Estimating Willingness to Pay

By | July 7, 2012

In the “the social network”, Mark Zuckerberg’s friend is interested in a girl and wants to know if he has a shot. Mark’s reply is something like, “I don’t know. It’s not like girls walk around with a sign on their forehead that says if they are single.” Then a light bulb goes off (ding!) and Mark runs to his dorm room to add “relationship status” to facebook.

 

In business, we don’t have the transparency that facebook has brought to our dating lives. Wouldn’t it be nice if our customers walked around with signs on their foreheads (or a digital status indicator) stating their willingness to pay?

If we could tell what each customer was willing to pay, we’d be able to customize prices in order to grab additional surplus from those with a higher willingness to pay, and still sell to those with a lower willingness to pay. In short, we’d be rich. Gloriously rich.

But let’s come back down to earth for a minute and realize that the customer is not going to give up this information so freely. Knowing that, how can we estimate willingness to pay (WTP) for a new product?

Determining the “Economic Value”

The Strategy and Tactics of Pricing suggests that determining the “economic value” of your product is a good place to start.

Economic Value Formula:
The value of the product to your customers = reference value + differentiation value

STEP 1: Identify Reference Values
Identify the reference prices that exist today (the last price they paid for the same product, or a substitute product). Obtain price points directly at point of sale, if possible. For B2B products and services, you will likely need to get creative. Try interviewing your competitor’s customers.

Step 2: Calculate Differentiation Value
Determine your positive of negative differentiation value (is your product worth more or less than the references?) Identify value drivers and assign quantified estimates to support pricing decisions. If value is tied to financial outcomes (saves time or money, increases revenue), it is straightforward to justify price increases over the competitor’s offering.

For more psychological values you need to understand how important the attribute is to the customer. If you are dealing with just a few features, you may be able to get a good sense for this from talking to the customer. But if there are many product attributes you are trying to test, you may be best served by doing a conjoint analysis. When done properly a conjoint analysis will give you quantitative data on how “happy” each feature in consideration makes your customer. Prices can increase with consumer “happiness” (also known as customer utility).

Using Conjoint Analysis

I recently performed a conjoint analysis for “triple play” offerings (phone, TV, internet). It revealed that customers value internet service much higher than phone service, and that no single premium service is a dominant influencer (if we give them high speed internet it makes them about as happy as premium TV channels).

The graph below shows the utility / “happiness” customers reported for various service levels by price point. It was no surprise that all customers preferred the highest level services for the least amount of money.

Willingness to pay for Triple Play services

You must give your customers a positive utility for them to be willing to buy.  The higher their utility, the more likely they will be to buy. You also want to make sure that your product gives them a higher utility than your closest competitors.

Of course, you have to balance making your customers feel warm and fuzzy with charging a price point that will bring you sufficient profits. Note that at a utility of “1″, all customers would have bought our “high end” triple play service for $30. But as marketers, we would never have offered that.

There are many firms that provide conjoint analysis services. With a little training, and a lot of excel skills, it is also possible to do yourself.

Translating the Economic Value to Pricing

Calculating the economic value is just a starting point. It should give you a good idea of how your customer should value your product, but not necessarily, how they will value it on first take.

Especially if you are introducing a product in a new market, you will need to educate the customer on the benefits in order for them to understand your value, and justify your price point. Before running to market, test out your messaging and price points with your target customers.

Testing Willingness to Pay

Once you’ve used the economic value exercise to identify your target price point (or perhaps a range), you should test your pricing hypothesis on your customers.

If you are the average marketer, you will conduct a survey, or perhaps conduct focus groups and at the end you’ll ask them the open ended question: “how much would you pay?” Trouble is, the answer usually isn’t accurate. Consumers tend to lowball.

It’s even worse if you give them a list of pricepoints and have them choose. People tend to choose one in the middle, so the set you provide will influence the outcome more than their actual willingness to pay.

It’s better to do a contingent evaluation. Ask: “If I price at $20, will you buy? How about $30? How about $40?”

It’s BEST to to have them get out their wallet. Want to really know how much your customers are willing to pay? Get them to purchase prototypes, or become beta customers.

For consumer products, try an auction! At the end of a focus group, offer to auction off the product to the highest bidder (I recommend using 2nd price sealed bid format). This idea isn’t so far fetched. When designing new products for Leapfrog, many of our focus groups ended with the participants asking if they could buy the product today because they didn’t want to wait. Unfortunately, we said no. If I could do it again, I would have auctioned off the prototypes…

By the way, ebay is sitting on an incredible database of knowledge about consumer’s willingness to pay. Particularity since they added the autobid feature where ebay will continue bidding for you until you’ve hit your maximum bid – also known as your willingness to pay.

For business to business products, test your price points with “early adopters” by signing them up as paying customer BEFORE your product has released. Not only is this a great way to test your pricepoint, it will test your overall product validity. Particularly for high-tech products, select visionary customers may be willing to fund the development of your product through early purchases, and may be willing to buy an incomplete or minimally viable product.

Factors Impacting Willingness to Pay

Be aware that there are factors at play making WTP more or less critical to a customers purchase decision. I won’t go into these in detail at this time, but be sure to consider the following:

  1. Substitute awareness effect: How easy is it for customers to identify similar products that are less expensive?
  2. Difficult comparison effect: Is it difficult to evaluate competing products? Perhaps becuase they have different pricing schemes (such as charging by the hour versus a set rate for service)?
  3. Switching cost effect: Are customers somehow locked in to your product or service? If so they will be less price sensitive
  4. Price/quality effect: Does price signify higher quality? Is it a product you have to experience to know the quality?
  5. Price elasticity: If you increase the price, will fewer units be sold?
  6. New market education: If you are a “brave new world” company or product, you will need to educate the customer for them to know how to value you. Your messaging will help shape their willingness to pay.
TwitterFacebookLinkedInPinterestEmail

2 Comments

RookieMom Whitney on May 8, 2011 at 3:48 pm.

Bookmarking this because as I sell advertising on my website, the door is wide open on my pricing strategy. I can try anything and everything, which has been totally confusing.

Also, a lot of folks in my space are selling e-books. Again, since the COGs are nothin’ they could go in any direction. You should advise them!

Reply

Laurie Peterson on May 9, 2011 at 5:46 pm.

Thanks for the comment Whitney!

It’s definitely a challenge if COGS are zero! When there is competition, prices get pushed down over time until the marginal revenue equals the marginal cost. In this case. MC = MR = 0 !

I wrote another blog post on this issue, where I claimed that all digital content needed to be free to users:
http://sfgirl.us/blog/2008/09/07/how-to-price-an-internet-product/

A few years later, I am more optimistic about the ability to charge users for digital content. Thanks in part to the itunes store, people are getting used to the idea of paying for digital content.

Take me, for example. I just paid $37 for an ebook and podcast on how to train my dog!!! I paid this much becuase I couldn’t get this content for free digitally, or pay the same price for a hardback. Here is the trainers website if you are interested:
http://www.gooddoghappybaby.com/get-the-book/

Good luck to you and your friends. This is an empowering time for authors.

Reply

Leave Your Comment

Your email will not be published or shared. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>