Renowned investor Warren Buffett has said, “The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.”
This sage advice from a man far smarter than 99% of us – may turn out not to be completely right.
Old School Pricing Theory
Pricing theory tried its best to explain large market behavior. Demand elasticity was touted as the answer to price setting, and, in a pre-computer world when it was developed, held some truth. Digital transformation has obliterated this theory and many pricing models build with it as a logical foundation. This means that the idea of a single price is no longer as relevant as it was.
With the advent of online price comparison you would think that the lowest, simplest price would win, in fact – in many instances, prices are more obfuscated by digital transformation than simplified and pricing simplicity does not increase the chance of conversion.
Dynamic pricing is the the next problem, not the next solution
Digital channels allow businesses to price dynamically based on a variety of factors. Value is not just based on utility, brand or comparative cost benefits of a product – it is a range of factors, many of which are external to the product, which can now be dynamically applied to personalize price. This both increases yield and expands the addressable customer segments.
The challenge is not the technology or understanding the concept of personalisation, but developing robust pricing models and the depth of thinking that enables new pricing variables to be created.
Don’t think in a line
When you stop thinking of price as the economic demand/supply curve but rather as a matrix, your entire approach to product design and pricing strategy changes. You are no longer looking for an elasticity curve to best fit your product but rather looking for a pricing strategy that maximizes revenue (and hopefully profitability) over a given time period. A pricing matrix allows you to look at price points in clusters which, inevitably, increases your price/revenue opportunities.
While revenue management is not a new concept (hotels and airlines have been doing it for years), it is often overlooked in many other industries and the role of methodically testing different pricing assumptions is ignored in favor of meeting a customer need. The best example of demand driven revenue management at the moment is by google, who mix demand based auctions and quality scores to ensure they not only push up price via bids, but also maximize revenue by rewarding ads that are clicked on more.
Product managers, in a desperation to have their product adopted, often prefer to have simpler, lower prices. This doesn’t make these pricing models correct – it makes them common and easy to execute.
How to Think About Price
As a childish rebellion against the need to create fancy, complex charts – the sandwich chart is a nice simple view of different layers of pricing. While not as comprehensive as a full matrix.. it highlights some of the key aspects that need to be put into consideration
Some examples of what these items mean:
Affordability vs Price
Affordability of a product is more important than price in many instances.
When South African mobile operator MTN- one of the largest operators globally, initially launching and expecting around 250 000 post-paid monthly subscribers as its total market.
Then they had a revolutionary ides – to do away with the monthly pricing model. To let consumers (generally lower income) pre-pay for usage as they need it. Not only could they charge much more per minute/per MB etc as a pre-paid customer, but the operator isn’t required you to give you credit (i.e. take risk) and gets upfront cashflow. It was a genius pricing insight, a customer segment will pay a premium to be given smaller increments. It also added around 200 million subscribers to their business and unlocked developing markets for all operators as it gained adoption.
The next idea was expiring the airtime i.e. if you don’t use it, you lose it . This created a new pricing variable – 1 day pricing vs 30 day pricing. The genius of this model is it creates comparative decision points based on when you will use your minute and obfuscate the value of the actual minute i.e. the cost per call. It creates multiple points of value for the same minute (which in itself is a pricing point and in no way linked to how mobile technology cost structures really work).
A recent study by Ali-Baba showed a 114% increase in conversion once special offers were provided after an abandoned cart. When we look at pricing purely as a retail price point versus a sequence of pricing including discounting as part of our strategy, we miss a key component of the matrix. How do we overcome fear or plug into greed in such a way that the consumer is convinced the price is too good to miss right now.
In the MIT paper “ markdowns versus everyday low prices”, the authors show the impact of behavioral economics on price perception, specifically fear and that consumer behavior is orientated towards” buying a deal” versus everyday low prices. In other words, emotional inducements are a powerful contributor in the pricing strategy – making pricing intrinsically illogical from a consumer perspective. Humans, prefer to “hunt” a deal than always pay a lower price.
You can test value/price before launching a product .Often, we see prices test well that don’t make sense. A specific pricing peak where we find higher conversion rates, these prices are usually not the cheapest nor are they based on specific rationality/logic other than a consumers value judgement on the right price for a product (i.e. too cheap/too expensive). Sometimes, the same product has two pricing peaks i.e. there is distinct interest for the same product in two different price segments and you need to choose how you will differentiate for the different pricing opportunities.
In a number of research studies we have seen that consumers have a weak link between what something costs them and what the price is -i.e. consumers latch on to a single number as “the price” but don’t understand the total cost of the transaction. This is prevalent in a number of industries like forex/low cost airlines/insurance/banking/investments/car rental/telecoms .
The industries that maximize value well are often finding ways of linking the value of your product to an external element that pushes up the value of your offer when it is used e.g. % of revenue (credit cards) or exchange rates (forex).
By Nevo Hadas – Nevo is the Founding Partner of &Innovation, now DYDX