributor  or the device and how this value should be shared by the three. In Amazon’s case they are both the distributor and the device maker and they captured significant part of the value through Kindle pricing. Publishers are afraid, based on iTunes history, that  Amazon with its Kindle store and  Kindle reader will gain upper hand in the value chain. They are going to seek out other distributors, like Google, who allows them to set prices.

Are the publishers losing out on potential eBook sales by refusing to release in that format at the same time as the hardcover book? According to The New York Times article, eBook sales are 1-2% of total book sales. So if these eBook readers want to read the latest books in their Kindle or other readers then they should be willing to pay for the convenience.

The net is, this is  new battle in the publishing value chain. Amazon wants to win the platform  battle with its set pricing but this is far from over. New players like Google is already in the fray and we should expect other players like Adobe and Microsoft to enter as well.

Amazon.com – Managing Reference Price

It is not news when I say that Amazon.com offers free shipping on orders of $25 or more. But there are two very interesting things I see in how they implement that offer:

  1. The free shipping option is a less convenient option. The offer states that it will take 5-7 business days compared to 3 business days for the next lowest priced standard shipping option. The shipping charges are not different but  Amazon manages customer perceptions of the service by signaling that it is the slowest of all options. Whether or not it would take 5-7 days is immaterial.
  2. When a customer checks out the check out page very clearly shows the shipping charges  and subtracts the same from the total price. This is about managing customer reference price for shipping. Amazon wants to say that shipping is not really free and signals the customers that they would have paid , for example $5.47, if not for the the promotion.

This is about managing customer perception and reference price. They do not want the customers to think that price for shipping is $0. Maintaining a non-zero reference price  enables amazon to start charging for this lowest option when they need to without causing customer backlash (like the one airlines faced with drink fee).