Noted economist Richard Thaler once surmised:
Next time you find yourself short of cash for lunch, try the following experiment in your class. Take a jar and fill it with coins, noting the total value of the coins. Now auction off the jar to your class (offering to pay the winning bidder in bills to control for penny aversion). Chances are very high that the following results will be obtained: (1) the average bid will be significantly less than the value of the coins (bidders are risk averse); (2) the winning bid will exceed the value of the jar. Therefore you will have money for lunch, and your students will have learned first-hand about the “winner’s curse.”
The winner’s curse is a phenomenon in which the winning bidder in common auctions with incomplete information (i.e. the jar full of coins where the actual value is unknown) tends to overpay.
It was first identified in the early 1970s when three petroleum engineers looked back at historical data and observed low financial returns for successful bidders in auctions of oil and drilling rights. The premise was that the winners were ‘cursed’ by paying too much for the leases. It’s a concept that continues to be prevalent today in everything from wireless spectrum auctions to baseball's free agency market.
Perhaps the simplest way to explain the phenomenon is to think about a scenario where parties are given access to certain data (they all observe the jar full of coins) and asked to estimate a quantity from that data (the exact dollar amount of the coins). Typically the different estimates will follow some sort of normal dispersion with the average estimate being lower than the actual quantity. But remember, it is not the average that matters. The only bid that matters is the most extreme estimate – the highest price in the auction. And as such, the winner is cursed because they have most likely bid too high.
The game theory scientists will say that the winner’s curse is the result of systematic errors – something akin to what economists label as irrational behavior. They may both be correct, but the fact of the matter is that despite the extensive research and increased public awareness, the phenomenon continues even today. So to avoid becoming yet another victim of this curse, here are a couple of simple rules to remember:
- As the number of bidders increases, so does the probability that the winner will overpay
- As uncertainly increases, so does the amount that the winner will overpay
- The more accurate the bid, the less chance there is to win the auction
Here’s the takeaway: In a perfect world where precise information is available to all and participants act completely rational, the winner’s curse would be non-existent. But this is just one more reminder that most situations aren’t so clear-cut in real life.
In a recent Wall Street Journal article that highlighted the real-time price war being fought between traditional brick-and-mortar stores and their online competitors, an interesting comment was made by one of the big box giants.
Black Friday, with its deep discounts, isn't good for profits. But chains that don't participate risk losing shoppers' attention at a time when a fifth or more of their sales can be on the line. Shawn Score, Best Buy's newly appointed head of U.S. retail operations, said the point of all the discounting is to earn shoppers' loyalty for future purposes.
I’m actually stunned by the last sentence. Does Best Buy’s newly appointed head of U.S. retail operations really believe that “the point of all the discounting is to earn shoppers' loyalty for future purposes”? If so, I'd sure like to see some supporting evidence. My guess is that the relationship is just the opposite. As discounting increases, buyers become conditioned to focus solely on price at the expense of everything else.
Forget customer loyalty. Because of these Black Friday promotions, more and more customers shop at Best Buy solely because of price. When competitors match or exceed Best Buy's price (which always happens in a price war) these customers are gone. And if they do come back to Best Buy for any future purchases, it's will be driven by price, not loyalty. Like the article said, deep discounts aren't good for profits. Best Buy has only themselves to blame by participating in these types of suicidal price wars. It reminds me, once again, of the old pricing joke. “You lose money on every sale…” - ”Yeah, but we [Best Buy] make it up in volume.”
We’ve said it many times before…price wars are a fool’s game.
Can the price of milk act as the de facto reference price used by consumers to determine the price competitiveness of an entire grocery store?
The answer is yes according to Tudor Bodea and Mark Ferguson, authors of Pricing Segmentation and Analytics. According to the authors;
Consumers are more aware of the “market” price of some items more than others. For grocery stores, an item that consumers frequently use is the price of a gallon of milk. Since most consumers buy milk every week, they tend to be very aware of its price. Thus if they enter a particular store for the first time and notice that the store prices a gallon of milk significantly higher that what they are used to paying (above their reference price), they will form an impression of the entire store as being a high-cost location. If, by comparison, the store prices an item such as nail clippers significantly higher than its competitors, consumers may not even notice this price difference since they buy nail clippers infrequently. For this reason, the price range for a gallon of milk is fairly small among competing stores; while the price range for items bought less frequently may exhibit a wide range of prices.
While the authors’ reference to nail clippers highlights the contrast in consumer awareness, it’s not what stores should be focusing on. The key to increasing revenues is to find those items that consumers purchase on a more frequent basis where reference prices have not been established. One easy area to focus on are items where size or weight is not uniform. A gallon of milk is a gallon of milk; the price comparison is quite easy. But other frequently bought items such as breakfast cereal come in so many different sizes that price comparisons are quite difficult. And these are the items where stores should be realizing higher than normal margins.
In their book Yes! 50 Scientifically Proven Ways to Be Persuasive, authors Noah J. Goldstein, Steve J. Martin and Robert B. Cialdini tell the story of an unexpected sales event that occurred in 2003.
“In the year 2003, there was clearly one car line that exceeded all U.S. sales projections to a far greater extent than any other. Ironically, this car line had previously proven itself to be a completely ineffective profit-maker for the manufacturer. Strange, then, that all of a sudden and without explanation, its sales skyrocketed. But why? It couldn’t have been driven by advertising; in fact, because of disappointing sales, there was even less money available for marketing. Nor was there any engineering or price change to account for the unexpected popularity. Which car line was it, and why did it become so successful?”
“The car line was Oldsmobile, and the reason for it’s success was paradoxical: General Motors, its manufacturer, had decided it was going to discontinue the line due to consistently poor sales. In response to the announcement that the Oldsmobile would soon no longer be available, sales jumped like never before.”
The question is why? Why did consumers flock to a product that they had previously ignored and sometimes disdained?
The reason goes back to that all-important concept of behavioral economics and this case, the scarcity principle: people tend to show a greater desire for things that are unique or scarce. Or to put it another way: we want what we're afraid we can't have.
If something becomes scarce, we anticipate possible regret that we did not acquire it, and so we desire it more. This desire is increased further if we think that someone else might get it..
One way to leverage this power principle is through your messaging. Create the perception of scarcity and people will follow. The classic example of this is advertise your product as available in limited quantities, or for a limited time only. Why do you think the Home Shopping Network displays a countdown timer for all its products? It’s the scarcity principle. Once the clock strikes zero, the product is no longer available.
Another way to leverage this is to control supply. If you can control supply, then you have a significant lever on demand. The De Beers company buys huge quantities of diamonds on the world market, simply to keep them scarce from other sellers so a high price is maintained.
Here’s the takeaway: The scarcity principle is a strong component of behavioral economics. It drives consumer behavior in ways that are sometimes inexplicable. I’ll wager that many of those Oldsmobile buyers in 2003 had vey little desire to buy that same car a year earlier. Make sure that you utilize the scarcity principle in your current sales arsenal.
The word is that the newspaper industry’s adoption of “paywalls” is going to pay off in spades…at least that the opinion of industry investors who have bid newspaper stocks up significantly—50% to 80%--this year. This recent rise is due to investor confidence that the decade-long drop in circulation revenue will finally be stemmed because of the use of paywalls where readers are finally being forced to pay to view content.
The Wall Street Journal’s Keach Hagey wrote about this earlier in the week. In an article titled Paywalls Giving Newspapers a Change at Comeback (I’d insert the link here, but the Journal utilizes a hard paywall; given the subject of this article, how apropos!), the author talks about how paywalls are being used by newspapers to stem the industry-wide revenue decline over the past decade.
For those unfamiliar with the concept of paywalls, here’s a primer according to Wikipedia:
A paywall is a system that prevents Internet users from accessing webpage content (most notably news content and scholarly publications) without a paid subscription. There are both "hard" and "soft" paywalls in use. "Hard" paywalls allow minimal to no access to content without subscription, while "soft" paywalls allow more flexibility in what users can view without subscribing such as selective free content and/or a limited number of articles per month. Newspapers have been implementing paywalls on their websites to increase their revenue which has been diminishing due to a decline in print subscriptions and advertising revenue.
While paywalls are used to bring in extra revenue for companies by charging for online content, they have also been used to increase the number of print subscribers. Some newspapers offer access to online content including delivery of a Sunday print edition at a lower price point than online access alone. News sites such as BostonGlobe.com and NYTimes.com use this tactic because it increases both their online revenue and their print circulation (which in turn provides more ad revenue).
The Wall Street Journal is pretty much the poster child for paywall success. It has used paywalls for the past fifteen years and its paid subscribers now exceed one million. The New York Times has tried a couple of times to implement paywalls for its readers – mostly without success. Its current model allows users to access a set number of articles per month for free before having to pay—termed a ‘soft paywall’ in industry jargon. While the Times claims to have over 200,000 paid readers, the impact so far on bottom-line results is said to be negligible.
The challenge for the industry is how it can increase circulation revenue (charging users) without affecting online advertising, which is a function of overall readership, not just paid users. While paywalls increase the amount of paid readers, it denies access for free users; negatively affecting overall readership which again, decreases advertising revenue.
The author seems to agree:
The big risk of paywalls is that by restricting online audiences, newspapers can hurt their ability to sell online advertising. Until recently, that concern had prevented many publishers—other than those with market-moving financial information like The Wall Street Journal and the Financial Times—from charging readers for online access. News Corp. owns Dow Jones & Co., which publishes The Wall Street Journal.
It will be interesting to see how this all unfolds. Industry investors have clearly made their bets. Personally, I’m not so optimistic. While the paywall revenue may work for the Journal, I think that it will far more difficult for the industry in general to succeed. The industry model is changing rapidly, and I think it will take more than just a pricing model change to save the newspaper industry. Only time will tell...
In the dynamic business marketing sphere, more and more startups are utilizing the freemium pricing model – offering versions of their product or service for free – in order to build their customer base, with the hope that some of these (free users) will upgrade to paid versions. Currently; this works very well for a handful of companies, with the majority failing to meet their expectations for some very precise reasons.
Some of the most well-known success stories using the freemium pricing model to drive sales are Dropbox, LinkedIn and Skype.
But for every LinkedIn success story, there are hundreds (if not thousands) of other freemium model adoptees who have failed to lure free into paid users.
While the reasons for success and failure vary based on the particular company offerings, here are three errors that that are guaranteed to sink your freemium pricing model.
1. Giving away your core product for free
This is probably the most common mistake that unsuccessful freemium approach users make.
Rather than create a core, paid offering that contains features and benefits that customers are willing to pay for, and then work backwards to create a subset of this core offering to give away for free to entice initial users, most unsuccessful freemium users do just the opposite. They create their core offering and then give it away. In doing so, they provide very little incentive for free users to become paid users; the really valuable features (and the benefits that accrue from these features) have already been given away for free. Tacking a couple of extra features to your core product is not nearly enough incentive for users to upgrade. While the approach of giving away your core is certainly the less time-consuming route initially - because you don’t have to do the work involved in stripping away the core and still putting together an attractive package worth offering to users - it can come back to haunt you as the most time-consuming option of all if the product doesn’t sell at all.
2. Not knowing the proper ratio of free to paid features
The trick is to expose your free users to as much of the product experience as possible without giving away the most valuable benefits. It’s an extremely difficult balance to achieve. Expose too many features for free and your users will have less incentive to pay for the remaining valuable features. Hold back on too many free features to in order preserve value, and you risk not generating enough product-interest to get free users to begin with.
3. Overestimating the monetary value of free users
Free users are just that: free users. They don’t add one penny to top-line revenue, yet they still take time, resources and money to acquire and additional incremental cost to service and maintain. Of course, it’s from this pool that you will obtain a percentage of paid users that might not otherwise have purchased your product, so they’re still quite important.
If your adoption rate of free users to paid users is near the industry standard of 2-4 percent, then the acquisition costs associated with paid users will be substantial – remember, for every paid user, there will be 25-50 free users and those (free user) acquisition costs will need to be accounted for. Essentially, the acquisition costs per paid user will need to take into account the acquisition costs of all your unpaid (free) users. High numerator over low denominator = really high number!
The network effect has been cited as a way to justify these free users, but unless you’re a Facebook or LinkedIn, the effect will actually have very little positive effect – certainly not enough to overcome the associated high customer acquisition costs mentioned above.
Take a cue from none other than Apple and their iOS games for the iPad and iPhone. Their freemium models are easily at the top of the class, because being able to play certain aspects of a great game or app frequently leads to the user eventually purchasing updates and more levels. In a sense, companies like Apple, Facebook and LinkedIn benefit tremendously from robust product marketing and a pricing strategy that guarantees large amounts; additionally, their core products are highly expandable - especially in Apple’s case - and thus encourage free users to become paid ones. Before launching into an actual release program for any service of product, you should have the three errors rectified to greatly reduce the chances that your freemium model doesn’t stay free.
While many in the freemium space continue to tout the value of free users (network effect, word-of-mouth marketing effects, etc.), perhaps the biggest mistake you can make is to overestimate the monetary value of these users.
Free users are just that: free users. They don’t add one penny to top-line revenue, yet they still take time, resources and money to acquire and additional incremental cost to service and maintain. Of course, it’s from this pool that you will obtain a percentage of paid users that might not otherwise have purchased your product, so they’re still quite important.
If your adoption rate of free users to paid users is near the industry standard of 2-4 percent, then the acquisition costs associated with paid users will be substantial – remember, for every paid user, there will be 25-50 free users and those (free user) acquisition costs will need to be accounted for. Essentially, the acquisition costs per paid user will need to take into account the acquisition costs of all your unpaid (free) users. The basic math is quite simple: High numerator over low denominator = really high number!
Giving away your core product for free is probably the most common mistake that unsuccessful freemium approach users make.
Rather than create a core, paid offering that contains features and benefits that customers are willing to pay for, and then work backwards to create enough of a subset of this core offering for free to entice initial users, most unsuccessful freemium users do just the opposite. They create their core offering and then give it away. In doing so, they provide very little incentive for free users to become paid users; the really valuable features (and the benefits that accrue from these features) have already been given away for free. Tacking a couple of extra features to your core product is not nearly enough incentive for users to upgrade. While the approach of giving away your core is certainly the less time-consuming route initially - because you don’t have to do the work involved in stripping away the core and still putting together an attractive package worth offering to users - it can come back to haunt you as the most time-consuming option of all if the product doesn’t sell at all.
Resist the temptation to offer your core product to free users. Rather, create a subset of this offering; good enough to get them interested and hooked but not enough to satisfy their needs. Make them want to upgrade...and then charge them for it.
Recent headlines have touted a new price war that has erupted between Apple and Amazon due to Amazon’s recently updated Kindle line of products. The Wall Street Journal had this to say in its Amazon Stirs up a Price War article:
Amazon.com Inc. kindled a price war in the tablet-computer market, unveiling a new slate of the devices that pack in more features at lower prices than Apple Inc.'s dominant iPad.
At an event in an airplane hangar Thursday, Amazon Chief Executive Jeff Bezos introduced a family of new Kindle Fire tablets. While the devices included technologies that are already available in many other tablets, Amazon's new products stood out for their low prices, especially compared with Apple's popular iPads.
But while Amazon may be brimming for a fight, Apple isn’t taking the bait. No price cuts by the folks from Cupertino. In fact, Apple has pretty much ignored the entire episode. Hard to label it a price war when Amazon is the only one dropping prices.
So what we have here is an attempt by Amazon to position its tablets as the low-price alternative to Apple's iPad. But if Apple plays its cards right and sticks to its current pricing policy, the only price war that breaks out will be between Amazon's Kindle Fire and Google with their Nexus 7″ tablet.
If you ask me, the best thing Apple can do is to continue to ignore Amazon’s Kindle offerings. Let Amazon and Google fight it out to see who can lead the downward spiral of ‘price driving value’ in what will soon be the low-end tablet space.
The price war between neighboring pizza joints here in Manhattan is over…for now at least.
We first highlighted the battle here and also here in which two 'pizza-by-the-slice' purveyors located on Sixth Avenue between 37th and 38th Streets were engaged in a downward spiral when it came to pricing pizza by the slice.
On Thursday evening a week ago [late March], Bombay Fast Food/6 Ave. Pizza — unprovoked, and without warning — cut its pizza price to 79 cents. The next morning, 2 Bros. retaliated by moving to 75 cents (its owners felt it was easier to make change from a dollar than at 79 cents). Bombay/6 Ave. matched the 75 cents, and that’s where everything sits.
“We don’t sell pizza at 75 cents,” Eli Halali [owner of 2 Bros. Pizza] said. “But if they think they’re going to sit next to us and sell at 75 cents, they’ve got another think coming.”
For his part, Eli Halali made it clear that 75 cents was a temporary price point. He said he could not make money at that level and eventually would return to $1. He said that if Bombay/6 Ave. Pizza went back to $1, he would as well.
If it didn’t, he said, it better watch out.
When we last looked at the battle six months ago, both Bombay Fast Food / 6th Ave. Pizza and 2 Bros. had each just lowered the price of a slice of cheese pizza to 75 cents and then lowered price of a full pie to $6.00. And in the final gasp of this foolish price war strategy, Bombay Fast Food/6 Ave. Pizza then lowered the price of their full pie to $5.99 – taking advantage of the well-known psychological effect of the .99 cent tail.
The price point for both slices and full pies remained staple until about a week ago when each raised their price to one dollar per slice. In addition, both vendors increased the price of a full cheese pie from $6.00 to $8.00
Like I mentioned before, I’ve been getting a front row seat in all of this for the past six months since I walk past the battling pizzerias each morning and evening when working in Manhattan. Bombay Fast Food/6 Ave. Pizza and 2 Bros. Pizza are both located on the same block – in fact, their storefronts are separated only by a small entrance to a upper floor barbershop; less than eight feet between the two.
While my feeling on price wars are well known, we’ll see how these two vendors react to pricing pressures in the future. I keep you informed…