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.