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 / First Quarter 2000 / Issue 18(originally published by Booz & Company)


To Hal Varian, the Price Is Always Right

With his quantitative background in the economics of information, Mr. Varian's skill is building simple but powerful economic models to explain information marketplaces. His work is widely cited, and - perhaps more importantly - attracts interest from computer scientists and financial engineers who derive inspiration from his observations.

For example, a recent Varian paper explores why it makes more sense - and even more dollars - for software developers to invest the bulk of their design efforts in making their programs friendlier to new users rather than more valuable to existing users. In rapidly growing software markets, the additional new user is far more valuable than a happier existing user. As Mr. Varian's differential equations counterintuitively affirm, software vendors rationally grow their marketplace at the expense of an installed base - a conclusion sure to confound advocates of relationship marketing, even as it helps explain the success of your friendly neighborhood software giant.

These kinds of insights comprise the bulk of "Information Rules" (Harvard Business School Press, 1999), co-written by Mr. Varian and his Haas Business School colleague Carl Shapiro. A value-added Economics 101 primer that views straightforward economic thought through the prism of an Internet Economy, "Information Rules" explains how economic theory and Internet marketplaces are colliding.

Talking with Mr. Varian, however, provides a more interactive perspective on the future of Internet economics. Where C.E.O.'s once devoted their energies to cutting costs, clever marketing and enhanced innovation, says Mr. Varian, in the Network Economy, their efforts must focus on creating compelling and cost-effective market mechanisms. Designing the right kind of auction will have as big an impact on the brand, customer loyalty and profit margins as designing the right kind of products. Tomorrow's marketplaces, in short, will be every bit as dynamic, customizable and innovative as tomorrow's products. "Everything's negotiable," Mr. Varian asserts cheerfully.

Mr. Varian predicts with equal good humor that the economic era of posted prices is rapidly coming to an end. If you want to know what pricing will mean in your business, he says, try buying an airline ticket. When you buy matters as much as how you buy. Price is no longer the place where supply intersects with demand; it's a vast continent of potential, where optional opportunities interact with multiple inquiries. You can use human agents, deploy software agents, or do it yourself on the Internet. You can create your own ticket auction or participate in someone else's. A single coach-class airline ticket may spawn a thousand different price points in the span of a single week.

As we move into a new millennium, dynamic pricing has become the rule. "Yield management," says Mr. Varian, "is where it's at."

Yield management refers to those irritating algorithms that explain why four weeks ago a coach ticket cost your seatmate $299, but cost you $1,852 the day before yesterday. Yield management is the science of segmenting the price-sensitive customers from their price- insensitive counterparts.

Say you're an airline C.E.O. If there are 180 seats on that Boeing 737 from Chicago to Washington, D.C., what is the optimal allocation of seats between the price-insensitives, who will pay a premium, and those time-insensitive bargain hunters who purchase 21 days in advance? Do you price to maximize market share per route, or to maximize profit per plane? How quickly can you reconfigure the pricing system to flip from one profit paradigm to the other? Literally billions of dollars ride on the answers to those questions.

In the Internet Economy, these calculations and counter-measures are fast becoming part of the purchasing process for practically all businesses and all customers. Even the Coca-Cola Company is trying to launch vending machines that will charge you a dime more for a can of Coke when it's really hot outside.

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