If a Business Lets You “Pay What You Want”, Could It Survive?

Come into most executives’ offices and say “I have a great promotional idea:  Let’s let customers pay what they want.  It will be great!” and your career there is all but over.  Yet, experiments recently demonstrated that it was great, and more specifically, it was great for profits.  How can this be?

Pay What You Want (PWYW) pricing schemes, at first glance, are an anathema in modern economies.  They promise to provide a good or service to any customer at any price they want to pay, at or above zero.  Any homoeconomicus customer would rationally agree to take the good or service and pay a price of zero.  Yet, we people are not simply homoeconomicus.

Recently, Kim et al. explored market actions and conducted experiments to demonstrate that, in some cases, customers pay substantially higher than zero under the PWYW pricing scheme, and furthermore that PWYW can actually be more profitable than the more standard pricing mechanisms.

As an example, between October 10 and December 10, 2007, Radiohead allowed listeners to download their new album for any price they desired as long as they paid the 45p credit card transaction fee.  During this period, their new album was downloaded more than 2 million times and people paid up to 99 euros for the privilege. Tom Yorke, Roadiohead’s lead singer, reported that the PWYW format was not only profitable, but that they made more money from this album during this sale than from all the digital downloads of all the band’s other studio albums combined.

Around this same timeframe, Kim et al. were looking at the PWYW format more formally, through market experiments, to examine the drivers which lead customers to pay for a product when not required, and whether such formats are in general profitable or are just a fluke or rock bands.

One of their experiments featured a Persian restaurant in central Frankfurt, Germany.  For two weeks during the end of November and beginning of December in 2007, the regular price of the lunch buffet was removed and customers were asked to pay what they wanted for the buffet.  Beverages were sold at regular prices.  They advertised it in a manner familiar to most Germans:  flyers were distributed in the city centre and an A-board promoting the offer was placed outside the doors.  The results were encouraging.

During this period, lunch buffets sold increased 61%, from 157 units to 253 units, while the transaction price under PWYW was 19% lower, from 7.99 euros to 6.44 euros on average.  Combined, the result was a 30% increase in revenue.  Since lunch buffets are a largely fixed cost offering, the increase in traffic more than offset the decrease in average price paid, yielding an overall profitable promotion.  Furthermore, the PWYW promotion was particularly successful at attracting new customers rather than increasing sales to existing customers.

(Mathematically, we can show that for any variable cost less than 3.90 euros, the PWYW period was more profitable than the regular posted price periods.  Persian lunch buffets in Frankfurt in 2007 were most likely less 3.90 euros per plate in variable costs, hence readers should strongly suspect that the PWYW period was more profitable than the regular pricing period.)

In addition, the Persian restaurateur noticed a marked increase in evening traffic.  During the evenings, when the restaurant would still list and charge regular prices, revenues almost doubled.  As a result, the restaurateur returned to the PWYW price format for the lunch buffet a few months after the experiment ended and decided to keep it for the long run.

Other experiments by Kim et al. did not show such a marked improvement in revenues and profits.  So, what contributed to the success of the format?

Kim et al. also surveyed customers in an attempt to uncover the drivers to their willingness to pay under a PWYW scheme.  They found that the price paid was strongly influenced by the customer’s internal reference price, that is, the price they would expect to pay in the absence of a promotion.  Moderating the reference price effect were concepts of fairness, satisfaction, price consciousness, income, loyalty, and altruism.

PWYW may not be as radical of an approach as some might think. Consider your last trip to a restaurant.  Did you tip the waitress?  If so, how much and why?  You may find many of the same influences in your own tipping decisions as these researchers found in payment decisions under PWYW promotions.

Which leads to the issue of whether PWYW is right for your offering.

First, there are external market environmental issues.  For instance, the culture in which these experiments were conducted may have strongly influenced the outcomes.  It is unlikely to be a pure German sensibility issue since PWYW restaurants can be found in the United States  (see http://www.terrabite.org/press.htm).  It is likely to be a result of the democratic nature of the societies in which it has been explored.  In democratic societies, on average, people have a strong desire for an equal allocation of resources.  (Hence, PWYW has mostly been explored within the context of consumer markets.  In business markets, it can strongly be suspected that the culture of homoeconomicus will drive the median transaction price to zero.)

Second, there are internal operational issues.  Both with music downloads and restaurant buffets, the business costs are largely fixed and the marginal costs of production (or digital reproduction for music downloads) is negligible.  While PWYW may be profitable with many cost structures, from a risk management point of view, low variable costs minimize the risk of PWYW price structures.

So, perhaps when that junior leaguer claims that it is time to try a PWYW pricing scheme, instead of ending his career, perhaps the executive should instead put hm in charge of the promotion and run the experiment.  In some cases, PWYW isn’t irrational ludicrous thinking, but instead a demonstrated rational route to profits.

References

• Ju-Young Kim, Martin Natter, and Martin Spann, “Pay What You Want:  A New Participative Pricing Mechanism,” Journal of Marketing 73, no. 1 (January 2009):  44-58.
• There is an unresolved difference between the total revenue reported in the Kim et al. study and that reported here based on the product of average price paid and units sold.  We were unable to clarify this difference prior to publication.