retail

Professors Pinpoint Discount That Turns Heads

Discounts Warehouse chains like Costco and Sam's Club may know all about how to tempt shoppers with Pop-Tarts by the ton or dental floss by the mile, but for brands with no history in volume discounts, figuring out how to price those discounts is usually a guessing game.

But a new study from two marketing professors, one at the Wharton School of the University of Pennsylvania and the other at Columbia University, nails down just how big that discount needs to be to sway shoppers.

The idea, Wharton's Raghuram Iyengar tells Marketing Daily, is simple. In the same way that the first bite of a great dessert always tastes best, "consumers' enjoyment of something diminishes over time. That's why a place like Disneyworld charges so much more for a single-day pass -- $79 -- than it does for 10 days, which is just $243. By making a week-long pass a better deal, people will be tempted to stay longer. Each unit you buy gives you less enjoyment."

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Columbia's Kamel Jedidi likens it to water. "If you are super thirsty, you might be willing to pay $10 for water. But after the first bottle, you will value the water less, and you know that."

The study, "A Conjoint Model of Quantity Discounts," used a conjoint model analysis to determine the most effective pricing structure for the online movie rental business, comparing two known companies -- Netflix and Blockbuster -- with a made-up company called MovieMail. The authors surveyed 250 consumers to collect data for their model, presenting participants with several plans and pricing tiers.

As expected, the price that shoppers are willing to pay falls somewhat after renting the first DVD, and then nosedives after the second. By calculating the exact value of a customer's willingness to pay, they arrived at optimal pricing. (The availability of Blu-Ray also factored into consumers' decisions.)

Iyengar says it surprised them that while Netflix had considerable brand equity, Blockbuster -- which recently filed for bankruptcy -- didn't, and had about as much impact with consumers as an unknown brand. In order to entice shoppers away from known brands, the newcomer had to offer significantly lower prices. On average, those in the survey were willing to pay about $1 more for Netflix, and about 65 cents more to have the Blu-ray option.

In terms of profitability, a small slice of Netflix's customers is extremely valuable: 10.7% of customers potentially would be worth $68.99 each to Netflix per month, because of their willingness to pay more. Another 19.1% -- light DVD unit renters but still with a higher willingness to pay more -- are worth an estimated $27.81 per month.

Another third fell into the heavy renter category, but said they wouldn't pay more, yielding an average-value $26.71 per month. But the largest group was also the least attractive, creating a monthly value of just $16.93 per consumer. The analysis also computed that for every 1% increase in Netflix's pricing, there would likely be a 1.15% decline in demand.

For the fictional MovieMail to compete, they found that it would have to charge considerably less -- but that if it did so, it stood a good chance of getting a 33% market share.

"Consumers need to be compensated for the intangible costs of switching," Iyengar says. "People spend a lot of time adding to their queues in Netflix, for example, and that would be lost in switching over. So there's a built-in reluctance to switch brands, and this model helps marketers know exactly how low the price needs to go to make it worth their while."

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