The most talked about EverNote numbers on freemium conversion shows, 3% paying customers and 97% free users (freeloaders and hopefully some Do-Gooders).
When a user signs up, if we use priors as an indication of posterior, the probability this user will upgrade to the paid version is 3% (will not upgrade is 97%).
Let us assume the Lifetime Value of a User is $250. Since all the infrastructure costs are sunk and the marginal cost to serve an additional user is $0, there is no cost in serving the free user.
So the expected Lifetime Value of this user is $7.5 (3% * $250). Since this a positive value, it would appear that there simply is no downside to sign up another user for free.
However, what about users who would have upgraded had it not been for the free version? This could be either due to the $0 reference price or the value they get from free is good enough (See: value step function). This is the opportunity cost.Let us assume the same conversion numbers and assume that an additional 3% would have upgraded had it not been for the free version. The value you would have gained is a forgone opportunity and hence coded as red. This brings the expected Lifetime Value to just $0.225. Model this for different forgone opportunities, does Free look attractive any more?
You could argue that not all of the 3% who pay now would not have upgraded had it not been for free.
You could argue that it isn’t another 3% that was forgone.
You are correct on both aspects. However, if you do not know how many will pay for your product or if your prospects do not value the product enough to pay for the value they get, isn’t that a bigger problem?
In a talk at Haas Alumni Luncheon Mr. Chris Anderson, the author of The Long Tail and Free, talked about his new book Free. First few minutes into the talk he talked about his previous work, The Long Tail, and how the marginal cost of shelf space. He said how physical goods (what he calls atoms) have a marginal cost to produce, store and sell and how information goods (what he calls bits) have declining marginal cost that approaches zero.
I will set aside my previous arguments on why costs do not matter with pricing and focus on just what is marginal cost. According to Mr. Anderson, the definition of marginal cost is simply the cost to produce, store and sell one widget. That is the right definition if there are no opportunity costs. In his example he talks about how there is a marginal shelf cost to selling physical goods through Wal Mart. Why is there a charge? Because Wal Mart is looking at opportunity cost of storing your wares vs. someone else wares. If you look closely all shelf costs are sunk for Wal Mart, but still it charges a marketer a fee because of this opportunity cost.
Marginal cost is not about the widget you sell, it is the “relevant cost of serving one additional customer”. It is the higher of either the cost to produce/store/sell the widget and the opportunity cost of serving that additional customer. The definition is easy to see for physical goods. For digital goods, for example music, the marginal cost is not zero (as Mr.Anderson says regarding digital music just because there are no CDs) but the revenue lost by selling this music vs. another or the future revenue lost by setting a very low reference price in the minds of customers.
Once you consider the opportunity costs you can see the deficiency in the definition and argument based on marginal cost being zero.
Shiller (of Case -Shiller index) wrote in The New York Times about why home prices fall slowly instead of crashing and why the prices may continue to fall. This is a great explanation of the averages and the reasons for slow decline. Two questions occur to me:
- Why does a homeowner start with a very high list price even though the market price (based on comparable homes) is lower?
- Why are homeowners willing to let go an offer only to settle later for the same or lower price?
The reason for the high list price can be attributed to endowment effect. People tend to value things they own more than the things they do not. This is nicely demonstrated in a video by Dan Ariely. There is considerable emotional connections that get translated into higher utility and hence a higher valuation. In addition to this people do not consider opportunity cost of carrying the home for longer time. This results in initial high priced listing despite the fact that comparable houses in the neighborhood have been in the market for a much longer time and are currently priced lower than this house. Unfortunately buyers do not share the same emotional value hence houses end up sitting in the market longer.
The reason for rejecting reasonable offers during the initial days only to settle for same or lower price later is due to mental accounting that ignores the opportunity cost of carrying the home longer. Opportunity cost here includes additional mortgage payments, carrying costs and most importantly lost revenue from capital tied up in the house. Even if they considered opportunity costs, homeowners overestimate the chances of getting better offer and underestimate the time they need to wait for such an offer. Due to high initial price, a low offer will also look substantially lower.
The net result is prices not reflecting what the market is willing to pay. Hence the slow decline of home prices.
What do amusement parks, airlines, hotels, baseball games, and theaters all have in common? Two things, first their capacity cannot be stored for future use and second the cost to serve one additional customer (marginal cost) is $0. Once a plane takes off, all the empty seats in the plane expire, generating no revenue for the airline. How should a business price its service that falls in this category? Just because the marginal cost is $0 and the lost revenue opportunity should the excess capacity be sold at the lowest possible price?
There is a renewed focus (in the echo chamber of blogosphere), almost an obsession, with marginal costs and the fact that it is “spiraling to $0” for digital goods. Wired magazine editor, Mr.Chris Anderson, has been talking and writing about this and has a book coming in July. Before we go further I would like to reiterate that what it costs to produce a product/service does not matter in how it is priced and higher capacity utilization is not a valid reason for lowering prices.
The answer to the pricing question lie in:
- Opportunity Costs: The cost to consider is not the marginal cost but the opportunity cost of admitting one additional customer – that is what is the lost revenue opportunity from selling one airline seat now at a lower price. Only airlines excel in implementing this pricing strategy that is based on yield management.
- Value: That said, the business should look at the value created for the customer using the service. It is common sense that a business makes profit not just by creating value but by capturing some of it. Note that the value created is different for different segments (technically it is different for each consumer but it is hard to quantify).
- Reference Price: Businesses must consider the impact of low (or zero) price now on future profits due to the reference price effects. Once an airline sets a very low price or allows a customer to travel free because the cost is $0, then it risks setting a very low reference price in the minds of customers. In the future, such customers will despise paying regular prices and may even be up in arms. The effect of reference price cannot be understated, despite the value added to consumers the reference price prevents the business from capturing a fair share of the value added.
Do you know your opportunity costs, value created and the reference price? Please use trackbacks to comment on this.
I received somewhat surprisingly high number of views on How to price your garage sale article I wrote. I think people are searching online because of the time of the year for tips on pricing their garage sale. The article I wrote was probably not suited for the most common garage sales that sells many items for less than $5. Here is a set of 4 things to consider before your sale:
- Is it worth it?: Think of the opportunity cost of time spent categorizing, labeling, advertising and finally spending 3-4 hours manning the shop. Suppose your time is worth $50/hour, would you make more than $250 from your garage sale? If not, is it worth doing? Frugal families blog says, “anything under $2 sells fast”. That means you need 125 such items just to break even (after the opportunity cost). Note that you value your junk, err treasures, more than your potential buyers would due to endowment effect. Don’t overestimate the total sales to justify the effort.
- Alternatives?: Are there alternatives to garage sale like giving the items away to local charity and claiming tax deduction? If you do not itemize your taxes this does not help you. But think of the time saved and the general euphoria, however fleeting, from donating things?
- It is sunk, now keep moving: You might have bought your item at a higher price or you might have spent considerable effort building or improving it. Do the money and time spent in the past justify additional time and money for holding a garage sale? No, what you spent in the past is sunk. You should only consider the effort not spent and pick the best among the alternatives.
- Doing it for the experience: May be you do value the experience more: If you really think that the experience of holding a garage sale means something to you, be it a lesson in negotiation or just a way to meet the neighbors then by all means do it. However see (2) again.