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“Pay what you want” gets some legitimate numbers

Shoestring entrepreneurs, home-based businesses, and especially Ebay businesses have used this pricing model on the Internet for years, particularly in music. Unknown musicians in particular have found that they can put up their otherwise obscure, otherwise forgotten music and albums on the Internet and set a price of . . . “whatever.” Others, such as podcasters and even some social networkers, provide their service for free but allow for “donations,” which is another way of saying, the price is “whatever.” Low production, overhead, and distribution costs mean that shoestring entrepreneurs and solopreneurs can easily recoup costs and make a fair return — nothing to throw a party about, but the utility bills get paid.

Called “pay-what-you-want” pricing, this pricing method in many ways has been deployed by people who simply don’t want to do the work pricing their product — one of the most difficult marketing decisions to make because it involves a complex trade-off between volume and margin as well as determining the ideal market clearing-point.

And pay-what-you-want would probably have been relegated to the far reaches of Internet long-tail marketing except for a big indie band called Radiohead. Because pay-what-you-want was thriving in the long-tail music industry — bands nobody had ever heard of were suddenly getting a real hearing in the market place — Radiohead in 2007 released their album, Rainbows, on the Internet at pay-what-you-want download prices. In itself, this move was guaranteed to produce big-time play in the media — literally millions of dollars of free publicity — but the universal opinion was that Radiohead had lost, well, its head since it was assumed that in this age of music piracy that most consumers would choose a price of “0.”

The odd thing about the experiment, however, is that only a handful of consumers picked a price of “0.” The album sold millions of copies, the band easily recaptured its studio and marketing costs, and made more money than if they had distributed the album through a label — which they did later and made even more money. Now, nothing in the discipline of marketing or economics can explain why consumers, when offered the chance to pay nothing or practically nothing, actually ponied up a profitable price. While you can speculate about why long-tail consumers are willing to be generous and actually pay for something that’s free — for instance, they are helping to support a poor merchant or band that they really believe in — it’s unclear why consumers would feel generous to a bunch of guitar-playing millionaires.

So, even though “pay-what-you-want” has been a staple of long-tail Internet marketing for years, we now have the first academic study of how well the pricing scheme works in a regular retail environment. Recently published in the Journal of Marketing, the study has valuable lessons not only for shoestring Internet entrepreneurs, but for mainstream retailers, as well. More after the break.

The researchers chose three bricks-and-mortar retailers. One was a buffet restaurant, the second a delicatessan, and the third a movie theatre. They converted the pricing scheme to a pay-what-you-want pricing scheme in which the lowest possible price was “0.” Averaging across all three businesses, consumers paid 86% of the prices the three would normally charge. Hardest hit was the movie theatre; but prices at theatres are massively inflated. At the delicatessan, consumers actually ended up paying more for many items (the shopowner had priced too low), and at the buffet, while patrons paid on average only 80% of the normal price, total revenues increased almost 40%.

In all three stores, pay-what-you-want resulted in an increase in revenues and profits, even though customers paid less.

There are a massive crowd of takeaways for small businesses and shoestring entrepreneurs.

The first is a caveat. Pay-what-you-want is, in my view, the equivalent of a liquidation sale. It only has meaning and relevance in a retail environment in which other retailers are not liquidating their merchandise or, in the case of pay-what-you-want, simply offering fixed prices. In the most practical terms, a “sale” has no meaning unless other goods are not on “sale.” If every retailer adopted a pay-what-you-want pricing strategy, then the market would start clearing at prices below cost.

The second is that the mechanism isn’t fully understood. In any economics or marketing textbook, paying “something” when you could pay “nothing” is irrational behavior. No, it’s utterly irrational behavior. I’d like to consider myself well-read in the economics doorstop books and journals, but even the behavioral economists have nothing to explain this. Some other mechanism is at play here — probably related to what I call the Katrina conundrum (I’ll explain in a later post) — that has to do with non-economic behavior and altruism.

The third is that the pay-what-you-want mechanism may be viable as long-tail merchandisers or producers move more into the mainstream. While the pay-what-you-want is provably successful for small, obscure, long-tail marketers, it hasn’t been proven as an ongoing mechanism in a product growth cycle as the product moves from low production (and low costs) to high production (and often higher costs). The entrepreneur is faced with a serious problem of changing the “contract” with the buyer and potentially losing the most passionate adherents.

Social scientists call this “path dependence”: the small decisions you make early in a business’s history become harder and harder to unmake as the business becomes more complex and your customer base becomes larger. The poster boy for path dependence is Netscape, which by 1996 was the number one browser by miles with Internet Explorer such a distance second that it really qualified for something more like tenth place rather than second. Netscape, like its predecessor Mosaic, was a free browser, available to anyone who could download it. When Netscape decided to charge for the browser (at a whopping $35 a pop), people lost interest. Within just three months, Internet Explorer raced into the lead as the number one browser and Netscape started its long, slow slide into irrelevance. That’s path dependence. By giving away the browser, Netscape set up a business model that other browser manufacturers had to adopt or they couldn’t compete. They then set up consumer expectations that browsers were a free product and all other manufacturers met that expectation. By 1996, the die was cast. Browsers would never be anything but free and Microsoft, which could afford to distribute free browsers because of the massive profits generated by its operating system, was the only browser manufacturer with the resources to compete in a free browser market. The only other competitive business model — as we would learn a few years later — was open-source where production costs were near-zero (free labor).

Pay-what-you-want is, in my view, as radical a pricing scheme as “free” — since it can, after all, mean “free.” So adopters are putting themselves on a path that they may not be able to undo. If you’re talking about creating an entire industry (like browsers or a social network), you’re creating what I call an “industry path,” and you better be able to compete when the entire industry works on a pay-what-you-want scheme (just as Netscape never figured out at the beginning how it could compete in a browser industry where every competitor was offering the product for free). If you’re an outlier within the industry (such as a long-tail marketer in, say, the music industry), then you have to evaluate pay-what-you-want for your entire product lifecycle.

And then there’s the one-off pay-what-you-want. We’re in a recession and consumers are starting to make choices. Low-traffic Internet and bricks-and-mortar retailers are hurt more by the decline in traffic than high-traffic retailers. For instance, I take my two-year old to a wonderful pizza buffet just down the mountain from us in LA. Its traffic has dropped 30%, but the traffic has always been low. Now, 30% is about right in the restaurant industry in this economic climate; however, Shakey’s or Pizza Hut franchises can probably survive such a drop. A low-traffic pizza house can’t.

One suggestion: run the pizza lunch buffet for one week at pay-what-you-want prices. Since competitors aren’t doing the same, the restaurant could attract huge traffic, they would probably generate prices 80%-90% of their regular prices (meaning that the volume will make up for the decreased price point), and, most importantly, it gives the store the chance to convert first-time customers into regular customers. The restaurant business is very unique in that the bulk of the revenues — unless the restaurant is in a high-traffic area such as a freeway stop — come from loyal customers. The primary job of a restaurant is to convert customers into loyal customers, or the restaurant goes out of business. Well, you can’t get repeat customers until you get first-time customers.

To me, that’s the most important takeaway — that pay-what-you-want could be used as a highly successful tool to attract first-time customers at a price point that will probably be profitable. view the PDF article here.

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