On Free Kindle

It appears, at least to Farhad Manjoo, Kindle is going to be free. He writes in recent Slate colum,

I can’t tell you when this will happen. But it will happen. Mark my words: The Kindle will be free.

Let us not delve into how he arrived at such a certainty couched as a measured statement with uncertainties.  Let us take his word for it and look at what it would mean to Amazon’s profits. According to Manjoo, who seems to have a window into Amazon decision maker’s mind and their business strategy,

First, why? Well, that’s easy—because Amazon’s long-term goal is to make money from selling content and general merchandise, not by peddling its own devices.

The case in point is the low-end $79 Kindle that will be free. So what kind of money should Amazon make by selling content and general merchandise by not peddling its device? Let us be aggressive and assume that this low-end Kindle is going to be great to sell general merchandise and not just content.

Again according to Manjoo, Amazon makes no profit on these devices or may be even losing money. Let us say they are indeed selling $79 Kindles at their marginal cost.

Say by making the Kindle free, they sell 20 million of them.

Cost? $1.58B for 20 million units. Just to stay where there are with current gross margin, they have to gain gross margin(not sales) of $1.58B from content and merchandise sales.  To put that in perspective, Amazon’s 2011 gross margin is $10.8B from sales of $48B. At its 22.4% gross margin, this $1.58B means $7B in sales.

And this $7B  sales will all have to be incremental new sales, sales that are made possible only because of the free Kindles. Sales that would have any way happened, because customers do shop even without free Kindle, cannot be counted towards these numbers.

On a per Kindle basis that means every free Kindle user must spend additional $350, above and beyond what they are already spending with Amazon. How likely is that scenario? Say amazon now has 100 million shoppers, its current revenue of $47B means, each shopper spends an average of $470 per year. Can a free kindle somehow add $175 per year (assuming device lifetime of 2 years) to this $470?

Now this is just the simplest of the math. You can see how unfavorable it gets when you add in lost profit from those who buy other Kindle models and Kindle Fire switching to free version.

On the flip side, say if Amazon were able to sell 5 million of the $79 Kindles. As per our marginal cost assumption they are no costs. If Amazon were able to generate the same $175/y in incremental sales from these 5 million customers that is $875 million in new sales and $196 million in new profit – not just the profit they had to make stay at same place but something that actually moves the needle.

Why wouldn’t they do that? If somehow a free Kindle buyer could be coaxed to spend $350 more why is not possible with the one that bought Kindle for $79?

I don’t have the window into Amazon’s strategic mind or the data they are looking at.May be you should ask Manjoo.  Amazon has said before, “economics don’t work for a free Kindle”. That appears as a bluff to Manjoo.

What appears like a bluff to us outsiders may really be the result of strategy guys doing their job – evaluating all possible paths ahead of them and making choices with constraints.

That is the difference between writing something based on one’s wishful thinking and having to make decisions that affects shareholder value.

 

J.K.Rowling Under Amazon’s Imperius Spell In her eBook Pricing

A while back I wrote about two kinds of companies – Price Setters and Price Takers. Amazon is a Price Setter. When it comes to eBook pricing they have set the definitive reference price that is becoming to harder to break even with magic.

J.K.Rowling, a master business woman and author (I admire her for both), is fiercely protective of her copyrights and monetization. While other authors were happy to get the Kindle version of their book out she held back for a very long time.

If you have been waiting for Harry Potter eBooks the wait is over. These are now available exclusively from her website. Rowling, apparently not happy with Amazon’s royalty scheme, is taking control of her eBook distribution.  By selling direct she gets to keep most of the sales price vs. sharing considerable portion of it with Amazon.

Clearly she is betting that the popularity of the boy wizard will deliver her enough traffic to offset any advantage from a powerful distribution channel like Amazon.com.

A likely scenario. (I cannot afford it.)

She may have wrested control from Amazon but she could not price it much different from  the standard  $7.99 and $9.99 pricing Amazon has set for eBooks.

J.K.Rowling priced the first three volumes in the series at $7.99 and the last four at $9.99 – a pricing model that seem to be based purely on the size of the books (the first three volumes are really thin while the last four are tomes) rather than on any other value factor.

There is no magic in this pricing.

If she had consulted the sorting hat she would have found that the first step with pricing is finding customer segments

  1. Which segments would prefer the eBook over the paper version?
  2. Specifically what is the value of eBook versions of the first three books vs. the later books.

This was a great opportunity for an author (likely the first time in history) to take control of their book pricing, to find customer segments and their willingness to pay and price it accordingly. Instead we have same old boring pricing under the imperius curse of a powerful Price Setter.

Note: Imperius curse is one of the spells in Harry Potter books that allows the one who casts the spell to control the victim’s actions.

There are two kinds of companies – Price Setters and Price Takers

When Amazon introduced its Kindle Fire it positioned it as a direct competition to Apple’s expensive iPad. In a letter published in its landing page, Mr. Bezos drew a clear distinction between Apple’s pricing strategy and Amazon’s pricing strategy. Apple was not explicitly named in the letter, but not hard for all to see who Mr. Bezos was talking about.

The two kinds of companies, according to Mr. Bezos, are those that focus on charging more vs. those that focus on charging less. While that is a pricing distinction Mr. Bezos want to drive for Kindle Fire positioning, there is another way to classify companies – based on the level of control they have in pricing their products. In fact I should say, the level of control they are willing to exercise and follow through in pricing their products.

There are indeed two types of companies; those that work hard to set prices (Price Setters) and those that just tag along, take market prices and work hard to stay alive (Price Takers). Be it charging for perceived value to customers (Apple’s pricing) or charging to reach the mass market and keep out the competition (Amazon), they both have a well defined strategy and work hard to implement it.

When Mr. Jobs was Apple’s CEO he used to say (some version of it)

If we knew how to make cheaper products that we are not ashamed of putting it in your hands, we would have made it

When Mr. Bezos talks about pricing (as recently as last week in Times) he seems to be saying (paraphrased)

We are not thinking short term, we can keep our prices low for a long long time, longer than our competitors can stay solvent

The core strategy and their commitment to follow through on it come through clearly in such statements. Apple and Amazon are Price Setters. They are not going to let the market set their prices.

Apple and Amazon are not alone in this class, Wal Mart , Whole Foods, lulu lemon, Wall Street Journal, REI, and most luxury brands (across all categories) are also  Price Setters. But this is small class of companies.

Price Takers are a large class of companies. They have no pricing strategy or if they have one they lack the will and wherewithal to follow through. They react. They let the markets decide their prices. You can go back and look at recent price drops of many products and see for yourselves who belong to this class.

Price Setters-3

Mr. Bezos wrote in his letter, companies that charge more and those that charge less can both thrive. Unfortunately that is not the case when it comes to Price Setters and Price Takers.

Price Setters will thrive and go on to create significant value over long term.

Price Takers will be relegated to the footnotes of history.

Is $99 the right price for the new Kindle?

If Pigou were alive and happened to look at Amazon’s new kindle pricing today, he would turn to the person beside him and say, “That my friend is second degree price discrimination, offering multiple versions and letting customer self-select themselves to the one they are willing to pay”.

Amazon introduced a new version of Kindle at $114 that is $25 cheaper than regular Kindle. It is the same Kindle with no difference in hardware. The $114 version shows Ads.

It is not far reaching to say there exist some customers who will buy the Kindle at lower prices. Introducing the “crippled” Ad supported $114 version enables Amazon to capture these customers without sacrificing profits from those who would rather pay $139 for Ad-free Kindle.

This to me is great versioning and given Amazon’s history of effective pricing it is highly likely they measured the demand distribution and the expected incremental profit before setting the price at $114 (more on this later).

There are predictable reactions in the social media from tech bloggers that Amazon got it wrong on pricing. The right price, they state, is $99

Imagine a Kindle for $99. There would be a frenzy. Amazon would sell so many of them.

A lower priced version will bring in new customers, but it will also cause many of the full price customers to trade down, leading to profit cannibalization. This is because customers look at a product as a package of benefits and price. They are willing to trade one for another.

If the price is right even a product with fewer benefits will deliver higher consumer surplus than a better product at a higher price.

Key to effective versioning is designing product benefits (features) and setting prices in such way that those who have high willingness to pay are not tempted by the lower priced version and buy it instead of the higher priced version.

If the lower priced version is priced too low or gave away too much benefits it will end up attracting those who would have bought the higher priced version.

At $99, even those who prefer the $139 version but not the Ad-supported $114 version may move down, adversely affecting profits.

$99 is the price only if that price yields better incremental profit than $114 price not because of its beauty or the notion, “psychological importance of losing that third digit cannot be downplayed”.


Update: corrected math, thanks to careful eyes of Saurabh Mathur. The conclusion that $99 is worse is even more strengthened.

For those who are mathematically inclined, let us try to build a simple model.

Let us say lifetime value of Kindle customer from book purchases and Ads is $50.

Let us say the marginal cost of Kindle is $89 (so the contribution margin on $99 price is $10 and $114 price is $24)

Let N1 be the number of new customers who will buy Kindle at $114 and  n1 be the number of people who will trade down from $139 version.

Let N2 be the number of new customers who will buy Kindle at $99 and  n2  be the number of people who will trade down from $139 version.

For $114 version to be profitable, Amazon has to attract one new customer for every  customer who trade down from $139. (Amazon loses $25 times n1 and gains $24 times N1, hence N1 >  n1)

For $99 version to be profitable, Amazon has to attract one new customer for every 4 customers who trade down from . (amazon loses $40 times  n2 and gains $10 times N2)

The ratio of new to lost customers quadruples when price drops to $99.

In addition, it is fair to say n2 is far greater than n1  because of the very reason $99 is attractive and gives away too much.

Is $99 still the killer price point?

Note: See my own past sins on Kindle pricing here.