Saturday, November 28, 2009

When selling for zero is a good business

One of the most amazing things I learned during my MBA was the power of auctions. There is a whole science behind it, with elements from game theory, microeconomics and much more. When well understood and incorporated to a business model, auctions can work wonders - just take look at Google and how they manage to get the highest price for every single advertising keyword.

But not only that: the psychology behind auctions is also fascinating. Auctions are much more than finding the customer with the highest willingness to pay. They have hidden, unique characteristics which allow businesses to offer more value to the customers, and also extract more value accordingly. Let's see:

You see a leather jacket on sale for US$ 400. Will you buy it? Is that a good price or not? To answer that, you need references: you think about the last jacket you bought, or some other jacket in a similar store, or even what percentage of your salary this US$400 represents. Complicated. So the store helps you decide: they add a sign that reads: From US$540 reduced to US$400. Wow! That's really cheap now, isn't it?

So auctions offer an even better point of reference: other people. If everyone is bidding for the jacket - four hundred, four hundred and ten, four hundred and thirty... - it must really be worth it.

But how can a business make money with auctions?

Answer number one is have people bid against each other, so that you get the highest price. That's old school - but worked for Google.

answer number two is have people pay to bid.

Some companies have discovered this and turned it into a huge business. The German version I know starts with the product being offered at full price. Each "bid" reduces the price by 20 cents, but for each bid you have to pay 50 cents to the website. The twist comes from the fact that prices are secret and only shown to people when they place a bid.

Why would someone bid? Well, it is true that each individual bid does not make economic sense in itself, but in reality you're paying to discover the current price and have a chance to buy it cheap. The value proposition is very unique. Plus, the value of each bid is so low that if benefits from the "low prince insensitivity barrier".

This is a beautiful, innovative business model. It turns the traditional auction upside down: the company makes money not from selling the good, but from selling the experience, or the thrill of the bargain hunting. In a way, it's just like if all retailers would charge each person coming for a Black Friday 2 dollars entry fee. How much money could they make this way?

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