4. Pricing Pitfalls

  1. Product Pricing
  2. Some Economics
  3. Pricing Psychology
  4. Pricing Pitfalls
  5. Advanced Pricing
  6. What a Price Says
  7. Pricing Checklist
  8. Bibliography & Credits

So far, we’ve looked at some economic theory, and the psychology of pricing. Hopefully, you’ve now got some idea of how to set a price. But there are some other factors to bear in mind too, and some pitfalls to watch out for.

Competitors

When you set your product’s price you need to think about how your competitors will react. If you undercut them, will they start a price war? Even if your competitor has a high-cost business model and cannot compete on price in the long term then there’s a risk they’ll respond in 27 kind if you pose a serious enough threat, and just hope you go out of business before they do.

The airline industry gives the best example of the futility of starting a price war. On September 26th 1977, Freddie Laker’s first ever Skytrain flight to New York took off from London Gatwick. The price for the return flight was $238.25 (plus an extra few dollars for a meal), well under half the price of rivals’ tickets.

Five years later, Laker Airways was bust, the victim of the vicious, dirty price war that it had initiated. As Laker had found out, and as EOS Air- lines (founded 2004, closed 2008), Silverjet (founded 2006, failed 2008) and MaxJet (founded 2003, failed 2007) subsequently relearned, taking on an incumbent on the basis of price is highly risky at best, suicidal at worst, especially when your competitors cannot afford to lose and have no option but to fight to the death.

If you are going to compete on price, then you should minimize the possibility of a counter-reaction from your competitors. Don’t bang your drum and tell the press how you’re going to destroy them (a mistake that Marc Andreessen of Netscape made when he said “we’re gonna smoke ‘em”, referring to Microsoft (or “those idiots up in Redmond” as Andreessen put it). Focus on their marginal customers and hope that by the time they notice you it will be too late.

On the other hand, if you set your product price too high, will other competitors emerge? Price the Time Tracker 3000 at $10,000 and you could create the market, only for a competitor to produce the Tyme Trakka 3000, undercut you, and steal your business.

Microsoft is famed for this. They wait for competitors (and often part- ners) to prove markets with low volume, high price products – whether it’s CRM, testing tools or business intelligence – and then jump in with a low-cost, high-volume model.

Fairness

However you price your product, remember that consumers have an acute, although often irrational, sense of fairness. Think twice before you betray that.

Books provide a good example. An economist would point out that I derive the same value (traditional economics is all about value) from reading a paperback version of Sebastian Faulks’s James Bond thriller ‘The Devil May Care’ as I do from reading the electronic version. But the list price is the same in both cases ($14). It’s just not fair that short-sighted book publishers charge the same for paper as they do for electrons. I feel screwed over, and I don’t like it.

Pirates

If your price is way off whack, you will provide an opening for a special type of competitor: the pirate. Price software too high, or at a price point that most people judge ‘unfair’, then be prepared to be ripped off in return.

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But pirates can also be your friends, in two ways.

Firstly, if your strategy is to achieve world domination by providing a product to every potential customer, at a price he or she can afford, then pirates provide a cheap back channel. They put a copy of your software into the hands of people who will not pay, cannot pay, are too dishonest or too principled to pay, or who simply don’t value your work that much. However, a pirated copy will end up, eventually, in the hand of somebody who will pay.

That’s how early shareware software operated. In the early 1980s, bulletin boards and user groups were a network commonly used to pass around pirated software. In 1982, Andrew Fluegleman and Jim Knopf piggy-backed onto this pre-existing network, added a notice in their software asking people to pay them if they liked their software, and invented shareware.

Adobe use pirates too, although possibly without realizing it. Photoshop costs $700, even though the product has many cheaper, or even free, competitors. How come? People use pirated versions of Photoshop and then buy when their conscience kicks in, or they get rich. If Adobe dropped the price to $300 then the pirates probably still wouldn’t buy, and they’d lose money from people who’d pay the full $700. They’re best keeping the prices high and having a product that pirates aspire, one day, to own legally.

The second reason that pirates can be your friends is that they are a bellwether. They indicate the existence of a market failure. Most people aren’t natural crooks, but high prices can force them to do things against their better nature. Apple realized that the success of illegal download sites indicated the need for cheap, downloadable music. Their strategy of satisfying people’s needs worked far better than the ostrich-like behavior of the music labels.

Switching costs

If you’re trying to persuade people to switch to your product from a competitor’s then you’ll need to position the price to overcome the switching costs your customers face.

Say you’re trying to persuade a customer to switch from his garbage $500 word processor to your superior $100 one. First of all, you’ll need to price to overcome the economic switching costs. It’ll take him time, and therefore money, to convert his files to a new format and to learn the new menu layouts.

Secondly, you’ll need to overcome the psychological switching costs. People overvalue what they have, and undervalue what they don’t have. What do you reckon the three balsawood penguins in the photograph are worth? They cost me ten dollars (from the Kontiki exhibition in Oslo). Care to raise your price? Didn’t think so, but I wouldn’t sell them to you for even a hundred. I bet your house is probably full of similar junk too.

Another powerful psychological factor people struggle to overcome is the emotional attachment to money they’ve already spent. Rationally, it’s gone. It’s a sunk cost. Your customer shouldn’t care that he’s already spent $500 on his garbage word processor. But he does.

To see this, take the case of a group of students who were told to imagine that they’d accidentally purchased tickets for both a $50 and a $100 ski trip for the same weekend, but that they’d have more fun on the $50 trip. Which trip would they give up and which trip would they go on? Rationally, they should have chosen to go on the cheaper trip. In fact, over half the students chose to go on the less enjoyable, but more expensive trip.

There are some things you can do to mitigate switching costs, and even to use them in your favor. Here are a couple of examples. Open Office, which includes open source word processing and spread sheet applica- tions, lets you open files saved by Microsoft Word. Early versions of Microsoft Word not only opened WordPerfect files, but had a dedicated section in the help for WordPerfect users, and even allowed you to use the WordPerfect shortcut keys.

Here’s another example. If you decide to stop using FogBugz within ninety days of your free trial expiring, then Fog Creek will refund you all the money you’ve spent.

These strategies have two effects: first of all, they reduce the psychological and economic impact of switching to Word or Fogbugz. Secondly, once you have switched, you’ll have invested time and energy into using the new software, and will have incurred a whole load of new switching costs, which will then stop you from switching back.

Should you take your costs into account?

Clearly, you cannot price your software for less than it costs you to produce, and sell, each unit. These are your marginal costs. You might think these costs are zero, but they are not.

You need to find potential customers and persuade them to buy. If you have a sales team then you’ll need to pay them commission. It will cost you money to support customers, and chase the customers who don’t pay.

If you’re relying on an intensive sales model, with face to face meetings, then your cost of sales will, of course, be higher than if you have a low- touch, web sales model. But you need to count the costs in both cases.

If you’re planning on not charging the majority of your users, then think very carefully about the cost of each additional user. If you think it is zero then you are almost certainly wrong. If you’re running a web site, then each additional user will cost you storage space, CPU cycles and bandwidth. This might be a very low cost – fractions of a penny, even – but if you need huge numbers of users to make money then small costs multiplied by vast numbers can equal big outlays.

Take YouTube. It’s a free service and, theoretically, supported by advertising. The cost of serving each additional video is tiny (about one tenth of a cent), but in 2009 it will serve up an estimated 75 billion video streams. Multiply together the tiny cost and the large volume and you can see understand why YouTube costs Google an estimated $710 million a year to run. It nowhere near covers its costs through advertising revenue.

Paperback Software offers another example of how misunderstanding how your software is sold, and failing to account for your costs, can lead to catastrophe. When Adam Osborne set up Paperback Software in 1984, it was founded on the premise that software cost too much.

They released VP-Planner for $99.95 in 1986 and marketed it directly against the $500 Lotus 123. Back in the 1980s, most software was sold through dealers. The dealers earned a commission for every piece of software they sold, but so hated the low margins on the low cost VP-Planner that they bad-mouthed it and encouraged people to buy the high-cost, high-margin Lotus 123 alternative. Furthermore, since VP-Planner was essentially a direct copy of Lotus 123, customers demanded as much support for the cheaper product as the more expensive one, destroying any profit that Paperback Software made. Paperback succeeded in harming Lotus’s market share, but failed to earn enough money to defend themselves against the lawsuit that Lotus launched.

If the price your customers are willing to pay is lower than what it costs you to sell your software, then you haven’t got a business and your product will flop. You need to cut your cost of sales, or change your 33 pricing mechanism so customers end up paying more over the lifetime of the product.

When Panasonic launched the 3DO, its gaming console, in 1994, Time Magazine nominated it its product of the year. With a 32-bit RISC processor, custom math co-processor and 2MB of RAM, it was far ahead of its time. But Panasonic priced it at $699, way above its competition and much higher than what even its target market of early adopters could bear to pay. That, combined with muddled marketing, caused it to bomb.

Other games console manufacturers learned from this mistake. When the PS3 and Xbox 360 were launched, they cost more to produce than the selling price that the market could bear, so Sony and Microsoft charged consumers a low price, and accepted that they would lose money (up to $300) on each console sold. They then recovered the revenue through royalties on games people bought. The real price of the console is hidden; buried in a clever pricing model.

With the Wii, Nintendo took a different approach. They wanted to reach a much wider market than their competitors’ 18 – 35 year old male sweet spot, but realized that older people, housewives and families would pay less for a console than hardcore gamers would. So they cut their cost of manufacture and used cheaper, slower components. When the Wii was launched in September 2006, Nintendo made a profit on every console sold. That made the games cheaper to produce too, since royalty payments can be lower, but not necessarily cheaper to buy. Why? By now, the answer should be obvious to you.

You’ll notice that there’s one factor I’ve not mentioned, and that’s how much your product has cost to develop. So far I’ve talked about marginal costs – how much it costs to produce, or sell, each additional unit of your software. Your up-front cost is different. You might have spent one hundred dollars developing your product, or a million, but that money is all spent. Gone. It’s a sunk cost. What matters now is not how much you’ve spent, but what people are prepared to pay.

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