[BLANK AUDIO]. A common problem that many online retailers face is the issue of whether to offer product delivery and at what speed and price. These decisions are not arbitrary. Instead, the levels that you choose should be a source of profits. Yes, you should make money off of offering, a delivery function for customers, and yes, customers are willing to pay for it. But how should a firm determine what that service level should be and what price? If you remember in the early days of Amazon before we had prime, you would have to spend at least $25 to get free shipping. And when you look around at the marketplace, there are dozens of options in terms of what speed and price you pay for shipping. What I'd like to show you now is how to profitably make those decisions. By now we've learned that all channel strategy decisions start by understanding the customer's demand or utility for a channel benefit. In this case, the benefit is shipping. Let's plot the firm's trade-offs. On the horizontal axis, we have the number of days a customer is willing to wait for delivery of a package. And on the vertical axis, we have their willingness to pay for that ship speed. Market research or a channel benefit analysis has revealed that there are three utility functions for three market segments. How do we now determine each segment's willingness to pay? Well, let's look at the first segment which we will label as the desperate. Now this customers maximum willing to pay is that one day for $20. This is the point at which the slope of her curve is maximized. Now, she is not willing to spend for two days, and she won't buy it all if it takes any longer than that. In other words, this benefit is so critical that past a certain point, if it is not supplied, the customer may simply not buy. So, this is me when I realized that I forgot that my dad's birthday is a few days away and I need to get him a present on time. Anything I buy at this point must get to him in two days, and if it doesn't, I won't even consider it. Now note also that a higher valuation on the shipping speed does not mean that I value every single level of it. So beyond two days, there's no value for me at all. This is how critical this channel benefit can be for some customers. The impatient will accept a longer number of days for delivery, and her maximum willingness to pay is at $16. Now, this might be my sister who manages to plan ahead and is more organized than me. However, she won't buy if it takes longer than seven days to deliver. Now maybe you're asking, how can we get the impatient customer to pay more? For example, in this region above $16. Well, you probably can't, unless you can give her less than one day shipping. And even then she will only be willing to pay a little bit more, because her utility curve is much flatter than the desperate customer's utility curve. Now, if you could give the desperate customer a half day shipping, she would gladly pay you much more, like at least 25% more than one day shipping. This is how desperate she is to achieve a needed shipping speed. Finally, the patient customer is willing to pay $6 and 35 cents for one day, $6 and 17 cents for two days, and $5 for seven day delivery. So at one day delivery, the segment's willingness to pay, is $20, 16 and $6 and 35 cents. Note how the valuations differ for one, two in seven days. Now, what should you charge each segment? For now, let's not worry about the profits on shipping. In other words, let's not incorporate the cost of the shipping channel function quite yet. Well, for the desperate, we would charge just under their maximum willingness to pay. In other words $20 minus 1 cent for one day shipping. For the impatient, we would charge $14 and 73 cents minus 1 cent for two days shipping. And for the patient segment, we would charge $5 minus 1 cent or 4.99 for seven day shipping. Why do we price just under a segment's maximum willingness to pay? Because this way, everyone is willing to buy. You're alternating one way and you don't lose a sale. And now, only the desperate will pop for one day shipping. They will not pop for two day shipping. The impatient choose two days because the one and seven days are priced higher than or outside their willingness to pay. Now, let's relax the assumption that costs don't matter. Suppose the shipper offers to do this for $4, $12 and $18. What price should you charge? Well, the answer is exactly the same, why? Because all of these price points ensure that you will make money off of the delivery benefit given the costs of these channel intermediaries. Now students often ask, can you make more money by charging less than the willingness to pay. Right now we charge just under $5 for seven day and we make almost $1 on shipping. Charging less than 4.99 is just not profit maximizing. Our one day price suggested is $20 and we make about $2. Can we lower the price on one day and get the impatient pop more money? Yes, but you would have to cut your price to $16. So you would gain all of the impatient segment which are cost to do it is $18. So you are losing money on the deal. Now, can you make patient people pop for 2 day delivery? Yes, but the cost cut is so great, you would lose $6 on every patient person. Keep in mind that your goal is not to maximize service to everyone. Just because patient people are willing to pay for faster delivery, does not mean it is optimal to do so. Particularly if your goal is to make money off of the channel benefit, and it is. So let's push this thinking a bit further. Do we ever want to subsidize a segment? Let's imagine that the supply side costs were $4, $15 and $16 instead. At this point the cost of shipping to the impatience are higher than their willingness to pay. So do you walk away from the impatient segment? Well, up to now we haven't discussed the proportion of buyers in each segment because this wasn't necessary. But now a $15 is more than the impatient people are willing to pay. It will not pay $18 for 1 day shipping, or $4, or $5 for 7 day shipping, so you are cooked. Now let's leave the patient people alone for now, and let's consider only the desperate and impatient segment. Suppose these are equal size, which is unlikely, but if they were equal, then you'd have to cut the two day delivery to $14.73 to get the impatient to buy, which is a 27 cent loss per package. Your alternative is to cut your overnight price to $16. So you see you're left with two options. Option number one, keep prices around $20 for one day and cut two day delivery to $14.70. This means you make $4 on desperate buyers and you lose about 27 cents on impatient buyers. With an equal segment size, you still come out ahead across the two segments combined. In other words, the profits made on the desperate buyers cover the costs of the impatience. The second possibility you face is to cut the one day delivery to $16 and to leave today delivery at 15. In this scenario, you make no money on shipping, but you don't lose 27 cents on the impatient segment. Now this pricing scheme will result in no one picking the two day option. Instead, the patient customers will pick the seven day. So this is how the segment size can determine whether or not you make money off of providing this key channel benefit. Remember though, the firm's goal is always to maximize profits, not the provision of services. You can maximize services for everyone, but it may be at the cost of profits. And that is not really a sustainable or rational strategy for the firm. So what do we take away at this point? Well, a key insight is that the optimal channel offering that aligns both the benefits demanded by customers. And the firm's ability to cost effectively supply the needed channel functions may not delight everyone and in fact it may require subsidies.
