Pricing Methods for Mere Mortals

This page describes methods of selecting a price (pricing models). If you are trying to figure out how you should earn money (business models), you'll want to read my page on revenue models instead.

Introduction

Once upon a time, pricing was pretty simple. A handful of manufacturers built everything that customers would buy. Each product category consisted of items with similar quality and value in the eyes of consumers.

Pricing was merely a matter of selecting the going rate. It was a simple afterthought tacked on to the end of the design of a product or service.

It's different now.

The number of competing vendors in this world is rapidly increasing. Instead of just vying against the guy next door, businesses are competing with sellers across the world.

Fortunately, there are many methods for selecting the optimal price. They are listed below:

Pricing Methods

  1. Auction
  2. Best Alternative to a Negotiated Agreement (BATNA)
  3. Copy a Competitor
  4. Cost-Plus
  5. Decoy Pricing
  6. Demand-Based (Surge) Pricing
  7. Drip Pricing
  8. Fire Sale Pricing
  9. Fraud
  10. Freemium
  11. Loss Leader Pricing
  12. Momentum Pricing
  13. Net Present Value
  14. Penetration Pricing
  15. Predatory Pricing
  16. Price Skimming
  17. Randomly Guessed Prices
  18. Razor and Blades Pricing
  19. Technical Analysis
  20. Time and Materials
  21. Value Pricing

Auction

Auctioneer: The man who proclaims with a hammer that he has picked a pocket with his tongue. -- Ambrose Bierce

There are many forms of auctions - entire books have been written describing their innermost workings. Various forms are used for all sorts of items including famous artwork, company stock, radio spectrum and even tuna.

The key idea behind an auction is that a product's final price is set via competition by potential customers.

Common auction methods include:

Besides the obvious excitement of the auction process, auctions feature the additional benefit of offloading the responsibility for setting prices from vendors to buyers.

Unlike the pay what you want model, the use of limiting rules such as reserve prices, as well as a scarcity of supply, will often prevent buyers from acquiring goods at prices that are not profitable for the vendors.

While many auctions take place over long periods of time, others are highly automated and quick. Many auctions for internet advertising space, for instance, are handled in real-time with an auction length of less than a second. The primary challenge in implementing auctions often isn't conducting the process at all. The difficulty lies in assembling and coordinating the bidders themselves. As a general rule, the greater the reach of the organization conducting the auction, the higher the odds of sizable bids being offered. All things being equal, a smaller pool of bidders will lead to suboptimal income for the vendor.

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Best Alternative to a Negotiated Agreement (BATNA)

To me, growing old is great. It's the very best thing - considering the alternative. -- Michael Caine

There are very few marketplaces for which there is exactly one vendor. Alternatives abound. Even if the alternatives are not an exact match for a specific offering, they may fit a similar need.

Levels of competition can be addressed through product specialization, but customer will rarely be forced to buy a specific product with alternatives disallowed from consideration.

That said, the fact that two products are able to solve the same problem is insufficient to cause them to be competitors.

Sure, both bicycles and sports cars can be used for the purpose of transportation, but they aren't really in the same sphere of consideration. Not only are the costs vastly different, but the typical uses for each are different as well.

Once a vendor understands the competition, he can ask a very important question:

What is a customer's best choice for a purchase, excluding my own offering?

In other words - What choice would maximize a particular customer's bang for his buck?

If you're offering a scoop of high quality ice cream for $5 and a competitor right next door is selling two scoops of the same brand for $4.50, you're probably going to have some financial problems ahead. All things being equal, a customer might as well go next door and save himself 50¢ and receive an additional scoop for his troubles. If you want to compete, you'll have to either add more value or drop your price (or some combination of the two).

Sometimes it's not so easy to determine what the next best alternative is for your product.

Let's say that you're selling five pounds of salt for $10, and a competitor is selling a single pound for $3.

Which would customers buy?

To use BATNA, you have to understand your customer!

There are two big mistakes that customers tend to make when implementing BATNA:

First, search costs matter. Most potential customers are unwilling to spend years of their lives in an attempt to pinch every penny and find the absolute best deal that they can. The more time, money, and effort that go into a search for the best alternative, the less they have to devote to other uses.

A person who wants a good roofer will likely only consider those in his geographic area - and possibly only those in his geographic area whom his neighbors have employed. Few homeowners would spend years of their lives searching the entire world for the best deal on a roofer - any benefit in terms of bang for the buck would be outweighed by the enormous search costs involved.

Second, there is one buying decision that is always present and almost always forgotten by vendors: a customer can decide not to make any purchase at all.

Take the example of a person looking to buy a bigger house. He examines the available stock and decides they are much too expensive and of particularly poor quality. Is he forced to purchase one of the houses?

Of course not. He can simply remain where he is. In other words, his best alternative may be to do nothing.

Especially when selling to businesses, vendors may face incredible resistance to change. Many managers find it both easier and less risky to avoid making any purchase at all, even when it's clear that a purchase needs to be made.

For this reason, one's biggest competitor might not be another firm at all. A buyer's perceived best alternative might be to do nothing.

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Copy a Competitor

Imitation is the sincerest form of flattery. -- Charles Caleb Colton

It can be very tempting to copy the pricing of a competitor. Delegating one's pricing can be very seductive - not only is pricing difficult, but this form of delegation comes without explicit cost.

As a general rule, if a given product falls into one of the following categories, copying a competitor may make sense:

Buyers who care first and foremost about price and shop primarily on price will often continue to do so, unless trained or given reason to do otherwise. In a sense, for many new entrants lacking a large bankroll, the price that customers are willing to pay is carved in stone. It simply cannot be changed in the short term.

If customers are exceedingly transitory and continually replaced by new buyers with few preconceived notions, copying another vendor's pricing may make a great deal of sense. Existing prices act as a starting point which require little time and effort to emulate. As he gains experience and gathers new information, he can then change his pricing with little fear of backlash from a continually refreshed customer base.

Of course, the selection of the proper competitor to emulate should be undertaken with the utmost care.

As each firm may have different goals, strategic strengths and cost structures, a price that proves highly profitable for one firm may prove ruinous for another.

Those with the facility in self-promotion and a sense of fearlessness may choose to clone the pricing of a competitor in an effort to build an image equal to that of the firm that it is attempting to emulate. As pointed out in The Differentiation Danger Zones, emulation of marketing techniques including price points can lead to a change in customer perception of a given offering. Such an effort, however, can prove challenging for those without significant background in the field.

Not to be confused with BATNA, a method that (depending upon circumstance) may involve the strategic copying of a competitor's price.

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Cost-Plus

This is a type of pricing scheme best suited for government contracts and agreements with other especially large vendors. It essentially breaks the profit and the costs into different buckets, making each explicit.

Here's how it works:

Here's what a very simplified cost-plus agreement might look like:

In the real world, the cost breakdown might be significantly more hazy. The exact cost of labor, supplies and other inputs may not be known ahead of time.

The key point is that the vendor knows exactly how much profit he'll be earning and takes on very little risk.

The buyer, on the other hand, takes on a fair amount of risk because costs could easily spiral out of control. Nevertheless, this type of contract may be favored by some buyers who wish to avoid lengthy contract negotiations or are requesting an offering with great uncertainty (a vendor may not wish to take on a risky projects, unless the risk is borne by another party).

Technically, this system only uses fixed markups. Many similar systems use a percentage markup instead. For instance, keystone pricing adds a 100% markup to all prices.

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Decoy Pricing

It's better to be a fake somebody than a real nobody. -- Matt Damon

Whereas most pricing methods listed in this document are designed to encourage sales, this one is actually intended to prevent sales. The best part is that when it works, it leads to more sales.

Confused yet? Read on.

Decoys are items that are supposed to confuse outsiders into thinking they are real. Whether one is talking about decoy ducks used by hunters to fool their prey or decoy assets used by the military to fool their enemies into wasting resources attacking worthless targets, decoys can prove highly useful in reaching one's goals.

Decoy prices follow the basic pattern - they provide a price for a good that looks like something that a vendor expects customers to buy. The exact details of decoy pricing will depend upon the needs of the vendor, but the common usage is outlined below:

Mathematically and logically, the decoy product should have no effect on buyer decision making. According to traditional economics, buyers will see the decoy offerings, note their lack of relative value, and simply ignore them.

In reality, a decoy price used as described will tend to increase purchases of the next-most expensive item. Shocking as it may be to admit, people are not inherently rational creatures and do not always follow traditional economic models. Human beings can be tricked into acting on their irrational thought processes by marketers.

Let's take a look at an example of some prices without any decoy product:

Given this list of prices, some movie goers will simply buy the ticket and others will buy the ticket, popcorn and soda combo.

Now let's see what happens when we add a decoy product:

This new ticket & soda offer appears to be a very weak offer. No soda of any reasonable size is worth an extra $4 over the cost of a movie ticket, right?

I'd be shocked if anyone found the new $11 offering tempting for even a moment. It looks like a total ripoff that wouldn't appeal to anyone. To those who are unfamiliar with pricing it looks like a mistake. To those who are familiar with pricing, it looks like a decoy product.

Let's see what happens when potential customers look at the new price list.

Folks who would have purchased the movie ticket plus popcorn and soda will continue buying that combination. The step down in value just isn't worth it for a $1 savings.

The types of people who would have bought just the movie ticket, however, go through a more complicated thought process. Now there are two items that are more expensive than just a single movie ticket. This causes their value system to go out of whack as the price for the experience is now anchored higher. Some buyers will look at the movie ticket and dismiss it as being a cheap, undesirable option.

Subconsciously, the price list will now look like this:

The buyers will then look to the remaining options, opting for the one that clearly offers the most value - the highest price option consisting of a movie ticket, a container of popcorn and a soda.

Not every customer will be pushed to the highest cost offering, but many will feel compelled to change their buying habits. Nevertheless, the additional offering will certainly have a noticeable effect on the vendor's bottom line in return for very little effort expended.

Decoy products are not always easy to spot from the outside - often they look like pricing mistakes. Nevertheless, they can prove highly profitable when properly used.

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Demand-Based (Surge) Pricing

Make hay while the sun shines. -- Anonymous

Sometimes picking the best price can be hard.

Sometimes picking the best price can be impossible.

There may be no "best" price that meets one's needs all of the time.

Fortunately, demand-based pricing, a technique the lets the price vary depending upon customer demand, can help.

It's surprisingly useful and surprisingly underused.

Imagine that you're selling a highly seasonal good:

You'll probably have a tough time selling Halloween decorations in November, just as you'll have a hard time selling surfboards in the winter or winter coats in the spring.

Similarly, imagine that you're selling something that is more in demand at certain times of the day:

There will be some times of the day, or the week, at which there is intense demand. More people probably order take-out food at lunchtime or dinnertime than at other times of the day. Similarly, more people probably want to go to the movies in the afternoon or evening than early in the morning.

For some of these products, there will likely be times when demand falls to almost nothing.

The creators of demand-based pricing noticed that demand for some offerings can cycle over time from high to low - even for products that are loved and highly valued by consumers.

They realized that when demand was at its peak, they could charge very high prices. Conversely, when demand was quite low, they would have to reduce their prices to achieve a respectable number of sales.

Many Floridians (including me) enjoy substantial discounts on everything from food to entertainment during the sweltering summer. Once the tourists leave, businesses have to offer great deals to attract stingy and price conscious locals.

Demand-based pricing isn't just used to keep money flowing in during slow periods. Many businesses rely upon it in order to throttle demand to manageable levels. For instance, cities are increasingly using this method for setting prices on toll roads.

By raising prices at times of peak demand, a city can push travelers to drive at less busy times. This reduces the maximum level of traffic at traditionally busy times, reducing the odds of traffic jams and accidents. As an added bonus, it potentially provides discounts to drivers who are willing to shift their schedules with lower rates.

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Drip Pricing

Give them an inch, and they'll take a mile

There's a problem with most potential deals. Buyers tend to want to buy items for as little money as possible. Sellers, on the other hand, prefer to sell items for as much money as they can.

Unfortunately, when sellers and buyers both hold firm to their desires, deals don't get made. If only there were some way for prices to be low enough to attract cheapskate buyers, but high enough to appease money-grubbing sellers.

This is where drip pricing shines. Items sold under this strategy advertise low prices to attract buyers. Then, after agreement by buyers, the price is raised through the addition of a small involuntary fee. Then, once the buyer agrees to accept the new price, an additional involuntary fee is added. This cycle repeats several times until the price rises to a level that customers would have thought absurd, had the final price simply been advertised from the start. By the end of negotiations, the buyer is so invested in the process, that he'll spend significant sums to acquire the product in question.

Vendors intending to utilize this method should note the following:

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Fire Sale Pricing

I used to believe that anything was better than nothing. Now I know that sometimes nothing is better. -- Glenda Jackson

Although perfectly legal in most instances, this method can easily lead to a ruinous result. As such, it should only be undertaken in the most extreme situations.

You may have heard many house sellers maintain high prices despite a lack of any interest. When asked about their approach, they always respond with the same reasoning, "I'm not just going to give it away."

Fire sellers say just the opposite, "I'm practically giving this away!"

In essence this strategy involves dropping one's prices to absurdly low levels in order to generate exceedingly quick sales from potential buyers. Any opportunity for income (not necessarily profit) is met with open arms.

This strategy is rarely useful, unless one of the following conditions has been met:

Fire sales are inherently dangerous because the return on investment is often severely negative. Yes, the sunk cost fallacy suggests that the cost basis of an item should never be used to determine pricing. Nevertheless, selling an item at below its "worth" represents a potential loss of income and no business can last long taking a loss on the sales of its inventory (Uber excepted).

In addition to possible loss per unit income, there exist two additional sources of risk from fire sales:

In many cases, if there is no immediate need for income, companies will choose to either donate or destroy their products to avoid these risks entirely.

Not to be confused with penetration pricing or loss leader pricing. Both use reduced pricing in order to achieve business goals.

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Fraud

There are things known and there are things unknown, and in between are the doors of perception. -- Aldous Huxley

While other methods may cause you to lose money, this one may cause you to be imprisoned (or in some jurisdictions killed). For this reason (and several others), please think twice before engaging in any sort of fraudulent activities.

Frank Abagnale, upon whose life the Academy Award-nominated film Catch Me If You Can was based, has demonstrated that fraud can be both lucrative and endearing to the public.

While this section will not go as far as to recommend its use, a brief overview of the methodology will be explored.

Although many forms of fraud can be challenging to explain, each amounts to little more than a variation upon a very straightforward theme.

Ultimately, the core of any fraud is to convince a buyer that a given item's value is significantly higher that its actual worth.

The most common frauds will cause victims (marks) to misjudge one or more of the following:

Although many defenses to charges of fraud amount to caveat emptor, the acquisition of airplane tickets to non-extradition countries tend to prove another highly desirable means of evading prosecution.

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Freemium

The only way to deal with an unfree world is to become so absolutely free that your very existence is an act of rebellion. -- Albert Camus

The freemium model has the distinction for being one of the most well known as well as one of the least well understood pricing methods on the internet.

Most marketers think that its implementation is simply a matter of giving something away for free. Unfortunately, it's not so simple.

Choosing the right product to give away for free can be extremely difficult and require significant research. Choosing the wrong thing can lead to a significant loss of income and increasing costs for a business.

The first thing to note is that freemium is not a panacea. It is best suited to only a subset of offerings.

Here are a few conditions that might indicate a freemium option is appropriate for a given product:

Once a decision has been made to select a freemium strategy, one must be certain to define the actual freemium offering.

The offering must balance two competing criteria:

Why not just give away the farm and make the freemium offering the best it can be?

Many companies try that approach. All of them fail.

Businesses need to earn a profit. Unless a firm is using the The San Francisco Hipster business model with the goal of selling out to Google, profit has to come from somewhere. That somewhere is the customer base.

The two most obvious ways to earn a profit from freemium offerings are to ensure that a significant portion of freemium users either convert to paying customers themselves or attract other freemium users who will themselves convert.

There will always be a percentage of freeloaders who use the system. This is to be expected. In some cases their existence may indicate a poorly crafted freemium offering. In others, they are simply a harmless result of offering any good or service for free.

When evaluating the value of a freemium plan, customers shouldn't just focus on the people who take without giving back. They should always look at the aggregate effect of the plan. Does it optimize for the goal of the firm (profit generation, lead generation, etc.) rather than are there any people who are taking advantage of it?

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Loss Leader Pricing

It takes money to make money.

There's always a chance that a given pricing strategy won't work. It could cause a firm to lose money, alienate customers or misrepresent the value being offered. A poorly chosen (or implemented) pricing system could cause one to lose significant sums of money. That's life, and that's just one risk with most pricing systems.

Techniques involving loss leaders, however, are different. There is zero risk that you'll wind up losing money by implementing a loss leader strategy.

That's the good news.

The bad news is that there is no risk because you are guaranteed to lose money instead.

So why would anyone use this pricing technique to deliberately try to lose money?

There are two main reasons:

  1. To get customers "in the door" so that they can be convinced to purchase other items. In addition to the benefit of physical proximity, the loss leaders may cause customers to believe that if the pricing of a specific good is attractive, other items being sold must necessarily be offered at desirable prices.
  2. To be added to a buyer's list of preferred vendors. Some governmental agencies and large businesses make it almost impossible to sell to them.

A sharp mind will note that both reasons can lead to higher profits. A sharper mind still will note that both reasons are essentially analogous to each other.

This method is so common that many buyers do not even realize that it is used at all. The three classic examples of loss leaders are milk, movie tickets and gasoline. Shoppers in supermarkets come for the milk and then wind up buying other food products. Similarly, customers at movie theaters buy movie tickets and then spend significant sums for refreshments. Gas stations also use this strategy. They sell gasoline at very low prices, but make significant profits via sales of their food products.

In each case, the vendor loses money on per-unit sales of the loss leaders, and indeed may lose money on sales to individual customers, but more than makes up for it with purchases from customers who want to purchase additional products.

Some companies will artificially limit the supply of loss leaders to a very small number (the items available in limited quantity are often referred to as doorbusters) in order to limit the cost to the store. Of course, this type of action has caused a great deal of cynicism on the part of buyers. As such, such limitations may backfire on the store and decrease the interest of potential shoppers.

So can any product act as a loss leader?

The short answer is yes, and the long answer is no.

Yes, in that most products can be sold at a loss (barring certain anti-monopolistic and anti-dumping regulations).

No, in that certain classes of products are more likely to lead to profits for the vendor.

The best items are those for which buyers are very cost conscious and familiar with the pricing. The average person knows what a gallon of gas costs down to the penny. He likely cannot say the same for many other products such as road salt or cayenne pepper. Ideally, loss leaders should be items for which he has a recurring need and which drive his shopping decisions.

Great care should be taken to ensure that loss leaders lead to corporate profits. If the deals are too tempting, shoppers may learn to take advantage of them by buying only the loss leaders and none of the other items being sold.

Not to be confused with fire sale pricing, penetration pricing or razor and blades pricing.

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Momentum Pricing

Who's the more foolish, the fool or the fool who follows him? -- Obi-Wan Kenobi in Star Wars

Predicated upon the greater fool theory, this method simply asks whether or not people think an item's price will increase in the future.

There is no analysis of intrinsic value or inherent worth. There is no analysis of end users. There is simply the question of what the next buyer will pay.

In an ideal and rational market, a product's value and a customer's willingness to pay will be the same.

Sometimes, such as in the midst of a speculative bubble, the actual value of the good being sold becomes irrelevant. All that matters is expectation of future price increases.

The higher the expectation, the greater the price that can be levied by the vendor. After all, what buyer would begrudge a vendor for demanding a large markup, if he were sure that he could sell the item for even more at a future date?

The greater the level of irrational exuberance, the more that can be charged. This cycle self-perpetuates with prices heading toward the stratosphere, with market participants becoming ever more confident based upon their increasing bottom lines.

As worried buyers begin to exit the market, the increasing prices become more and more difficult to maintain, until eventually the prices crash, often below the actual products' worth.

Proper analysis using this method is often focused on buyer psychology than on other pricing methods. A strong marketing effort focusing on fears of missing out as well as greed is all that is necessarily to succeed, until the tipping point at which prices drop.

If the sale results in a loss for the buyer, the buyer is often referred to as a (falling) knife catcher or bag holder. If the sale results in an eventual profit, the appropriate appellation for the buyer is shrewd investor.

This pricing method is, by necessity, a short term play, due to the need for irrationality on the part of buyers. Of course, as is often said:

Markets can remain irrational longer than you can remain solvent.

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Net Present Value

Your net worth to the world is usually determined by what remains after your bad habits are subtracted from your good ones. -- Benjamin Franklin

Net Present Value (often abbreviated as NPV) is a specialized version of value pricing and is typically used for financial instruments (such as loans, bonds and annuities).

The method used to calculate net present value is as follows:

  1. Determine the repayment schedule. For instance, a personal loan might require one payment each month for six months.
  2. For each payment, determine its worth in today's dollars. Each subsequent payment will likely be worth less than the one before it. This is due to risk of nonpayment, inflationary effects, the availability of alternative investment opportunities and other external and internal pressures.
  3. Add up the value of each of the payments from above.

If the result of the net present value calculation is zero, neither buyer nor seller will benefit from a transaction. The higher the NPV, the more attractive the deal is to the buyer and the less so to the seller.

Note that it is possible for each party to disagree about the NPV of a given offering, if assumptions about risk or similar matters are in dispute.

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Penetration Pricing

How low can you go? -- Chubby Checker

Traditional economics teaches that as price goes up, demand for a good will fall.

This strategy takes that lesson to the extreme and is built upon one simple follow-up question:

What will happen if I drop my prices substantially?"

In many cases, demand will increase. This isn't true for some offerings like Veblen goods, for which a high price is actually a compelling feature, but it will work for many others. A 95% off sale? That will certainly attract the attention of many buyers!

A very low price may convince fence sitters, shoppers with loyalty to other brands, and the general public to purchase a given product.

For shoppers who only care about price, their purchases of the product being offered represent a one-time loss of income for the vendor. Once the price rises to its long-term level, these customers will not purchase the item again.

However, buyers who viewed the product with suspicion or unfamiliarity, but were pleasantly surprised, might just change their shopping habits. With their new experience and mental framework, they will adjust the product's perceived value and be much more likely to purchase the product in the future.

These buyers (assuming that their opinion of the product is high) may develop a loyalty to both the offering and to the brand. They are the real targets of any penetration pricing campaign, as they represent future streams of income at higher price points.

Although penetration pricing is typically thought of as a means of introducing a product to a new customer base, there are several characteristics which should be met by the offering to increase the odds of long-term success.

Not to be confused with predatory pricing or loss leader

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Predatory Pricing

You don't see sick animals in the wild. You don't see lame animals in the wild, and it's all because of the predator: the lion, the tiger, the leopard, all the cats. -- Tippi Hedren

This method will flat-out not work unless you have a lot of money backing your business. In addition, it is explicitly illegal (though often difficult to prove) in many jurisdictions.

Nevertheless, it has been (and continues to be) used with great success by many firms.

The method is simple:

  1. Figure out how much competitors have to charge in order to stay in business.
  2. Charge significantly less than that, even if it causes you to lose large sums of money.

There are two obvious benefits to this approach:

Venture-backed firms are notorious for using this strategy. Uber, for instance, is losing hundreds of millions of dollars on a regular basis by charging customers below their own costs to provide service (see Support Traditional Taxis: Use Uber for the details).

Predatory pricing is usually a short-term strategy. Unless a firm is able to raise prices at some point, it will eventually run out of money and wind up bankrupt. Raising additional rounds of financing is a stopgap and can allow penetration pricing to continue for a while, but eventually a firm's ability to borrow will approach zero, causing the entire practice to collapse.

The key to predatory prices is to cause competitors to leave the market or force them into receivership before the firm using this method runs out of cash.

Once the competition is eliminated, the firm will have significant market clout (as the major remaining supplier) and can raise prices due to its market power.

Not to be confused with penetration pricing

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Price Skimming

It is not well for a man to pray cream and live skim milk. -- Henry Ward Beecher

The name for this method comes from a process long used in dairy production.

Many years ago, farmers realized something interesting. Milk isn't homogenized when it comes out of the cow. Rather, milk is a collection of several layers. The tasty and fat-laden cream tends to be at the top, while the liquid at the bottom tends to be watery and unflavorful.

Rather than selling their milk for a middling cost, they realized they could process it and make substantially more money.

The rich cream (less dense than the rest of the milk) could be skimmed (removed) and sold to wealthy buyers for a premium price. The remaining liquid could then be sold to the masses who lacked sufficient coin to purchase the higher quality cream.

Skimming in modern economy takes after those dairy farmers. It relies upon the idea that there are some people out there (either due to wealth or interests) who will pay significantly more for a given product than will the masses.

With a little planning, a skimmer can set a very high price for those who are most willing to pay. Once those buyers are satiated and have minimal interest in making additional purchases, a vendor can reduce his prices and sell to his next-most interested customers. While these buyers weren't willing or able to pay the previous prices, the newer, somewhat lower, prices prove more attractive and palatable.

There is little fear of cannibalization, because those who already purchased at the higher price have already demonstrated that they are satiated and unwilling to buy more at the original price.

The vendor can then repeat this process of price reduction and retargeting to groups with a lower price threshold until further price drops would prove unprofitable.

This method is extremely attractive when either potential customers have a vast difference in willingness to pay or when production ability is currently lower than it will be in the future (thus, demand would outstrip supply at market clearing price levels).

Although this pricing method has proven highly profitable for many firms, there are several significant dangers that should be noted:

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Randomly Guessed Prices

Maybe life is random, but I doubt it. -- Steven Tyler

A popular method from the hope-based school of economics.

This method is easy to implement and almost universally wrong. Hope isn't an effective tool for customer analysis, because it has very little to do with the customer and quite a bit to do with the seller's luck.

As Ralph Waldo Emerson once said:

Shallow men believe in luck. Strong men believe in cause and effect.

An incorrect guess will cause significant damage to a company by helping to build the wrong image, positioning, or clientele for a given business. As such, recovering from an incorrect pricing model will often necessitate significant rework and repositioning efforts that many companies cannot afford.

The steps for price guessing are as follows:
  1. Make a guess as to an appropriate price.
  2. Declare Bankruptcy.

Variations on the guessing method include:

Unless either you or your friend happens to be named Nostradamus, I'd certainly recommend entertaining other methods of divining a proper pricing strategy.

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Razor and Blades Pricing

Anything worth doing is worth doing twice. -- Arthur Leonard Schawlow

I would argue that this is the most challenging pricing method of all. The reason for this is that it splits an offering into two components that must both be priced.

In the prototypical case of razors and blades, a vendor must ask two pricing questions:

  1. What should we charge for the razors?
  2. What should we charge for the blades?

The question proved so difficult and so profound that many manufacturers simply decided to sell disposable razors that could be combined into a single unit.

Of course, this pricing strategy isn't limited to the world of shaving implements. Many offerings that consist of two tightly-bound complementary goods will prove excellent candidates, though the method works best for those for which one item is a fixed cost good that must be purchased only once and a less expensive variable cost item that must be purchased repeatedly.

The more expensive of the two is generally sold at or below cost. To compensate, the lesser-cost item is marked up significantly.

Not only does this method require substantial thought for the pricing of each part, but it entails significant risk on the part of the vendor:

Not to be confused with loss leaders.

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Technical Analysis

The Shape of Things to Come -- H. G. Wells

This methodology has long been controversial and has been likened to modern-day augury. Nevertheless, many investors in the financial field continue to use and rely upon it for their livelihoods.

The approach depends upon a theory that is disputed by many economists. Adherents believe that changes in prices follow templates of movement - well-known patterns that occur repeatedly. Given enough time and effort by analysts and their computer systems, early recognition of these patterns will inevitably lead to very powerful insights into future price movements.

Many of these patterns have been identified and given names.

Here are but a few:

Interestingly, the ability for such a method to actually predict the future may be irrelevant.

As more and more participants look for (and trade with) technical patterns, the market will begin to demonstrate greater levels of conformance to technical analysis predictions. This feedback loop can prove very profitable for technical traders but cause significant financial damage should technical predictions cause the pricing in a marketplace to deviate from underlying market values.

It should be noted that this method may prove difficult to utilize without a significant quantity of historical data. The less liquid (and more opaque) the market, the more difficult it will be to implement.

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Time and Materials

If you love life, don't waste time, for time is what life is made up of. -- Bruce Lee

There are times in which the cost of a product is unknowable to the vendor, the buyer, or both.

There are many possible causes for this to occur including:

Even when none of the above cases hold, many customers are so used to utilizing this method that they are unwilling (or unable) to select any other due to internal regulations or red tape.

From a vendor's point of view, the main advantage of this method is that it shifts all estimation risk from the vendor onto the buyer.

The main disadvantage of this method is that it penalizes efficiency and risk avoidance. The more quickly and defect-free a product is created, the less the vendor will be paid. Some contracts attempt to address this failing by adding rewards or bonuses for hitting certain milestones.

This method is particularly useful for companies with:

Firms that are efficient and produce quality work should shy away from this method. For several reasons:

Nevertheless, there are cases for which hourly pricing might make sense.

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Value Pricing

Price is what you pay. Value is what you get. -- Warren Buffett

This seemingly straightforward method can be very effective, but is often difficult to implement properly.

It is fundamentally a two-part process:

  1. Determine how much value a buyer will place upon your offering.
  2. Charge an amount somewhat less than that. Why less? Don't worry. We'll cover that later.

The main complication of this method relates to the valuation of your offering. One of the fundamental mistakes vendors make is to think solely in terms of actual value delivered.

In truth, unless a vendor has sufficient credibility to simply cause customers to take what he claims at face value, buyers will have to use their best judgment to estimate the actual value to be received. These estimates will often be too low.

Why is this the case? Here are a few reasons:

For this reason, honest vendors would be well advised to use documentation, training and information products to ensure that actual value is closely aligned with the perceived value of their products. This will help them maintain higher prices and faster sales processes.

Identifying the value that a given customer (or set of customers) will ascribe to a good can be challenging. Outside of economic textbooks, such information is often unavailable. It's not as if a customer will walk around with a note pinned to his chest stating that he values your goods at $100.

For this reason, a bit of pricing discovery (what I refer to as economic archaeology) is often required.

If a customer base is pretty much all the same - if its members all share the same willingness and ability to pay for your offerings (and are unlikely to change their levels of interest), a survey of likely buyers may prove sufficient to determine pricing prior to any sales taking place.

Many vendors, however, do not have the luxury of a unified customer base. In many markets, a vendor's customers share little in common with each other.

Value pricing can still be used with great effectiveness in such markets, but a structured process should be used to determine the relative valuations each customer places on an offering. Such formality will greatly aid in the determination of potential customer value, both in terms of speed and precision. Not only will such a technique expose the value that customers place upon a collection of goods, but it will also serve to uncover and fix a pricing level in the minds of potential customers.

Whether conducting an overall survey, or an interview with a single buyer, there are generic questions and questions specific to a given offering that will prove helpful in establishing the appropriate pricing level.

The questions specific to each market or industry are too numerous to list here. That said, here are some generic questions that will likely prove helpful for most vendors:

In general, it is not a good idea to ask how much a customer would value your product directly. He may not know, or he may pick a low number which you must first refute before beginning the discovery process.

A common misconception is that this method leads to the highest sales prices. This is not necessarily the case. This strategy may determine that the value a potential buyer would receive is well below the going rate. Noting when customers should not invest in a given good may cost a vendor a sale, but could potentially help build a reputation for honesty and forthrightness.

Some buyers may not be willing to go along with the information gathering process and simply demand an upfront price - either due to fear of revealing their internal workings, distaste for a drawn-out buying process, or fear of being pushed to pay more than they should. When implementing this process, it is vital to explain that the information gathering process is as much for their benefit as it is for yours. One benefit for them is to guarantee that whatever is sold will be the optimal fit to meet the needs of their organization and to ensure that their money is not wasted on solutions that will not address their problems as efficiently as possible. The more types of solutions that a company offers, the more easily the discussions can be framed around the determination of which solution is appropriate.

As a final note, the discount that is applied in step two of the process will vary based upon a number of factors, including industry, vendor reputation and the availability of substitutes. If no discount were applied, customers would be very uninterested, because the interaction would leave them no better off than they had been prior to purchase. A company that didn't offer a discount would essentially be offering to trade a twenty-dollar bill for two ten-dollar bills. No buyer is going to go out of his way to pursue such a deal.

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Conclusion

Which method(s) will you choose for your business?

Now that you've learned about many of the most popular pricing models, you're ready to start pricing your offerings more effectively. As a quick check, can you tell me under which model I released this document?

If you have questions or an idea you’d like to discuss, please feel free to contact me. I’d love to hear your thoughts on this manual and learn how you plan to utilize the information to improve your business.