Strategic Pricing AEM 4160
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Transcript Strategic Pricing AEM 4160
Lecture 7: Bundling and Tying – Examples
Virgin Pricing Case
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
1
Bundling: An Example
Two television stations offered two old Hollywood films
Casablanca and Son of Godzilla
Willingness to pay
Willingness to
pay for
Casablanca
Willingness to
pay for
Godzilla
Station A
$8,000
$2,500
Station B
$7,000
$3,000
Bundling: An Example
Willingness to pay
Willingness to
pay for
Casablanca
Willingness to
pay for
Godzilla
Total
Willingness
to pay
Station A
$8,000
$2,500
$10,500
Station B
$7,000
$3,000
$10,000
When Bundling Increases Profit
Requirement to increase profits
Consumer Demand is
1.
2.
negatively correlated:
Consumers who value one good much more than
other
There is heterogeneity in tastes.
Bundling
Extend
this example to allow for
Costs
Mixed bundling: offering
separately
products in a bundle and
Setting
Suppose
a firm is selling two goods, 1 and 2
A
consumer’s reservation prices for the two
goods are given by R1 and R2
Without
bundling, the firm sets the prices of the
goods P1 and P2
With
bundling, the firm sets a price PB per bundle
containing one unit of each good
Consumption Without Bundling
r2
R1 P1
R1 P1
R2 P2
R2 P2
II
I
Consumers buy
only good 2
P2
Consumers buy
both goods
R1 P1
R1 P1
R2 P2
R2 P2
III
IV
Consumers buy
neither good
Consumers buy
only Good 1
P1
r1
For any prices P1 and P2,
consumers can be
categorized according to
whether they have higher
reservation prices R1 and R2
for one of the goods, none
of the goods, or both of the
goods
Pure Bundling
R2
With pure bundling only
bundles, and not separate
goods, are offered
Consumers will buy the
good if and only if
R1+ R2 ≥ PB
I
Consumers
buy bundle
R1+ R2 >PB
R1+ R2 =PB
II
Consumers do
not buy bundle
R1+ R2 <PB
R1
Bundling – Basic Idea
entree
Two consumers
Two goods (E,D)
Valuations of consumers:
(3,1), (1,3)
3
2
1
1
2
3
dessert
Price goods separately:
pE = pD = 3
Profits = 6
Better alternative:
sell menus for $4
Profits = 8
Key idea: Make consumers more
homogeneous by aggregation.
Can be less extreme.
Necessary condition: Negative
correlation in values (Rank
reversal )
When Bundling Increases Profit
Requirement to increase profits
Consumer Demand is
1.
2.
negatively correlated:
Consumers who value one good much more than
other
There is heterogeneity in tastes.
Bundling
Extend
this example to allow for
Mixed bundling: offering
separately
products in a bundle and
Example
Suppose
the firm produces two goods, 1, and 2,
at unit cost c=0.5
There
are two consumers:
James has
reservation prices R1J=1 and R2J=2
Karen has reservation prices R1K=2 and R2K=1
Example: No Bundling or Pure
Bundling
Without bundling
the firm should set P1=2 and P2=2 and
sell one unit of each good
This
would give a profit of 2•2-2•0.5=3
With
pure bundling, the firm could charge PB=3 for each
bundle
This
would give profit 2•3-4•0.5=4
Example: Mixed Bundling
Suppose
there are two more consumers
Al
has reservation prices R1A=2 and R2A=0.5 and
Beth has reservation prices R1B=0.5 and R2B=2
Without
bundling the optimal prices would be
P1=2, P2=2 giving a profit of 4•2-4•0.5=6
With
pure bundling neither Al nor Beth would
buy the bundle at price PB=3
Example: Mixed Bundling
However,
if the goods were also sold separately
at prices P1=2 and P2=2, then Al would buy good
1, Beth would buy good 2, and James and Karen
would buy the bundle
This
would give a profit of
2•3+2•2-6•0.5=7
Bundling Again
Bundling does
not always work
Mixed bundling
is usually more profitable than pure
bundling
But pure
bundling is not necessarily better than no
bundling
Requires that there are reasonably large differences in consumer
valuations of the goods
Bundling is
a form of price discrimination
May limit competition
VIRGIN PRICING CASE
Issue
Problem: How should Virgin Mobile price its plans
Situation
Target
Market
Entering a highly saturated cell phone service industry,
while targeting
an unsaturated market segment
Attempting to earn a profit from a limited income market
Young (15-29)
Trendy
Different than traditional cell phone users
Different spending habits
Different usage
Different needs
Limited purchasing power
“According to marketing research, target market does not trust
industry pricing plans.” -Dan Schulman, CEO, Virgin Mobile USA
Objectives
1
Create value and profitability in cell phone service industry
2
Target market ages 15-29, opportunity for growth with this
market segment
3
1 million subscribers by year 1 and 3 million by year 4
4
Be different:“By focusing on the youth market from the
ground up, we’re putting ourselves in a position to serve these
customers in a way they have never been served before”
-Dan Schulman, CEO, Virgin Mobile USA
Discussed Alternatives
1
Clone Industry Prices: contracts
2
Set prices below competition: contracts
3
A whole new plan: prepaid pricing
Clone Industry Prices
Pros
Cons
Give customers more features
for the same price
May drive margins down if
additional features are costly
Easy to promote, use current
models
Reduces competitive advantage
Difficult to penetrate saturated
market with similar offer as
competitors
Competitive with other cell
phone providers and packages;
does not support strong market
differentiation
Limited spending power on
promotion may be a justifiable
factor
Viable with Virgin Mobile’s
limited advertising budget
Price Below Competition
Pros
Cons
Drive sales and market share
Accounts for limited spending
power of target market
Margins and profitability will be
driven down
Inconsistent with company goal
of profitability
Cannot compete in price wars
Not a long term solution
A Whole New Plan: Prepaid Pricing
Pros
Cons
Differentiate from competition
Cater to the needs of target
market
Risk of limited returns and
loyalty
Churn rate may increase
Flexibility is attractive to target
market
Profitability is key
Eliminates risk of missed
payments
Pricing Structure from the Carrier
Perspective
Contracts:
Annual churn rate WITH contracts
Annual churn rate WITHOUT contracts
The difference:
=2% * 12 months = 24% (p.8)
=6% * 12 months = 72% (p.8)
72% - 24% = 48%
Take AT&T example: customer base = 20.5 million
If AT&T abandons the contract based plan how many new customers would it
need to acquire to offset customers from an increased churn rate?
Additional customers lost to churn:
Acquisition cost per customer:
Total cost of offsetting higher churn rate:
Not surprising that major players still continue to hold the contracts.
__________________
$370 (case p.2)
__________________
“Menu” Pricing: Actual Usage
Bucket/“Menu” Pricing
In reality most consumers are paying more than their optimal
rate = if they new exactly how much they will consume
“Industry makes money from consumer confusion”
Pricing menus allow carriers to advertise low per minute rates
But most consumers end up choosing the wrong menu.
Hidden Fees
Able to promote low per minute prices, but still collect
additional revenues
Acquisition Costs
Advertising per gross add: from $75 to $100 (p.5)
Sales commission paid per subscriber: $100 (p.5)
Handset subsidy provided to the subscriber: $100 to $200 (p.9)
Total: from $275 to $405
(let’s assume somewhere in the middle = $370)
Break Even Point
Monthly ARPU (average revenue per unit): $52 (p.3)
Monthly Cost-to-Serve: $30 (p.3)
Monthly Margin: $22
Time required to break even on the acquisition cost
= __________________
In the cellular industry the monthly margin is relatively fixed across
periods, therefore the traditional LTV can be simplified (assuming
infinite horizon):
LTV =
M
1- r+ i
- AC
M = margin the customer generates in a year
r = annual retention rate = (1-12*monthly churn rate)
i = interest rate (assume 5%)
AC = acquisition cost
LTV With Contracts
The annual retention rate in the industry
= ______________
LTV =
- 370 =
LTV Without Contracts
Eliminate contracts -> churn rate increases to 6%
Calculate the LTV:
LTV =
- 370 =
Eliminate Hidden Costs
$ 29 cellular bill becomes $35 due to hidden costs
Increase of 21%
If these costs were eliminated, the $22 margin would be
reduced to _______________
Break even would become _________= __________
What Happens to LTV?
Without hidden costs, but with contracts
LTV =
- 370 =
Without hidden costs and without contracts
LTV =
- 370 =
Elimination of contracts drives LTV below zero
Hidden costs boost the bottom line
Option 3: Different Pricing
Approach
Target audience: Youth
Loathe contracts
Fail credit checks
Ideal plan: no contracts, no menus, no hidden fees…
How to differentiate itself, and have a positive LTV
Look at the factors that affect LTV
Options for Lowering Acquisition
Costs
Advertising costs per customer
Industry=from $75 to $100
Virgin planned ad costs = 60 mil/1min= $60 (p.5)
Handset subsidies:
Current industry handset cost: $150 to $300 (assume $225) (p.5)
Current industry handset subsidy: $100 to $200 (assume $150)
(p.9)
Current industry handset subsidy as a %: 67%
Virgin’s handset cost: $60 to $100 (assume $80)
Assume Virgin’s subsidy around 30% = $30
Acquisition Costs
Then Virgin’s AC would be just ____vs. industry average $370
Sales commission: $30
Advertising per gross add: $60
Handset Subsidy $30
Total: _______
Consumer Friendly Plan: How to
Achieve Profitability
Break Even analysis: at what per minute price would Virgin
break even:
Virgin’s monthly ARPU: ______________ where p=price per
minute
Assume Virgin’s customers use 200 minutes per month
(midpoint of estimate between 100 and 300, p.7)
Monthly cost to serve: ______________
Assume monlty cost to serve is 45% of revenues (Exhibit 11)
Monthly margin: _______________
LTV =
- _____ > 0
p > ________
Other Price Points
What if Virgin charged per minute price comparable to other
industry prices, somewhere in between 10 and 25 cents:
At 10 cents:
LTV =
- ____ = _____
At 25 cents:
LTV =
- _____ = ____
Virgin’s Pricing Plan: What
Happened?
A prepaid plan
No contracts
No hidden charges
No peak off peak hours
Very low handset subsidies
No credit checks
No Monthly bills
Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest
of the day
No exact numbers, but churn rate lower than 6%