Thursday, July 31, 2008

How to Price Virtual Goods: Anchor Pricing and Free Gifts

With the flurry of virtual goods soon to come to market in the gaming space, the question consistently raised to me by gaming folks is: how do I set a price for a virtual item?

My stock answer: as high as possible.  After all, the value of a virtual item in the eyes of a consumers is established by price as much as by the quality of its graphical representation (i.e. no cares about Susan Kare).  So now, I'll tell you why I think you need to price things as high as possible (i.e. as much as the top 1% of consumers will pay - after all that's where most of your revenue will come from, anyway - just ask Mike Sego of (fluff) friends or Daniel James of Three Rings.)

Anchor Pricing

It's all about anchor pricing.  An anchor price is the price we expect to pay for something in a particular category.  For example, I expect to pay around $1.50 for a cup of black tea.  This morning, I paid $4.10 for a cup of black tea and I felt ripped off even though it was supposedly premium tea.

For most American consumers, virtual items are an entirely new category and therefore have no anchor price.  As an industry, we have the opportunity to establish them, here's what the blog Neuromarketing says about setting anchor prices for a new category:

"The more interesting challenge is how to deal with new products for which consumers have no clearly established anchor price. Ariely’s research (from the book Predictably Irrational which I recommend - Bret) shows that anchor pricing for such products is quite fungible, and marketers would do well to avoid inadvertently establishing a low anchor price. If a higher anchor price can be established, then offers involving lower prices will be attractive to consumers. Apple’s iPhone marketing has done a good job of using anchor pricing to keep demand strong. When they first released the iPhone, it was at a price of $499 to $599, establishing the initial anchor for what the unique product should cost. To the chagrin of early adopters, they dropped the price by $200 after only a few months - creating an apparent bargain and stimulating more sales. When they introduced the iPhone 3G, pricing was as low as $199, and they sold a million phones in three days.

There are many reasons why marketers start with a high price initially. One big one is to work the demand curve, i.e., get a high price from the portion of the market willing to pay that much before dropping the price to reach a larger number of customers. A key benefit of this strategy for new products, though, is that a high anchor price is established in the minds of customers, making each subsequent reduction a bigger bargain."

A decent argument for starting your prices high.  But unfortunately when it comes the category of virtual gifts on Facebook you have some history with which to contend.

Free Gifts on Facebook

When your virtual items live on Facebook, two anchor prices may affect consumer perception: One dollar and FREE.

Facebook charges one dollar for their virtual gifts, and for many Facebook users this was their introduction to virtual goods as a category.  Of course, then Free Gifts, with their motto "Gifts should be free" came along and established free as the anchor prices for virtual gifts.  Other apps followed, and now millions of free gifts are exchanged on Facebook.

But a virtual goods strategy on Facebook expects users to pay for the same thing they were used to giving for free.  Crap!  Before we all descend with torches upon Zach Allia (the creator of Free Gifts who now works at SGN), keep the following in mind:

Fortunately, as I stated earlier, the value of a virtual item is established by price.  When giving a gift, a consumer will generally opt for a gift with a perceived value that mirrors the value that person has for the relationship.  For Xmas, you give your girlfriend a Kate Spade purse, while you give you second cousin a discounted Kwanzaa card...if he's lucky.

The key to pulling virtual gifts away from the free price point is to make the price point egregiously clear to the gift recipient and anyone who sees it on their profile.  It may be crass to leave the price tag on a gift, but with a virtual good how else can someone know if the picture of a teddy bear is worth one dollar or ten dollars?

Of course, the problem arises when a two very similar teddy bear pictures are priced vastly differently by two different app makers.  This problem doesn't arise when you control the economy as in virtual worlds like Habbo Hotel or Whirled.  However, in an open economy like Facebook where prices for a virtual item can be set by anyone with a little PHP knowledge and access to Google Images, the maintaining higher prices is pretty impossible.

It's my speculation that the need to maintain artificial (non-market determined) prices will be the most powerful reason for social games company to establish their own destination site using Facebook Connect to leverage the social graph, but maintaining their own context where they can control their virtual economies.

And if that doesn't work, we can always sell Zach Allia's body parts, at a healthy markup, of course.