I went to Fry’s last week and, as usual, made a bee-line to the games section. Again as usual, there were several games I wanted: D&D Online, RF Online, WW2 Tank Commander, Dungeon Lords, and others. Even though I really want a game I walked out empty-handed. Why? I have a certain budget I decide I can afford and a certain quality of game I have in mind. The prices were too high so I got nothing. If the prices on one or more games had been below my threshold, assuming that price was still above cost, the developer would have made a profit. A smaller profit is better than none at all right?
x = the profit you made
- y = the profit you lost because your price was higher than the customer’s price threshold.
If x – y > 0 then you should sell the product because some profit is better than none at all. If it < 0, or negative profit, then you should not sell because you are losing money.
The problem for stores is they don't set the price threshold for each individual customer. They also don't have salesmen for each product. As a result, they set one price. That price is more or less determined by a profit curve, where your total profit = profit per customer * the number of customers who will buy at that price. You pick the point that will generate the maximum profit on the curve, and sell for that much. The problem is you lose the profit of the customers who would have bought your product more cheaply than the price you pick, but still at a profit.
How about a different approach: Voluntary pricing. Lets say that at point A you make 1 cent of profit and at point B you make maximum profit, such that if you listed a price higher than B people would picket your office for being a greedy capitalist. What would happen if you let the customers themselves pick a price point between A and B, depending on what they feel about the value of your product?
Well in most cases this would simply destroy your profit margin.
If you have a high price per unit, you don't have much room to move, and so you lack the price flexibility to attract many bargain bin hunters. Stores only make about $10 profit on games they sell. Lowering a $50 game to $40 won't generate many more sales because there are other games that originally sold for $30 at cost, some of which are more appealing than your $50 game. However, selling at $40 instead of $50 would have resulted in essentially no profit. So offering voluntary pricing doesn't make sense when you have a high cost per unit.
People tend not to feel loyal to large corporations. They tend to feel, sometimes justifiably, they are paying for the CEO's personal jet to his private golf course in Hawaii. The products were made by Chinese for 1/10th the price anyway so why should you pay more than the minimum? Conversely, if people feel that they are helping the environment or some other noble cause they will be more loyal, and thus more likely to give a bit extra. This is why Whole Foods is in business. It's not that organic necessarily costs twice as much to grow but that people feel they are helping a small chain selling organics against pesticide wielding meglofarms.
If you have a monopoly, people will buy your product no matter what you charge. Offering voluntary pricing in this case is just foolish. People will buy Windows whether the cost is $99 or $69 so why charge less? There's no viable alternative for the mass-market yet although Linux is coming close.
So suppose you have a small company, behind a noble cause, selling an item with virtually no incremental cost per sale? This the case with most companies selling intellectual property. Magnatune does this and this is why I paid more than the minimum $5 when I bought a music CD from them. Half of the sale goes towards the artist, who I am much more inclined to support than a large publisher. I feel that the music industry is evil, thus they have a noble cause. And the cost of the download was only about 25 cents to Magnatune for the 600 full-quality .wav files.
If you think about it, this is the case with most intellectual property providers. Many intellectual property providers are single or small groups of artists or programmers trying to sell online and get away from the man. It's generally true that companies that sell solely through the internet tend to be small compared to companies that are able to sell through Walmart. When a small company uses a publisher most of the profit goes to the publisher anyway. For example, if you buy a $50 game only $8 of that is allocated to the developer. But the developer doesn't see that money, it goes to the publisher anyway to offset costs such as marketing or FMVs. These costs are charged to the developer and are simply written off by the publisher if the game turns out to not pay for it (which is part of the whole plan to not pay royalties). Developers never see royalties unless their game sells between 1 and 4 million units, unheard of except for the largest blockbusters.
Letting your customers choose the price they feel your product makes sense for intellectual property with virtually no per-unit cost. Going back to our x - y equation, we can now suppose that we lose no sales due to price sensitivity because now the customers choose their own price.
The variables are now redefined as:
x = the profit you made, which is whatever you charged
- y = the profit you lost by not charging a higher fixed price that the customer would have paid anyway.
I'll argue that in most cases now, x - y > 0 because 9 times out of 10 people won’t buy your product not because they don’t want it at any price but because of price sensitivity. If that’s the case, then even if you make 90% less profit per sale, you’d still break even. If people feel you have a high quality product and they pay more than the minimum then you made more profit using voluntary pricing than you did fixed pricing.
Starting April 1, or slightly sooner, I’m trying this out with my network library RakNet by letting people choose what they feel the library is worth. In a future post we can see how it works out.