Subject: Fixed-price vs. per-use price

From: "Nadav Har'El" <[email-masked]>
Date: Sat, 28 Sep 2002 02:04:56 +0300

Recently I've stumbled upon an interesting economic tidbit that surprised me.

In the Yediot Achronot economic section from few days ago, there was an
editorial discussing Bezek's pricing plans, and the fact that they have a
fixed monthly fee plus a fee per minute. The guy who wrote that editorial
claimed that it is well-known that for a monopoly it is better (for their
profits) to have fixed price plans (such as all-you-can-talk for 100 shekels
a month) rather pay-per-minute plans. He said that this is why Bezek are now
(after the VAT raise) trying to increase the monthly fee while slightly
lowering the per-minute charges.

At first reading, I thought to myself - where does this guy get his research?
It seemed completely absurd. After all, everybody knows that fixed fees
are better for the consumer than per-use fees, right? Per-use fees, such as
per-minute phone fees, pay-per-view movies and sport events, pay-per-rental
video rentals, pay-per-SMS, etc., are just scams the companies to squeeze
more money from the consumers, right?

Computer and Internet companies have also been trying (or at least talking
about) to embrace the pay-per-use model: pay per site you want to use, pay
per song or movie you want to listen or watch, pay per use of a word
processor, pay per SMS you send online, and so on.

In fact, resisting the per-use fee has become (as I thought) somewhat of a
moto in various free-* communities fighting the software and media giants.
Take a look at all the slashdot articles against things like DRM, renting
movies for 24 hours online, and so on, all the newspaper articles against
paying extra to watch the Mundial on cable, etc.

But I guess I was wrong, and the guy from Yediot was right. In O'Reilly's
Peer-to-Peer book [1] I found a reference to research [2, 3] by Fishburn and
Odlyzko from AT&T Labs, which seems to explain why content bundling and
fixed-price plans actually bring a monopoly more profits than per-use price
plans, and also discuss companies who are in competition.
Interestingly, consumers also seem [2] to psychologically prefer flat-rate
schemes. So we're not likely to see many companies voluntarily convert to
per-use pricing schemes. Ever wonder why there has been a lot of talk of a
pay-per-use word processor but one never materialized? Maybe that's because
Microsoft know that they will profit more from their current system, where
you buy their software and use it as much as you want?

Perhaps pay-per-use pricing isn't as "evil" as I always thought.

After I found this evidence, the claim that fixed-rate price plans are
better for the seller actually make some sense.

For example, how many people who use Bezek's 99-shekels-per-month fixed
price for Internet phone calls actually would have paid more on the pay-per-
minute plans? Not many, I presume. I'm a relatively heavy modem user
(about 2-3 hours a day, on average). And still, these calls cost me as
little as 50 shekels a month.

Another example is those rent-as-many-videos-you-want-in-a-year deals in
video rental stores. You pay as much as you would have paid for, say,
100 movies, but get to take as many as you want. After viewing 50 movies
you realize that you've gone through the store's entire inventory (or
at least through the interesting movies), and that you're sick and tired
of watching movies all the time just to make that deal worthwhile. If
you'd paid per movie during that year, you'd probably only watch (and pay
for) 30 movies.

An even more obvious example is places like gyms, pools and concert halls.
They know that if they charged per-visit, people will come a few times
and quit. So they charge per-year, and some of them do not even give you
the option of a per-visit charge.

Note that the issues that [2, page 5] raise about why consumers prefer
fixed-price plans are still valid. These plans might be less cost-effective
for consumers but better for these consumer's peace of mind.

[1] http://www.oreilly.com/catalog/peertopeer/
[2] http://www.dtc.umn.edu/~odlyzko/doc/price.war.ps
[3] http://www.dtc.umn.edu/~odlyzko/doc/competitive.pricing.ps

-- 
Nadav Har'El                        |    Saturday, Sep 28 2002, 22 Tishri 5763
[email-masked]             |-----------------------------------------
Phone: +972-53-245868, ICQ 13349191 |Earth First! We can strip-mine the other
http://nadav.harel.org.il           |planets later...

---

From: Oleg Goldshmidt <[email-masked]>
Date: 28 Sep 2002 11:55:52 +0300

"Nadav Har'El" <[email-masked]> writes:

> are better for the consumer than per-use fees, right? 

Of course not. It depends (as you yourself pointed out) on whether
your typical usage exceeds the flat fee or not. For quite a long time
I had a purely per-use dial-up account with Netvision ($1/day on the
days I connected), and they kept calling me offering a flat-fee deal
(unlimited usage for a fixed monthly fee). I always asked the nice
girl on the other end of the line to check how much I paid during the
previous 3 months - it was invariably less than the offered monthly
fee.

There are many different factors to think of. I have studied the
pricing schemes of network owners to some (limited) extent in one of
my previous jobs. They are (or used to be at that time, when network
owners were solvent ;-) really intricate, and generally included fixed
price, per-usage, and peak-usage components. The latter can work in
the following manner: your monthly usage is summarized, the 10%
percent of the time your usage was the heaviest were determined, and
you paid for the whole month according to that rate. How about it?

Another common pattern: below certain level, you pay a flat fee, but
once you cross the barrier you pay very stiff per-usage penalty.

The range of SLAs is practically infinite. Clearly, providers factor
their problems, bottlenecks, risks into their pricing schemes. If they
sometimes rip their customers off in the process, I won't be surprised
at all.

Now, the customers' needs might also differ. Let's drop the
residential retail consumer for now, and assume you are a big
organization, just to level the playing field a bit.

Assume you need a service with a certain SLA, and a backup in case the
primary service is unavailable. It is practically obvious that you'd
want a flat rate (assuming you are a heavy user) on the primary, and a
per-use rate on the backup. This is what I have now for my internet
connection: I have ADSL, which is flat rate, and I kept the dial-up
account which is purely per-use, so I am not paying anything for
it. But if ADSL will ever go down (or if I am away from home) I will
be able to use it, paying on a daily basis.

Now let's make you, the customer, even more sophisticated. To borrow
terms from financial markets (yet another of my previous incarnations)
the sell side is often more sophisticated than the buy side, but let's
make the buy side really smart. If you know that there is a variable
component to your costs, and that your costs are to some extent
unpredictable, you can, in principle, hedge, i.e. buy some sort of
insurance against the peaks. In financial markets there are all sorts
of instruments, such as options, that will provide such protection. In
the simplest form, such insurance will convert the variable component
into an additional fixed component, and you can do that independently
of your service provider, even if they don't give you such an option
themselves. Fair pricing of such insurance is a very interesting
and complicated problem. A similarity with familiar types of insurance
is obvious: a disaster strikes, and you either have to pay a premium
rate for backup connectivity or spend a few thousand repairing your
car - no principal difference.

More sophisticated protection schemes may include what would in effect
be options on the average rate, or ceilings on the rate, etc. the
possibilities are infinite.

Going back to the sell side rationale, another advantage of the flat
rate scheme is that the payment can be collected in full earlier. It
not necessarily is, but for variable rate you need to wait till the
end of the month (or whatever the temporal granularity is), summarize
usage, send the bill, wait for payment, etc. Flat rate schemes often
involve automatic payments by credit card or direct deposit order,
sometimes even in advance. For large scale operations a few weeks of
interest amounts to *a lot* of money.

Another consideration for providers is what effect the pricing scheme
will have on usage patterns, and hence stress on the system. Some 10
years ago most internet connections were dial-up. In the US, local
phone calls were (and still are, I believe) charged as a fixed monthly
fee. So a lot of people who had internet access through work or place
of study (such as college or university) simply dialed in and left it
permanently on, since for them it was flat rate. For the
curcuit-switched guaranteed resource PSTN it was quite a load at that
time, I imagine.

Finally, IIRC there is a rather popular political movement in the US
called libertarianism, whose platform includes abolition of taxation
(flat fee, sort of) in favor of paying for all the services on a
per-use basis. In some form, don't grill me on details. I just thought
it would be amusing to mention in the context of possible
psychological preference of flat rate services. 
 
-- 
Oleg Goldshmidt | [email-masked] 
=================================================================
"... Of theoretical physics and programming, programming embodied 
the greater intellectual challenge." [E.W.Dijkstra, 1930 - 2002.]

---

From: guy keren <[email-masked]>
Date: Sat, 28 Sep 2002 21:01:16 +0300 (IDT)

> Perhaps pay-per-use pricing isn't as "evil" as I always thought.

actually, payment for software is different then payment for a service. 
the service provided would charge you a _yearly_ (or monthly) fee - not a 
single life-time one-time fee. for software - you pay for it once, and use 
for a _long_ period of time. now, microsoft _Assumes_ that you replace 
your software every X years, and thus buy an upgrade. so now they offer 
you to rent this software on a yearly bases, with a price such that you'll 
pay the full price of the software after 3 years of usage - but will be 
entitled for free upgrades during those 3 years. 

that sounds fair, but only if you are overlooking an important factor: 
people buy new software now less often then they did in the past, and its 
likely that they'll upgrade even less often in the future. the same thing 
happened in the hardware arena, btw - in the past, people replaced their 
PCs every 2 or so years - and then they did every 3 years, and now this 
figure is rising. thus, by offering a fixed rate price now, microsoft 
perceives that the software upgrade rate is going to drop in the future. 
by renting you software instead of selling it now, they ensure you'll keep 
paying at the same rate as you did before - cause you will _have_ to.

this issue is true, actually, for services that give you some service with 
a payment of 3 years in advance (i.e. various cellular providers in the 
past). the idea is that they _assume_ that prices till drop during those 3 
years - but not for those you have agreed to commit to the deal for 3 
years, and thus will have to pay a penalty if they quit the service in the 
middle of those 3 years - pure extra profit for the provider.

> little as 50 shekels a month.

this is indeed true - and most people don't seem to estmate properly how 
much they want to use a given service - and fall for these traps. many 
people simply don't perform the simple mathematical calculation, or do not 
guess the variance of their usage.

but there is another reason why providers would take flat fee rates - this 
is because it makes their income more predictable, thus making it easier 
to decide how much to spend on various operations - just like you, as a 
singular user, would rather pay a flat fee and know, in advance, that you 
would be able to sustain the spending, then pay a per-usage, and then find 
that your sun over-used the service and you have to pay a fortune. or that 
osmeone stole your internet password, and used your account for a large 
ammount of hours, and now you need to argue about this with the provider - 
you wouldn't have to do that, with a flat fee service.

finally, there is one more (socialistic) reason for charging a flat fee - 
subsudizing the heavy users. suppose that you give some service, that a 
most people want to use only moderately, but a few users want to use very 
very heavily. if you charged a per-use price, those heavy users wouldn't 
be able to afford their heavy use, and would look for a provider that 
charges a flat-fee, and (ab)use their service. you'll stay with only the 
low-use clients, which cost you more in support and with 'steady costs'. 
if you charge a flat fee, you can afford having those heavy users, while 
the low-usage clients cover the loss you have from the heavy users. now, 
why would you want to have those heavy users in the first place, if they 
make you lose money? the reason is that these heavy users are the people 
that the low-use clients refer to, for recommendation of a service. thus, 
the losses on the heavy users actually turn into very low expanses 
advertisement costs. each such heavy user is likely to bring quite a few 
low-user clients, that will earn you extra income that'd justify having 
this heavy-user in the first place.

-- 
guy

"For world domination - press 1,
 or dial 0, and please hold, for the creator." -- nob o. dy