3.2 Generating Additional Revenues: Willingness-to-Pay
It might appear obvious that the goal is to extricate as much as possible from the universe of consumers. But many large and small businesses, for reasons of simplicity, turn to the one-product, one-price solution in order to have a simplified management agenda. Adding additional product versions introduces complexity and requires additional investment in the supply chain as well as having an impact on the cost structure for each version. The one-version, one-price approach is a natural solution for the harried entrepreneur who has gazillion things to worry about. However, offering just one version is not a good strategy for several reasons.
If Joan offers only the high-end version, then the profit accrued will be $1,000 [($60 − $30) × 100 − $2,000]. If Joan offers only the low-end version, then the profit accrued would be $1,000. If Joan decides to offer only one product, then it makes sense to go with the middle-level product and the middle-level price, where the profit is $3,000. However, such a strategy leaves a lot of money on the table. First, the high-end consumers would be willing to pay more for the product. Economists call this additional amount they are willing-to-pay as consumer surplus. The consumer surplusThe difference between the amount the nonprice-sensitive or affluent person would be willing to pay for the high-end product and how much they actually paid for the product. is the difference between the amount the nonprice-sensitive or affluent person would be willing to pay for the high-end product and how much they actually paid for the product. Second, price-sensitive consumers can be drawn into the market if an affordable option is made available.
By adding two additional versions, Joan has dramatically increased the present value of her business. A very simple way to calculate the value of a business is to use the perpetual annuity formula of cash-flow/cost-of-capital. If we assume a cost-of-capital number of 10%, then having one product leads to a firm value of $360,000 (12 × $3000/0.10). The present value of the business with three products is higher at $540,000 (12 × $4,500/0.10). The business is worth $540,000 rather than $360,000. There is a $180,000 difference. (Additional discussion on the time value of money and how it affects the value of the firm will be presented in a later chapter.)
From the above discussion, we can infer that offering two or more versions of a product is a better strategy than offering only one version. We believe that the best strategy is to always offer at least three different versions of a product; that is, a high-end version, a middle range version, and a low-end version. Varian refers to this type of price discrimination as Goldilocks pricing. However, the value of price and product differentiation goes above the short-term profit considerations. Versioning is critical for long-term survival of the firm because price and product differentiation puts the firm closer to consumers. Versioning helps the seller to understand what product and features are desired by consumers. Versioning is a form of experimentation that affords the seller the opportunity to conduct experiments by introducing versions of products with different features and observing how consumers react.
Price and product differentiation permits consumers to acquire goods that they want at their price point. Consumers come in a variety of sizes with different wants and satisfaction levels and different levels of discretionary income. They have different degrees of their willingness-to-pay for products and services. Price and product differentiation can not only facilitate the extraction of money from the affluent, but it can also benefit the four billion people who live on less than $1,500 per year.Prahalad (2006). This is the so-called bottom-of-the-pyramid. Indeed, price and product differentiation is the basic strategy for selling to the bottom of the pyramid and for providing pharmaceuticals, health care, and many other products to the poor.
We are sometimes asked whether the low-end product will cannibalize the demand for the higher-priced products. That is, will affluent consumers with more money who are less price-sensitive buy the low-end product and ignore more expensive products? This can, of course, occur if the products are not perceived as being adequately differentiated with higher-end features and additional functionality. The key activity for the producer is to conduct experiments by offering differentiated products and watching economic buying behavior unfold.Traditional marketing analysis techniques such as focus groups can still be used to identify features. However, they are just part of the input used to identify product versions. The information garnered from these experiments can then be used to continually refine product offerings and understand the willingness-to-pay functions of your consumers. In essence, if the buyers flock to the low-end product, then this information can be used in future product design decisions.