How to Price Your Product Like the Last Unit Sets the Market

Opinions expressed by Entrepreneur contributors are their own.

Key Takeaways

- Pricing isn’t driven by averages; the highest-cost marginal customer sets market price.

- Identify your “last unit” and price around scarcity, not typical user behavior.

Setting the price for your product is confusing, and many assume that averages set prices. If you want a clean mental model for why that’s not what’s happening, look at power.

I’m a former quant researcher on Citadel’s commodities team covering power, and one of the most important properties is that the market clears at the economically efficient price.

It’s supply, demand and various constraints. The price everyone pays is how much it costs to produce the last megawatt of power.

Once you internalize that, it changes how you think about pricing in your own business, because you stop talking about the “average user” and start asking what the marginal unit is.

The last megawatt sets the price

Here’s the simplified way I think about power pricing: the system takes the cheapest power first, which is solar or wind. Then it moves to more expensive sources, like natural gas and coal.

Sometimes it’s cheaper to make power somewhere else and send it over a power line. Sometimes you can’t, because the power lines are already full.

Now the important part: the price that everyone pays is the amount of money it costs to produce that very last megawatt of power.

Imagine most of the power is cheap; maybe it’s coming from wind or solar. But the last bit of power needed to meet demand is expensive. That last megawatt sets the price, so everyone ends up paying the expensive price, not the cheap one.

That’s the whole point: once you see ‘the last unit sets the price,’ you start asking what the last unit is – and what’s driving the cost.

In a competitive market, the price is whatever it costs to “clear” your product

If you want to figure out what your “last unit” is in a business, start with your own costs. Ask: For your lower cost vs. higher cost offerings, how many customers can you actually support?

This is where founders can get tripped up. They’ll talk about “the average user,” or what they personally like about the product, and then they’ll try to price off that. That’s a question about your customers’ preferences. But the marginal cost is a property of your own production process.

For example, enterprises use Google Docs for the sharing and collaboration features. They use it for storage. They have various needs that Google bears some cost to support. And Google, in theory, only has so many resources. If they get a big enough customer, they literally do have to go out and buy more compute to support that customer. That’s the customer who’s setting the marginal price. I use Google Docs for free as an individual, but I’m not setting the price as an individual because I’m a low-value user.

That’s the competitive market pricing mistake hiding in plain sight: if you build your pricing model around the value that the low-value user gets, you end up acting like the “last unit” doesn’t exist. But it does exist. You just have to look for it.

Most people think prices are set by averages, but markets usually tell the truth at the margin. That applies well beyond power.

The solution is just as simple: figure out what your last unit is. In business terms, that usually means starting with your most expensive customers and working backward.

What changes once you understand competitive pricing

Once you see what the marginal unit is, the next question is, what changes in your decision-making?

One: You start reallocating your supply toward the high-value customers.

Two: If you’re smart, you might realize that you don’t want to treat pricing as a direct function of your costs, so you might look to enter a less competitive market.

That second point is where I see a common mistake. People think, “Okay, I need a margin, so I’m going to take my costs and add 20%.” But if that’s really what’s required to sell in your industry, then your market is a race to the bottom.

In an ideal world, there are three ways to think about it.

First, cost-based pricing. That’s the “cost plus 20%” instinct. It’s simple, but it ignores the question that matters, which is what the customer is actually paying for.

Second, savings-based pricing. If you’re saving the customer some number of hours of their time, and they have some hourly rate, then presumably you can infer some take rate based on that.

Third, value-based pricing. You ask: What value am I generating for the customer, and can I charge a fraction of that? That’s the best-case scenario, because you’re a revenue driver. The amount you can earn is unbou