In this lecture we're going to focus on one of the most important and

most challenging decisions that any entrepreneur ever faces,

and that's how to price the product or service.

And the way we're going to do it is, we're going to focus on some key principles and

a framework, rather than get into the nitty gritty, but

we will look at some interesting examples as well.

So, just to get us going, really two things we're going to focus on.

First of all a framework for what I call value extraction.

So any time a price is set, value is created, both for the firm, and

maybe also for the customer.

So, we're going to look at that through the lens of what we call the four C's of

pricing.

And then we're going to review an important concept from economics and

marketing, the concept of price discrimination.

Moving on from there, we'll get into how does one actually measure price

sensitivity, which is after all, the key drive of how we set prices.

People are very, very price sensitive, that gives us much less latitude, or room,

to change price that are people are relatively price sensitive.

And how do we actually measure that.

We'll then look at a few principle's from psychology that are quite robust,

in terms of, explaining how people respond to different kinds of prices as a function

of what they remember or what their expectations are about prices.

And then, just to conclude, this is not supposed to be exhaustive, but we're going

to talk about some of the new innovations in pricing, like freemium pricing and

in pricing that's really customized through mobile applications, and so forth,

to the level of the individual.

And so now a question mark at the key question.

How do we set the price, and just exactly why it is so important?

So, we'll start with he second piece, which is why the price is so important and

so critical with one of my favorite quotes from perhaps

the most Renowned investors in history, Mister Warren Buffett and

here's a piece of pricing wisdom just to anchor us an entrepreneurs.

So Mister Buffett said the single more important decision in

evaluating a business is what he calls pricing power.

If you've got the power to raise prices without losing business to a competitor.

You've got a very good business.

If you have to have as he says a prayer session before you raise prices by 10%

then you have a terrible business.

So the pricing decision is not only important because of its ability to

influence customers,

but ultimately is says a lot about the value of the entire enterprise.

So let's keep ourselves firmly anchored on that as we go through and

think about how to price.

Now my favorite frame work for setting prices is really this very simple

notion of the four Cs of pricing and we're going to step through them one by one.

So first of all we have the cost factors or the floor the first C.

So typically we would never really want to price below the marginal cost to produce

the product, unless we would have do so for a very short period of time for

some other objective like for example to acquire customers.

In the hope that we would then recuperate profits in the future.

That's always a bit dangerous, but that's the first C.

What's the cost.

Then, we have the ceiling, the very upper limit on our pricing.

Well, that's going to be determined by demand factors.

In particular, two important acronyms, EVC, the economic values of the customer,

and then WTP, the customer's willingness to pay.

I'll disentangle those two things in a moment.

Then what might raise the floor of the price?

The floor of the price might be raised by some marginal,

some value that we had to give away to a collaborator.

So if had I manufactured the suit and I have decided to sell it through my friend

Canton, whose a realtor, I'm going have to raise the price a little bit just so

that she has some mobility to get margin from it.

So if it cost me $50 to make this jacket, I might have to sell it to her at

a price that allows her to then also get a margin from her end customer.

So we may have to raise the ultimate price to take that into account.

On the top end, we've got the price that the customer is willing to bear, but

we can't always charge customers their exact maximum willingness to pay, and

typically it's because they have not only us, but other options.

They have competitive factors that then bring the price down.

Now before I move on I'm going to step through an example that's quite a famous

one here at the Wharton School.

It's was for a chemical product that was introduced by some entrepreneurs and

the idea of this chemical product was would clean fluid that was being used in

factories.

So whenever you’re in a factory and you're producing products made out of metal, you

need to have fluid going on to the surface to keep everything functioning properly.

Now, the marginal cost of this product was about $0.50 to produce.

It was a tablet that you would add to the liquid that would purify the liquid.

So the marginal cost was about $0.50.

If we were to sell it through distributors though,

we would have to raise the price to about $5 or $6 to make the distributor

indifferent between selling our product and selling somebody else.

So now we've gone from $0.50 Up to $6.

At the top level we determined that the customer's willingness to pay for

this little tablet that would clean up the fluid was about $40,

because they didn't have to replace fluid, they didn't have to have somebody coming

to their factory and changing the fluid out.

So the economic value was about $40, however, because of other competitors in

the market, the same overall function could be accomplished for about $18.

So what we see from this example is the cost of $0.50 and the value to

the customer of $40 then starts to get squeezed to more like 6 to 18.

So I'd encourage you to go through the steps on those in that particular order.

First of all, cost.

Second of all, what margin do I need to give away to a potential collaborator or

distributor.

Then figure out the customer's willingness to pay and by what amount do we need to

drop that in order to make us parity at least with competitive offerings.

So, with this background in mind, because cost and

collaborators are pretty easy to figure out, relatively speaking,

we're going to spend most of our time now focused on the customer factors.

How do we figure out that ultimate willingness to pay?

And so now let's continue this elaboration of

the ceiling around the Four Cs of Pricing.

So focusing on the ceiling determined by the customer's willingness to pay or

the economic value that they get.

So let's start with that first idea, the Economic Value to the customer.

This is the monetary value the customer places on what you're offering Given

the benefits and maybe cost savings relative to the alternatives provided by

your new product or service.

Now this is typically relevant to three things.

So, I could be for example be wearing a pair of Warby Parker sunglasses or

I could have no sunglasses at all or I could buy a competitor product.

So when you think about the economic value you should be thinking about relative to

whatever the status quo is which might not even be using the product category at all.

You'll also need to think about economic value as it relates to a particular

customer or segment.

Some people have a higher inherent need for the product than others.

And then the monetary value is a combination of the two things.

It's the functional value And the psychological value.

So again, for a product like Warby Packer eyewear, I get a functional value,

because I'm able to see better with my sunglasses.

And perhaps also a psychological value, because now people maybe think that

I'm stylish or a bit more trendy, because I'm associated with this particular brand.

The challenge in coming up with the true economic value to the customer,

is that customers might not believe everything we're

telling them about the economic value to them is.

Then secondly the competitors might undermine it.

We're often in markets where competitors price very very aggressive labels and

of course that causes us also to come down in price.

So just by way of review for most of us, but this is critical for

the entrepreneur thinking about the idea of price discrimination.

Ways to charge different prices to different people depending on their price

sensitivity.

Well, this works when, of course, you can identify individuals or

segments according to the price sensitivity.

So maybe people who want the product shipped more

quickly are willing to pay more for that privilege.

And they may be people who live in New York City.

If we're here in the United States versus some other part of the country.

So they've revealed themselves through their location.

Also, you need to be able to enforce the price discrimination scheme.

So let me give a simple example here that's going to relate to an exercise I

want you to think about, or to look at at the end.

So, if I offer a ticket to the movies on a Tuesday afternoon,

typically the price is lower than it is on a Friday evening.

Because more people want to watch movies on Friday evening

at 7:00 than they do on Tuesday afternoon at 2:00.

So it wouldn't make sense for

me just to offer a general ticket that people could buy and use in both places.

I need to check the ticket when people come in.

So, there should be some way that the price discrimination scheme can be

enforced by identifying who is who and also confirming that when the person is

actually going through the act of purchase of the product.

So the challenge with price discrimination is of course figuring out who is who,

who are the price sensitive people and who are the price insensitive people.

So, let me give you a fairly famous example that illustrates

this point that whenever there is any leakage and

customers find out that different people are being charged different prices there

can be notions of fairness and equity that can reflect negatively on the firm.

Eventhough this is an optimal thing to do for us as entrepreneurs.

So, here's the example, it was a few years ago that Amazon

actually optimally was charging different people different prices for the same book.

So let's say there's my friend Kat who's a very very loyal customer of Amazon.

She would end up paying more for

the latest marketing textbook than I would if I were a new customer and the reason

is when someone's a very loyal customer they've been on Amazon a long time.

Amazon knew a lot about the purchasing history and

figured that person was relatively unlikely to leave the platform,

therefore somewhat less price sensitive, so Kat was charged a higher price and

I was charged a lower price for the same thing.

Now that makes sense, so long as people actually don't find that out, so

understanding whether or not customers are willing to tolerate price discrimination

should it be be found out is also an important consideration here.

So now let's continue on, and let's look at the three different

levels of price discrimination that will give you some insight into whether or

not you can in fact charge variable prices to different customers for

different products or sometimes for the same product itself.

So now the three most important concepts in price discrimination or

levels in degrees of price discrimination if you will.

So the first is something called first degree price discrimination where you

really try to charge a different price to every customer that comes to the business.

Classic example here would be negotiated business to business contracts or

car sales on a lot.

If I'm a good sales person, when somebody comes onto the lot I try and

figure out their willingness for the negotiating process,

whether they are going to be me more or less price sensitive, and

may literally charge a different price to every single customer.

That's often difficult to do outside of those contexts though,

so then we sometimes get into the notion of second degree price discrimination.

I know there are different customs out there with high willingness to pay,

some with low, but I don't really know who is who.

So one way to get people to reveal their price sensitivity

is to offer something like a quantity discount or a nonlinear contract.

What does this look like?

Well, imagine for example I'm a phone company like AT&T, and I charge

customers $100 dollars a month for the privilege for connecting to the network.

But once their usage gets over a certain point, I charge them by the minute.

So a non-linear contract looks like a fixed fee up to a certain point and then I

am charging you a marginal price for every additional unit that you are using.

Then beyond a certain level of consumption there may be even a second marginal price,

so by doing that I'm able to charge different kinds of customers

different average prices for the same product.

That's a fairly common tactic particularly for companies like phone companies.

And then finally there's the idea of third degree price discrimination,

where I charge different prices to different customers

depending on some proxy that I have for their price sensitivity.

Like, actually knowing who they are, through the mobile phone, or

knowing their specific location, or their contacts.

So for example, if somebody is booking a hotel room tonight on Thursday for

Friday, I know they probably don't have much freedom or latitude or flights.

So I may charge a higher price to a person who leaves the booking

towards the last minute.

Now what I'm doing here is I'm discriminating on my customers who

are willing to book early and maybe are more price sensitive than customers

who are willing to book late and who are therefore less price sensitive.

So this is really a key concept, discriminating among customers

based on their willingness to pay or their price sensitivity.

So the next thing we're going to do is to get in to figure out well,

how do we measure price sensitivity?

So a framework that I like to use to think about how I can measure price sensitivity

is really just the two by two matrix that you see in front of you.

So, first of all I think about what variable

am I measuring to figure out price sensitivity?

Is it the actual purchase that you made or some intention or preference?

So I asked you perhaps on a survey question,

how likely are you in the next six months to buy a new pair of sunglasses?

And you tell me, I'm very unlikely, I'm not sure, or I'm very likely.

So am I measuring actual purchase or am I measuring your preference or

your intention?

And then the second thing there are the columns of that matrix,

am I actually observing your true purchase that took place or

am I manipulating things somehow in an experiment?

So that gives us the four possible combinations of

figuring out price sensitivity.

So if we're in the upper left what we're doing there is we're

relating sales data to prices.

Doing things like running a regression and computing price elasticity.

If we're in the upper right we may be running experiments,

so changing the price of the product on the website and seeing how demand reacts.

We're bringing people into a lab or

an artificial situation where again we're manipulating the price.

If we're dealing with intentions down the bottom that's really the focus of surveys,

so asking people what they would be willing to pay.

The trick there of course is that you never really ask someone directly.

What you want to do is if you're using surveys to measure price sensitivity is

the following, is to specify a price so the price of the sunglasses is $95 and

then you ask people on a one to seven scale how likely are you to buy.

One are very unlikely, seven are very likely.

Then another group of people you give the same survey but

this time, you anchor the price perhaps at $125 and ask the same question.

So when the data come back, you now have an x axis with different price points, 95,

125 and so on and then you have a y axis, where you can plot out the demand curve.

Now if you want to be even more sophisticated,

you can use a technique like conjoint analysis.

I'm not going to explain all the details here, I'll give you a simple example.

You can of course look this up, there's a lot of commercially available software

that will allow you as an entrepreneur to use conjoint analysis.

So let's go now through a couple of examples.

The first example is going to be a hypothetical conjoint.

So let me explain how this hypothetical conjoint analysis works.

So we have six options that we give customers to evaluate and

customers are asked to give each option some score or some number between 0 and

100 and the scores are there in the fourth column, you can see.

So then the idea is if we look at Apple versus Samsung.

If we take the average score that Apple has, everything else equal, and

the average score Samsung has, everything else equal.

Apple comes in at 60, Samsung comes in at 90.

So price taken off the table, in this example Samsung is preferred to Apple.

Then the second thing we do is we average out the ratings that

different price points get and you can see obviously at a lower price like $80 on

average people are giving 85 points.

At a higher price of a $100, the points are going down to 75.

And at the higher price of $120 or the highest, the average goes down to 65.

So now what we can do is we can figure out that Samsung is worth 30 more rating

points than Apple, and also every 10 rating points are worth about $20,

so if we want to get the product rated more highly,

we have to reduce the price by about $20.

Now this is a contrived example just so you can see how it works.

Conjoint allows you to focus on one attribute holding the others constant.

And it's a very, very powerful technique for

entrepreneurs to use when they think about setting prices.

And so for the entrepreneur conjoint analysis is a great tool for

helping us figure out how we should set price, holding everything else constant?

And now what I'd like to do is give an example that

was developed here at the Wharton School, actually, by our friends at Warby Parker.

So the entrepreneurs at Warby Parker, you can go to the website,

had the important question that many of you are facing,

is what price should we set for these products.

Sunglasses and other kinds of eyewear that we're selling online.

So what we did is we did a conjoint analysis holding other things constant

like the delivery time and the shipping and those kinds of things.

In addition, we did some survey research that was very, very helpful.

So, we asked a group of people in a survey if the price was $75 and

we showed them the stimuli, how likely would they be to buy, if it were 85,

to another group, and yet to another group, if it were 95, 105 and so on.

And what we identified from the research was the demand, both 85 and

95, was roughly the same.

And so that taught us fairly quickly that we should choose $95 as the price point

because once we went to Three digits, $125 let's say,

the demand, at least in our study, started to drop off.

Some of you out there who are watching might wonder well, why not go to $99.

That's a whole other story.

But interestingly, the psychology of pricing says that sometimes when you use

a nine ending, at least in Western culture,

there's a perception of lower value or a perception of being too discounted.

Somehow five is just a, don't ask me why, just a classier number.

So you'll see brands that are trying to have a more upscale kind of image

typically focus on prices that end in fives.

Or maybe even even numbers as well, like $10 and

$20 as opposed to 9.99 on the 19.99.

And so now that we understand the price sensitivity is really the key that tells

us how high we can go raise that ceiling economic value to the customer willingness

to pay, and we follow a little bit about how one could measure price sensitivity.

Now let's think about some things that also mitigated, either make people

more price sensitive or they moderate it and make people less price sensitive.

So, here's some common examples from psychology.

So, when you give people an imperative to act quickly, I'm showing here on the slide

Gilt group which is a flash sale site, selling handbags.

If I tell you, the products are going to be gone by midday, that causes you

some urgency, and therefore you'll less willing to undertake search for

lower prices, and on average might be willing to pay a little bit more.

So that's one way that you can raise price sensitivity by reducing

the customers incentive to search.

The second thing if you are really the low price leader and

you want to be transparent that you have the best price in the competitive setting,

you might want to increase ease of comparison which is what Amazon is doing

here by showing you very, very clearly who is the cheapest item,

because that's part of the value proposition.

If you again want to make customers less price sensitive, so say for example, I'm

selling the globe in that picture there, not the computer, I remind the customer

when she's coming to college that she's buying a whole portfolio of stuff.

And my little option embedded in that is not particularly important or

relevant to the total expenditure that she is out laying that's going to make her

less price sensitive and allow me to charge more.

Another common tactic that we use in marketing sometimes is we use loyalty

programs or rewards systems or other tie ins to increase people switching cost or

the perception of sunk cost that also makes them less price sensitive.

Now let's move on to a couple of other things from psychology again that

are very, very interesting.

You can look at the Dilbert cartoon here, but

the idea of reference pricing is really key.

So, an economist might say, when you come into a shop and you see a bottle

of water like this, you care about the fact that the price is one dollar.

A psychologist would say, well, yeah that one dollar price is important, but

if the last time I bought the product, it was only fifty cents because of some deal,

now it looks like sort of a bad experience,

because I'm expecting to pay 50, and instead now, I have to pay a dollar.

So a key component to influencing

what a customer's willingness to pay is the setting of the reference price.

If I can set the reference price very high, that gives me a lot more latitude

in terms of reducing the costumer's price sensitivity.

And now I'd like to share with you one of my favorite results from the psychology of

pricing, and of course there are number of these, and

I really encourage you to explore some of these things on your own as well.

But the compromise effect is one we all should know, and it's very, very robust,

and it influences how, in fact, we should display prices to customers?

So, I'm going to show you the classic study that was done

by Etima Simmons over at Stanford University.

So, if you look on the left-hand side of the screen,

you see that customers were offered two products that they could choose,

two kinds of cameras, one's a little more expensive than the other one.

The more expensive one has better features, and so on.

And we notice when those two products are offered to people,

about 43% of the people choose the $239 option,

and about 57% of the people choose the $169 option.

So, there are slightly more people choosing the cheaper option relative to

the more expensive one.

Now let's say, for whatever reason, and again I should encourage you to think

about the ethical issues here too, because this is a pretty robust effect, but

let's imagine we wanted to sell more of the higher priced option, the $239 option.

Well research says one way we could do this is to then add a third option,

which is even more expensive, and

that's what you see in the right hand side of the screen.

Once we add a third option that's $469, the camera has more features, but

it's also more expensive,

notice what has happened to the share of the middle option.

So, the share of the middle option now has gone up to 60%, so

what we were able to do is we were able to increase the sales and

the market share of $239 camera just by adding a third option to the choice end.

Now whether or not this was done deliberately you see this,

all kinds of examples all over the internet.

One of the companies that many of you may have seen

has some very funny content on the website.

There's a company called Dollar Shave Club.

If you go to the Dollar Shave Club website,

you'll see something like what's on the screen here, three product offerings,

a $1, a $6, and a $9 option, and the brand is called Dollar Shave Club.

But you might wonder to yourself, well,

which of those three is the product that's the most commonly sold?

And if we go back to our compromise effect, it wouldn't perhaps surprise you

that the most commonly chosen option, by a large amount, is in fact the $6 option.

So, we've looked at a number of things around the importance of pricing, and

the principles that we should focus on, and also a framework for setting price.

Now I want to close with just three concluding remarks.

One about testing, and then two things around some innovation in pricing

that I'd like you to take a look at.

So, the first one around testing, I'm going to give you an example actually from

President Obama's first campaign when he was running for President,

before he was President Obama.

What the campaign engaged in was a lot of A,B testing, changing the way Mr.

Obama was represented on the website.

Whether it is a photograph or whether there was video content,

many other elements of the execution to figure out what was the right way to

attract customers and in particular to generate donations.

What the team found was through the optimization of the content on the site,

they were able to increase the amount of money raised by about $75 million.

If you're interested, I've got the reference there.

You can look up the article.

The point for us when we think about pricing is to be

constantly testing pricing, either through surveying or

direct server experimentation on limited groups of customers

to make sure that we have the right product mix and the right price points.

On the second part of the slide I want to

get you to think about a new innovation in pricing.

That perhaps many of you are involved in if you're doing software or

software as a service and so on and this is the idea of Freemium pricing.

So it wasn't so long ago when Dropbox,

you know even at fairly healthy revenues of about $400 or $500 million,

most of the people who were using Dropbox weren't actually paying anything.

They were using the free version.

So when does freemium pricing work, or why might we think about freemium?

Well, freemium is good because free is a really powerful message.

Free is good because it lowers the acquisition cost potentially, and

also it amplifies any business with a network effect.

So if I sign on to Dropbox because it's free, and Dropbox is more valuable to me

if my academic collaborators also use it, I might then refer that to them as well.

And also to avoid sort of tricking customers.

So these are products where you sign up and

then you're automatically placed in to some renewal program.

Customers tend not to like that.

So the tension of course with Freemium is that trying to get people in through

the gate as quickly as possible, but at some point monetize them.

So that's one new form of pricing that you might like to think about.

And so here's the final example that I'd like to share with you,

maybe have you think about it since we're all entrepreneurs here.

As a homework exercise and something, whether or

not you believe this can actually be done efficiently.

So there's an article that I'm sharing with you about customized pricing.

For movies, and

a company who is doing this out in Los Angeles called Atom Tickets.

So maybe you're somebody who likes to watch movies like I do, and you might have

wondered, when a movie first opens on a Friday night, Star Wars or something like

that, presumably the people who show up first are the most interested and

might actually have the highest willingness to pay for the product.

So why not charge those people a little bit more than the people who show up and

watch the movie two weeks later.

Now there's a whole range of pros and cons around why you could or could not do that.

So I'd like you to read the article and think about it.

And then as part of your own exercise try and push the envelope on whether for

your product or service, customized pricing through technology, like

the mobile phone platform that's being offered here, would actually be possible.

Are you able to identify people who have different willingnesses to pay?

Are you able to keep those prices

separate in a way that doesn't undermine a feeling of equity, and hurt your brand?

And if you were able to do it, what would be the increase in

revenue that you would get relative to offering a constant price?

So again, a lot of things that we went through today but hopefully

these key concepts around frameworks for pricing, price discrimination,

measurement of pricing sensitivity and little bit of that psychology.

Will help all of you as you go through your journey in setting the price.

I can't emphasize enough what a critical decision this is, and so it's one that

you should research and think about and constantly challenge and test.

How to Price the Product or Service

Entrepreneurship 3: Growth Strategies

Meet the Instructors