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April 16, 2008

Pricing for Profitability

Factoring in consumer behavior and consumption rates can help firms optimize their multipart pricing schemes.

Topics: Marketing

Selecting a cell-phone plan today involves many decisions: Pick a plan with a low monthly rate or one that offers more minutes? Add text messaging? Opt for rollover minutes? This array of choices comes from the increasing popularity of a method for building service plans known as multipart pricing.

In contrast with traditional flat-rate plans ($75 a month for a gym membership, for example), multipart pricing schemes include a fixed fee for a specific duration, a usage allowance, a variable fee for use beyond the base level and additional charges for add-on services — for example, the familiar cell phone plan charging $40 per month for 400 minutes, $0.20 per minute thereafter and $5 to add voice mail. Businesses such as cell-phone providers, HMOs and car-rental firms, among many others, have embraced multipart pricing because it allows them to tailor prices to target specific consumer segments and has been shown to boost profitability.

Consumers have responded positively to multipart pricing because it lets them choose the option that most closely meets their needs. Frequent cell-phone users, for example, are likely to select a plan with a lot of minutes, while infrequent users can opt for a cheaper plan offering fewer minutes. Many companies, however, fail to factor in these consumption rates when developing their multipart pricing schemes and, as a result, offer plans that are suboptimal, Professor Kamel Jedidi says. “In deciding what plans to offer, a company has to properly measure how consumers react to changes in fixed fees, usage allowances and marginal prices as well as how these changes affect consumption,” he explains.

To help companies do just that, Jedidi worked with Professor Rajeev Kohli and Raghuram Iyengar of the University of Pennsylvania to develop an improved model for generating multipart pricing schemes. Their model, Jedidi says, allows companies to estimate the market share and usage of a service or a product, identify the best pricing plan for maximizing profit and calculate optimal prices for add-on features. “The novelty in our approach,” Jedidi explains, “is understanding that the plan’s benefits arise not only from its features but also from the consumer’s expected consumption under this plan.”

The key to devising optimal multipart pricing schemes is to understand the value that individual consumers attribute to each service feature, rather than simply looking at the service as a whole. When choosing among plans, Jedidi notes, consumers weigh the benefits and costs of each plan by analyzing each aspect of the plan.

Jedidi, Kohli and Iyengar developed their model using data from a study that asked subjects to select the best hypothetical cell-phone service plan from a variety of options, based on a number of different attributes. The researchers then compared the multipart pricing plans built using their model against those built using six other models and found theirs to be a better predictor of consumer demand. “Being able to predict demand volume under different pricing schemes is exactly what is needed to bring optimal multipart pricing schemes to market,” Jedidi says.

The researchers’ model also offers insights about how consumers respond to changes in prices and plan-usage allowances. For example, the researchers found that reducing the monthly fee did not affect the number of minutes customers used if they normally used fewer minutes than the monthly plan allowed. Similarly, increasing the number of free minutes allowed by a plan did not change how many minutes customers actually used if their normal consumption rate was below the plan’s limits. By contrast, existing multipart pricing models incorrectly predict that lower prices or higher usage allowances are always associated with higher consumption.

This new model can help companies improve what is already an effective strategy. By accurately targeting the needs of a wide range of users, companies using multipart pricing plans can increase profitability and stimulate demand. In addition, these plans can help firms retain customers for a certain period. “Once customers pay the plan’s fixed fee, they are unlikely to switch to a competitor, because they would have to pay the fixed fee again,” Jedidi explains. “Multipart pricing has the added advantage of locking customers in for a while.”

 

Kamel Jedidi is professor of marketing and chair of the Marketing Division and Rajeev Kohli is professor of marketing at Columbia Business School.

 

Read the Research

Raghuram Iyengar, Kamel Jedidi, Rajeev Kohli

"A Conjoint Approach to Multi-Part Pricing"

View abstract/citation  Download PDF  

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