The virtue of price discrimination

Keith Schacht| January 8th, 2012
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I was reading Clay Shirky’s latest post about the new pricing model that will supposedly save newspapers, and it struck me how little talk there is about the real fundamental issue at work here: price discrimination.

The same product or service is worth different amounts to different customers. You maximize revenue by figuring out how to charge the right amount to each customer without complicating (and therefore adding friction to) the buying experience.

My previous business was building social games on the Facebook platform that monetized with virtual currency. One of the reasons this has been one of the fastest growing sectors in history is because of this brilliant pricing ¬†model that allows for very efficient price discrimination (I didn’t develop it, I just recognized and emulated it). You let people play your game for free but something about the game play is restricted: limited number of turns per day, a certain class of accessories that cannot be purchased, levels or regions of gameplay that are off limits, etc. Then you allow people to purchase units which get them access to the restricted game play. The more they purchase, the more they get the restricted game play.

90-95% of your players will never pay, but then a good chunk of customers will spend a little and a very small fraction of a percent will spend incredible amounts of money: hundreds to thousands of dollars per month. You get a standard exponential decay when you graph the distribution of revenue, and these “whales” (high rollers) make up for all the non-paying users. Even when you include all the non-paying users, the revenue per user of virtual currency games is typically 10x per user greater than games that are entirely free but monetize through ads.

If the game is designed well you get almost a perfectly efficient discrimination — people pay exactly what the game is worth to them. Arcade games and casinos both have this same property as well.

Online advertising revenue models do a good job of discriminating as well but they typically undercharge the most valued customers. Your pageviews (and typically clicks on advertisements) are fairly proportional to the amount you use the product. However, the users who are receiving 100x or 1000x more value from the product are not generating proportionally more revenue for the business.

For physical products, price discrimination is crude. Typically there are 2-3 version of products; it’s the good, better, best approach. I’ve been been surprised how often online software — which sheds the constraints of physical goods — holds on to this approach.¬†37signals, often commended for being a pioneer with their products, still has a good, better, best packages.

I’ve always been impressed with WordPress in this regard. The vast majority of their customers use their free open source software, but if you don’t want to mess with hosting or configuring software you can sign up for wordpress.com. From that point the features are a la carte. I bet most customers pay $5 – $20 per year. But if you want all the goodies: video posting, custom domain, customizing CSS, a pretty theme, no ads, and lots of extra storage space — soon you’re paying $500 per year.

This is is a powerful revenue lever for iPhone/iPad and and the Kindle as well. I’m sure there are iPhone users who have spent many thousands of dollars on applications after purchasing their phone.

Reading Clay’s post, it sounds like newspapers are finally figuring out how to price discriminate. I bet a lot of businesses (and ultimately customers!) could benefit from revisiting their approach to pricing.

6 Responses to “The virtue of price discrimination”

  1. Alex Epstein Says:
    January 8th, 2012 at 10:01 pm

    Hi Keith, what do you take to be price discrimination here? I think of price discrimination as selling the exact same product to different users for different prices based on their different abilities and/or willingness to pay. E.g., a pharmaceutical company that sells a product for $100 in the US and $1 in Africa, still profiting from both since its marginal cost is <$1. This kind of price discrimination can be an attempt to get around the marginal nature of most prices, which lead to most of us paying vastly less for things than they are worth to us. See Eric Dennis's discussion here: http://centerforindustrialprogress.com/2011/12/08/whats-in-a-price/

    It seems like what you're talking about here is upselling–offering different packages with greater options. Am I missing something?

  2. Keith Schacht Says:
    January 8th, 2012 at 10:33 pm

    Alex, I would define it as selling *essentially* the same product to different people for different prices based on their willingness to pay.

    In the world of digital products, every instance of a product can be unique so the idea of two customers having the “exact same product” is fuzzy. The perspective by which I consider products to be the same is an operational one — if it required a single product development effort, is the same code base running on servers, shares a unified customer support team — things like that.

    A business has an idea about a market need. They undertake considerable effort to develop this product and then they have to figure out how to sell it to customers (e.g. 37signals making Basecamp). Versioning the product, locking features, etc are all techniques to help you sell this same product to different people for different prices.

  3. Ricardo Says:
    January 9th, 2012 at 10:11 pm

    I think Alex is correct

  4. PeterisP Says:
    January 10th, 2012 at 3:47 am

    For digital services with zero marginal cost, any version other than the maximum one is a way of price discrimination.
    If you have developed the full version, then the “entry level” one is not another product, it’s most often just some features disabled to target a different price point – i.e., price discrimination, not upselling.

    A person buying an used Honda instead of a Ferrari is buying a different product.
    A person buying an virtual ‘used Honda’ instead of a virtual ‘Ferrari’ is buying the same product mangled to a different price point.

  5. Justin Roff-Marsh Says:
    January 11th, 2012 at 11:24 am

    Keith

    I’ve generally referred to this as dynamic pricing. I’m not totally comfortable with ‘price discrimination’.

    This is easy when you’re dealing with discrete transactions. It become more complex when customers purchase frequently or when market segments are not insulated from one another.

    Generally speaking, however, this is a huge opportunity for many businesses. Market segmentation, in conjunction with dynamic pricing enables management to take a ‘portfolio management’ approach — as opposed to considering the ‘profitability’ discrete transactions or customers (which is always harmful).

  6. George Says:
    January 28th, 2012 at 8:54 am

    One area that could perhaps use some price descrimination is cell phones. The world’s richest man is likely to be carrying the same iPhone the average Joe does.

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