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\n\t\tOpinions expressed by Entrepreneur contributors are their own.\t<\/p>\n
Setting the price for your product is confusing, and many assume that averages set prices. If you want a clean mental model for why that\u2019s not<\/i> what\u2019s happening, look at power.<\/p>\n
I\u2019m a former quant researcher on Citadel\u2019s commodities team covering power, and one of the most important properties is that the market clears at the economically efficient price.<\/p>\n
It\u2019s supply, demand and various constraints. The price everyone pays is how much it costs to produce the last megawatt of power.<\/p>\n
Once you internalize that, it changes how you think about pricing in your own business, because you stop talking about the \u201caverage user\u201d and start asking what the marginal unit is.<\/p>\n
Here\u2019s the simplified way I think about power pricing: the system takes the cheapest power first, which is solar or wind. Then it moves to more expensive sources, like natural gas and coal.<\/p>\n
Sometimes it\u2019s cheaper to make power somewhere else and send it over a power line. Sometimes you can\u2019t, because the power lines are already full.<\/p>\n
Now the important part: the price that everyone pays is the amount of money it costs to produce that very last megawatt of power.<\/p>\n
Imagine most of the power is cheap; maybe it\u2019s coming from wind or solar. But the last bit of power needed to meet demand is expensive. That last megawatt sets the price, so everyone ends up paying the expensive price, not the cheap one.<\/p>\n
That\u2019s the whole point: once you see \u2018the last unit sets the price,\u2019 you start asking what the last unit is \u2013 and what\u2019s driving the cost.<\/p>\n
If you want to figure out what your \u201clast unit\u201d is in a business, start with your own costs. Ask: For your lower cost vs. higher cost offerings, how many customers can you actually support?<\/p>\n
This is where founders can get tripped up. They\u2019ll talk about \u201cthe average user,\u201d or what they personally like about the product, and then they\u2019ll try to price off that. That\u2019s a question about your customers\u2019 preferences. But the marginal cost is a property of your own production process.<\/p>\n
For example, enterprises use Google Docs for the sharing and collaboration features. They use it for storage. They have various needs that Google bears some cost to support. And Google, in theory, only has so many resources. If they get a big enough customer, they literally do have to go out and buy more compute to support that customer. That\u2019s the customer who\u2019s setting the marginal price. I use Google Docs for free as an individual, but I\u2019m not setting the price as an individual because I\u2019m a low-value user.<\/p>\n
That\u2019s the competitive market pricing mistake hiding in plain sight: if you build your pricing model around the value that the low-value user gets, you end up acting like the \u201clast unit\u201d doesn\u2019t exist. But it does exist. You just have to look for it.<\/p>\n