Pricing and revenue models

Can the firm set its own price?

Companies in markets with many competitors and little or no product differentiation are price takers: they receive the market price set by supply and demand. They are commodity producers . Wheat farmers, crude oil producers and makers of standard-grade steel are examples.

Companies with few competitors or highly differentiated products have pricing power : the ability to keep prices above costs, or raise them, without losing much demand. A firm without pricing power usually pursues cost leadership , aiming to be the lowest-cost producer, as discount grocers and no-frills airlines do. The market structures lessons in Economics explain why: perfect or near-perfect competition leaves no room to set prices.

What is a pricing model?

A pricing model describes how customers are billed for units of a product or service. Many exist because “a unit” can be defined in many ways, and prices can vary by quality, units sold, channel, customer size and type, or unit cost.

Firms often leave list prices alone and use discounts, promotions and bundles instead. Customer A may get an offer that customer B does not, and the firm adjusts the generosity of promotions rather than the published price. The price after these adjustments is the net price .

$$N = L\,(1 - \delta)$$

Here $L$ is the list price and $\delta$ is the total of discounts and promotions as a share of list.

Pricing and revenue modelshow customers are billed

• Different prices for different buyers Memorize price discrimination
  • Tiered pricing Memorize by volume or feature level
  • Dynamic pricing Memorize by time, supply and demand
  • Value-based pricing Memorize by value delivered to the customer
  • Auction / reverse auction Memorize bidding sets the price
• Multiple or complex products Memorize one customer, several items
  • Bundling Memorize products sold together
  • Razor-razorblade Memorize cheap durable item, high-margin consumables
  • Add-on pricing Memorize optional extras after the main purchase
• Growing the user base Memorize scale first, profit later
  • Penetration pricing Memorize low prices to win share
  • Freemium Memorize basic use free, pay for more
  • Hidden revenue Memorize users pay nothing; others pay
• Use without owning Memorize recurring payments
  • Subscriptions Memorize recurring fee for access or delivery
  • Leasing Use it physical assets such as real estate
  • Licensing Use it intellectual property
  • Franchising Use it a full business system and brand

Which models charge different customers different prices?

The aim of price discrimination is to maximize profit when customers differ in willingness to pay. It can also make sense when some customers, such as large-volume buyers, cost less to serve. Four common forms:

Model	How it works	Own example
tiered pricing	price varies with volume purchased or feature level	basic, plus and pro editions of one app
dynamic pricing	price varies with time, supply and demand	concert tickets that rise as seats sell
value-based pricing	price set by the value the customer receives, often estimated from the customer’s opportunity cost	scheduling software priced on the staff hours it saves
auction and reverse auction models	a bidding process sets the price, now automated by digital technology	online advertising slots sold by auction

Value-based prices differ across products because the value delivered differs. A tool that spares a factory a week of downtime can be priced far above one that saves an hour.

How do firms price several or complex products?

Three models suit firms that sell multiple or complex products.

Bundling combines multiple products or services so customers are encouraged, or required, to buy them together, usually at a discount to the sum of the parts. It works best for complementary products with high incremental margins and high marketing costs relative to the product cost, such as a ski resort selling the lift pass, equipment rental and lessons as one package.

Razor-razorblade pricing combines a low price on the initial equipment with high-margin prices on the repeat-purchase consumables it needs. Examples: a low-priced water filter jug with pricey cartridges, or an electric toothbrush sold cheaply with costly replacement heads. Firms often design the equipment to work only with their own consumables. If other companies sell generic consumables, the model can become unprofitable.

Add-on pricing sells optional services or features, either at the time of purchase or during use. The firm tries to price the add-on profitably once the customer is committed, such as extra baggage on a flight or in-app purchases. Pushed too far, it damages customer goodwill and reputation.

Exam tip Razor-razorblade: you cannot use the cheap item without the dear one. Add-on: you can, but you might want the extra.

How do firms price to grow quickly?

A firm that wants to expand its footprint quickly may use penetration pricing , willingly pricing low or discounting to build scale and market share at the expense of margins. It works like a marketing expense for acquiring customers. A new streaming service charging half price for its first year is an example. If it continues for a long time, regulators may see it as unfair or anti-competitive, and investors may ask when, or whether, the firm will make a profit.

For digital businesses, growing the user base is often the main goal. The cost of one more subscriber is often tiny, and benefits can be large: word of mouth and, possibly, network effects. Two pricing models encourage trial and adoption.

• The freemium business model gives customers a level of usage or functionality at no charge (or with ads), for example a note-taking app with free basic notes and paid sync. It is widely used in digital services with network effects when the firm is scaling up.
• The hidden revenue business model gives services to users at no charge and earns revenue elsewhere. Media with free content and paid advertising is the classic case. Online marketplaces where sellers pay and buyers do not, and financial services that appear free, are others.

How do firms charge for use without ownership?

Some models let customers use a product without buying the asset. Simple electronic invoicing and payments, and the value that businesses and investors put on predictable recurring revenue, have spread them into new areas.

Subscriptions deliver products, services or access to them in exchange for recurring fees. They were traditional in media and utilities and now cover application software and cloud computing. Fees may be fixed, discounted for promotional offers, tiered by features, or based on usage, as in utilities, payment processing and cloud computing.

Leasing , licensing arrangements and franchising are different, but all are like subscriptions in that they involve recurring payments for the transfer of property or access to it, not a product. Leasing is typically used for real estate or another physical asset. Licensing is for intellectual property, such as a cookware maker paying a celebrity chef a royalty to use the chef’s name. Franchising is a more comprehensive form of licensing: the franchisor gives the franchisee the right to sell or distribute its product or service in a specified territory, along with marketing and other support, and the franchisee typically pays the franchisor a share of its sales.

Go deeper Why investors value recurring revenue

Subscriptions and leases make future revenue more predictable than one-off sales. Predictable revenue lowers the uncertainty in forecasts and can support a higher valuation. It also makes customer retention a central measure: a subscriber who stays pays back the cost of winning them, as in the unit economics check in the first lesson.

Go deeper When price discrimination goes too far

Charging customers different prices is lawful in most settings, but regulators and customers can object when it looks unfair, targets vulnerable buyers or is used to shut out rivals. A business model that depends on opaque, personalized prices can therefore carry reputation and legal risk. Analysts should ask whether price differences rest on cost, volume or willingness to pay that customers would see as reasonable.