Wednesday, September 22, 2010

What do BBQ sauce, coffee, and CPU's have in common?

Delicious pizza, fresh from the wood-burning oven. Did the sausage really cost $1.50?
The other day, my friend Eddy introduced me to a really tasty family-owned barbecue joint. While enjoying our delicious beef brisket he commented how expensive barbecue cuisine is, considering this style of cooking uses cheaper cuts of meat. He conjectured the price was raised by the lengthy preparation time needed to get the meat so tender. I actually blame Eddy (and all the other regular customers) for the bloated price of my barbecue dinner. Prices are set by what consumers are willing to pay, not the cost of materials/production.

My dinner was made even more expensive because I had to throw in an extra buck to try the hot ghost pepper vodka barbecue sauce. Did it cost an entire dollar to produce this tiny cup of sauce? Probably not. But it's what spicy food fanatics are willing to pay. The restaurant uses the ghost pepper sauce as a clever way to get customers to volunteer more money for their meal. Each customer has a maximum price they are willing to pay for a barbecue dinner. Ideally, the restaurant wants to charge each customer their personal maximum price. When a single price is set for all customers, some customers are lost because the price is too high and some money is lost because other customers are willing to pay more. However, the individualized pricing system has two problems: haggling with each customer is time-consuming and customers feel "ripped off" when they find out they paid more than others. The tiered/add-on pricing model is a clever way to get the best of both worlds.

Now, Eddy also brought some coupons that scored us free side dishes and drinks, essentially lowering the price of our meals. Coupons can capture new sales (from customers who wouldn't have bought at the regular price) without cutting the revenue from customers who are willing to pay the regular price.

This practice is quite common. Once you understand this, a lot of "inconsistent" prices start to make sense. In The Undercover Ecomomist, Tim Harford describes how coffee shops use fair trade coffee to vet out the high-rollers. And this also explains why Intel wants to charge $50 to unlock stuff your CPU can already do. I could go on: pizza toppings (does a few bits of mushroom really cost $2?), the practice of tipping (set your own price for service), software (extra time/effort is spent crippling the "Pro" version into the "Standard" version), special "sales" prices/events, ...

Joel Spolsky discusses this topic as it relates to software pricing. He goes into more depth, throwing in terms like "demand curve," "segmentation," "consumer surplus," and "NVP."

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