Ten Years' Worth of Learning About Pricing
tomtunguz.com
tomtunguz.com
The best book I'm aware of on the topic is Nagle, but it's getting dated and is focused on older B2B business models. If anyone had recommendations for a more recent book on the topic, I'd love to hear it.
[1] https://ocw.mit.edu/courses/sloan-school-of-management/15-81...
[2] https://ocw.mit.edu/courses/sloan-school-of-management/15-81...
> the 3 part tariff is proven to be best. It provides many different ways for the sales team to negotiate on price and captures the most valu
The idea is he following: In a old-school normal market, where you sell one good to a whole bunch of guys each etc, and everyone wants just one good, you may just post one price. You will not do better, no matter what you know or do not know.
But in most cases, posting a single price will not be optimal for you. This is because you sell multiple units to multiple customers, each possibly very different. And, you do not know what they would be willing to give you. You have asymmetric information. If you KNEW everything, you could tailor a contract for each customer. But you don't.
In economics, we can tackle this problem using Mechanism Design. Using game theory and nonlinear pricing (the non-linear is important here), you may be able to set a menu of possible contracts in a way that the customer self-identifies by choosing the best option for him.
The intuition of the problem is the following: Choose a menu of contracts that allows you, the company, to maximize profit, while also making the customer choose truthfully and thereby "tell you" what he is willing to pay. This is what the three part price may do for you.
Now why is this not entirely correct? There is a (rather theoretical question) as to basically how far a two-part or three-part price is "nonlinear enough" for your set of customers. This is called implementation theory.
An excellent book to get behind this mystery is Tilman Borgers book on mechanism design http://www-personal.umich.edu/~tborgers/ This was a free download for many years, so you can probably find the pdf.
If you can identify features of the customers, you may be able to price discriminate on that. Customer usually really, really hate this.
If your product can be differentiated, you can use non-linear pricing. Bundles and other things are known. x-part prices more generally work like this. I have mentioned in another reply many examples showing that companies usually try very hard to implement non-linear pricing and most people don't really notice...
So what is the magic slice of products for which 3part is a good idea? All enterprise software? Some enterprise software? Only enterprise software?
The most impressive pricing I've seen is Salesforce.com. The pricing is simple but genius. Per seat pricing, where the cost per seat goes up with functionality. I was boiled like a frog: the cost went from $300 per year to $300K per year, and there was nothing I could do about it. How would a 3-part tariff help them?
It has happened on the internet (targeting), but people get very angry. Uber extracts from two sides of the platform, which is a more complicated matter.
For the other examples, you are not exactly correct. Health insurance is clearly a two-part price, indeed it is a classical example. You pick your tariff and coverage. Whenever you pick, it's a nonlinear pricing scheme.
Salaries are another thing. A base and a bonus are very, very common. That's two part. Also comissions and somesuch.
Hotel rooms? Rate and extras? Minibar?
Cars? Extras and bundling...
All of that is non-linear pricing.
So your point is basically correct. If the customer notices you get to extract all surplus, he might get annoyed. But a two part tariff most often seems beneficial to the consumer, because he gets to choose!
Your examples have convinced me that a 3 part tariff is generally bad and an indication of extractive desperation on the part of the vendor, and fundamentally based on deception. If you wonder why people hate their banks, pricing is the reason.
An all-knowing monopolist will extract 100-epsilon% consumer surplus. That's why economists are big about regulation and taxation.
Is it deception? Not necessarily. A pricing scheme is a menu of deals from which you pick the most beneficial for you. You then optimize as well - just that the company gets to set up the menu.
If a company were to decide to leave a minimum surplus to you, the optimization problem would be almost identical. We just assume that companies set this minimum value small. Perhaps, however, this may not be the best long term strategy? Not all companies may try to extract everything.
But what is a good and fair amount?
Toms writing is targeted to entrepreneurs who need to consider all aspects of the business, unlike product managers at Faceless BigCo, who “win” solely by the shitty little optimizations that you so love.
Entrepreneurs probably employ such pricing methods more often than BigCo as well, simply because they sell less uniform products to less anonymous customers.
Your point?
So my question (not point) is, when/for what is a 3 part tariff the best choice, when you consider all the other issues (like, what would annoy customers, etc).
In the case of Salesforce, the day I signed up, if there were a significant base cost over-and-above the per-seat price, there's a good chance I would have avoided Salesforce, and Salesforce would never have gotten that (eventual) $300K a year from me. So it seems that their pricing is better than a 3 part tariff.
Non-optimality just means you are leaving surplus on the table, out of your control. It certainly doesn't mean you will be better off in the long run. If you are comfortable with that decision, go ahead and choose a flat tariff. Since a business is also driven by cost, I would bet you will consider that decision sooner or later.
Non-linear pricing is "the best" when you are doing a theoretical argument, since you just can't do worse with more instruments than less - if you employ them wisely. That's what is written in the article, and that's what I elaborated on. It may just mean it gives you most control in deciding about consumer surplus, whatever that strategic decision may be.
Second, with regards to salesforce: A x-part price does allow you to set fixed components to zero, if that corresponds to the customer base. The "best" mentioned in the article is a theoretical construct in the sense that nonlinear pricing is simply more general. You are not the only customer, and in the end it depends on the whole demand base as to what is optimal. A product delivering high value per seat may just simply be best off with a low-to-zero fixed component. Again, it all depends on who you are targeting.
You spend 300k a year? So what if I offer you a contract with 200k a year plus a fixed 50k? Will you not take it? What if you do, and I tell you we both win in this deal?
My point is that there is a general thing to understand about pricing, and there is a reason why this article refers to something as best, while being sparse on actual implementation.
The best business decision, as you put it, depends entirely on your assessment of what customers want. This much will never change. But this article wants to point out that you can deal with information asymmetries with a nonlinear pricing scheme, something everyone should study deeply before pricing one's product.
As a consumer, you are faced with price menus in almost every purchasing decision you take outside a supermarket. That's for a reason. If you are an entrepreneur, and you do not understand why or when one may employ a nonlinear pricing scheme, then you are lacking knowledge.
Meanwhile, I don’t think anyone but us are reading this thread.
Um - no. Certainly not once a company is publicly owned or where the focus of the board of directors shifts from focusing on how to be the best company doing whatever we are doing to maximizing "value" for the shareholders. Once the focus is on the shareholders instead of the core business that core business starts to be talked about as a commodity and its value is its cash flow not how good it is at the business it is in. cf: Virgin America.
Regarding the issues with Wells Fargo it may be some stay "because the competitors are just as bad" but may also simply indicate how entrenched the services Wells provided are to the company. Things like credit card processing, loans (which you can't just switch easily), lockbox services and so on. I know from personal experience there's no problem with the folks having to interact with the bank referring to them in highly negative terms all the while that interaction takes place.
"Unhappy customers is bad for business." Really? That's why Comcast is having such a hard time? Why it's facing so much opposition to the micro monopolies it creates and perpetuates? No one likes Comcast. OK, that's a bit broad. I do not personally know anyone who likes Comcast and I know a lot of folks, including myself personally and professionally, who have been and are customers.
They use the 3 tarrif pricing model BTW: you pay the monthly fee for your basket of services which include some amount of unit transactions and an overage when you bust your limit.
I like a pod cast called "Make me smart". The folks who run it have a question they like to ask at the end of interviews: "What's the one thing you thought you knew and found out you were wrong?" I'm 63 and started my first restaurant when I was 21 and my second when I was 23. I thought if I worked as hard as I could, was fair with the people I dealt with, produced the best product I possibly could while keeping costs in check and charged a fair price everything would be OK. I was wrong. For better or worse I held on to my ideals instead of adapting to the realities of business.
It looks to me like the focus of being in business has shifted from business as a way to be better/bigger/faster at whatever the bussiness does to simply being a means to establish a cash flow and sell to a larger business. I don't know if that's inherently good or bad but it certainly looks and sounds like the new normal.
So, from what I see, business has indeed become about extracting the most you can as fast as you can from as many as you can.
That is a terrible example. Comcast would be out of business if their customers had something to switch to. But they are a monopoly (or at best a duopoly) in most of their markets.
I'd say most utilities work in a similar way, maybe with a 2part (fixed costs + metered consumption).
https://www.joelonsoftware.com/2004/12/15/camels-and-rubber-...
Wouldn't that be the price that gets you one, or very few, sales? Isn't demand elasticity still a thing?
What you are thinking of is a market demand, which is a useful approximation when the market is large and anonymous. Instead, he gets at the idea that each customer has an individual reservation price, upon which he will still buy your service or good. If you manage to ask exactly this price, you can extract the maximum profit from each customer.
Edit: I could do a write-up of the details. I don't have a blog or something like that tho.
Besides the risk of spreading ill-will, it also seems to me that price discrimination can be risky because there is no way to firewall it against a correlation with some legally protected class.
Edit: Also something that occurred to me just now - price discrimination seems to me to lead to a reductio ad absurdam - suppose that it was absolutely perfect and captured all the consumer surplus; then doesn't that destroy the rationale for the transaction in the first place and make it purely exploitative? If it is not desirable to get to that place, then maybe splitting the surplus at least evenly between producer and consumer is the way free markets should work?
To your second point, customers often do try to fool vendors into thinking they are in the consumer group that is offered lower prices. As an example, non-students use their old student IDs all the time.
Re: correlation with a legally protected class, this can be solved with marketing. Price discrimination based directly on gender would be illegal. But if you put one product in a blue box in the "men's" section and one in a pink box in the "women's" section, consumers will self-select. This is very common with razors, soap, and other such products.
Lastly regarding your edit, if a consumer pays his or her reservation price they are left with zero surplus. But that doesn't mean the transaction was pointless. The consumer gets the consumption value of the product. I'm willing to pay at most $2 for a bottle of Coke. That's my reservation price. If I'm offered a Coke for $2, and no vendor offering a lower price is available, I will pay that price and enjoy the Coke.
Since it is impossible to make a completely one-sided trade, one may ask how one-sided is acceptable, and if perhaps the optimal situation is where it is balanced in favor of the consumer...
1. If you sell a good where you can not sell different qualities at all, customers get angry. This happened on the internet for example, when there is geo-targeting and other things.
2. In most cases, customers do not notice non-linear pricing. Bonuses, packages, bundles, feature choices, customize, build-your-own, editions, - all just names for nonlinear pricing schemes.
3. You do not actually get to extract all surplus. You have to pay an information rent to the consumer, which comes from not actually knowing his reservation price. If you set only one price, then it depends on many fundamentals who gets how much. With nonlinear pricing, you can approximate the actual demand better by making consumers choose their own poison. But it is still a "second best".
4. "Perfect" markets in any case guarantee only efficiency in terms of allocation. Fairness and distribution are another matter entirely. A market in which I, the monopolist, use a two-part price to extract 100% of the consumer surplus is in fact welfare maximizing. All surplus is there, and the company is owned by someone. Classical free market econ theory literally does not concern itself with how the ownership is distributed. That's why we need taxes and redistribution.
Edit: to be fair to econ, the classical should really be underlined thrice
The underlying reason for this is that the producer basically has to pay you a bit of surplus to reveal your willingness to pay.
So, there is consumer surplus.
In this case, we are talking about a shift of surplus towards the consumer. If you have a high willingness to pay, it is beneficial for you to signal that your willingness to pay is actually low. If there was only one price, this would incentivize the firm to give you (and everyone else) a lower price. Instead, to get you to pay more, the contract proposed to you must be relatively more beneficial to you than just choosing a simpler service plan or a lower value good and bagging the surplus for later. This "relative benefit" is the information rent you will earn.
I have been thinking that why is it like this.
My current hypothesis is that it demonstrates hostility. Someone who actively tries to extract the last penny out of you does not work for your interests.
Note: I am in no way affiliated with Price Intelligently and do not in any way intend to promote their service. Just wanted to share this free PDF.
For example, you can't have a complete discussion about pricing without talking about packaging and fencing. So if you're interested in pricing as a topic, make sure you find another sources that go deeper in those areas.
https://www.amazon.com/Strategy-Tactics-Pricing-New-Internat...
For example if an agent wants a 10% rebate we need to calculate the markup from our standard selling price to accommodate this. If we sell a product for £100 then we'd need to invoice it for £111.11 because 10% of that brings our real selling price back to £100.
If we mark it up by 10% we'd invoice out at £110, the 10% rebate to the agent would be £11 and we'd have sold for only £99.
Comprehending that you don't use the same percentage up and back down is too much for most people here. They eventually get to understand that they can't do it that way, but actually doing it correctly is a dark art.
Moral of the story: pay attention in math class kids. If you don't, one day you might have to hand out free cookies.