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.

An Alternative Look At GroupOn Marginal Costs

In my previous article I wrote about the necessary and sufficient conditions for choosing to run GroupOn campaign for your business.  I made a case for looking at the marginal cost of each unit sold to decide on whether or not to run a campaign. Alternatively, and in all fairness to GroupOn, we can look at the entire cost of running the campaign as “Fixed Costs” or “customer acquisition costs” and hence can ignore the marginal cost argument.

For instance,  let us use the $4 cupcakes that you make for $1.5. If you run a campaign to get 1000 new customers with a 50% deal  (for a promotion price of $2) and let GroupOn get its 50% cut, your total promotion cost is 1000 X ($2-$1-$1.5)  = $500

Yes you are selling each cupcake for less that what it costs to make and sell it. But another way to look at is, you spent $500 to sell 1000 units at $1 each, there by ignoring the marginal cost argument with the HOPE that these first-timers will spend more in the future.

That said, every other cost component – incremental investment, opportunity cost, etc – remain the same.

Next we can model the Lifetime Value of such first-timers based on:

  1. How likely will the customer revisit (or what percentage of customers will revisit) .
  2. On the average how many additional times they will revisit
  3. On the average what you will gain from each visit. Note that this not just average spend per visit but the profit from that spend.

If the total lifetime value is more than the total costs, then one can argue that it is worth doing.

See here for a very simple calculator.

Does Wii Stand To Gain Or Lose With its $50 Price Cut

A few weeks back both Sony and Microsoft did a $100 price cut on their respective  game consoles. Sony was the first to do the price cut and was immediately followed by Microsoft. At that time I wrote that Sony’s decision to cut prices by $100 means it needs to generate 23% incremental sales, above and beyond what it would it have achieved without the price cut. The 23% number was based on gross margin and customer margin assumptions I made. Now the third game console maker and the market leader in the next generation game consoles, Nintendo announced a $50 price cut on its Wii. Is  this the right move? For Nintendo? For the market profit?

Let us use gross margin and customer margin numbers of $100 and $200 for each Wii. Customer margin here is the net present value of profits from sales of games, complements and other accessories that a console owner buys over the period they own the console.

According to Bloomberg News Service, Nintendo has sold 52 million Wii, Sony 24 million PS3 and Microsoft 30 million. So their units market share numbers are 49%, 22.7% and 28.3%. Nintendo says the addressable market in US is 50 million units. If Sony and Microsoft had not cut their prices, we can assume their share of the addressable market would remain the same. Let us assume Nintendo’s models show Sony selling 23% more units than they would have normally sold due to $100 price cut. Let us also assume Microsoft gains the same – both PS3 and XBox gaining at the expense of Wii. This means  Wii stands to lose 5.86 million units sales (email me for numbers).

The drop in total profit to Nintendo, based on $200 customer margin per console is $1.17 billion.

With the $50 price cut, its customer margin falls to $150. If this price cut negates the effects of PS3 and XBox price cut, Nintendo can manage to keep its market share of 49% in the addressable market of 50 million. That is 24.5 million units. The lost profit here is the $50 price cut which comes to $1.226 billion.

In other words their lost profit from price cut even if it helped them retain market share is more (by about $50 million) than the lost profit from loss in market share. But only barely. Since we used assumptions about margins, it is possible that Nintendo’s models showed the price cut would deliver them incremental profit over letting Sony and Microsoft gain market share.

This in the end is a good move for Nintendo. But as a whole, on the 50 million US market identified by Nintendo, because of Sony’s price cut the total market profit  shrank by $4 BILLION. That is value destruction!

Starbucks Price Increase – A Case Study In Analysis

[tweetmeme source=”pricingright”]

Value Signal: This article is worth $99 to most readers like yourself.

Starbucks decided to raise its drink prices by as much as 8% (5 cents to 30 cents), They are doing this just when  customers are cutting back on their Starbucks trips and switching to cheaper alternatives from McDonalds and Dunkin Donuts.

The conventional “wisdom”  on pricing is, when recession pushes customers to cut  back on expenses and switch from your products to cheaper alternatives,  you cut your prices to keep the customers. While this is a usually accepted and followed practice, it is neither wisdom nor based on analysis.

To be successful, businesses cannot make decisions based on hunch, gut feel, latest management fad, or so called conventional wisdom. Decisions need to be based on data and analysis which is easier said than done.

In the case of Starbucks, how did they arrive at price increase, going against the flow? The simplest calculation here is, when price conscious customers moved out all they are left with are price insensitive customers who prefer their products. Hence it makes sense to charge more for them as long as the loss in profit from further drop in customers is less than the increase in profit from higher price. (Here is an attempt at formal proof on why increasing prices yields better profits).

Starbucks has a gross margin of 22%. This is however the average. On their high priced premium drinks we can assume that their margins are at least twice as much. So let us say it is 44% gross margin. Their premium drinks retail for $3.75 or higher, so the new price is $4.05 and at 44% margin, their profit per cup is$1.78 . (Please note that gross margin numbers from GAAP income statements are not based on just marginal costs and include fixed cost allocations.)

Let us say they sell ‘N’ premium drinks in a year at the current price. The increase in profit from 30 cent price increase (if the number of drinks sold remains ‘N’) is  0.3N. You will see the value of N is not important to the analysis.

However, there is bound to be fall in sales. But how far should the sales fall to negate the benefits of price increase?

Let us say the sales falls from  by ΔN cups, then lost profit from this lost sales is   1.78ΔN

Their price increase will result in net loss only if 1.78ΔN  > 0.3N, that is sales has to fall by 17% from its current levels.  One in six people has to stop buying the premium drink.  (Note: We assumed a 44% margin, if it is lower  that that then the sales have to drop much more than 17% to make the price increase option unattractive)

Another way to look at this is from price elasticity of demand – % change in volume for one % change in price. For the price increase to be unprofitable, price elasticity of demand must be just over 2 (every % increase in price should result in  drop in volume of 2%).

The New York Times asks, “Will the hard-core customers pay more”? How likely is a 17% sales drop? Not very given that most price sensitive customers have moved out and what they are left with are those who prefer Starbucks over other brands. So their price sensitivity is most likely to be lower than it would have been before the recession.

Hence a 17% drop in sales is  highly unlikely. In terms of elasticity, premium drinks moved to inelastic part of the demand curve. As long as the sales drop stays below the 17%  mark, the price increase is a profitable and a smart move for Starbucks.

You can see how  Starbucks would have made this counter-intuitive decision – because it is based on evidence and analysis. Unfortunately this does not come naturally to most marketers, because no one wants to go against the flow or stand-up to authority. Worse, most marketers accept conventional wisdom without a challenge  because they lack  inclination and wherewithal to seek the right data and do the relevant analysis.

How was your last marketing decision made?

Before you cut prices

In 3 components of effective price management I talked about the need for doing an incremental analysis before making changes to pricing. For instance:

  1. What is the sales change expected for a given price cut?
  2. What is the minimum  increase in sales required to keep profit at levels before the price cut?

In other words  what is the price elasticity of demand for your product and does it justify the price cut?

Here is a real business example of such an analysis for the proposed $10 price cut by at&t for its iPhone subscribers.