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October 11, 2001
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*Chapter 11 Info*

Priceline's Magic Show

Issue Date: Apr 24 2000

The name-your-price retailer has an old trick up its sleeve.

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There's an old saying among magicians: "If you know 100 ways to find a card and one way to reveal it, the audience thinks you know one trick. But if you know one way to find a card and 100 ways to reveal it, the audience thinks you know 100 tricks." The same is true in business models: There are only a few ways to make money, but there are a lot of marketing gimmicks that make them appear different.

The "new market models" used by and other online merchants are a good example. Priceline uses the name-your-own-price or reverse-auction model. If the merchant accepts your price, you get the goods. Priceline started out with airline tickets but has subsequently expanded to hotel rooms, rental cars and, most recently, groceries. It has also announced plans to sell gasoline using the same model starting in May.

Priceline has a patent on the reverse-auction model, which is currently being challenged by Microsoft (MSFT) (it wants to offer a similar service). Priceline has a market cap of $11 billion - not bad for a virtual business that has never had a profitable quarter.

But what is really going on with Priceline? Why should consumers expect to get a better deal from the company than from any other purchasing model? To understand Priceline, we have to think about the basic economics of shopping. The critical point to recognize is that all consumers aren't created equal. Some have strong brand preferences, while some are sensitive to price and care little about brands. A smart merchant would like to sell at a high price to those with strong brand preferences and at a low price to those who are not so loyal.

The trouble is that the price-sensitive and the price-insensitive shoppers look the same when they walk into a store, so merchants have to come up with a way to get them to identify themselves. Coupons are a common device: If you are willing to go to all the trouble of clipping the coupons and schlepping them to the store, you must be price-conscious - otherwise you wouldn't bother.

Economists say that coupon clipping is a costly signal of price sensitivity. Note the adjective "costly." A signal has to be costly, otherwise it wouldn't be effective in separating the price-sensitive and price-insensitive groups. Look at how Priceline does this same separation online. When you bid for a travel ticket, you are asked whether you are willing to be "flexible" in your departure time, number of connections and type of aircraft. Similarly, when you bid for groceries, you are asked to "tell us two or more brands you like."

Consumers, by revealing their flexibility, are signaling that they are sensitive to price. Indeed, the very act of going through the "bidding" process for the online grocery purchase is the same sort of mindless activity as clipping coupons - busywork designed to separate the sheep from the goats.

Jay Walker, Priceline's founder, is upfront about what's really going on. In a Jan. 6 interview with the New York Times, he said, "The manufacturers would rather not give you a discount, of course, but if you prove that you're willing to switch brands, they're willing to pay to keep you."

The new gasoline model is a variation on this theme. Customers will "name a price" and indicate whether they want a particular brand or are willing to accept substitutes. Oil companies have long known that only about a quarter of gasoline purchasers are price-sensitive, and they invest a lot in marketing to try to push that number even lower.

But if the customer is willing to do the equivalent of clipping Priceline's coupons, the oil companies will give him a price break, because he is almost certainly one of those 25 percent who values price more than brand.

Priceline has a good trick, but it's not new - it's just another way to reveal the card. The basic economics is the same as with coupons: Segment the market by creating a costly signal.

Hal R. Varian is dean of the School of Information Management and Systems at the University of California at Berkeley and coauthor of Information Rules.

* Microsoft Corporation (MSFT)

*Read the Instructions
Jun 04, 2001
*The Divide Divide
Jun 04, 2001
*The Net Effect
May 28, 2001

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