If you are going to charge for content

If you are you going to charge for content it pays to start to with the customer segments that value your content (more than other alternatives available) and are willing to pay for that value. Recently Mathew Ingram of GigaOm wrote about a proposal that involves dynamic pricing

A model could work like this: The piece costs $1.99 for the first 5,000 articles sold, garnering $10,000 in revenue [and] once that threshold hits, the price adjusts dynamically to maintain at least $10,000 in overall revenue, but adjusting downward against the paying population as more and more readers commit (which also earns Esquire additional advertising revenue). A ‘clearing price’ is set, perhaps at 50 cents, after which all profits go to Esquire.

Let me tell you at the outset that I do not like this for one primary reason – it ties price to your revenue goals vs. value to customers. That is as bad as cost based pricing. I does not merit further discussion just for that reason but let me dissect it anyway.

For the sake of this article let me call this proposal as Group Buying Pricing.

This is not new. In fact it is almost hard to find anything new in pricing. Recently a variation of Matthew’s proposal was studied by researchers from Kellogg School of Management. And that method itself is a variation of really old Dutch Auction. Kellogg study called their pricing Purple Pricing. This fixes two flaws in Matthew’s proposal,

  1. Those who wait (till others buy) for the price to drop (sideline issue)
  2. Those who paid higher price than those who came behind them (fairness issue)

Purple pricing works like this

  1. Start with limited number of units to sell or set a time after which the product has no value
  2. Start with a set high price and periodically drop the price
  3. Anyone who buys the product at a given price is guaranteed they will only have to pay the lowest price the last unit is sold for

So if you like the product at a given price you should pay. You may not have liked it at $2.99 but when it drops to $1.99 you might find it attractive. You should agree to pay that price. The scheme guarantees you will not pay more than the lowest price someone else who buys the product after you pays. If the last price is $0.39, that is the price you will pay even if you bought in at $2.99. So it does not suffer from sideline or fairness issue.

In many ways a magazine fits well for Purple Pricing. While there is no limit on number of digital copies, its relevance is lost after the week. So Purple pricing will work and it is not operationally any more complex.

In addition Purple Pricing helps us find the distribution of customer willingness to pay (and hence the demand schedule) while Mathew’s Group Buying Pricing says nothing on that front. Customers have no reason to reveal their true willingness to pay with Group Buying Pricing.

If you are asking, “doesn’t that compromise revenue goals?”, you should recognize that you will not be dropping prices if what you get from new sales is not enough to lose the price premium you captured from all the previous buyers. In fact the proponents of Purple Pricing recommend that only as a method to find the demand schedule and use it to set a price that maximizes profit.

Both schemes do suffer from one common problem – What if the value for the content increases as more people read it?

As long as we are coming up with proposals for pricing for content let me also tell you about another old method – Becker-DeGroot-Marschack (abstract only) method. Here is how you do it

  1. At the time customer tries to read the magazine ask them to quote a price they are willing to pay – give them a range low and high
  2. Let them know right there that you will pick a random number between low and high right after they state their price
  3. If the price they quoted is greater than the random number you picked they only have to pay the lower number you picked and happily read the magazine.
  4. If the price they quoted is lesser than the number you picked, they don’t get to read (I assume your engineers can figure out how to enforce it so that people don’t try many times until they get lower price)

It is in everyone’s best interest to quote the price they are willing to pay – not high-ball (that would be silly) not low-ball (No magazine for you!). And you get to find the demand distribution as well.

All is well. But imagine all the complexity in the buying process when a customer goes to read a magazine. Think of all the cognitive costs. You surely do not want this to be the buying experience every time someone wants to read a magazine do you?

By all means do pricing experiments but use those experiments only to find the demand distribution. Then set a price that will maximize your profit and make it very easy for your customers to do business with you.



Why Do We Pay High Price for Wines in Restaurants?

Consider the following  three scenarios  and see if you can think of the answers

  1. Wine by the bottle: Why do restaurants charge such a high price for wines that you could buy cheaper retail (and even lower price in wholesale clubs)?
  2. Wine by the glass: How do restaurants price wine by the glass? Why does a glass of wine costs so high? Why not all varieties are available by the glass?
  3. Wine corkage: Why do restaurants charge corkage fee? Why allow customers to bring their own wine at all?

A common theme in all three scenarios is we are parting with lot more of our consumer surplus than we would in other situations. More bluntly, we leave with lighter wallet and not really know the value we got.

A recent analysis of wine prices in Manhattan restaurants found restaurants markup wine prices by 4-5 times the wholesale price they paid.

Restaurant Sciences tracks thousands of wine, beer and liquor brands across tens of thousands of restaurants, nightclubs and bars in the U.S. and Canada, and in the past six months, the company’s researchers found an “absolute increase” in wine markups.

But why? That article, while expressing anger at such high markups, did not take to task the wine guys who tried to justify the high markups with their costs.

Wine markup has to cover other costs

As a revenue center, wine has to support several other costs, said Mr. Sun. For example, there is the expensive stemware (Riedel), the salaries of the sommeliers (Jean-Georges has four) and even the cost of the wine list itself. For example, the 16 leather wine-list binders at the Jean-Georges flagship cost $500 apiece and every page in the book costs 15 cents a sheet. The list is 32 pages long and changes almost daily.

And then there’s the cost of inventory, particularly with wines that are kept for a period of years before they’re placed on the list. It’s expensive to buy wines and then store them. While these wines may be more pleasurable to drink after a few years of age, they restrict cash flow—and take up precious cellar space.

First customers do not go to restaurants or order wine to cover the restaurant costs. Customers hire restaurants for many reasons – none of which is to cover its costs.

So what the wine was served in Riedel? Did the restaurant buy the stemware just for this customer? Will they give a discount if I ask for my wine to be served in ordinary stemware?  NO and NO. The restaurants realized either they have to justify the higher prices by using value signals like Riedel stemware or found that using expensive stemware (one time fixed cost to the restaurant) helps set higher prices for the same bottle of wine. So to say the prices has to be high because of expensive stemware is an illogical argument that one would buy only after two bottles of wine (inside them).

So what the salaries of the sommeliers are high? Did they hire the sommeliers just for you?  If you know the exact wine you want to order and did not ask the sommelier do you get a discount? NO and NO. Once again the restaurant would not have hired four high-paid sommeliers had it not been sure that would help with higher price premium.

Same argument for $500 a piece wine-list or the decision to stock up an inventory. You get the idea of why a fixed cost component does not matter. In the absence of absolute value from a bottle of wine the restaurant is relying on all these external signals to bump up customer willingness to pay (which is malleable) or justify a higher markup using cost as as the argument.

To say these are valid reasons to justify 2-3 times but not 4-5 times markup is just plain wrong. As the article indeed does just that,

Take, for example, Montmartre in New York. This simple French bistro doesn’t have a wine list in a fancy leather binder (it’s one page in a plastic sleeve) or a team of sommeliers, and I doubt that it has the wines in its cellar for more than few weeks. The restaurant has been open for only a few months, after all. And yet, the markup on its wine list is close to four times wholesale—and often more.

There is no validity to the argument that  certain markup is good but anything higher than that is not.

So why are wine prices so high in restaurants? Two reasons, either it is a mistake or done with diligence.

Restaurants can set whatever price they believe will help maximize their profit. They can set this high price because they have no clue  and simply doing it because someone else is doing it or because they have done the math on how many will choose wine at what prices and what that means to profits.

It is possible most restaurants don’t know better. From the anecdotal evidence I have seen they do adopt the 3x multiplier blindly without understanding customers they serve, their preference, what budget are customers paying for wine and their willingness to pay.

That evening at Montmartre, I noticed that both of the couples on either side of our table were drinking, respectively, water and cocktails. And that’s not a scene that any wine director, winemaker or wine lover is ever happy to see.

So what some customers do not choose wine? Other restaurants know their customers and are okay if not all of their customers choose wine because the profit from those who order wine is more than what would have been had they set the prices lower with larger sales.

If you think wines are overpriced in a restaurant, do not order it. If the occasion warrants it or some else is paying for it, you will, regardless of the price.

Regarding wine by the glass?

Wines by the glass are priced to make it attractive for customers to buy the full bottle. For those insist on buying by the glass the restaurant is only happy to oblige and capture higher customer surplus. Here is the skinny on wine by the glass pricing,

 the conventional rule of thumb calls for the price of the glass to equal the wholesale cost of the bottle, plus, often, a few dollars more. And with five glasses in a bottle (or four, at a more conservative measure) that’s a profit margin so large that only the greediest restaurateurs would dare to charge a similar markup on a full bottle.

Regarding corkage, see what I wrote before.

Sometimes pricing is just wrong

Take a moment and think about this pricing scenario. What do you think the pricing for slim-fit shirts should be compared to regular-fit shirts of same brand, material and design?

Logical answer would be slim-fit shirts should be priced higher than regular-fit because there exists a smaller set of customers who prefers the look of slim-fit and value it enough to pay more for it. After all, demographically there are not many that would fit (and look) stylish in slim-fit and for those who want to look good with a slim-fit there is value that can be captured as higher price.

This would appear to be a perfect case of second degree price discrimination. Present two different versions at two different price points and let the customers self-select. It is fair too because all customers have the option to choose either one.

Except that is not how shirt makers think about pricing or set pricing. Here is how shirt makers set pricing

First they add up all the costs – including hours spent and fixed cost (overheads) allocation. The use “standard industry markups” to set wholesale price. Finally double it to get retail price. (And mark it down to generate sales)

It is as simple (or simplistic) as that. Cost based pricing with price markups and not based on customer value and willingness to pay.

Hence if you see same pricing for slim-fit and regular-fit it is not just a matter of missing out price discrimination it is a matter of setting the price wrong to begin with.

If you see different pricing it is highly likely that shirt makers chose to allocate different overheads – likely more to slim-fit because of smaller volume – than because they recognized opportunity for price discrimination.

Sometimes things are not as smart as you would like to believe.

Customer Job To Be Done Growth Matrix

There is a very simple way to think about how to grow business. It requires us to think in terms of markets and products.

Markets – Current market segment you play in and new markets you do not serve yet
Products – Your existing products and new products you have not built yet (and are outside of your current product line)

That gives us four ways to grow any business

  1. Sell more of what you make now in markets you already play
  2. Sell something new – not just product extension, something outside your product line – in markets you already play
  3. Enter new markets with your current products
  4. Enter new markets with something new – not just product extension, something outside your product line

It is more popularly known as Ansoff Growth Matrix.

Ansoff Growth MatrixThe matrix tells us it is easier to do 1 and gets progressively difficult to do steps 2, 3 and 4.

Loyalty proponents believe in staying with 1 and may be add a bit of 2. Product proponents get bored with 1 and want to build new and great (facebook phone). Those who believe buying growth spend more time and resources on 2 and 3 by acquiring businesses that sell in new markets or acquiring companies outside their core (eBay/Microsoft acquiring Skype)

There is a problem with this matrix. It is product driven as opposed to being customer needs (jobs to be done)  driven. When you look through the lens of your current products and new products you end up with approaches like unnecessary M&A and Facebook phone that are not aligned with how customer needs and how those needs are changing.

Let us redraw the matrix but now with Customers (customer segments) and Jobs as the two axes. If you are not aware of the “jobs to be done metaphor“, please see here before reading further.

Briefly, the metaphor asks us to think about customer needs as jobs to be done. Customers hire products among many alternatives to fulfill those jobs.

Customer Jobs To Be Done Growth MatrixNow it is not anymore the question of how to sell more of same products or build new products but a question of what are the current jobs we are addressing and what new customers and new jobs provide us opportunities for growth with our core competence.

Here is the recommended strategy for each quadrant

  1. Existing Customers and Jobs: Continue product evolution that cements your product as the best candidate for the job.  
  2. Existing Customers and New Jobs: The new jobs could arise because of trends impacting customers or simply adjacent jobs you never positioned your product for. Remember positioning is telling customers which job your product is applying for. Instead of going after jobs that are outside your core competence you are better off investing your limited resources on evolving customer jobs and related jobs that can be served by product pivots vs. completely new products (facebook phone)
  3. New Customers and Jobs you currently address with Existing Customers: Here the invariant is the jobs – two different segments have the same job to be done but you chose one segment over other and now considering serving the second segment. Understand the reasons why you did not choose that segment in the first place – is it the challenges in reaching them?, is it their willingness to pay? etc.
    Understand that different customer segments have different alternatives for the same job and hence different reference price. Choosing to serve lower willingness to pay segment should not come at the expense of price erosion in higher willingness to pay segment.
    My recommendations are to focus on packaging and pricing innovations that help protect current profits and add net new profits from new segments. It is not revenue growth at the expense of overall profit drop.
  4. New Customers and New Jobs: You still have the option of better product positioning to help capture new markets. But most times you are looking at completely new jobs that require product innovations and business model innovations.
    But the advantage is your focus on customer jobs and not on products – your innovations are aligned with customer jobs. While this step once again proves to be most resource intensive with most uncertainty, taking the jobs approach helps you ease into this without taking big risks, pie in the sky product innovation or expensive acquisitions.

There you have it, your recipe for growth derived from customer job to be done.

Willingness to Pay and Reference Price

Take a look at this Yelp review

 went through a mess of salons to get some price ideas for mens haircut and I am sorry, I’ve been paying 10-15 dollars for a haircut for 22 years. I cannot and will not pay $80. That’s the price of a new video game! I called the salon and I got a price of $16 for mens! $1 more than my maximum?

ref-priceWhat do we see here? An illustration of the fact that,  as customers we do not walk around with a price we are willing to pay for every product and service. To a large extent this number is shaped by experience and what we have seen and trained to pay. That becomes our reference price.

Any price above the reference price – like the $16 vs. $15 – is seen as a pain or price increase that need to be reconciled. And you can see how this reviewer felt after paying $1 over his old reference price.

Reference price is not a fixed number, fortunately for all of us marketers. It is malleable – newer products, cost justifications, options, or extras – can be used to move it. If the customer is convinced they are seeing value for the extras they will happily move to the new higher reference price and will settle there until next movement. The same reviewer ends with,

I can truly say with a tremendous amount of confidence. I have found my PERMANENT salon.

Back to Willingness to Pay – the $80 price limit this reviewer quotes is his absolute reservation price. No amount of benefits, features, brand, customer service etc. can move this user to pay $80 for a haircut. His willingness to pay is somewhere close (tad below ) that number. You should know that this is just one customer and may be there are lot of them like him while there are many others who are more than willing to pay hundreds of dollars for a haircut (or the salon).

What do these two parameters mean to you as a marketer or entrepreneur?

First stop asking questions like,

“Would you pay $3.99 for my product?”

Because customers do not know.

Second do not be afraid of raising prices, as long as you understand the effect of reference price and execute this change correctly.

Finally, if your product used to be free and you are considering pay model do not assume no one will be willing to pay that price. You need to find those who value it enough, target them and move their reference price sufficiently to get the price that is fair share of your value add.

How do you manage your pricing?

See also: Multi-version pricing at salons.

Amazon Price Discrimination Done Well

I wrote a while back about price discrimination and its bad rep. It is actually not all bad. My attempt to rebrand it as price harmonization did not catch on. The right kind of price discrimination is offering multiple versions at different price points so customers will self-select themselves to the version they want to pay.

Like you pick retina display with MacBook Pro or SSD disk over HDD. This is second degree price discrimination. With price discrimination, as long as you do not restrict customers from choosing certain versions and let them choose any of your versions then it is perfectly acceptable.

The success of second degree discrimination also depends on packaging and pricing the cheapest version such that it helps bring-in low-end of the market without being attractive to those who would gladly pick the higher priced version had there not been the cheaper version.

Amazon has a product that very nicely executes second degree price discrimination, while also capturing a little bit extra consumer surplus from one of the genders. (Yes, pure gender based price discrimination is bad but I will show you why in this case it is not the case.)

Take a look at the 3 versions of the same model of GPS watch.

The first version

base-gpsThe base model without heart rate monitor costs you $147.35 (at a discount of $52.64). If you want heart rate monitor to go with the black model, it is sold separately for $45, bringing the total to $192.35.

Now the second version

red-gpsIt is the red model with included heart rate monitor, priced at $184.91. That is $7 cheaper than black base model plus heart rate monitor add-on.

Why is the drab base model priced such that its combo price is more than buying bundled red model? Because they are targeting the base model  at low-end customers with lower willingness to pay.  And if some of those insist on heart rate monitor with that color they likely value it more hence have higher willingness to pay and should pay $7 extra over the bundled red model.

Also note the list prices of the base and red models – $199.99 vs. $229.99 – a difference of $30. But how they are discounted is much different from the $30 difference. You would expect discounted price of red model to be just $30 over black base model. Instead it is $37.56 over base model. In other words the amount Amazon has to discount to make the sale goes down as they move up the model.

That is $7.56 in profit from effective pricing.

Finally, the pink one

pink-gpsThe pink model, arguably a choice targeted only at women, is $1.22 more than the red model. But still cheaper than black combo.   Nothing prevents men from buying it so the pink model pricing is not at all a gender based price discrimination. But helps to capture additional consumer surplus from women who most likely will buy it. (I am succumbing to stereotype here! Sorry!)

So is $1.22 a big deal? For the razor thin per-product margin Amazon operates at and the volume it does, it most likely does. The $1.22 flows directly to their net-income.

Overall a very fine management of pricing.

But don’t attempt this at your business – most businesses, especially small businesses and startups do not have the volume, data and computational wherewithal to fine tune pricing to this level. Worse, most are not even in the right zipcode to attempt any such fine tuning.

Ask me what your business should do instead!