The Crisis in Pricing for Digital—Free? Paid? How Much?
The dynamics of networked commerce combined with the essentially free replication of digital offerings has created devilish problems that our current economics has yet to tame. Sellers have no clear rationale for setting prices and consumers feel they should not have to pay anything at all. Publishers seek to impose artificial scarcity (creating deadweight losses) and sometime impose practices that are downright customer-hostile. There is much debate and confusion over what should be free, ad-supported, and paid, and if paid, at what price?
The Value-Pricing Demon
The Prolog of this book proposed a thought experiment—hypothesizing an imaginary value-pricing demon that would know how to set optimally fair and efficient prices.
What good is a thought experiment? Einstein changed how we think about our world by doing thought experiments about what would happen when riding on a beam of light. Some influential thought experiments in physics involve imagining benevolent “demons” with special supernatural powers and knowledge: Laplace’s demon, with its perfect knowledge of the state of the universe and all its natural laws, and Maxwell’s Demon, with its ability to individually sort hot from cold molecules. Maybe we cannot build such demons in reality, but thinking about them can clarify our ideas and possibly point to approximations that can be built or applied—and can suggest directions for looking outside the box, as Einstein did to great effect.
Here we recap my pricing demon and expand on how its special knowledge can be approximated to power a system of commerce. Again, my demon has perfect ability to read the minds of buyers and sellers to determine individualized “value-in-use.”
The demon knows how each buyer uses the service, how much they like it, what value it provides them, and how that relates to their larger objectives and willingness/ability to pay. It understands the ever-changing attributes of current context, where the value of a given item can depend on when and how it is experienced.
Furthermore, this demon can determine the economic value surplus of the offering—how much value it generates beyond the cost to produce and deliver it.
The demon can go even farther, to act as an arbiter of how the economic surplus can be shared fairly between the producer and the customer. How much of the surplus should go to the customer, as a value gain over the price paid, and how much should go to the producer, as a profit over the cost of production and delivery, to sustain their ability to continue those activities.
This commerce demon could serve as the brains of a system that sets prices that are adaptive and personalized—to set a price for each person, at each time, that is fair to both the producer and the customer. We could build services such as Amazon, iTunes, Netflix, or a newspaper subscription that were priced by the demon.
With such a demon setting prices, we could reap the cornucopia of goods and services that the infinite replication of digital offerings promise (“information wants to be free”) while still providing fair profits to the producers (“information wants to be expensive”). Every customer who is willing to pay more than the marginal cost of production would be able to buy, while those who get and can pay for significant value would pay appropriately higher prices.
This would be a win–win for producers and consumers, because it allows producers to sell to all consumers who find value in the producer’s service, at prices that are dynamically personalized to approximate ideal price discrimination. That leads to a near-maximum number of profitable and loyal relationships, to maximize total revenue and total value creation. It also enables a near-maximum number of risk-free trials by consumers who think they might find value. All of this brings more value to more people.
As explained in the discussion of value-based pricing earlier, my demon has already been harnessed and proven highly successful—but this has been restricted to high-end, sophisticated B2B markets, and generally ignored in most other markets. So let’s look more closely at how FairPay makes this concept workable in a simple, light-weight form suitable for consumer markets.
Driving FairPay Consumer Relationships
The FairPay architecture works as an emergent approximation of my demon. Not perfect, but still workable, as a process that uses simple procedures and dialogs to approach what the demon knows.
FairPay shifts our perspective from individual transactions to a series of transactions over time in a relationship. That is what really matters.
Instead of the invisible hand of supply and demand pushing the buyer and seller from outside, it brings an invisible handshake in which the buyer and seller agree to cooperate to seek a fair basis to exchange value. This can inform a new balance of powers, centered on “dialogs about value.”
The buyer’s power is to set prices for a current transaction—“fair pay what you want”—with the understanding that he agrees to be fair, and that this is a temporary privilege that the seller will continue only as long as he agrees the prices set by that buyer are usually fair.
The seller’s power is to decide whether to continue these attractive offers, or not. That gives the buyer full buy-in on all prices, but motivates him to keep up his end of the bargain.
Related data feeds in to the process, including the seller’s suggested price to each buyer, the buyer’s reasons for pricing higher or lower, and all of the increasingly rich individual details that digital system instrumentation can make available about usage levels, patterns, and contexts, to inform and validate these dialogs.
Based on all of that, the seller tracks each buyer’s fairness rating, much like a credit rating.
Consumers will warm to the idea of this pricing privilege, and will seek to protect it by maintaining their fairness ratings just as they do for credit ratings.
The result is an emergent process that seeks to discover the price, just as the demon understands it. The approximation may start out being quite crude, but digital sellers can afford a few unprofitable cycles in the early stages of each relationship, if that soon leads toward convergence on fair prices. As experience is gained, this will become a science of Big Data and predictive analytics—one that works to serve both the buyer and the seller.
So this FairPay process acts as an engine that approximates what the demon knows. It draws out the knowledge of the buyer, encourages truth-telling, nudges that with the views of the seller, and provides a context for the dialogs about value that lead to a fair split between the producer and customer surplus. Such a process can totally change the game of selling digital stuff, for more profit, and more value to society.
(Note that my demon takes us in a direction very different from the early vision of e-commerce “bots” that would negotiate prices on behalf of customers. The demon I propose is in some ways analogous to a bot, but instead of negotiating a single transaction, it works at a higher level that centers on value, not just negotiating power. Even if some forms of bot are important, such as the simple “chatbots” now gaining interest for business-consumer messaging, as from Facebook, this is still a far cry from a bot that negotiates prices on behalf of customers.)
Economics has generally ignored my demon, but it has been lurking in the background. First-degree price discrimination was defined by Pigot as applying some willingness to pay information in idealized monopoly situations—but has been viewed as not realistic for reasons such as arbitrage (those who bought cheaply could resell to others so they did not have to pay the full amount they would be willing to pay). I propose that the workings of FairPay enable something much like first-degree price discrimination, but instead of the entire surplus going to the monopoly, my demon shares it fairly between producer and customer. And since resale of digital services can often be made impractical, the arbitrage problem generally does not apply.
Adam Smith’s Demon of Scarcity
As we saw, Adam Smith’s invisible hand can be thought of as a similar demon that helps balance supply and demand in a market with respect to scarcity—and this has worked very nicely for many markets over many years. The beauty of the Smith’s invisible hand is that it set prices in a way that worked not only at a micro level, but also as a basis for an allocation of resources for society at large. The whole edifice of market economics has been based upon this.
The core challenge of the economics of real goods and services is this allocation of limited resources: physical resources, labor, and capital. As Adam Smith said in 1776 in The Wealth of Nations, “… price … is regulated by the proportion between the quantity … brought to market, and the demand of those … willing to pay ….” Smith went on to describe how
… he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. … By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. (Smith 1776)
So in the face of scarcity across a market, prices are set by the invisible hand to allocate the supply where it is most wanted. Hayek (1944, The Road to Serfdom) expanded on Smith to argue that an economy needs market prices as the only effective way to signal how resources should be allocated. Debate on how well this works for society continues, but it is widely recognized that it works to build wealth.
Is there something to replace that in the digital world? Here the challenge is not the scarcity of supply of existing items, but the ability to sustain the ongoing creation of new items.
We now have freemium and other new models, but do they have any real economic rationale? Do they tell us how to allocate resources in a way that is good and efficient for individual producers and consumers, and across society?
Many producers rely on some form of artificial scarcity as a way to sustain revenues, but put the accent on artificial—this has no fundamental basis, and creates no balance or fairness in resource allocation. That is a deadweight loss to society. It may help keep producers solvent, but is fundamentally inefficient.
We also have the sharing economy, which recognizes digital abundance by emphasizing collaboration and open-source, but with concerns as to efficiency, effectiveness, and sustainability at scale.
An Invisible Handshake—Allocating Share of Wallet
It is time to replace the invisible hand of Adam Smith with something more suited to the strange and challenging nature of digital products. Think instead of an “invisible handshake,” that draws producers and customers into a more cooperative, balanced, and productive relationship. It takes a handshake, because digital is a post-scarcity economics.
What matters here is not a balance of demand and finite supply over a population of producers and customers in a single market.
What matters is a compatible understanding of value between individual pairs of producers and customers who are free to act and build relationships without any production constraint.
Of course some scarcity is unavoidable. Our solution is not the extreme peer-to-peer “economics of abundance” that some now advocate—with its limited ability to motivate and sustain large-scale creation of value. The solution is to reimagine the socioeconomic contract between customers and the producers that create value for them, to ensure a business model for producers. To maximize the value produced, and the related entrepreneurial creativity, we need to motivate organizations that continue to be selfishly driven by a desire for profit. I suggest a new kind of market that rewards the creation of intangible stuff, based on this new socioeconomic contract—neither the limited motivational power of pure altruism, nor the deadweight loss of artificial scarcity. This new economy can evolve from where we are, starting now, with the FairPay architecture.
This new handshake is not on a transaction price, but on a continuing relationship. The contrast with the invisible hand is depicted in Figure 5.1. As shown, this fundamentally changes our economics from working across markets (horizontally, for the invisible hand on the left) without regard to past or future, to working through time (vertically in an ongoing chain, for the invisible handshake on the right), in relationships with individual customers.
Doing allocation in digital markets with this invisible handshake makes sense because the game changes without scarcity of supply. What matters is no longer a dance of a market as a whole at a given point in time, but a dance of each customer with each producer over time. So what should determine price?
Figure 5.1 The invisible handshake
Each producer can provide as much as is desired by each customer. There is no inherent supply constraint—all that matters is whether the compensation from that customer satisfies that producer (as providing a fair contribution to sustainable creation of more products).
Prices for different customers need not bear any direct relationship. What does it matter if some pay more and some pay less? Maybe that depends on how much they want to use, what value they get, and how able they are to pay. (We are conditioned to think that price discrimination is unfair, but that is true only when unilaterally enforced through excess producer power, not if done for reasons acceptable to customers.)
The new allocation is not of supply, but of share of wallet. If each customer deals with a market full of suppliers for all their various digital products and services, the scarcity that matters is the scarcity in their wallet—how much can I spend on all my digital desires, and how do I split that among my providers?
If I negotiate over time, in dialogs about value, to share the economic surplus of my digital purchases, I am forced to allocate my spending within some budget, across all my suppliers. I can do that any way I wish (to the extent that each supplier permits).
If all customers do that, then all suppliers get their fair share of all the wallets for all their customers. They sell as much as their aggregate market population desires, at a sum of individual prices, each the maximum that each market participant is comfortable allocating.
Given a scarcity of nothing but wallet, what works for each individual pair in the market leads to a result for all pairs that approximates a market-wide optimum.
Thus the handshake is essentially a moral contract between the individual parties. That may sound utopian, but it is a moral contract with teeth. There are strong practical incentives to adhere—and data that can be applied to help verify adherence.
Digital products and services can be instrumented to generate detailed usage data that correlates to the actual value received.
Both parties participate in ongoing dialogs about value, which add subjective insight, but still can be partially validated by the usage data.
Based on these dialogs, the producer extends pricing “credit” to the customer. If the customer abuses this credit, they are given less credit, and lose some or all of the ongoing privileges of the handshake.
This process generates customer reputation ratings for fairness with each producer. Since a good reputation rating has benefits (much like a credit rating), customers will seek to maintain it.
It is this balance of forces—the subject of the handshake—that governs the allocation of wallet (in an approximation of the wisdom of the pricing demon). Different producers can manage their own policies to make their handshakes very strict and demanding, or more loose and forgiving. Different segments of the population may play the game more or less fairly and honestly. But the process will adapt, and find workable relationships for most segments of the market. (And conventional pricing can be applied for those segments that fail the handshake.)
Some notes on scarcity:
A secondary level of scarcity does remain—scarcity of resources needed for creating new services. My demon would factor that into its assessment of how to fairly divide the value surplus. It would maintain a touch of the old invisible hand, with that element of cross-market balancing of demand to gauge the proper supply of creative resources. Customers of services that are desired by few others would be expected to grant more share of the value surplus to sustain desired levels of ongoing creation—more than customers of services with large markets that share that cost more broadly. That would simply be factored into the dialogs about value, as just another aspect of value.
Of course conventional set prices (or any pricing scheme at all) will also effect some kind of allocation of wallet. But is there any economically sound rationale?—it is arbitrary, crude, and not personalized (as the pricing demon would suggest), and thus results in significant deadweight losses (notably the value not provided to those who would benefit from and pay fairly for it).
There is also the important case of ad-supported digital services that take no share of wallet. It seems increasingly clear that this is not sufficient to support most digital services but it will remain an important contributor. The handshake process can factor in the value of ad-viewing as one part of the compensation that offsets any monetary price, and thus takes less share of wallet. In fact, any aspect of value (attention paid to ads, personal information made available for sale, referrals, etc.) can be factored in as credits, as part of these dialogs about value.
A More Accommodating, More Sustainable Market
This invisible handshake provides the basis for a post-scarcity economy (at least for digital, and more broadly as discussed later). The digital goods and services are not scarce, but the willingness of customers to sustain producers is scarce. The invisible handshake governs an allocation of that willingness to sustain. To/from each customer according to his willingness and ability to pay. To/from each producer according to their ability to create realized and recognized value.
Like the invisible hand, the invisible handshakes between each of the individual pairs lead indirectly to a socially beneficial allocation. Like the invisible hand, it refers to an emergent process that by seeking local solutions, leads to globally optimal solutions.
The invisible hand applies external market-wide forces (supply versus demand) to producers and customers at a given point in time (actually a short interval). It pushes them together to a market price. That pricing process indirectly leads toward a narrowly optimal distribution of scarce supply resources—but one that ignores broader “externalities.”
The invisible handshake is driven by an agreement between individual customers and producers to seek a mutually beneficial relationship. That binds them in an emergent process that generates prices over the course of the relationship, and indirectly allocates the wallet share of each participating customer to demand as much digital wealth as each is willing to pay for—at prices that work for each of them individually—to compensate producers for creating as much as each customer (and thus the total population) values—and reflecting any externalities that they both desire.
FairPay enables prices to reflect a much broader sense of economic value than is generally addressable in conventional markets. We expand on this in Chapter 22.
Participative Pricing, Co-Creation of Value, and FairPay as Co-Pricing
The points made here align with emerging trends in marketing theory that have caused FairPay to resonate with many researchers. Some of those trends are summarized in this section.
One of my first significant connections to researchers in marketing was Marco Bertini, a leading pricing scholar who had been researching “participative pricing” (Bertini and Koenigsberg 2014)—that led to our collaboration on the item published in the HBR Blog series in 2013 ( Bertini and Reisman 2013), and a paper pending publication (Reisman and Bertini 2014).
More recently, I presented the concepts of FairPay—in collaboration with two prominent professors of marketing, Adrian Payne and Pennie Frow—to international leaders in an emerging branch of marketing theory at the Naples Forum on Service in 2015 (Frow, Reisman, and Payne 2015). This series is dedicated to the areas of Service Science, Service-Dominant Logic, and Network Theory, which all relate to recognition that business is really about the “co-creation of value” by customers, service providers, and other “actors,” and that the production and sale of goods (which provide “value-in-use”) is just one aspect of this larger concept of service. This has become a focus not only in academia, but in forward-thinking companies such as IBM.
The idea of a “Service-Dominant Logic” is in contrast to the “Goods-Dominant Logic” that developed over the past centuries—a “yesterday’s logic” (Lusch and Vargo 2014). Now we are in a service-centered economy, and it has become apparent that the value of goods is really in how they enable a service—for example, the value of a car is not the physical product in itself—but in how it provides the service of transportation, in a particular use and context. Is it reliable, comfortable, safe, economical, fun? … in what mixture, to meet what needs? The value of services is understood to be “co-created” by the provider and the customer in a particular use-context. This has many important implications that have been the subject of an extensive body of work. Proponents of this thinking (including the related field of service science) have been among the most receptive to the ideas of FairPay.
(A note on terminology. Service-Dominant Logic suggests that there is no real distinction between producers and consumers, or firms and customers, and that all are just actors. I support that, and use those terms merely for their familiarity. Also, I mean consumer and customer to be interchangeable, but use consumer to emphasize reference to an individual person, rather than a business, as customer, without intending to mean one who consumes.)
My collaboration with Adrian Payne and Pennie Frow was tied to their work on business as co-creation (Payne and Frow 2013), and how that involves many co-creation activities, including co-pricing. The co-pricing aspect had not yet been well developed, partly because examples of co-pricing (like value- or outcomes-based pricing, and pay what you want (PWYW)) have been limited in applicability relative to other aspects of co-creation.
We think that FairPay has immediate potential to radically change business practices in a way that puts a powerful new form of co-pricing at the forefront of digital content businesses (as described in this book and in a paper we are writing).
Research Directions—Value-Dominant Logic and Cloud of Value Marketing
FairPay adds an important new research agenda in marketing and the behavioral economics of pricing, going well beyond the early work in PWYW and other participatory pricing practices. This book makes the case for experimentation—for proof of concept, and on to refinement (or to any pivots needed)—to move toward a new era in customer relationships with broad ramifications.
What FairPay adds might be thought of as a Value-Dominant Logic (V-D L)—as opposed to yesterday’s Price-Dominant Logic (P-D L). FairPay offers a process for seeking fair value, in which price becomes emergent from the buyers and seller’s interactions over time. Thus price remains the metric of net value-in-exchange, on which our economy is centered, but now price tracks to value-in-context instead of being pre-set in ways that track poorly to value. This can not only transform business, but also make a better economics, because prices that track to value make the economy more efficient and productive. The central operational data for this Value-Dominant Logic is the Cloud of Value we spoke of earlier. So we can think of how this applies to business as Cloud of Value Marketing.
Another implication of this Value-Dominant Logic is that value should be very broadly defined to include all aspects that matter to the producer and the customer. Many of the current challenges in getting businesses to better address social values stem from the limited scope of prices, which currently do not reflect such broader values. We speak of corporate social responsibility (CSR) and creating shared value (CSV) and triple or quadruple bottom lines because our current bottom lines are missing many important components of value. Here again, FairPay provides a needed broadening—price is set in accord with value, including whatever social aspects of value matter to the customer. If the customer values broader social benefits, they can explicitly reflect that directly in the price they pay, which then adds directly into the bottom line. (Product/ service prices could even have distinct components for customer value and broader value, all as set by the customer.)
Moving to a macroeconomic level, one of the open challenges of service research is that its focus on value-in-context works well at a microeconomic level, but does not translate well into macroeconomics—because value-in-context is hard to measure at a macro level. I suggest that the issue is that macroeconomics is centered on price, which in current practice correlates poorly with value. Revenue is the total of a firm’s prices, but the total of prices now tracks poorly to the total of value; similarly for gross domestic product (GDP). If we can get prices to track better to value, then our whole economics will be driven by that, and will work better.