Optimal pricing of close to zero marginal cost content
With near zero marginal cost, and infinite supply, your prices are going to be decided by entry cost, competition, and what the market will bear. Generally speaking, though, there are no accurate models for getting these kinds of optimal prices in advance - your best bet is to test, experiment, and then build a business and market specific model based on what you observe.  Look at the Steam network, as an example. They are in the business of selling 0 marginal cost software (games), in a market with a significant but quickly decreasing entry cost, and with solid competition. Despite being around for years in a mature market, they're still discovering unexpected optimal price points when testing how their customers behave. "It seems this will be very much driven by price discrimination.  If there are some customers who will pay up to $100, sell at that; and if there are others who'll pay $1 sell at that price. For instance you see computer games, which have zero marginal cost of production, sold at ""normal new release"" prices, at premium prices with a special box or doo-dad, and at discount prices once the game is a bit old." "Software or any online service fits this category I suppose.  There are two apps I pay for that are ""free."" Evernote and Pandora.  Evernote is free for 40MB, $45/yr for 500MB/mo transfer. Pandora is free for 40hrs/mo, $36/yr unlimited. When I use a free product and hit the limit it's a sign to me that I value that product and the owners deserve to get paid. To me, both products provide value that's well above the cost they are asking. In this case, both products are annual subscriptions, but offer monthly as well.  You don't mention the type of product you have, the two I listed are similar in billing type, but very difference end uses. The question is - How do you provide value and make your customers want to pay you?  BTW - the ~$40/yr give or take, seems a good price point. Under $50, it feels a fair price to pay for a useful product."
"I agree completely.  ""I don't always agree with John Cochrane, but when I do, I agree completely.""  I think heavy reliance on either approach to pricing is generally a bad idea.  Equilibrium models always include something that you're supposed to inherently know, but never do.  No-arbitrage models don't necessarily *say* anything that you don't (in some mathematical sense) already know.  So you're either stuck with unknown parameters, or you can't explain why you're something is worth what you say it is beyond, ""Herp derp, other people are doing it.""  So I think if buy-side people made some use of no-arbitrage models, they'd have a better understanding of the parameters they're making up, and if sell-side people sometimes used equilibrium models, they'd have a better grasp of what's going on economically.  Also, it would have the beneficial effect of reminding people that their models are always wrong, even if they're frequently useful." "I highly recommend http://pages.stern.nyu.edu/~adamodar/ Professor Damodaran. He's written some of the best valuation books in existence (my favorite, simply ""Investment Valuation""). On his website you'll find a big pile of spreadsheets, that are models for working the various approaches to valuing a company.  Also, he teaches an MBA-level valuation course at Stern School of Business in NYC. And he videotapes it and you can watch it for free. Very smart, kind, generous man." ZeroHedge is valuable because it provides an alternative perspective. I rarely, if ever, agree with their conclusions or make investments motivated by them; but they are sometimes insightful and bring up datapoints of interest.  Most financial journalism is written by non-finance people; that's why it's so shitty and useless. Hold on a moment - you were getting 5-7.5% commission on a product that only had a 40% gross margin?  That's.... amazingly high.  Really.  Considering that you are saying that the cost of goods sold for a typical TV is 60% (which sounds close enough to be realistic - my business is typically about 56% COGS), and then add to that the overhead of base salary, utilities, leasehold and leasehold improvements, taxes, operating costs...  Sears was probably making a final total of about 2% net margin on that TV sale, which isn't particular great.    Getting paid a commission that high on commodity goods is really quite good. There are companies who sell data gleaned in aggregate from credit card providers to show how much of what category of product is sold online or offline, but that data is not cheap.  1010data is one such data aggregator we are talking to right now. Haven’t seen pricing yet but I expect 6 figures to access the data The profit maximising level of employment: Now we consider how many people a business might decide to employ. The profit maximising level of employment occurs when a firm hires workers up to the point where the marginal cost of employing an extra worker equals the marginal revenue product of labour. I.e. MCL = MRPL.  This is shown in the labour demand diagram shown below.  http://tutor2u.net/economics/revision-notes/a2-micro-demand-for-labour.html  So the cost of each additional unit of labor is 8 (MCL = 8) as the wage is 16/hour and Q = 2*L in the short run. Find the right quantity produced by taking dP/dQ of your original inverse demand curve, which will give you the marginal revenue of each product. Set it equal to 8 and solve for q. "So it seems like a lot of people here aren't exactly sure about why this works and its financial implications.   So what you are referring to is in Finance something called Funds Transfer Pricing or FTP (often referred to as just Transfer Pricing). Like anything else, FTP has its place. Most companies; however, don't use it properly. FTP, theoretically, has one primary purpose (although it's developed a second): to properly allocate opportunity costs across divisions.  Let's say Company A produces widgets. They sell these widgets for $200 at a TOTAL COST of $150 and book profits of $50. Now to produce the widget Division 1 makes a computer chip at a cost of $50 that it then ""sells"" to Division 2 for $60. Division 1 then books a profit of $10. Division 2 then makes some plastic stuff and assembles the device. This is labor intensive so Division 2's costs are $100. Company A sells the completed device for $150. Division 2 subsequently books profits of $40, and appears much more profitable than Division 1, on the surface.  The problem arises when Division 1 could sell the chip to the open market for $125. Now it costs them $50 to produce, and they could make a theoretical profit of $75. This is MORE than the company makes AS A WHOLE on the entire device. By having Division 2 pay effectively ""fair market price"" for that chip, you realize that Division 2 is really operating at a loss (the *opportunity cost* of not selling the chip to market is greater than producing the completed device). Company A would be better off getting rid of Division 2 and solely focusing on Division 1. In a good FTP system, Division 2 would pay the fair market price of $125. If done properly, management would  hopefully realize it should divest Division 2.  That's the ***fundamental premise*** behind FTP. In actuality things get much more complicated because of economics, the company itself, branding, IT, operations, management, PPE, labor laws, etc. Thats why most companies screw it up. All that other stuff falls under whats called cost allocation accounting. It gets VERY complex and entire masters courses are dedicated to it (different methods, etc.)   The other thing you can do with FTP is get crazy tax breaks due to various tax laws. The simplified explanation is that divisions pay taxes on profits to the government ***that division*** is located in (this works on the state level, too btw.). GE does a lot of this and it's a big part of why they pay almost no-taxes. Again, it gets more complicated when you involve audits as there's some grey area legally.   For simplicity, assume tax rates are 40% in the US and 10% in India. So let's say GE makes an airplane engine in the US but ""finishes"" manufacturing in India. These specific engines costs $5,000,000 for the US division to make, up to a certain point.  The US division can then sell the engine at a break even to India. So India ""pays"" $5,000,000 for the engine. The US division then books no profit. India finishes the manufacturing with additional costs of $1,000,000. The India division then sells the engine to the open market for $9,000,000 . Therefore, the India division books a profit of $3,000,000 and pays taxes of $300,000. Now GE as a whole makes a profit of $3,000,000 less taxes of $300,000 = net profit of $2,700,00.  Further, let's say the fair market value of the engine, as is, when the US sells to India is $7,000,000. That would mean US ***should*** book profits of $2,000,000 and India ***should*** book profits of $1,000,000. Total taxes by GE are now $800,000 (US) + $100,000 (India) = $900,000. However, what's important is that NET PROFIT is now $2,100,000. ***GE just saved $600,000 in taxes by doing this***. The beauty of this is, divisions are supposed to charge fair market value for products FTP'd internationally; however, it's REALLY hard for the IRS to say what the value of an unfinished product really is (heck, you could be offering bulk discounts, etc.)...  The fact is, often, US divisions have skilled labor that is difficult to replicate elsewhere. They just show US divisions operating at losses to make the company as a whole better. The problem, again, arises when top management don't fully appreciate or understand the reasoning behind this stuff. They end up making cuts to US labor because it's ""unprofitable"" without thinking about the entire story.   I know this is very long winded but hope it helps!  ***tldr; companies FTP to recognizes profitability and opportunity costs of divisions as well as use it for overseas tax breaks.***  Side note: Politically speaking, people who know how this works are pissed off about it in the U.S. (don't worry though, most politicians on both sides don't have a clue). We have high corporate tax rates relative to other countries and IRS loopholes allow this kind of thing (lobbying $$). It's also why, economically, you can't just raise ***corporate*** tax rates to increase domestic tax reciepts as more companies will just implement this process (it's complicated to do properly). Also, please don't say 50 years ago tax rates were higher and raising taxes increased receipts. The fact is most companies couldn't even FATHOM doing this 50 years ago, no less even 20.  edit: some clarification in wording" Unfortunately I believe there is not a good answer to this because it's not a well posed problem.  It sounds like you are looking for a theoretically sound criteria to decide whether to sell or hold.  Such a criteria would take the form of calculating the cost of continuing to hold a stock and comparing it to the transactions cost of replacing it in your portfolio. However, your criteria for stock selection doesn't take this form.  You appear to have some ad hoc rules defining whether you want the stock in your portfolio that provide no way to calculate a cost of having something in your portfolio you don't want or failing to have something you do want.  Criteria for optimally rebalancing a portfolio can't really be more quantitative than the rules that define the portfolio. This article may be a good place to start [Introduction to Smart Pricing: How Google, Priceline, and Leading Businesses Use Pricing Innovation for Profitability](http://www.ftpress.com/articles/article.aspx?p=1569334)   It gives a brief overview of three pricing strategies, cost plus, competition based pricing and consumer based pricing.  **Edit** -This may also be helpful [Social Science Research Network](http://www.ssrn.com/en/) One explanation is that movie patrons are considering their total willingness to pay for the movie experience so that if the ticket price plus the market price of popcorn is less than their willingness to pay (WTP), the theater has an opportunity to extract more consumer surplus by charging higher than market prices for the popcorn (that is, price discrimination). There is a working paper on the subject by Gill and Hartmann (2008), the abstract of which reads: Prices for goods such as blades for razors, ink for printers and concessions at movies are often    set well above cost.  Theory has shown that this could yield  a profitable price discrimination    strategy often termed “metering.”  The idea is that a customer’s intensity of demand for    aftermarket goods (e.g. the concessions) provides a meter of how much the customer is willing to    pay for the primary good (e.g. admission).  If this correlation in tastes for the two goods is    positive, a high price on the aftermarket good allows firms to extract a greater total price    (admissions plus concessions) from higher type  customers.  This paper develops a simple    aggregate model of discrete-continuous demand to motivate how this correlation can be tested    using simple regression techniques and readily available firm data.  Model simulations illustrate    that the regressions can be used to predict whether aftermarket prices should be above, below or    equal to their marginal cost.  We then apply the approach to box-office and concession data from    a chain of Spanish theaters and find that high priced concessions do extract more surplus from    customers with a greater willingness to pay for the admission ticket.  Locay and Rodriquez (1992) make a similar argument in a JPE article.  They essentially argue that purchases of things like movie tickets are made by groups; once individuals are constrained by the group's choice, the firm has additional market power: We present models in which price discrimination in the context of  a   two-part price can occur in some competitive markets. Purchases  take   place in groups, which choose which firms to patronize. While  firms   are perfectly competitive with respect to  groups, they have  some   market power over individual consumers, who are constrained  by their   groups' choices. We find that firms will charge an entry fee  that is    below marginal cost,  and  the  second part of  the  price is  marked   up  above marginal cost. The  markup not only is positive  but   increases with the quality of the product. The quote you are looking for is similar, and again attributes the discrepancy to price discrimination.  From the Armchair Economist (p. 159): The purpose of expensive popcorn is not to extract a lot of money from   customers. That purpose would be better served by cheap popcorn and   expensive movie tickets. Instead, the purpose of expensive popcorn is   to extract different sums from  different customers. Popcorn lovers,   who have more fun at the movies, pay more for their additional   pleasure. That is, some people like popcorn more than others.  The latter idea is that the movie experience for popcorn lovers is worth more than the sum of its parts: that a movie ticket + popcorn is worth more than either of them separately for some people. This is great! I'm not a CPA, but work in finance. As such, my course/professional work is focused more on the economic and profitability aspects of transfer pricing. As you might imagine, it tended to analyze corporate strategy decisions under various cost allocation models, which you thoroughly discuss.  I would agree with the statement that it is based on the matching principle but would like to add that transfer pricing is interesting as it falls under several fields: accounting, finance, and economics. Fundamentally it is based on the matching principal, but it's real world applications are based on all three (it's often used to determine divisional and even individual sales peoples profitability; as is the case with bank related funds transfer pricing on stuff like time deposits). In this case, the correct accounting principal allows you to, when done properly, better understand the economics, strategy, and operations of an organization.   In effect, when done correctly, it provides transparency for strategic decision making to executives. As I said, since my coursework tended to focus more on that aspect, I definitely have a natural tendency towards it.  This is an amazing explanation (esp. about interest on M&amp;A bridge loans, I get that) of the more detailed stuff! Truthfully, I'm not as familiar with it and was just trying to show more of the conceptual than nitty-gritty.   Thanks for the reply! "I think ""Psychological Pricing"" is a similar phenomenon to what you are looking for.  This is where retailers use certain numbers in prices because those prices are more appealing to consumers.  Since stocks - and in your case bitcoin - have prices, they too will be more or less appealing at different prices based on psychology alone." This is a wonderful comprehensive answer as it relates to transferring goods, and evaluating profitability. I would like to add to your post and comment about a few other costs that are transferred.  First though, I disagree with your comment about transfer pricing being about opportunity cost. I think transfer pricing is first and primarily about the matching principal. Properly matching expenses incurred to the revenues generated from those expenditures, or in the case of period expenses, to those entities that received a benefit in the proper period. I don't work in tax, so I'm by no means an expert in this subject, but I am a CPA and I feel I have a solid understanding of the subject.  Some additional items going through TP might be: interest, shared corporate services, the amortization of intellectual property, technology fees, and depreciation charges. This is not a comprehensive list, and please don't take it as such.   None of these need apply to every company, and certain industries and even individual companies will have exceptions. For example, for various reasons, a multi-national conglomerate may choose to maintain separate treasury functions for it's vastly different businesses, so you may not see much interest TP.   Interest is pretty straight forward, and is the interest a company is paying on a debt. Not all interest is transferable, but a classic example might be borrowed funds used for an acquisition. The interest cost associated with that should be transferred in part back to the original entity. Short term borrowing costs used for operating capital is another classic example.   Shared corporate services are centralized functions like a legal department, accounting department, executive offices, and the like. This can also be an IT department or in the instance of an international website (maybe google), an operations team monitoring the server loads and up-times.  IP could just be patents that have definite lives that a number of businesses are benefiting from. IP is a bit of a mess to get into for various reasons and I'm trying to stay focused in this post. Some reasons for complexity include: the valuation, life of the asset, benefit of use, is the entity even really using it?, etc. I would imagine this is where companies get away with A LOT.   Technology fees can be software licenses (Windows ain't free).  Depreciation can be capitalized proprietary software.  I'm running out of gas and wanted to comment about OP's question.   I don't think SLA's and Internal billing services are a matter of directly increasing efficiency, more a matter of not creating inefficiencies. Going anecdotal, anywhere I've worked, the best person to do the job has been whoever's closest to the work. It wouldn't make much sense to me  to have accounting gather up internal support during the VERY time sensitive month-end close for something like one division's trade magazine that another division placed an ad in. On the other hand, I think the allocation of copy expenses on an activity basis is an absolute waste of time. It all depends on the specific transaction in question.  Great post bctich. Don't mean to detract, just looking to help others understand. Setting a precedence with demands at the beginning should not be undervalued. Agreed that you emphasize long term value but establishing your requests ( not in demand form) also plays into your long term value because it is retribution to what you offer. I implemented this in MatLab about 10 years back. You just calculate your conditional variance of the required assets (x_i), use matrix multiplication on the correlation matrix (rho_i_j) from the same asset (this could be a point of research but unless you are using extreme conditions on the VaR it makes little difference) then apply a standard Markiowitz optimisation approach. You can then just use simple Sharpe ratio (marginal return over conditional risk) at every point on the efficient frontier. Then choose the maximum Sharpe ratio point.