A must read pricing book with ‘Free’ in its title

There are two books on pricing with free in their titles.

One is by Chris Anderson and has the subtitle of, “How Today’s Smart Businesses Profit By Giving Something For Nothing.  I wonder how these companies do that, must be the volume. This is of course the new title for the paperback edition, the original subtitle was “The Future of a Radical Price”. I guess the future is here.

Rest assured I am not recommending you read this book.

The other book with free in its title is by Saul J. Berman, “Not for Free: Revenue Strategies for a New World”.  By new world Saul refers to the current business world that drank the kool-aid of previous book or obsessed with monetization model innovations.

And I recommend this book.

Saul isn’t as popular or a household name as Chris Anderson is, although a WSJ reported asked me, “who is Chris Anderson?”, when she was interviewing me on my GigaOm freemium article. This book has just 4 reviews on Amazon (all 5 stars, likely his colleagues?) compared to Chris’ book that has 170 reviews.

But don’t let what is popular and accepted by your peers let you decide the book to read or your pricing strategy.

Chris Anderson’s book talked about the abundance of computing power, abundance of bandwidth etc and how these forces led to a marginal cost of $0 which naturally means $0 price. Saul starts with those same trends disrupting business models and comes to a different conclusion – how important it is to have a differentiated revenue strategy in order to not let these forces drive your business to dust.

The first step in Saul’s revenue strategy roadmap? Segmentation (chapter 1 in the book):

 traditional segmentation approaches are at best correlative—they take an identifiable characteristic and match it with a likely behavior. Why be so indirect? Why not look directly for the behaviors relevant to your industry? Doing so can reveal when consumers are well served with an existing business model and when consumers would be open to new ways of doing things, especially for incumbents.

In other words start with the customer needs or the jobs they are hiring a product for and not whether they are in 25-35 demographics.

This alone is worth the price of the book. What are you waiting for? Go get now – Not For Free

Questioning the inanities

Here are five extremely well written articles this week (except may be the fifth one) that take down popular and feel-good but false theories and claims.

  1. Power of Positive Thinking
    “Nearly every technique in which positive thought is meant to bring about better results may actually backfire”. Don’t go walking on coal based on Guru’s goading.
  2. Role of Luck
    “Work by Watts, Sagalnik, and Dodds suggests that although market success does depend on the quality of a product, the link is extremely variable and uncertain. Even the best contestant in a product category may fail, and even the worst one sometimes wins. And for an overwhelming majority of contestants in the intermediate-quality range, they found success to be largely a matter of chance.”
  3. Ideas not worth spreading 
    “Today TED is an insatiable kingpin of international meme laundering—a place where ideas, regardless of their quality, go to seek celebrity, to live in the form of videos, tweets, and now e-books.” One TED video I watched about a man standing up and dancing and everyone joining him comes to my mind as classic example of stories told without considering alternative explanations.
  4. How to write a Malcolm Gladwell book
    Or a Seth Godin book, or a Chris Anderson book. They are all the same. Just ask Mr. Godin to explain what he means by “remarkable
  5. Effect of Boards on Stock Performance
    Do board of directors have any influence on a stock’s performance? Given that how can a study make a case that companies that have at least one woman board member performed better than those that did not?

Finally here is another article about Nigerian scammers that can explain why Gurus seem to be producing theories and articles that have no evidence other than the only stories they used to develop the very theories. They are not writing for the thinking public. They are targeting those who have willfully suspended their thought.

Variations of the World Famous Hershey’s Experiment

There is one behavioral economics experiment that has been in blogs and mainstream media more than any other, it is the Hersheys and Lindt experiment done by Dan Ariely, Professor at Duke and author of Predictably Irrational. It is quoted as unassailable evidence by every article extolling the virtue of the so called “freemium” model.

For those who are fortunate enough to not know about this magical experiment and its far reaching implications on pricing here is a quick summary,

In a busy  food court, where people already come everyday to make lunch purchases, Ariely and team did two tests. Tests were conducted at the check out counter, when customers pay for the food. I will let Ariely summarize the rest

 in one trial of one study we offered students a Lindt Truffle for 26 cents and a Hershey’s Kiss for 1 cent and observed the buying behavior: 40 percent went with the truffle and 40 percent with the Kiss. When we dropped the price of both chocolates by just 1 cent, we observed that suddenly 90 percent of participants opted for the free Kiss, even though the relative price between the two was the same. We concluded that FREE! is indeed a very powerful force.

This finding from one trial, the 90% conversion is enough for most. And we are not stopping to do the expected value math on giving a free product to 90% of customers.

Success and popularity of two startups, Dropbox and Evernote, add to this madness. I wrote about cognitive biases in making a case for freemium and making blanket statements like, “free is free marketing”. Even now we see articles that base their case for giving our products away for free on Hershey’s.

Much has been written about the Psychology of Free. Two books that looked specifically into the subject are “Free” by Chris Anderson and “Predictably Irrational” by Dan Ariely. Putting it simply, Free is an emotional hot button that immediately reduces the mental barriers for the customer. Free makes people think that they have “nothing to lose” since many ignore time as an investment.

How relevant is one trial to every possible pricing situation out there? It is not enough to say we are in San Diego just because we see white sandy beaches. What are the variations of the experiment that model the webapp and iOS app worlds? Since they are not looking for it, let us look at other variations of the experiment and see how solid and relevant that one trial is for basing pricing model of web startups. (Consider these experiments in the context of thousands of webapps and iOS apps out there)

  1. Run the  experiment with Lindt and with a no name brand of chocolate offered free. Will free win over Lindt’s brand and value proposition?
  2. Run the experiment with Lindt and  Hershey’s and 20, 50, or  100 different no name brands. What will a no name brand’s share be compared to Hershey’s?
  3. Run the experiment with Lindt and 20, 50, or 100  no name brands.  Will the 90% conversion still hold?  What will each brand’s share be?
  4. Run the experiment with Lindt and some thing else that is not labeled as chocolate. Test participants should not be told what that second item is. It is just that it was offered free. Will the mystery item find bigger taking than a product whose value proposition is clear?
  5. Lastly, don’t run the experiment in a food court where there are already people. Run it in the middle of no where. Will free still mean free marketing?
In all these cases will free still be the, “emotional hot button that immediately reduces the mental barriers for the customer and make people think that they have ‘nothing to lose’ since many ignore time as an investment”?
How is free means free marketing when you are one of many free offerings (case 3 above)?

Pricing Digital Goods – (Hint: Not Free)

The problem with digital goods is it is easy to get confused by its economics, the marginal cost is $0, selling a unit to customer does not make it unavailable to another and there are challenges in restricting use. This has led to supposedly new branch of economics, “economics of free and abundance”, led by Mr. Chris Anderson and has built a large following.

I have written several articles on the need to sell the value and not focus on the marginal cost. In the digital world matching price to value is more difficult than it is in physical world.  Economist Brad DeLong from UC Berkeley (my alma mater) writes in his 1999 paper titled, Speculative Microeconomics for Tomorrow’s economy,

In many information-based sectors of the next economy, the purchase of a good will no longer be transparent. The invisible hand theory assumes that purchasers know what they want and what they are buying so that they can effectively take advantage of competition and comparison-shop. If purchasers need first to figure out what they want and what they are buying, there is no good reason to assume that their willingness to pay corresponds to its true value to them.

When customers do not exactly know what they want and the value they get, the marketer will find it hard to make a value proposition and charge a price that captures that value. Difficult does not make it a good reason to give up on charging for digital goods and give it away for free.

In a Nov 1998 article in Harvard Business Review, economists Hal Varian  (also from Berkeley now at Google) and Carl Shapiro wrote (Harvard Business Review, 00178012, Nov/Dec98, Vol. 76, Issue 6)

But there is a practical way to set different prices for basically the same information without incurring high costs or offending customers. You do it by offering the information in different versions designed to appeal to different types of customers. With this strategy, which we call versioning, customers in effect segment themselves. The version they choose reveals the value they place on the information and the price they’re willing to pay for it.

It takes us back to what Ted Levitt said about customers buying holes and later what Clayton Christensen said about, “what job is your customer hiring your product for?”. The difficulty in value calculation comes from focusing on the “drill” and not on the “hole”. If marketers focus on what the customers really want and what job they are hiring the digital information for it becomes easier to tease out the value to customers and how it differs across segments. Then the marketer can target the segments with specific versions and position it appropriately to capture a share of the the value through effective pricing.

Proposals to give away your offering (Mr. Chris Anderson in Free/Freemium) or let the customer decide what they want to pay may capture your imagination but as Hal Varian (who was described by Mr. Chris Anderson as someone who taught him more about economics than any of his professors) said in 1998 (full ten years before these new models):

Success in selling digital goods does not require a whole new way of thinking about business. Rather, it requires the same kind of smart managing and smart marketing that have always set apart the best companies. The real power of versioning is that it enables you to apply tried-and-true product-management techniques-segmentation, differentiation, positioning-in a way that takes into account both the unusual economics of information production and the endless malleability of digital data.

The road to profitability in any market goes through STP! That’s Segmentation – Targeting – Positioning. The rule does not change whether you are selling physical or digital goods.

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Wi-Fi In Airplanes – Stuck in $0 Reference Price

Update 2/1/2010: Southwest planning to offer Wifi (for a price). It definitely will help them to read this.

How much is getting Internet connectivity at 30,000 feet above sea level and while moving at 240 miles per hour worth to you?  How much are you willing to pay for it? How much are you willing to pay for WiFi connection in an airplane?

I predict that most will say different numbers  for these questions, progressively decreasing from a non-zero number to none other than $0 for the Wi-Fi question. The Wall Street Journal writes on the uptake of Wi-Fi in airplanes:

“There’s a very substantial decline in passenger usage the minute you start charging for the service,” said Michael Planey, a consultant specializing in in-flight passenger technologies. “It really begins to invalidate the model on which this service is being built for the next 10 years.”

wifi_demanAlaska Airlines found that even at a price of $1 lot fewer people used its service then when it was free. So the demand curve for this service will look something like the one shown here, dropping abruptly at a price just above $0.

Having connectivity is definitely of value to customers, some segments valuing it more than the others. But why are customers unwilling to pay for this value? The answer once again is the same one I showed in my Airline Unbundling study – Reference Price. Reference price is the price a customer used to paying for the service or expects to pay despite the value they get.  The purchase context does not matter to the customers, it is the price for the service. Everywhere they go, from coffee shops to hotels they received free Wi-Fi. So their reference price is $0.

The airlines should not have made this offer free to begin with but they need to do that for testing. They should have recognized this reference price effect and should have first worked on improving it before charging for it. One option I showed that worked in the unbundling study is introducing options, one high priced and another low priced. Presence of high priced option helps to improve reference price and hence customer acceptance of lower priced option. The airlines could have introduced a guaranteed speed, unlimited bandwidth version and a limited speed, limited bandwidth version at two different price points.

Another takeaway in this story is how a marketer can destroy future profit by setting a low (or $0) reference price. I am afraid however that this story is going to be  used by “Free” proponents like Mr. Chris Anderson. A case will be made about why free is the future and once again a reference will be made to the attractiveness of  $0 price, quoting Prof. Ariely’s work. I would like you as a marketer to be aware of the reference price effect and find ways to charge for this service that adds value to customers.

It is true that providing Wi-Fi at 30,000 feet is a high fixed cost operation and once you rolled out the service your costs are sunk and your marginal costs are $0. But before you made the business case for the investment the costs were not sunk and you should have made an analysis how much you expect to charge and how many customers would pay. You should not have invested with the hope that you will first get the customers and then figure out how to monetize it.

The net is, if the service is of value to customers then you should charge for it. What the customers are willing to pay for the service is not commensurate with value but lower because of the reference price. Focus on improving the reference price to capture a fair share of the value you add.