Rafi Mohammed

Razor-Razor Blades, PlayStation 3-Game Cartridges, CDs-Rock Concerts: Pricing Products with Correlated Demands

Posted on December 15th, 2006 (0 Comments)

Pricing products with correlated demands poses a unique challenge for companies. The concept of “correlated demands” is not as complex as the phrase implies. Correlated demand simply means that demand for one product is related (influenced) to sales of another product. A classic example is razor and razor blade sales. Demand for razor blades is directly tied to how many customers purchase a razor. As a result, a fundamental pricing axiom is to set low prices on razors (attract as many customers as possible) and make your money from razor blade sales. Sony has taken this pricing axiom to the next level. Sony recently released its long awaited PlayStation 3 (PS 3) in two versions: a 20GB model priced at $499 and a 60GB model priced at $599. Here’s what’s interesting: industry insiders estimate that Sony loses $306.85 on each 20GB model and loses $241.35 on each 60GB model it sells. Pretty unbelievable, don’t you think? Sony incurs these significant losses in hopes that once a gamer purchases a PS 3, it can make up these losses and rack up profits from game cartridge sales.

Suppose that Sony only profited from game console sales and did not make money from cartridge sales. Well…there’d be no way that it’d sell PS 3 consoles at a loss! If this were the case, Sony would raise prices on PS 3 consoles (thus reducing demand) and as a result, sales for game cartridges would suffer.

Companies that control both correlated demand products tend to price the “razor product” lower and the “razor blade” product the same or higher. “Razor blade” prices can be increased to capitalize on additional demand generated from lower priced “razor” sales. Just to be clear, the “razor product” does not have to be priced at a loss, it just should be priced lower than if “razors” and “razor blades” are sold by two independent companies.

The music industry is a classic example of pricing products with correlated demand. Successful musicians profit from CD, concert, merchandise, ring tones, and commercial sales. For most artists, demand for ancillary products (concerts, ring tones, merchandise, and commercials) is correlated with CD sales. Much like pharmaceutical companies invest for their next blockbuster drug, music companies heavily invest (recording, publicity, marketing) to make an artist a blockbuster star. Mass adoption of an artist’s CDs is a key driver for ancillary products sales. Interestingly enough, music companies typically do not profit from these ancillary products, despite playing a significant role in creating demand for these products.

Jeff Leeds, a New York Times writer, recently wrote a fascinating article titled Squeezing Money from Music. Jeff mentioned that music companies are now demanding that new artists share profits from these ancillary products. Here’s what’s interesting, if this model of profiting from all of an artist’s income streams catches on, music companies will have a financial incentive to lower CD prices. Additionally, with new profit as a carrot, music companies will invest more to promote artists. It’s a classic correlated product demand pricing issue: CDs are the razors that bring in the profits from razor blades (concerts, ring tones, merchandise, advertisements). Lower prices will also promote growth in the faltering music industry - music companies will be able to better compete against low priced iTunes single sales and piracy. Fans benefit from lower CD prices, music companies & artists make more profit – what’s not to love about correlated demand product pricing?

An important footnote to keep in mind, the tie between CD sales and ancillary products is strongest for up-and-coming bands. For these bands, fans go to concerts to hear the latest hits being played on the radio. For well-established acts like the Rolling Stones, new CD sales don’t have as much of an impact on ancillary sales. Despite garnering rave reviews for their new CD titled A Bigger Bang, my bet is that like myself, most fans attend a Rolling Stones concert to relive classics such as Satisfaction, Midnight Rambler, and Honky Tonk Woman.

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