Results From Pay-What-You-Can Experiment

Facing down economy, customers cutting expenses due to unemployment and overall drop in consumer confidence many small businesses  face excess capacity, high fixed costs  and drop in customers. One such business is Sensorielle spa in Boulder Colorado. For Sensorielle, or for any business, there were two options when they faced such steep drop in sales,

  1. Cut costs: operating costs  including staff cuts and marketing expenses
  2. Drop prices to appeal to wider customer base

Cutting marketing costs is not a good idea especially during recession. For a spa the differentiation comes from telling a convincing story and making a value proposition to customers that the services are far better than a simple massage they could get from cheaper alternatives.

The talented staff are the most important asset to a service based business like a spa, without them there is no convincing value proposition. It will also be very difficult to hire them back when the economy turns around.

Price cuts are never a good idea  especially when the service provided is valued highly by customers but they decide not to consume it because of changes in their wherewithal to pay. For a luxury spa, price acts as  signal of quality and value. It is also very difficult to increase prices after price cuts.

Ms. Jewl Petteway, owner of Sensorielle spa decided to experiment with “Pay-What-You-Can” pricing scheme. The net is, there are posted list prices but customers are encouraged to pay “what-they-can”. The pricing also served as marketing message to bring back customers, especially long time regulars.  A key point to note is that while this resembles “First degree price discrimination”, which is charging each customer their true willingness to pay, the “Pay-What-You-Can” is not aimed at capturing value.

Should this have worked? My hypothesis, when I first learned of this pricing, is that there are other ways to increase profits than leaving it up to the customer to pay. The customers do not always know the value they get. While the posted list price serves as a great anchor, “Pay-What-You-Can” tells the customers that the price is negotiable or that the list price is an upper bound the spa set but the true value is below that number.

M.Petteway published results from her experience in the Boulder Net LinkedIn discussion board. She talks about how  few customers interpret the pricing plan as “pay what I want” and ask for high-end services even though they pay less than the posted prices. For any rational customer (Homo Economicus) whose goal is to maximize their utility, it makes sense to pay the minimum they can get away with. But that is not the only reason why customers are paying less for the services.

When a business has a list price and then says, “pay-what-you-can”  it signals to customers, “you may value more but you don not have to pay the list price”. The list price is treated by customers as “full price”. Pay-What-You-Can ends up destroying value and decreasing the reference price in the minds of the customers. Even if there is not an explicit price cut, the signaling ends up decreasing customer willingness to pay.

My recommendation:  I do not believe in leaving it up to the customer to pay for the services. I instead believe in segmentation and targeting. They should have offered multiple versions at different price points and with unbundled pricing that allows customers to self select themselves to the version that matches their willingness to pay. The classic example in services is salon pricing. Price discrimination is not about leaving it up to the customers to decide what they want or can pay, it is about giving them enough choices and nudging them to the version they are most likely to choose and profitable to you at the same time.

Here are my other suggestions for small business pricing.

Suppose You Made Pricing Decisions Based On Your Marginal Cost

Let us suppose you made pricing decisions based on your marginal cost. One of the examples quoted in Mr. Chris Anderson’s series on “free” is digital music. Mr. Anderson says, since the cost to produce, store, distribute digital music is $0 (or approaches $0) it makes sense to give it away and find other ways to make money, like concert tours and other paraphernalia. Let us take the marginal cost argument to the extreme and apply to the concert itself.

The marginal cost to admit one additional person into the concert arena is, you guessed it, $0. Once you decide to put on a concert, pay for marketing, stage, security etc it does not cost anything additional to allow one more person for  free into the concert arena. So why not do that?  Because the marginal cost is relevant only up to the point whether or not you can breakeven on your initial investment and is always irrelevant to your pricing decision as long as you do not charge below your marginal cost.

Before you put on a concert , you add up all your costs of what it would take to do it. Then you look at what is your “average price” below which you cannot breakeven and hence makes no sense to do your concert. This is the floor for the average price. Then you determine the multiple customer segments and their willingness to pay for the tickets and design a multi-version pricing scheme that appeals to those segments. You design your pricing and product mix such that those with higher willingess to pay will self-select themselves to the higher priced version (because of closer seat etc). Then you determine the total profit  and see if this is net positive over the total cost of your concert. At no point you are deciding based on the marginal cost.

Why is this any different when you cho0se to distribute your music digitally?  I am not saying do not make your digital music free, by all means do it if that is the best among all available options in terms of total profits delivered. Make your business decisions because you have done the analysis and evaluated all options and not based on “everyone else is doing it” or “free is the law”.

But the problem with writing a book that says, make it free when it drives maximum profit through other means, charge for it when that delivers maximum profit,  is you are seen as hedging your bets. As Professor Dan Ariely points out, people trust confidence more than expertise. Prof. Ariely says, “We’re Swayed by Confidence More than Expertise“. You can sell more books with confident assertions.

Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want.  Maybe this is why so many pundits on TV for example exaggerate their certainty?

Reversal of Irrational Consumption

Have we been buying things that are worth less to us that the price we paid for them? If we all are rational we should not pay more than our willingness to pay which is a function of  what the product is worth and our reference price.  A recent Financial Times article on changing consumer preferences in recessionary times had quotes from several marketing professionals and academics. One of the quote was from Mr. Seth Godin, author of several marketing books,

Seth Godin, a marketing trendspotter, calls this the “affordable premium” product, which, like a McDonald’s coffee, is deemed to be worth more than it costs.

If we are rational (left image) we should only be buying products that leaves us a positive consumer surplus. What Mr.Godin suggests (or to be specific the FT’s quote states) is that we have been behaving like the right image.consumption

Does that mean we have been buying goods that are not worth the price  we paid for them? Perhaps. There are two possible explanations:

  1. Our consumptions were hedonistic and we convinced ourselves that the products are really worth more than the price we paid for them.
  2. Our consumptions were conspicuous – that is we have been doing them for keeping up with appearances and with the Joneses.

Availability of easy credit and high home prices drove us to behave like the right image and buy things that we were not getting the value for the price we paid. Now with bad economy we see the reversal to the expected rational behavior.

The bigger question is how do consumers value the products they buy? Even consumers do not know the exact dollar figure of value. A marketer can tease out this value and make a reasonable estimate of the relative weights we assign to the components of a product like is utility, hedonistic value, brand and luxury. Next up I will discuss the factors that go into the valuation and the current shift in consumer valuation.

Why we still buy incandescent bulbs?

CFL (Compact Flourescent Light) delivers savings in two forms

  1. Longer life and hence savings from replacement costs
  2. Energy efficient leading to savings on operational costs

The lowest grade  CFL lasts  five times as long as a high quality, “long life” incandescent bulb and saves $36 over its lifetime in energy costs.  The  said CFL costs $5.22 and the long life incandescent costs $0.42 each. Even excluding opportunity costs of buying and changing light bulbs, that is a total savings of  $33 over five years. (Source WSJ)

This does not even address the environmental costs savings from using less energy.

So why do we still keep buying incandescent bulbs when the economics of a CFL are clearly better?  I think the answer lies in our we discount future benefits. If we are rational decision makers then  the present value of $33 will guide us to simply choose the CFL option.

We are not. We have the tendency to underestimate future benefits and hence value it lower than the value of an option with near term benefits. We read news stories, we understand the benefits of CFL but when it comes to the moment of choice our value curves switch and we pick the incandescent bulb which is priced at $0.42 compared to $5.22 for a CFL. George Ainslie called this the hyperbolic discounting, the same concept that is used to explain addiction and temptation. In some sense we give in to the temptation of the present and forgo future benefits because of our ways of discounting the future.

The EU and the US Governments have announced plans to phase out the incandescent bulb in the coming years. I wonder why wait a few years? Is it not time to put some Nudge to work? Why not take away the temptation that stems from higher near term benefit? The Governments should charge a very high tax on these bulbs, to bring their price close to that of a CFL. Anyone buying incandescent bulb even after  these highly taxed prices do really have a need for them and should be charged another price premium.

Wherewithal To Pay

My next work on behavioral economics is about  pricing effects in changed economic conditions. Here is a sketch of the ideas I am working on. Here I introduce a new phrase that mirrors “Willingness to Pay” – Wherewithal to Pay. While you are there do check out my other decks as well.

Unlike an Economist

An economist is trained to assign value (in measurable units too) to every action we undertake and everything we buy. There are always trade-offs and costs including opportunity cost of not picking the next best option. If an option does not offer positive expected net present value it is not worth undertaking. If there are multiple options, then you pick the one that offers the maximum expected net present value.

We do not run our lives like an economist. Our decision making is flawed and is based on emotions than rational thinking. When looking at the decisions made by others, with the advantage of hindsight and emotional detachment, we make commentaries about the qualities of those decisions. The New York Times has an article by DAVID STREITFELD on the unfortunate homeowners who used storage to stash their belongings after foreclosure on their homes. David says,

“… some people cannot keep up with their storage bills any better than they could handle their mortgage payments and the storage companies are auctioning of their property for a pittance”

An economist would ask, have these people considered all options before choosing storage as the best option? David asks,

This is the eternal mystery of self-storage. If the material was worth
money, it was foolish to let it go to default. If it was not worth
much, why spend at least $50 a month to store it?

The problem is most people, and we can safely say all of these people who used storage only to lose the contents, do not have a formal decision process. One could argue that if they did, they would not have reached this stage in the first place. But if we give people the benefit of doubt, unexpected events and bad luck could easily be the reasons that drove them to foreclosure. Kirchler and Rodler of University of Vienna say in one of their cases on Consumer behavior,

“People in private households make decisions when they are still groggy in the morning or tired again in the evening after a day’s work. Economics decision making is imbedded (sic) in the daily routine of a relationship, which is faced with a multitude of different decision topics which often do not present themselves one after the other but rather demand simultaneous solutions”.

At the time of foreclosure they are already stressed and are trying to make a living and/or support their families. Their already sub-optimal decision making process is further weakened by their current state. They cannot make economic decisions on whether to sell the stuff right away or pay the rental charges to the self storage.

People tend to look at their property as a representation of their past, a life they once had and want to have back in the future. While it might make economic sense to sell these off rather than spend $600 a year to store them, only to lose them later, their emotional attachment makes them choose the option of storing instead of selling.

Unlike an economist people are not rational. Unlike a economist people are emotional. Unfortunately, this emotional decision process destroys private and public wealth.

This brings us to the questions,

  1. Should people be making their own decisions?
  2. Should there be professional decision makers, trained economists, who can take on the multitude of decision problems that require simultaneous solutions?
  3. Just like people are not qualified to treat their own medical conditions, should they leave their economic decision making to professionals?

Addendum: People may very well be making a valid decision if they think they value their possessions to be more than the cost to replace them. This could easily be the case as explained by Endowment effect that states we value things that we own more than what the market is willing to pay to buy from us.