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3 minute read / Aug 1, 2016 /

A Structural Pricing Competitive Advantage in SaaS - The Three Part Tariff

There are three pricing strategies for startups. Maximization dominates SaaS products in the mid-market and enterprise markets; penetration is synonymous with freemium in the SMB market. Once you’ve decided on the right strategy for your company, what is the best way to price? By seat? By minute? With or without a platform fee?

Modern behavioral economics study three different pricing structures. Let’s contrast them for a hypothetical web analytics vendor.

  1. Linear Pricing (LP) - Each analytics event costs $0.10.
  2. 2 Part Tariff (2PT) - The analytics software has a base platform fee of $10,000 and each analytics event processed by the system costs $0.10 more.
  3. 3 Part Tariff (3PT) - Again, the software has a base platform fee but the fee is $25,000 because it includes the first 150k events are free. Each marginal event costs $0.15.

Which is the best for software companies? For the first ten years of SaaS, the linear pricing model dominated. Recently, 2PTs have emerged, but are still uncommon. However, several academics argue the 3PT may be the optimal strategy especially when the number of vendors in a category is small.

Professor Yong Chao crafted a game theory simulation of two competitors and tested the three different pricing strategies.

We find that a 3PT is always a profitable tool over LP or a 2PT for the dominant firm to compete against its rival, in both cases of perfect substitutes and imperfect substitutes.

Strategic Effects of Three-Part Tariffs Under Oligopoly

Another surprising conclusion from his analysis: 3PT reduces competition in commodity markets, but increases it in markets with a differentiated product in favor of it. That’s because 3PT pricing mechanisms capture more value from the buyer. SaaS startups with differentiated products can reinforce their competitive strategy with their pricing, aligning the 4Ps of Marketing.

3PTs capture more value because customers tend to buy larger plans than they might need. From a study on consumers buying cell phone plans:

Customers choose flat-rate or three-part tariffs with large allowances even when these entail a greater bill than tariffs with a lower allowance The Effect of Tariff Structure on Usage under Two and Three-Part Tariffs

But, the money doesn’t necessarily go to waste. Customers end up using more of the service. “Customers who switched to a three-part tariff increased their usage by 15.1%, while customers who remained on a two-part tariff increased their usage by 0.9%.” And this increase cannot be accounted for with a traditional demand model.

“It is consistent, however, with previous research that shows that free goods lead to a positive affective response, hence increase the valuation of the product or service, and consequently, its demand.”

One of the most consistent pieces of advice we share with founders is to increase prices of their software products. Software is a kind of Veblen good. As prices increase, so does demand. In the buyer’s mind, the more expensive the product, the more valuable it is. Of course, demand doesn’t increase forever with price.

Modern behavioral economics suggest that the most effective way of increasing prices is to structure a logical three part tariff. In addition to achieving more effective value based pricing, 3PTs reinforce competitive advantage and potentially lead to more satisfied customers who may use the product more.

Note: the research cited focused on consumer purchasing plans of cell phone products, not software. I’m assuming the buying characteristics of software customers are similar to those of cell phone consumers. I haven’t been able to find studies of software purchasing, but anecdotes from several founders indicates that many of the same principles do apply for their businesses.

Read More:

The Quirky M&A Environment for SaaS Companies in 2016