Goldilocks Tries Price Discrimination For Size
Sydney Morning Herald
Saturday June 8, 2002
Like baby bear's porridge, the middle product looks just right.
Why do the ink cartridges for computer printers cost so much? It can be as much as 20 or 30 per cent of the cost of the printer itself.
Why do the makers of software usually offer it in different-priced versions? Why does Microsoft sell its Word, Excel and PowerPoint programs bundled together in one Office ``suite"?
Why do software programs for sale in shops often come with the offer of $10 ``cash back"? Why not just cut the price?
And why do the hardback versions of books cost a lot more than the paperback version? (If your answer is because they cost more to produce, go to the bottom of the class.)
The short answer to all these questions is: because it makes the company more money.
The long answer is that all these things are ingenious examples of what economists call ``price discrimination". They're discussed in the best-ever book about Internet economics, Information Rules, by Carl Shapiro and Hal Varian (both professors at the University of California, Berkeley) and published by Harvard Business School Press.
If you think the way for a firm to maximise its profit is to charge the highest price possible, it just shows you haven't thought about it. When you do, you realise that every potential customer will expect to extract a different amount of satisfaction (``utility" in the jargon) from the purchase of a particular item, and so each will have their own maximum price they're ``willing to pay".
If you set your price too high, you'll lose the sales of all those people whose willingness to pay (WTP in economists' shorthand) is lower than your price. (And provided their WTP is higher than the marginal cost of producing the item ie, the cost of producing one extra copy you've sacrificed some profit.)
But if you set your price too low, you'll have charged all those people whose WTP is higher than your price less than they would have been prepared to pay. In which case, you'll have sacrificed potential profit yet again.
The gap between a consumer's WTP and the price they actually pay is called their ``consumer surplus". And the goal of every profit-maximising firm is to leave their customers with as little consumer surplus as possible. In other words, the thing business people fantasise about is being able to charge a personalised price to every customer. That price would be the customer's WTP.
Economists call that fantasy ``perfect price discrimination". But there are obvious reasons why it doesn't exist. For one thing, how could a seller ascertain what each person's WTP was?
And if you accept that you do have to settle on a range of prices, and make those prices public, how do you stop someone who'd be prepared to pay the higher price if they had to from saving themselves money by choosing to pay the lower price? In other words, how do you keep the different-priced ``markets" separate from each other?
These are the practical problems of price discrimination, faced and solved by most firms in most industries most of the time.
Since it's not possible to ascertain each customer's WTP, the common solution is to offer a range of similar products at differing prices and allow customers to ``self-select" which one they want according to their WTP.
How do you stop them all choosing the cheapest in the range? Product differentiation. You make the customer think the products are very different, whether or not they really are.
Price discrimination is an issue for almost all businesses (it even explains why they put little stickers on apples these days) but it's especially important for New Economy businesses because selling over the Internet offers an opportunity for ``one-on-one marketing" (and thus greater scope for tailoring prices to the individual's assumed WTP) and because, unlike most things, many ``information goods" (particularly software) have a marginal cost that's next to zero (meaning you can make a quid from an extra sale no matter how low you set the price).
Now, getting down to cases, the price of hardback books is much higher than the extra production cost would justify. That's why the release of the paperback version is always delayed.
What's really happening is that the people who just can't wait to read the latest book by their favourite author are being charged a sort of ``impatience premium" above people who are happy to wait (and thus have lower WTPs). The hardcovers are just there to disguise this shocking truth.
The ``versioning" of software programs may take the form of offering a dearer, high-end version for ``professionals" and a cheaper version for amateur users. This will almost certainly pull in more revenue than selling a single version.
But the smartest operators engage in ``Goldilocks pricing" and sell three versions standard, professional and ``gold" ie, too cold, just right and too hot. You'll pick up a bit of extra bread from the snobbish dummies willing to pay through the nose for the alleged gold version, but mainly you help most people quickly decide on the ``not too hot, not too cold" middle version (ie, the standard version, which you've hyped up as ``professional").
And the smart way to do it is to design a single, full-feature version of your program, then disable some features to produce the cheaper versions. Because there's a cost to disable features, this may give the cheaper-priced versions a higher production cost than the dearest-priced version but that doesn't matter! You'll still be making a higher profit than if you'd neglected to pick up the sales to the people with low WTPs.
The point of ``bundling" different software programs into a single suite such as MS Office is that each potential customer has a differing WTP for each individual program. By combining all these WTPs into bundles, you've reduced their dispersion and thus made it possible to appropriate more consumer surplus than if you'd sold the programs separately.
Why do software sellers offer small ``cash-back" vouchers? So they don't lose the sales of their more price-sensitive customers. Why do they put you to the trouble of sending the voucher in and getting a cheque back? To make sure you're fair dinkum about your lower WTP. (Most people aren't and don't return the voucher.)
The point about ink cartridges is not so much that their price is so high, but that the price of the original printer was so low. The printer companies want to make sales both to people who use their printers a lot and home users who use them infrequently.
So they set their hardware prices low to pick up both groups, but then recoup what they could have charged the high users by wildly overcharging for ink cartridges and other items that get used up. (The profit margin on ink cartridges is reported to be 50 per cent.)
They're able to do this because ink cartridges haven't been designed to be interchangeable between makes and models.
So, once you've bought the hardware, you suffer from ``lock-in" you have to buy the same maker's cartridges (known as ``complementary goods" but note the ``e"!).
Unless, of course, you're game to use the services of those naughty niche-players who do very nicely by offering to refill your old cartridge for a fraction of the new cost. Ain't capitalism grand?
© 2002 Sydney Morning Herald