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Buying and selling

Pay whatever you like

München, 06/08/2015

Letting customers determine the price can sometimes pay off for the seller.

Source: keart / fotolia.com / thp

In interactive pricing models like Pay-What-You-Want (PWYW) the buyer decides on the price to be paid. Here, LMU professors Klaus Schmidt and Martin Spann explain how such models work, and when they make economic sense.

Schmidt (Institute for Economic Theory) and Spann (Institute for Electronic Commerce and Digital Markets) are collaborating in a DFG-funded research project devoted to identifying the advantages and disadvantages of interactive price mechanisms, and their first publication on the topic recently received a best paper award. In the interview, they discuss situations in which customer-driven pricing mechanisms can be beneficial for buyers and sellers, and why this is more likely to be the case for a restaurants than for a car dealer.

You have been studying situations in which consumers voluntarily pay for an item although they are not obliged to do so. Who would want to pay more than she has to?
Klaus Schmidt
: Many people are willing to pay for a good or service although they don’t have to, even in the rather anonymous context of a laboratory experiment. And customers with a well-developed sense of fairness pay significantly more than others. Repeated interactions between buyer and seller tend to motivate the customer to pay more. People are more likely to pay if they want the seller to stay in the market.

And what is the proportion of free-riders?
Martin Spann
: In our experiments they make up no more than 40% of all customers, averaged over all the situations we investigated. If a seller decides to use Pay-What-You Want, he must expect that a fraction of buyers will pay nothing at all. But most customers do pay.

Are there firms out there that actually apply this model?
Schmidt: There are indeed, and far more than one might expect. The model is especially popular in situations where profit maximization is not the principal objective – where a seller wants to introduce a product to as many people as possible, without giving it away for free. Museums are a good example. Particularly in English-speaking countries, museums normally do not charge a fixed price for admission. And of course, churchgoers in America and France make voluntary contributions to their parish community. In fact, this is a very good example of the role of regular and repeated interactions between consumer and service provider: If I have an interest in the survival of the congregation, then I should be prepared to do something for it. Wikipedia also recently appealed to users for voluntary contributions, and received several million dollars. For-profit firms also apply PWYW, but their prime motivation is the advertising impact and such initiatives are usually restricted to a limited period. Pay-What-You-Want, on the other hand, offers a means of fully penetrating the market, because in principle everyone can get the product for nothing, but in practice many will voluntarily contribute to the costs. PWYW can also be useful in cases where the firm has related, complementary products which it hopes to sell at fixed prices.
Spann: The basic prerequisite for PWYW is that unit costs are low. That makes it easier to bear the losses imposed by customers who pay little or nothing at all. This is why the model is largely restricted to the service sector – restaurants, hotels, museums. Software firms employ it when they provide a basic version of a program for nothing, but charge the customer for a desirable add-on.

Does the idea that consumers can set their own price represent a new trend?
Spann: The introduction of fixed posted prices was one of the greatest innovations in pricing mechanisms over the past 150 years. It simplified transactions for all, because it got rid of negotiation costs. The internet has made both interactions and transactions much easier, which accounts for the comeback of interactive pricing mechanisms. Here, ebay is a good example.
Schmidt: But 150 years ago, haggling over the price was a normal part of commercial transactions. PWYW models leave it entirely up to the customer to determine the price.

You are studying also other pricing models as part of a DFG-funded project. Can you give me an example?
Spann: We are interested in the functioning of customer-driven price mechanisms in general. Take the case of the ‘Name-Your-Own-Price’ auctions conducted online by a large American company that offers hotel reservations and travel arrangements. Here the would-be customer suggests a price for the service, which however may not be accepted because the seller has a set minimum price unknown to the customer.
Schmidt: This procedure resembles PWYW, insofar as the buyer decides what to pay. But here, the customer who offers too little gets nothing at all. This model makes no appeal to the customer’s social preferences. The relevant factors are risk aversion and willingness to pay. A businessman who needs a hotel room in a certain location on a given date is more likely to accept a fixed price to ensure that he really gets it. But the auction model permits the seller to reach diverse types of customers, and he can set the minimum price accordingly. NYOP offers a way of segmenting and broadening the market for his products. The advantage of NYOP is that it eliminates the risk of incurring high losses because too many customers pay too little for the service. The drawback is that market penetration is limited.

Are online customers more likely to pay their own price than buyers who interact directly with a salesperson?
Spann
: In principle, one would expect that a face-to-face interaction would be beneficial to the seller. If I have to look the waiter in the eye when I pay the bill in a restaurant that is certainly the case. But our experiments have shown that PWYW can also work when there is no personal contact between buyer and seller.
Schmidt: I would be very surprised if more than 10% of customers in a restaurant would simply stand up and walk out without paying anything. Of course it might not be advisable to use PWYW in a restaurant near the Central Railway Station, where lots of the customers will never come back. But it could be done in a suburban neighborhood, where non-paying guests are would be known in the local community.
Spann: One of the best known examples concerns the rock band Radiohead. The band produced an album and made it available for download on the basis of the PWYW principle. In this way, the band was able to avoid the costs inherent in the music industry’s usual value chain, which results in the musicians receiving only about $1.50 of the $10 that a CD costs in the shops. With PWYW, the band earned an average of $2 on each download.
Schmidt: It is, however, a striking fact that the group never repeated the experiment, perhaps because the positive effect wears off with time. In 2007 it was a terrific marketing gimmick, and everyone talked about it. Nevertheless, this example shows that there are niches for PWYW. And we would certainly not argue that PWYW will be the dominant business model in the future and that firms in all sectors of the economy should use it. It will remain something for a minority of sellers, and even they will not apply it to all their products or on all occasions. But in specific contexts, it can be a profitable mechanism.

Normally, customers are annoyed to learn that they have paid more than someone else. Does PWYW not institutionalize this effect, as everyone can set his own price?
Schmidt: If I’m sitting in a plane, and I know that the person next to me has paid 20 euros for a ticket that cost me 500, of course I will be extremely annoyed. But if I decided what I wanted to pay, I have no reason to be dissatisfied – and there is no reference price available for comparison.

You will analyze a PWYW project that the publishing firm Thieme is currently planning. What do you hope to learn?
Spann
: The publisher plans to set up a new open-access online journal and intends to offer authors a PWYW scheme for publication of their articles. Academic publishers usually demand payment of 1000 to 2000 euros for this service. We are interested in finding out how much authors – who have been informed what it would normally cost – will pay voluntarily for the publication of their work.

Are there products for which PWYW would be totally unsuitable?
Spann
: Many people feel bad if they believe they have paid less than a fair price for something. But someone who has the chance to buy a BMW for 5 euros may decide that he can live with that guilt. In the case of an expensive product, the temptation to ignore one’s social norms and pay far too little or nothing at all would simply be too strong.
Schmidt: Some restaurants offer a PWYW menu at lunchtime, but a normal fixed-price menu for dinner in the evenings. And, as a rule, the PWYW model applies only to the food and not for beverages. It is certainly not the case that consumers possess a fundamental sense of fairness and will pay a fair price every time. There will always be those who, given the chance, will order the most expensive whiskey or champagne if they can get it for nothing.                                 (Nicola Holzapfel)

Prof. Dr. Klaus M. SchmidtProfessor Klaus Schmidt holds a Chair in Economic Theory at LMU‘s Faculty of Economics. He also serves as the Spokesperson for the Collaborative Research Center on “Governance and the Efficiency of Economic Systems”, and is Founding Director of the Munich Experimental Laboratory for the Economic and Social Sciences (MELESSA).

Prof. Dr. Martin SpannProfessor Martin Spann is Director of the Institute for Electronic Commerce and Digital Markets in the Faculty of Business Administration at LMU. He also heads the Center for Advanced Management Studies at LMU and is Scientific Director of the Center for Digital Technology and Management (CDTM).