How Discounting Affects Product Value Perception?

It is fair to say everyone loves a discount. There is data to support the claim from years of Black Friday discounting that not only makes customers skip sleep and stand in cold weather for hours but also generates considerable revenue for the retailers. Then there are the group buying discounts made popular by GroupOn.

At the individual customer level, previous research done on customer preference for discounting point to both rational economic and emotional reasons.  Kahneman and Tversky showed, customers prefer discounts even if they saved lower amount in absolute terms.

Thaler in his work on Mental Accounting and Consumer  choice provide evidence of emotional (non-financial) reasons for why we may be motivated by discounts.

So we all value deals for rational and irrational reasons. But how much do we value the product after the initial buying decision? More specifically, since we do not know the absolute values, how much relative value do we place on a product bought on a discount vs. an identical and substitutable product bought without the discount?

There are three distinct possibilities.

Hypothesis 1: If we treat our customers as rational (ignoring the contradiction), once they bought the product at whatever price, the costs are sunk. How much relative value consumers get from each product should depend only on its own merits and independent of initial discount. At the very least, the choice between the two should be no different from  a random choice.

Hypothesis 2: If we treat our customers consistent with their previous action of seeking discounts for non-financial reasons, we should expect them to value the product bought at a discount higher than that of the one bought at full price.  This hypothesis is further reinforced by endowment effect and cognitive dissonance (I must really value this product, otherwise I would not have stood in line for it).

Hypothesis 3: Customers value the full price product more than the one bought at discount (remember the preconditions – identical and substitutable products).

So I conducted an experiment. The data and analysis show that  the last scenario, Hypothesis 3, is more likely than the other two.

The experiment was designed to get customers to reveal their preference by asking them to give away one of the two identical products of same price:

1. One they bought at full price
2. Other they bought at 50% discount

As it turns out, customers are more likely to keep for themselves the full priced product and happily give away half-priced identical product.  So while discounting may bring in customers, it may hurt by depressing the relative value of the product to the customers.

What does this mean to you as a marketer?

1. Think again before running 50% deals on any group buying site or allowing your product to be bundled and sold at a discount by other channels.
2. Attracted by large user base from giving away your product for free? Consider loss in perceived value to the customer.
3. Know the customer’s end use of the product. If they are predominantly buying it for their own use, discounting most likely will not help improve lifetime value of the customer.  If they are buying it for others, discounting helps.

Want more actionable insights? Talk to me.

Further readings:

Kahneman and Tversky – Choices, Values and Frames, American Psychologist,  1984

Thaler – Mental Accounting and Consumer Choice, Marketing Science 1985

Note on the Experimental Method:

I relied on convenient sampling and applied Bayesian hypothesis testing. Compared to conventional, run of the mill hypothesis testing, say testing for statistical significance at 95% confidence level using Chi-square test for this case, Bayesian Hypothesis testing allows to test multiple hypothesis at the same time and help state the results in terms of probabilities instead of as absolute truths.

Results are subject to sampling errors, and do not take into account segmentation differences. This is also stated preference study and not a revealed preference study.

From Price Leadership to Price-Less Leadership

The common analytical modeling methods used in pricing, model a product’s value as a sum of the values of its attributes.  Different customers value the attributes differently but in general they are willing to trade one for the other as long as the products in the choice set have the same total value.

There are indeed innumerable products and each has numerous attributes. But all the attributes across all products fall into just two categories:

1. Price – that adds negative value to the customers
2. Everything else that adds positive value to the customers

What if?

What if we removed all attributes but price?

What if  we asked the customers to rate the products based purely on price?

The product that customers rate the highest will be the Price leader . It probably varies across segments but it is hard to tell the segments with price as the only attribute.

Again What if?

What if we removed price as an attribute from the model?

What if we asked the customers to rate the options based purely on the non-price attributes?

The product that customers rate the highest is the Price-Less leader. The leadership most likely varies across segments but it is defined only by non-price attributes.

In general price leader and priceless leader are never the same. Either one will do as long as your product is the leader.

But …

1. Price leader either has just one segment or treats the whole market as one but the Price-Less leader knows the different segments and what is relevant to them
2. Price leader has one lever to control  but the Price-Less leader  has many levers available at their disposal.
3. Price leader has one message to convey but the Price-Less leader gets to have conversations on a variety of topics that are relevant to the customers.
4. Price leader innovates on driving out costs and inefficiencies in their products and processes but Price-Less leader does that and  innovates on driving out costs and inefficiencies in customer’s systems and processes.
5. Price leader worries about ending digits in their price, whether to list the $ sign or not, creative packaging etc. but the Price-Less leader gets to focus on versioning, what is relevant to each segment and how to create unique position in the minds of customers.
6. There can be only one Price leader and it is not easy to keep the title.  There can be many Price-Less leaders, based on segmentation and the end purpose the customer is hiring the product for.

Strategy is about making choices. Your choice is whether to be the Price leader or the Price-Less leader.

What is it going to be?

The Value Waterfall

[tweetmeme source=”pricingright”] You have a great product – be it a software offering or a physical product and your economic value-add analysis shows that your product creates considerable value for the customer. But does your customer see it that way?  Since price represents your fair share of the value created, do you get a fair share if there is a gap between the true value created and the value realized by the customer?

What is stopping your customers from seeing the full product value?

In the context of Price Realization, I wrote about Price waterfall (first introduced in the book The Price Advantage). Price waterfall shows the price leakages that reduce your price realization. Another common, yet not so obvious, factor at work is the value leakage – the loss in value perceived by your customers. This is the  Value Waterfall. In pricing and cost-benefit analysis marketers focus on the costs incurred by them and the value created for the customers but not many consider the costs imposed on the customers in selecting and using their product. Value leaks are the costs incurred by the customer that leads to the following Value Waterfall:

There are five factors that decrease the perceived value of your product, creating the Value Waterfall:

1. Credibility Discount:  While your calculations may be supported by analytical rigor, there are generalizations and assumptions that went into your estimate, not to mention some bias. Does your customer trust and believe your numbers? This is the credibility discount applied by your customer.
2. Selection Cost: I wrote about the cognitive cost to customers in selecting a product. Be it evaluating all the options available in the market or evaluating the multiple versions you offer, there is a definite cost to the customer. The effect of these costs carries over from initial selection to product usage and hence decreases the product value.
3. Cost of Doing Business: These are the costs to customers in adapting their buying process, business processes and operations, training their employees,  etc so they can start doing and continue to do business with you and use your product. For example, do you only deliver on Fridays? Do you fit within their procurement system? Does your billing cycle fit customer’s accounting needs? The net is another reduction applied to the product value.
4. Risk Aversion Discount: What is the risk your customer is taking in going with your product? Are there social concerns – how will they be perceived by their friends, peers or their bosses? For instance, if you are selling bike helmet, will it make them look more dorky? If you are selling SaaS, are they worried about availability?
5. Reference Price Difference: What does your customer consider as the substitute or alternative to your product? What is the price they pay for that? That is their reference price. If customers had always relied on cheap offering, despite its low value-add, they will be evaluating your product base on this reference price regardless of the true economic value from your product. Reference price has been proven to decrease customer’s willingness to pay for the value-add.

So despite starting with a large pie, the one you gets a share of is considerably reduced in size due to value leakage.

What can a marketer do about it?

How can you not only stop the value leakage but also turn each incident into a value addition?

Stay tuned for Value Staircase.

Pricing Kindle Books

Dan Brown had the opportunity to decide how his new book, The Lost Symbol, must be priced (or more precisely when it should be released if it were to be priced at the standard $9.99 price). He decided that it would be better to reach as many readers as possible. Here is what he said to WSJ,

“As an author, you want your book to be available in as many formats as possible,” Mr. Brown says. “I know that some of my readers have e-book readers, and I wanted my book available for them.” He says it was ultimately a group decision.

From the author’s point of view the cost and efforts he invested on writing the book are sunk. There is also the risk associated with  delaying the Kindle version, if for any reason the book turned out to be a flop then the expected Kindle sales could be much lower than what it would be if  released at the same time as hardcover format.

But why would he not want to price it at the same level as the hardcover books or at a higher price point that the standard $9.99? People who prefer reading on Kindle know the trade-offs and prefer the Kindle version over the hardcover version.  If the Kindle owners wanted to read the book at the same time as it was released then it should not matter to them that it is priced at the same level as the hardcover books.

Let us do some numbers. The lowest price  one could pay for the hardcover version was $14.50 at Wal Mart (I am not sure if the price is still good). By choosing $9.99 price, the lost profit per book is $4.51 per Kindle version sold. To make up for the lost profit, the number of Kindle versions sold at $9.99  must be 45% more than it would have been at $14.5 price. Conversely, the sales at $14.50 must be at least 31% lower than it would have been at $9.99 to warrant a $9.99 price.

Either way you look at it, that is large sales increase (or drop) for the lower price to be more profitable. This leads me to believe that there was lost value  (pun intended) by offering The Lost Symbol at the lower price.

Free Radical

[tweetmeme source=”pricingright”] As a follow-up to Mr. Chris Anderson’s talk at Haas Alumni Luncheon and his description of continuously decreasing marginal cost I talked about opportunity costs and when it replaced the cost to produce/store/serve one additional unit.

Let us set aside the cost discussion and focus on price. Mr. Anderson’s new book’s sub-title is “The Future of a Radical Price”. Free service with Ad supported business model is not new and Mr. Anderson says that as well. What he says about free model is the emergence of a “freemium” model. What is “freemium”? Mr. Anderson explains this in a letter he wrote to The Economist,

The big shift since the crisis has been the rise of “freemium” (free+premium) models, where products and services are offered in free basic and paid premium versions. Think Flickr and Flicker Pro (more storage), virtually all online games and even your own site (some free and some paid content).

So many users pay nothing and get limited service and some pay to get a different class of service. I am not certain why this is radical or new. Let us consider following scenarios

1. Taxation on Paying Customers: The free users are irrelevant to provide service to the paid customers. In this case the business is simply throwing away money by serving the free customers. There is nothing new here. Paying customers subsidize the free customers – so paying a higher price to support the marketer’s higher cost structure. What is in it for these customers to support the freeloaders? If the business one day decides to jettison all free users, it is simply eliminating a cost function that has no associated revenue and giving value back to paying customers.
2. Up-sell: The business depends on converting a part of the free users to paid users over a period but otherwise it does not need the presence of free users to serve paid users. In this case it is no different from a business spending on marketing to bring in paid customers. Any one free user  by herself is not important but as a collection she is. This is similar to a mail campaign that has 1% conversion rate. Each mail you send out by itself is not important, but it is as part of the whole bunch you send out. So suddenly eliminating free customers is the equivalent of completely cutting off marketing spend. As long as the business can hold on to current paid customers and  has other ways to acquire new customers it can cut-off free users. In this case too the model is no different from what exists  in non digital businesses. Incidentally, whether or not there is a  cost to serve one single free user is irrelevant because the relevant cost to consider is the total cost to serve all free customers.
3. Value Distribution: The business needs the presence of free users to serve its paid users, in other words presence of the free customers adds value that is shared between the marketer, paying customers and the free customers. This is the classic two sided market, like eBay, in which one side creates value and hence is not charged and the other side consumed value and is charged for that. One again this is not radical. The presence of free customers is essential for the service and the paying customers who are not subsidizing free customers but compensating them for the value add.

Price is about capturing value created for customers, if the business chooses not to charge for that value-add then they do not have a working business model. Free is not a price, definitely not radical,  it is either failure to capture value, customer acquisition activity or  simply matching price with value added.

Do we know value when we see it?

In past few articles I wrote about the price consumers pay and the price marketers get to charge. Those explanations depended on the value consumers get from buying the product. In B2B segments and in some  utilitarian product categories (like a light bulb) it is fairly easy to calculate economic value to the consumers.  But how can a marketer find the value added for the rest of the products? Do the consumers even know the value they get? I would like to remind you here that there is no magic value reader that is available.

I was looking at a JCPenney survey that asked, “Did you get value from your purchase?”. If customers do not know the value how can they answer this? Even if they did, this question does not help find what that value was.

There is one advanced analytical method, it is called by an esoteric and not so relevant name – conjoint analysis. Stated in simple terms the method is about

1. Consumers do not know the absolute value of products they buy but we can deduce that from their preferences and likelihood of purchase. Instead of asking  consumes for how much they value ask them about how likely are they to purchase a given product on a scale of 1 to 100. This is called “Utility” in conjoint analysis. Note that the use of the term Utility does not imply that the product is  utilitarian.
2. Any product can be modeled as a sum of its components, not just utilitarian features (like price and screen size of a TV) but hedonistic features like 1080 dpi and conspicuous features like diamond studded TV. The price should always be a component in your modeling.
3. Show consumes a series of products with different feature set and ask for their rating. From these ratings we can deduce not only the  utility values  of different products but also the relative weights they assign to the components.

This explanation barely scratches the surface, you can find more information on this in a SlideShare presentation I published.  The net is that there are analytical methods that can be employed to get consumers to reveal the values and what components go into that value equation.

With this setup and my previous classification of consumption I will try to model consumer behavior with respect to  utilitarian, hedonistic and conspicuous consumptions and the shift in consumer buying patterns from luxury product categories to “premium” or  utilitarian categories.