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Understanding substitutes

This is a pretty long post, and I know that you could easily substitute another round of Angry Birds instead of reading it. I hope you’ll find it useful.

One of the key elements of pricing is realizing that people have choices, and that substitutes are available. This is more nuanced than it sounds, though, and I want to highlight key things to keep in mind when you think about how much to charge and how people might react.

Marketers make two mistakes over and over. They create average, commodity products and expect that people will pay extra for them. Or, in the other direction, they lose their nerve and don't charge a fair price for the extraordinary work they're doing, afraid that people will find a substitute.

"Why should I buy this from you, that guy over there sells something just like it?"

"Why should I buy anything from any of you guys? I'll just watch TV/eat in/skip it..."

The highlights:

  • There are two kinds of substitutes--between markets and between competitors
  • Commodity goods and services have easy substitutes between competitors
  • Some goods are difficult to understand before purchase and use, and most consumers undervalue them and treat them like commodities
  • Industry norms are an important signalling device, part of the way price tells a story, and a way that substitutes across categories often come into play. Norms make us think something is fair and safe
  • Network effects make substitution difficult and need to be amplified in many markets in order to create more value
  • In commodity markets, price often drops to marginal cost, and in digital markets, that’s often zero
  • Luxury goods, for many of the reasons stated above, have few substitutes for those that value them

Consider the market for a dozen eggs, sold at the supermarket.

There are commodity eggs, normal, regular, use-these-eggs-in-your-cake-or-your-omelet sort of eggs. When you have a choice of two brands of normal eggs, you buy the cheap ones, because, of course, all eggs are the same. One is a perfect substitute for the other.

Right next to those eggs, though, are eggs with a story. Eggs that are free range or organic or cruelty-free or high in this or low in that. And these eggs cost more. Some people happily buy these eggs, substituting them for normal eggs, because to them, they’re worth more.

If you want to charge extra for eggs, then, you need people to believe that they are worth more than the substitutes. This sounds obvious, but it is the key wisdom that gets us started. How much it costs you to make an egg is completely irrelevant to this discussion (or even how much it costs the chicken, but that's a whole different discussion). People will switch to a similar good any time you haven't given them a good reason to pay extra.

When the price of all eggs goes up, because of an egg truckers strike or because of increasing costs, very few people stop buying eggs and start buying cream cheese instead. That’s because if you want to make a cake, you need an egg. And because if you sell tamago, you need eggs. Eventually, if the price goes really high or the high price sticks around for a long time, some people will find a substitute in a different market, eating Cheerios instead of eggs for breakfast, for example. (This is called elasticity, and we could talk about it forever, but one thing that's worth noting is that elasticity varies wildly across and within categories).

This leads to opportunity and challenge of marketers who choose to sell something that we don't buy very often and that we can't tell if it's better (or if the story is true) until after we buy it. In situations like this, our instinct is to assume that the thing is generic, a commodity, not worth extra. 

Paradoxically, pricing itself also tells a story. If we're picking a surgeon or a restaurant or yes, even a dozen eggs, sometimes we intentionally don't buy the cheapest one. It has to do with the story we tell ourselves about money, certainly, but it's also based on an awareness of how markets work. When we don't want to make a mistake, we seek information, and expensive successful items in the market carry with them the information that other people like me have bought this more than once, that it's probably worth it.

Industry norms become critical when we try to understand substitutes. Take the seventy-year run that paperback books had as a dominant form of spreading a certain kind of idea. At the beginning, they were just a dime, a throwaway item featuring detective stories and romances. As established publishers started putting their books out in paperback, the industry set norms as to what price people should expect to pay for a book. It was a price that was considerably higher than the cost of making a book, but it was also seen as fair, particularly when compared to the price of a hardcover book (the only sensible substitute). 

Because the industry established a price range as a norm, the story of appropriate value was established—not the other way around.

Norms are especially important in markets where the marginal cost of delivering the good or service is really low. How much should image processing software cost? What about a movie ticket? In commodity markets with no marginal cost and many competitors, rational economics would predict that the price would go to zero. But of course, in many markets, it doesn't. That's because industry leaders set a standard and deliver goods that feel fairly priced, so people don't seek inferior substitutes in other markets.

If you're unknown and making a digital good, it makes a lot of sense to charge zero, because it's free marketing, a powerful way to spread your reputation. But the second digital good you make, presuming it's worth paying for, ought to have no substitute, and thus your pricing strategy is very different.

And every marketer must consider network effects. What really creates a lack of substitution is the fact that, due to connections made and stories told, there are no substitutes. If you want to send a fax to someone with a fax machine, you can't buy a typewriter. If you want to share files in Photoshop format, well, then, you're going to have to pay for Photoshop. Money well spent to create the value a network provides.

And for anyone who seeks to offer a good or a service that costs more than the good-enough commodity substitute, we have to understand and embrace the fact that we are in the business of making luxury goods.

Bottled water is an example. A luxury good doesn't have to be for the wealthy--in this case, it's a product with an historically available (and largely free) substitute, and yet many people buy it. And it's worth noting that in most places, a norm for the price of bottled water exists, a norm that's high enough for everyone in the chain to make a profit and to lead to ubiquitous distribution.

Consider the market for ebooks. David Streitfeld, writing in the Times, quotes George Orwell: 

“It is of course a great mistake to imagine that cheap books are good for the book trade,” he wrote. “Actually it is just the other way about … The cheaper books become, the less money is spent on books.”

“If our book consumption remains as low as it has been,” he wrote, “at least let us admit that it is because reading is a less exciting pastime than going to the dogs, the pictures or the pub, and not because books, whether bought or borrowed, are too expensive.”

It's surprising but true that now, books and ebooks are a luxury good, something that (if we're considering all the ways we have to spend time) has many substitutes, costs more than it should, is better than it needs to be and most of all, has a network effect that allows us to tell ourselves and other people a story about what kind of person we are.

Lowering the price of ebooks won't increase the number of people who read them much, as evidenced by how many free ebooks aren't read by everyone (a viral video might be seen by five hundred to a thousand times as many people as a viral ebook). Increasing the urgency, the network effect and the quality (and setting a new, higher norm that allows that) will serve the people who love books in the long run and the short urn.

Booksellers will only be able to do their best work (and enable their industry) when they acknowledge and embrace that this is a luxury good, not something for everyone (most people in the US buy one book a year) but something for people who realize that for the right book, there is no substitute. 

Email and web surfing are a free substitute for reading, even when it comes to reading books that are priced at zero. This blog and many others compete with books every day. There is no price at which everyone will start reading books. Instead, we have to set a norm, figure out a price that (having nothing to do with the cost of delivering one more unit) enables the creation of a powerful stream of goods worth talking about.

That norm elevates a platform for great work.

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