From RadioHead to restaurants, hotels, real estate, graphic design services, magazines, and even ballet performances, the idea of pay-what-you-like pricing has really been catching on. The viral nature of the pay-what-you-like pricing-scheme scheme has proven very successful for many companies. But why? How does it work? Nate Chenenko offers a unique service in the Washington, D.C. area as a bicycle taxi driver and has agreed to share some of his views on the subject of pay-what-you-like pricing. I hope you enjoy his guest post here on EdgeHopper about this interesting topic. Thanks Nate. (By the way, that’s Nate in the picture above)
GUEST POST FROM NATE CHENENKO:
O.K., I confess: I’m a moonlighter. On weekdays I write and administer government contracts, but on the weekends I pedal a bicycle taxi, also called a pedicab, around the streets of Washington, DC. I really enjoy the physical and social aspects of the job, but it’s the economic and business aspects that truly intrigue me. I’m particularly attentive to the intricacies of pedicab ride pricing, and I’d like to use this opportunity (thanks Chris!) to discuss the theory behind pedicab pay-what-you-like pricing.
It’s tough to sell pedicab rides, and I estimate that I typically experience a failure rate of over 99%. When people visit a shopping mall, they visit because they are either interested in buying clothes, or interested in the idea of browsing, of seeing clothes to buy. When people visit the National Mall, they don’t come to buy pedicab rides, they come to visit the museums and photograph the monuments. Since I only expect one person out of one hundred to indicate any interest, it’s critical that I convert that an interested person into a customer.
The first question potential customers typically ask is “how much do you charge?” When I answer, they don’t realize how carefully I’ve crafted my response: “Whatever you think is fair. Pay when we get there!”
This statement comes as a shock to some people and a surprise to most. Our economy, once so centered on bartering and trade, has in recent years become much more fixed in its pricing schemes. I’m only 22, but I remember when my father taught me how to haggle with the hot-dog vendors in Manhattan. That was ten years ago. Try to do that now and they’ll laugh you straight to the next block. But take a pedicab ride in many cities across the country. You’ll enter a scenario where you’re receiving a service with no concept of what you should pay the service provider.
The second question I typically receive from potential riders is “Why? Don’t you get cheated a lot?” My answer: “Very rarely.” Again, riders don’t realize the consideration behind that sentence fragment, but the response is completely true. I rarely get cheated. I rarely get cheated, but I do many rides where I receive less money than I’d like. Often I’ll take customers on a long ride and receive a four-dollar tip when I would have asked for ten or 15 dollars.
So if it’s common to receive low tips, isn’t that great justification to start charging a set fare? Absolutely not, and there are four reasons to avoid set pricing. The first reason is a loose application of opportunity costs. For example, if a family of three with a toddler asks for a ten-minute ride, they might be willing to pay five dollars. What if I ask for seven dollars? A six-hour shift yields an average of only ten to 20 rides, and an average of $150 in gross earnings. After a half-year spent on the pedicab, my gross fares average out to about 25 dollars per hour. With that data, I know my opportunity cost is $25 per hour, and I should engage in any activity from which I expect to earn more than $25 per hour. Theoretically, I can do six ten-minute rides in an hour. At $25/hour, this means that my opportunity cost for ten minutes is just over four dollars. This means the family of three who is willing to pay five dollars for a ten-minute ride exceeds my opportunity cost. I should certainly take their business and provide a ride. If I were to set a fare of seven dollars, I lose a hard-to-find customer. I’ve failed to consider my opportunity cost when making business decisions, and I’ve lowered my potential profit for the day.
A second rationale for charging a pay-what-you-like rate is purely related to marketing: I want people in my cab. I want the hundreds on the sides of the street to see that laughing toddler as his pedicab speeds down the road. I want people to see a cab not as a gimmick that no one actually uses, but as a legitimate, enjoyable mode of transportation. More rides at noon leads to more people in my cab for the rest of the day. This is why I don’t mind competition from other pedicabs – competitors help put the idea of a pedicab ride into the minds of pedestrians.
The third reason for avoiding set fares focuses on the entertainment aspect of pedicabs. At the beginning of the ride, that cute toddler’s parents were willing to pay five dollars. At the end of the ride, when the child says how much he’s enjoyed himself, that ride might be worth ten dollars. Setting a fare at the beginning of the ride keeps that additional five dollars out of my pocket. Ever buy a book and absolutely love it? If I get halfway through a John Grisham novel, you might be able to sell me the second half of the book for twice the price. Prior to purchase, my expected level of enjoyment was just that: an expectation. On page 200, however, I have a higher level of information about the product, and my demand adjusts accordingly. A pay-what-you-like pricing system accounts for that change in demand as one consumes a service.
But it’s truly the fourth reason that ensures I will never charge a set fare. This is a risk-management concern, and it’s heavily influenced by economics as well as observed evidence. Readers who invest in the stock market have no doubt heard of upside potential and downside risk. I think about these devices constantly while working on my pedicab. Let’s use the example of a fare for which I would typically expect (and typically receive, based on evidence): 15 dollars. A 15-dollar fare might take a customer from the Washington Monument to the Lincoln Memorial. My downside risk on this ride is 15 dollars – it’s possible the customer could jump out and run away. This is highly unlikely, but it still represents the lower bound of the risk spectrum. My upside potential is infinite, as it’s possible I could get a multimillion-dollar tip. Unfortunately, this is also unlikely.
Let’s narrow the parameters based on the evidence. I’ve received four dollars for a 15 dollar ride, and, as a result, I’ve “lost” or “been cheated out of” nine dollars. I’ve also received 50-dollars for a 15-dollar ride. How many “losses” can that 35-dollar gain cover? About four, and that’s the reason I don’t charge a fare. Pay-what-you-like pricing allows for the possibility of that 50-dollar fare while reducing the opportunity for losses to five or ten dollars. In other words, I’ve tightly limited my downside risk while preserving my entire achievable upside.
Pay-what-you-like pricing maximizes the customer base because price details will never turn a customer away. This in turn contributes to my bottom line as well as my marketing image. It allows for the retrieval of otherwise-lost “demand” that occurs during service provision. Additionally, pay-what-you-like pricing allows me to capitalize on the big tipper, the guy at the top of my upside potential spectrum. But maybe it’s possible to make my system better. If you have suggestions or comments, or you simply enjoyed this piece, please post below in the comments. I’d also love to hear feedback directly. Please, email me at Chen...@gmail.com.