Mike Stevens | Apr 22, 2009

I want to talk to you about iDrive, which of course is BMW’s in-cabin computer system that provides an interface for its creature comforts – the satellite navigation, various entertainment options, the vehicle’s settings, your telephone, and so on.

I rather liked it even when it first appeared almost a decade ago on the 7 Series.

Then, the entire motoring world seemed to criticise it for being overly complicated, distracting and fidgety. Most have since come to grips with it and the latest version looks more fabulous than ever. The graphics are markedly better and the whole system is less intimidating to use even for a technophobe.

It is almost as good as the benchmark set by Audi’s MMI, and arguably better.

idrive-pricing

All very dandy then. However, what I really want to draw your attention to is the following. Do you know how much it costs to add iDrive, as an option, to BMW’s most humble offering, the '1er'?

The answer: theoretically, about the same as the cost of a new Tata Nano plus all the options on offer.

After quietly chuckling at this realisation, it got me thinking: how are options priced on a car? For that matter, how do manufacturers set prices for their various models, given their own offerings and those of likely competitors?

I think that there are two things happening that deserve some attention, and a basic understanding of both provides some interesting insight into the minds of car sellers.

The first effect is known as ‘price discrimination’ and the second is sometimes called the ‘third law of demand’. (Incidentally, the 'first law' is painfully boring and obvious and 'the second' is a whole lot of fun, but sadly irrelevant here.)

hair-cut-sign So what kind of bird is price discrimination then?

It is actually rather like it sounds. The idea is that the seller discriminates amongst its customers based on their willingness to shell out their 'hard earned'.

The idea is that you sock it to those who are more willing (and, presumably, able) to pay, and resist gouging those who are more tight-fisted.

Sounds obvious enough, but the trick is to identify the type of customer walking in the door, who rather unhelpfully is neither wearing a ‘sucker’ nor a ‘stingy’ badge on his forehead.

A good salesman should be able to suss this information by seeing whether he can interest the customer in splurging on the prestige pack including leather made from ostrich eyelids or whether the poverty pack with a wooden bench is as far as he’ll go.

As a matter of fact, this packaging of options, or bundling, is another great way to price-discriminate because it allows the seller to emphasise to the wary customer that he is actually getting ‘more for less’ and he’d be virtually daft not to go for it. (No matter that the package actually has eight things of which only one is great, two are fine, but the other five you would actually be better without.)

configure-mazda

Most manufacturers worth their salt are now using very nifty configurators on their internet sites to allow increasingly aware and discerning customers to self-select their level of discrimination.

This, I think, is just genius because the manufacturer serves up a dizzying array of eye-candy and the customer clicks his way exactly to his level of extravagance. No guessing required by the manufacturer and the result is minimal effort for 'maximal' gouging.

Even if you have nerves of steel and padlocks on your wallet, surely you can still find a few little nothings to add to your modestly optioned car. A digital compass perhaps? Or maybe some hooks for the grocery bags?

And if, by chance, it’s a car you really want, oh boy does it work! I was configuring a 911 for (cough) research the other night and clicked on so many options that I could have easily bought two Boxsters for the money.

porsche-pricing

The second insight, the third law of demand, is brilliantly simple but sometimes slightly counter-intuitive. Essentially it says that by adding a fixed cost to two rival choices of different price, the customer is more likely to opt for the more expensive option.

So let’s say Car A costs $60,000. Car B costs $75,000, making it 25 percent more expensive than Car A.

Customers make their decisions about buying one or the other car based on this relative price differential.

Now say that we add a $10,000 option bundle to both cars. The relative price difference falls and the cars are now 21.4 percent apart, making it more likely that customers are drawn away from Car A. The bigger the fixed price of the option, the narrower the relative price difference becomes.

Now admittedly manufacturers do not always price options identically on different models, and various taxes and levies blunt this effect as well. Nonetheless the logic of the third law is sound and its effect on the customer’s psyche is undeniable.

porsche-911-turbo

For instance, let’s go back to Porsche. Go play around with their configurator and option up a 911 C4s till your mouse starts bleeding.

What you should end up with is a figure surprisingly close to a 911 Turbo which has at least a few of those options already standard. The relative price difference is a lot smaller now and much more palatable.

Consequently, you are now less likely to burned alive by the laser-glare if you were to say, “Honey, let’s get the Turbo. It’s only 10 percent more after all”, than if you had said, “Honey, I think the Turbo is still a performance bargain. So what if it asks for a 30 percent premium over the C4s.”

So the pricing of options and cars is hardly a task done willy-nilly. It requires some intelligent and permissible discrimination while making the ludicrously expensive appear relatively cheap.

Prateek is a Lecturer at the Deakin Business School in Melbourne

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