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Managing Consumer Perceptions With A Reference Price

In my previous posts I identified a problem with unbundled pricing, managing consumer perceptions. When a marketer itemizes components and prices them separately, the consumers are bound to feel nickel and dimed. Since the components have never been sold separately there is no reference price for these.

United Airlines, the first among airlines to introduce unbundled pricing, charges $25 for the first bag and $50 for the second. In the absence of a substitute the fees are viewed dimly by travellers. Now United has entered into a contract with FedEx to introduce expedited bag service.

United and Fedex service costs $149 for less than 1000 miles and $179 for more than 1000 miles, a single 50 lbs bag, to be delivered by 430PM. For most passengers who check in bags and balk at the $25 and $50 fees at the check-in will not consider the FedEx option. But it helps to set a higher priced comparable in their minds hence help alleviate the resistance to unbundled pricing. For those with a higher willingness to pay to avoid the hassles of hauling the bags to and from the airport and deal with lost or delayed bags, the FedEx service will be attractive.

It is not clear if United agreed to pay a fixed fee to FedEx regardless of volume. If there is no such fee then FedEx is really using the idle capacity (marginal cost of which is zero) to transport the bags. So even if no one uses this feature, the very existence of it helps United to justify its baggage fees because now there is a reference price.

Consumer behavior On Unbundling - Valuing Free

 United Airlines used to run an Ad showing their early days when a business man hitches a ride on a two-seater. The pilot asks, " let us see, you want to have coffee, while we are in the air?". As far as we can look back air travel always included the entire package, from free two checked in bags to coffee. How would customers value something that has been free all along? What is the reference price?  Dan Ariely, author of the book Predictably Irrational and a behavioral economist, says this in an interview with the WSJ.

BUSINESS INSIGHT: On the other hand, what about companies that set the initial price of something too low, even offering a product or service free of charge in order to encourage people to use it? Isn't that why so many online publishers are facing such great difficulties, because they initially offered their content for free and then consumers couldn't move past that anchoring point?
DR. ARIELY: The truth of the matter is that it's very hard to realize the value of something even after you've used it. Say you use e-mail. How valuable is it to you? Sure, if something is free then people will start using it. But what companies don't realize is that the mapping of utility to money is very difficult. People won't say, "This is so great. I'll pay $20 for it." Instead they'll say, "I used it for free all along and now you're charging me? I'm not interested."

If there are substitutes, like other email services that are still free, the reference price stays at $0 in their mind. But if there are no clear substitutes or if there are services that have a higher price, then these serve to assign values to the unbundled services. In the Airline baggage fee case, the next best thing is  to use overnight shipping with FedEx or UPS to your destination. The high price of these services help to serve as the reference points and help to improve perceived value of the unbundled components in the minds of the consumers.

Where to start looking for modeling Unbundling

In his paper titled, How to Build an Economic Model in Your Spare Time, Hal Varian, UC Berkeley Professor now serving as Chief Economist at Google says this about where to get ideas:

 I think that you should look for your ideas outside the academic journals---in newspapers, in magazines, in conversations, and in TV and radio programs. When you read the newspaper, look for the articles about economics : : : and then look at the ones that aren’t about economics, because lots of the time they end up being about economics too

Given the stories I have been talking about, all of mine came from news media. The academic papers I read seem to have no managerial implications to me. 
Here are other stories I have been thinking about in the context of unbundling

1. Korean online video game firm Nexon that gives its service free but charges you for every small thing you want to purchase. You want better weapon? better shield to withstand weapons?  you get the picture.
   
2. I was at Target stores the other day and saw packs of gift cards that read IMVU credits. IMVU online 3D chat forum that is free to signup but asks people to pay through credits for better style, outfit, rooms, and "moves". 

Both these fall in my definition of unbundled pricing. What used to be part of the monolith is now separated and sold at a price. When you bought a video game, everything came with it. When you reached certain levels you get the appropriate weapons. The last video game I played is Zelda: The Wind Waker.  The title charecter Link starts out with just a sword but works his way through the islands and collects multiple weapons. Sometimes I paid for things, using the game coins I collected.

Now by unbundling the game, Nexon is appealing to those willing to gain superiority in their game by paying for it.

Shrink wrapped video game is a monolith. Make it free and charge for components to make the game play worthwhile, you have unbundling.

A Case of Unbundled Newspaper

Take the case of Wall Street Journal online edition. As a non-subscriber you can read some of their free articles but not the premium-subscriber only articles. You would like to have some of the articles but not ready to signup for the whole subscription, after all you do not want to pay for  for content you can get for free from other sources or do not want to pay for the the opinion pieces  that you do not agree with.

Your demand is about 3-4 articles per week. Suppose the WSJ unbundled its online edition and allowed people to pay per article. Let us ignore for now details like, how long can readers access the article etc. How would they price each article?

The WSJ at the newsstand costs $2 per day. So in theory, WSJ cannot price an article  for more than $2. Or Can they? Take the case of what they do for articles sold through Factiva, a DowJones service. Factiva Individual subscription requires you to pay an annual fee, just for the ability to search for the article and $2.95 per article you view. The moment you click on a link to view the article you are charged $2.95. Since they have your credit card information, it is simply added up to your account.

Sample monthly charges

First Month: Sign-up: $69.00 Viewed 10 documents: $29.50 Set up 1 Track folder: $9.95   -------- Total Charges: $108.45

Second Month: Viewed 12 documents: $35.40 Set up 1 Track folder: $9.95 Existing track folder: $9.95   -------- Total Charges: $55.30

Of course the Factiva service is subscription service and not pure unbundled service. The entry fee is the access to years of archives. Then the articles are sold in unbundled manner. This is2-part tariff. Factiva website says this individual plan  is for occasional users who buy a few articles per month.

In sum, unbundling does not mean you destroy value and lose pricing advantage. When getting the customers to commit to a higher subscription fee is difficult, it is possible to charge significantly higher fee per unbundled component when this offer is targeted to the right segment.

Transaction Costs of Unbundled Pricing

First you buy a plane ticket, then pay curbside check-in and for baggage fees at the airport. Once in the plane you pay, separately, for drinks, meals, pillows, inflight movie, Wifi.  Fortunately you can complete all these transactions with your credit card. The price of the additional services you used are large enough, in the $5 to $50 range, to subsume the credit card transaction fee.

Now consider unbundling of content from an website, like  newspaper. Readers are allowed to purchase unbundled articles without buying the whole subscription. The bigger hurdle with this service is how to complete the transaction in a way it is easier and cheaper for the readers and publishers.

Readers cannot be burdened with entering their credit card information every time.
On the other hand, readers can't be asked to register and provide their credit card information because of consumer psychology. Besides, if the articles are priced at just a few cents per view, the transaction cost for the credit cards will end up costing more than the price of the articles.

The transaction costs of unbundling may force firms to not consider it at all. But unbundled pricing does not have to mean  unbundled payments.  There are options like acommon third party systems, like a prepaid calling card or iTunes gift card. I will discuss these in detail in the coming days.

When Baggage Fees Unbundling Was First Introduced

In 2006, when Ryan Air decided to offer a no-frill service to keep its advertised price for airline ticket low, it offered a basic service and charged for everything else. The Economist reported (this time a news piece and not a views piece), posing the question, "Why airlines have started charging for check-in bags?". The article reported (bold format added by me)

As fuel costs have escalated, airlines have been tightening up their baggage rules. Some of those rules are now being completely rewritten. British-based Flybe introduced a "fair deal for baggage" scheme on February 1st, which it says means passengers unburdened by bags will no longer have to pay towards carrying other people's suitcases. Five days later, Ireland's Ryanair announced details of a similar plan to encourage passengers to travel with fewer bags.

...

Speeding up the check-in is likely to prove popular among passengers, especially those taking short trips. Flybe says only 55% of its passengers have bags to check, and it expects that number will now fall slightly. Because anything that persuades passengers to travel more lightly saves fuel and cuts the cost of ground services, other carriers will be studying this particular flight plan very carefully.

 The fairness argument appeals to the claimed 50% who do not check in bags. The airlines make this a "cost-based" argument, stating that, "if we don't incur the cost we won't charge you".
The issue is with differentiated pricing that aims to capture all consumer surplus for those who need this service and  does not reflect the cost. Consumers will view this as unfair pricing. For those who do use the service, it will  be unfair unless the airlines can show the value add that is more than the basic service that was included in the base price of the ticket.

Fairness Questions on Unbundled Pricing

There is a scathing opinion piece in The Econonist web-only edition on the Airline fees. Titled, "Come fly the fee-filled skies", the article frames the entire unbundled pricing as a fairness question wondering whether the passengers will be asked to pay for reclining in their seats or using the bathroom.

And in the midst of this malaise, airline executives have been casting around for new ways to make money—including charging customers more for “extras” that were previously embedded in a basic ticket price.

Fairness in pricing is definitely a factor that marketers should consider when unbundling. In the case of airlines, there is also considerable history behind th outrage. With the practice of "yield pricing", almost everyone views airline pricing as not "fair".

Combined with it when customers do not get the value for the price they pay, the fairness issue is going to cause outrage. For example, when United charges $50 for the second bag and still manages to lose it (albeit temporarily) the customer sees no value for the cost incurred.

Unbundled pricing is not about wringing the last dollar out of every customer without providing value. It is about identifying those with higher Reservation Price for certain components and delivering them value that is well above what they would get with bundled pricing.

This topic on fairness and consumer behavior have a much larger significance in the success of unbundled pricing. I will revisit these in the future.

Unbundling Of Industrial Systems

In their paper titled, Unbundling of Industrial System, LYNN O. WILSON, ALLEN M. WEISS, and GEORGE JOHN  talk about unbundling as a decision problem for a firm selling multicomponent system.  Combined with the Strategic Bundling paper I have referred before, the two model criteria for deciding when to unbundle and not.


In Unbundling of Industrial Systems, the authors say

We focus on a firm that currently sells its system only in a bundled form, and ask when it might be more profitable to unbundle the system and possibly even withdraw some of the components.

With a customer base with heterogeneous preferences, they look at bundled system as those offering better integration vs. unbundled systems that offer greater modularity.  This also assumes that there are competitors who can supply the modular components. Then their rule for unbundling is

A simple decision rule is to compare the
per-unit margin of the bundled system with the various
unit margins of the unbundled components; unbundle if
the former is smaller. If the margin rule does not signal
unbundling, an appraisal of the added systems' attributes
in comparison with the focal system's attributes is needed.

The conditions they describe for industrial system apply in general to products and services, of materal and information. But I am not convinced that the decision rule is as simple with information goods and services and even in some material services.
In the case of Newspaper unbundling, the individual articles are the components and the newspaper is the bundle. When the distribution moves to Internet, there exists competitors to supply many of the components. For example,  the news (not commentary, Op-Ed and Opinions) on most events are indistinguishable between major newspapers.  But today there is no market for selling unbundled stories.  Generalizing this, the two conditions that require reconciling are

1. When the components have never been sold separately and hence they have no market and have no published prices but the customers may have a non-zero Reservation Price
2. The marginal cost of the individual components  is close to 0, that is most of the cost is incurred by the integration itself.

Nevertheless the work done by Wilson et al covers significant ground. My work is to add these conditions and refine the decision rule for unbundling.

The Effect of Costs and Economies of Scale on Bundling

Stremersch and Tellis make this proposition in their paper on Strategic Bundling.

P10: The profitability of price bundling is likely to be higher
than that of unbundling (a) the higher the relative contribution
margin and (b) the stronger the economies of scale
or scope.

Relative contribution margin is the ratio of price less variable cost to the price.

Given their condition (a) there are special cases that exist in which unbundling is preferrable

1. The Variable cost is 0 or close to 0
2. The price approaches zero

 For example, in case of newspapers the variable cost of a single article is 0. It is a fixed cost operation. The costs of setting up the reporter network, building distribution and printing newspapers are fixed cost. The variable cost to print the newspaper is independent of the decision to whether or not print any single article. To take this example to the Internet, the variable cost of whether or not to  display an article to a reader is 0.

Sticking with the same example for the second point, when articles are always sold as bundles, the price an individual article can be sold for is 0.  The price approaching 0 does not mean that the customer RP is 0 as well.  When denied access to certain articles, customers may have a non zero RP for certain articles and will be willing to pay for single articles instead of buying the whole subscription.

Given these two conditions, it would be more profitable to unbundle than bundle.

Unbundling Along two Dimensions

The Two Unbundling Dimensions

Over this summer I commuted everyday on BART. On Mondays I bought a ticket worth 5 round trip to my destination at exactly five times the price of 10 one way trips. Bay Area Rapid Transit (BART), says this in its web page about its tickets,

BART tickets are like debit cards with stored value. All BART stations have automatic ticket vending machines that accept nickels, dimes, quarters and $1 coins, as well as $1 $5, $10 and $20 bills. BART fares are set with a mileage-based formula, therefore time-based passes (e.g., weekly or monthly) are not available. [you can buy ] A 6.25% discount in two denominations: $48 ticket for $45; $64 ticket for $60

So every time you take a trip you pay for the mileage. Even with the high value ticket the amount is deducted for every trip. The only discount you get is probably due to their lower transaction cost and breakage (depending on you to not use all the amount). By not offering a unlimited travel pass and charging every trip based on mileage, BART has unbundled its offering. This is more like usage based pricing, where you pay per use.

This leads me to define that unbundling can happen along two dimensions, along product or along usage.  BART ticket unbundling is not like the airline baggage fee in which the unbundled product/services are distinct. The airline baggage fee is along product dimension and BART pricing is  along the usage dimension. 

Unbundling At The Gas Station

The pricing at the pump has long been debated and much maligned. Without going into those details I would like to point out a form of unbundled pricing practiced by some gas stattions. Gas prices at the pump is a fixed charge that includes all federal and state taxes and credit card commission the owners pay to the card companies. As the oil prices soared their credit card charges per gallon increases as well. Some gas stations started listing two prices, one lower price for cash and the other  that is 10 cents higher for credit card purchase.

Before the oil crunch everyone paid the same price. The credit card commision is distributed across the entire customer base in the form of higher gas price. When gas was selling for $1-$2, no one minded. Now at $4 a gallon and extreme competition with other gas stations (this is a high operational leverage business with low contribution margin) the owners started separating out the credit card commision and list the lower price to attract customers.

This is unbundling. The main service offered is filling up your tank. For the convenient pay, which is now optional, you pay 10 cents more per gallon.

Is there a problem with it. In some cases, some of the gas station owners advertised only the lower price to attract people and implicitly tacked on the added fee. That is unacceptable unless the customers knew exactly what services they are getting for the per gallon price.

When done explicitly and deliberately, this falls under unbundling. Another point to note here is that, like airline travel, gas stations are commodity businesses. The consumer expectations and loyalty is low. Unbundling fits this business model well.

Mental Accounting Examples

The Washington Post has an article explaining Thaler's Mental Accounting in the context of everyday life. When people make a mental account of how much a product or service is going to cost and have spent that amount, then any event that causes them to exceed that budget is viewed disapprovingly.

Mental accounting is really the household equivalent of financial accounting, said Richard Thaler, an economist at the University of Chicago who was the first to describe how the phenomenon works. Just as an office expense-account maven might tell you that your budget for lunch is no more than $25, you make projections on how much you will spend using your own money. This mostly ends up saving you time. You don't have to think twice (although maybe you should) about the $3 latte you get each morning because you have a mental account that says you are entitled to a $3 latte each day.

Customer Reaction and Unbundling

From the customer perspective, how would they react to the itemized pricing? What are their pain-points? What are the budgetary, psychological and transaction costs? How would they react to taking out their wallet to pay multiple times?

I serve as the elected VP of Technology of the student body in my school. I received a very detailed email from one of my classmates regarding the need for one unified payment scheme for all services we use. This person did not like the fact that after paying close to $20,000 for the MBA tuition, we are asked to pay separately for

1. Student association fee
2. Orientation fee
3. Club membership fee
4. Printing supplies fee
5. Business card charges
6. Gym fee
7. etc

The complaint is rooted in both psychological costs and transaction hassles. For the latter, we pay each one of these fees through a separate payment system to separate payees. Psychological reasoning was, " I already decided to spend so much on business school, why are you asking me separately for every thing I need. Why don't you just add these up to the tuition and take it as one upfront payment".

This is not an isolated example. Thaler talks about this in Mental Accounting. I will talk more about this in later articles. But to respond to this customer reaction, I would like to point to the Singapore Airlines example of classes of service.

The complaint I received and Mental Acounting are not about discarding unbundling. They point to the need for serving different segments differently. In the business class Singapore Airlines pampered their customers and did not unbundle their pricing. Similarly, MBAs paying high fee in top schools should be treated as business class (no pun) passengers.

Is Unbundling The Opposite of Bundling?

As we saw before, bundling is selling two or more products together. Is Unbundling the opposite of bundling?

Unbundling is not just undoing the bundling effect. It is deliberately separating product and service components that used to be treated and charged as part of the monolith.

For example, take the case of product warranties. Almost any product we buy come with 1-2 year warranties. It is taken for granted by all consumers. Manufacturers account for it in their balance sheet with deferred liability based on their model for warranty expenses. The stores usually sell additional service plan, for an additional fee,that extends the warranty period. This is optional but many retailers end up making considerable profit from these sales. Suppose the manufacturers decided to do away with automatic warranties and decided to sell a 3-year service plan, that is unbundling.

Getting The Definitions Right

This is an attempt to get a more precise definition of  Bundling and Unbundling.  To add to the definition mix, there are different two kinds of bundling, Product and Price Bundling. The definitions here are based on "Strategic Bundling of Products and Services" by Stefan Stremersch & Gerard J. Tellis. The definitions are lifted verbatim from their work.

Bundling: Bundling is the sale of two or more separate products in one package.
                  Examples: Opera season tickets, multimedia PC
Price bundling: Price bundling is the sale of two or more separate products as a package at a discount,    without any integration of the products.
                 Examples: Luggage sets, variety pack of cereals
Product bundling: Product bundling is the integration and sale of two or more separate products at any price.
                 Examples: Multimedia PC, sound system
Pure bundling: Pure bundling is a strategy in which a firm sells only the bundle and not (all) the products separately.
                 Examples:Apple Computers (Cannot buy it without the software but you can buy its OS X separately)
Mixed bundling: Mixed bundling is a strategy in which a firm sells both the bundle and (all) the products separately.
                 Examples: Telecom bundles


So what is Unbundling? The literature definition is, "selling all products separately and never as a bundle".  I define unbundling as
" a deliberate pricing strategy to separate  truly optional components in a product/service and price these individually giving customers the option to buy or not"

The key word is "optional". If a component is essential for for the customer to achieve their primary goal then it is unbundling even if priced separately.

Unbundled pricing is a la carte pricing, except that products were always marketed and viewed as a one monolith and not as a bundle of components. For example, until now Airlines never separated out or itemized in-flight meals, baggage service etc. An airline customer never considered they were purchasing a bundle.  What is happening now is unbundling the seemingly monolithic components into their sub-parts and pricing them separately.

Unbundling Is Working For Jet Blue

Jet Blue took unbundling air travel one step farther than most airlines did. They started charging their customers for more legrooms, airline blankets and pillows. Once again, the customer has the option of not buying, so this qualifies as unbundling and not partitioning. JetBlue reported that this unbundled pricing is on track to bring in $60 million this year.

There is some product innovation is included in JetBlue's unbundling. For example JetBlue claims that they are giving them eco-friendly fabric that eliminates dust and pollen. So they eliminated the free option and trying to increase the perceived value of the product through branding and messaging.

The opportunity to serve the needs of high value customers, those with higher RP, is made possible by unbundling their product. On the flip side, there is bound to customer backlash if they get the same old bad service for the additional fee. The baggage fee does look like one. While they try to capture value from those who have a need to check-in bags, the airlines are not offering an improvement.

This is an important takeaway in managing customer perception. If the unbundling is complemented with increase in perceived value, there is a better chance of customer acceptance.

Partioned Pricing Is Not Unbundled Pricing

In their paper titled Bundling of Products and Prices published in Journal of Marketing 2002, Stremersch and Tellis say this about Partioned pricing

Morwitz, Greenleaf, and Johnson (1998) show that partitioned
pricing, in which a firm divides a product’s price into
two mandatory parts, the product and shipping charges, can
increase consumer demand because of lower recalled costs.

 The key word here is "mandatory".  One part cannot function or will be of any use without the other. For example,take the case of  product plus shipping case they quote. When customers buy from an online only seller, there is no avoidance on purchasing the shipping. The customer does not have a choice on whether or not to purchse shipping even though they may have options for multiple classes of shipping.

Partitioned pricing is not same as unbundling. In the Airline that I love talking about, suppose the airline charged a separate fee for your seat cushion and offer you three choices

1. basic          $8
   
2. comfort     $16
   
3. super comfort   $20
   

 This is not unbundling, passengers have to pick an option. Compare this to baggage fee, inflight meals and movies. In all these the customers have the option of not buying.  Unbundling is about giving customers that option and making them self-select on which additional services they want to buy and which they don't.

Two Part Tariff And Relation to Unbundling

Two part pricing is another form of price discrimination,

A two-part tariff is a price discrimination technique in which the price of a product or service is composed of two parts - a lump-sum fee as well as a per-unit charge.

The seller sets an "entry fee" to get into the store and sells items withn in the store separately. Once inside the store, the customer decides whether or not to purchase items at listed prices and the amount to buy. For a rational cutomer, once the subscription fee is paid, it is sunk and should have no impact on the decision to buy other goods or not.

A profit maximizing seller will set the price of goods sold at or above their marginal cost. The fixed subscription fee or entry fee is targeted to capture the consumer surplus. There is some parallel to between two-part tariff and airline baggage fees scheme. The list price for the ticket can be looked  at as the entry fee and the itemized charges for meals and baggage are the second part.

The traveler has the option of whether or not purchase the plane ticket at the set price (the entry fee).  When they show up to the airport they have the option of purchasing additional items like, better seat in the same class, baggage check-ins. Once inside the plane, they have more options like meals and drinks.

When looked along this dimension, current Airline price unbundling does look like two part tariff. The key is that airline is able to unbundle what used to be one service into multiple recognizable components.