Of all the functions in marketing, pricing is the most important from a profitability perspective. Unfortunately, most managers do not adopt an analytical approach to the pricing process. I cannot go into all the complexities of pricing in a short piece, but I would like to present a counterintuitive insight that is referred to as "versioning". This requires marketers to concentrate not only on making their products better, but also on making those products worse.
To develop this argument I will use a demand curve, but do not get lost in the technicalities (even if you skip this and the next paragraph, you can still follow the argument). The simple downward sloping demand curve in figure 01 illustrates that as price goes down the quantity sold will go up. As a result, a rational marketer with a single product would price ‘P*’ – all other things being equal – where the blue box is the largest (total revenues).
This leaves the marketer with two problems. First, some consumers are willing to pay more, but because one cannot charge different prices for the same product, this consumer surplus is lost to the business. Second, at price P*, some consumers who are willing to buy the product at a price lower than P* but above the marginal cost of the marketer – assume zero – are also lost. This is referred to as deadweight loss. There are several strategies, such as price discrimination, available to a firm to capture some of the lost revenues. Here I will expand on versioning.
With one version of a product, since the marketer can reasonably set only a single price for it, one fails to capture additional revenues from customers who are willing to pay more than P* but now shell out a lower amount, as well as from customers who are willing to pay less but do not make the purchase (since the set price for P* is too high for them).
To solve this problem, just as companies expend efforts trying to make products better, they should direct some thought to making products worse. By having three versions of the product, the prices can be set as in figure 02, with the consequence that the total revenues of the company increase. Of course, some of you are thinking that by having even more than three versions of the product, one could further reduce consumer surplus and deadweight loss. However, before setting down that path one must consider the cost of making different versions, the complexity of operations, and the resulting customer confusion.
Beyond economic theory, an additional factor supporting three versions is consumer psychology. In a famous experiment, when customers were asked to choose between two versions of a microwave, priced at $109.99 and $179.99, 55 percent of them chose the cheaper one, while the remaining 45 percent went for the one priced at $179.99. When the experimenters added a third version, at $199.99, 60 percent of consumers chose the $179.99 version.
Extremeness aversion is what drives such behavior: people dislike selecting extreme options, instead preferring compromise. That’s why Starbucks or McDonalds offers a choice between small, medium and large. Given a choice between small and large, the majority of consumers will choose small. But with three versions, 70% of consumers (on average) choose the middle option.
The reason to have the high-priced third version in the set is to get more consumers to select the version that the company wants to sell – the middle one. Who cares if no one buys the highest priced version?
There are many examples of companies making their products worse in order to be able to extract a premium from consumers for the better version. And sometimes the version that is "worse" costs more to manufacture than the superior variety. A printer company made a fast printer and then, subsequently, added a chip to slow the product down in order to have a worse version. Similarly, Hewlett-Packard devoted R&D resources to developing the wait cycle on their printers so that they could charge more for the faster ones.
A few important lessons emerge here.
First, pricing should not be based on production costs, but rather on value to consumers. Second, when there is a product line one cannot price products individually. Instead, one must price the entire product line simultaneously as there are interdependencies between the products. Third, smart pricing requires a deep knowledge of economics as well as psychology.
Let me end with a case of a famous company manufacturing disposable contact lenses. Realising the power of having three versions, they came up with one-day, one-week, and one-month disposable lenses. The one-day and one-week lenses were identical, save for the marketing and branding. A consumer in the United States sued the company, which got away by the defense that the one-day lens lasting for one week is hardly a breach. How can an enterprise be sued for putting in too much quality?
Nirmalya Kumar is Member-Group Executive Council at Tata Sons and Visiting Professor of Marketing at London Business School. His Twitter handle is @ProfKumar. This article is written in his personal capacity.
