Smart Firms Run Experiments

First a note about Google Adsense. I must have misread their TOS when I posted about this before. I thought you got a check when you accrued $10 from blog ads, but it turns out you need $100. So, I will be sending a $100 check to the Utah Food Bank sometime in the far-distant future, assuming I live that long. (Current tally: $18.58.)

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Continuing on the theme of statistics and data mining...

Every year I teach pricing.

I always conclude that optimal prices depend on two things: Demand elasticity and marginal cost.

Every year students ask how they can learn about demand elasticity.

I say that learning about demand elasticity is really pretty easy. Just do some simple pricing experiments. Change your price a bit here and there, and see how quantity demanded varies with price. Use this to construct some estimates of demand elasticity to plug into your pricing formulas.

And every year one or two students argue that this is really completely unrealistic; that there's no way a real firm would vary prices just to see what happens.

Here's a response, courtesy of Monday's WSJ.

Google, it turns out, is constantly experimenting not with price (since their searches are free to users), but with quality. Users told Google they wanted more search results on a page. So the firm tried it.... and found search traffic actually went down. The extra results slowed down the page, and consumers noticed the difference. Here Google isn't measuring the elasticity of demand with respect to price, they're measuring the elasticity of demand with respect to the number of search results listed. Having measured this elasticity carefully in its experiment, it is now able to make better decisions.

It turns out that the smart firms are doing this all the time, and they're changing not only price but also product characteristics. They're carefully measuring the results of their experiments, and using these estimates to make better managerial decisions. It also turns out that the cost of such experimentation is dropping quickly... Which means the pace of experimentation and change is only going to quicken.