How to Price Generative AI Products

It seems like a new generative AI startup is calling me every other day with the same question: how should they set their prices? 

Helping startups set their prices is not exactly new to me—I’ve spent years thinking about pricing in my work helping software and internet companies monetize their products. However, the recent uptick in questions from generative AI startups is worrying. Generative AI introduces a problem into software pricing that startups previously didn’t have to deal with: marginal cost.

Marginal cost (of running large language models, for example) breaks the startup product-launch playbook of “engagement first, monetization later.” Freemium is now a dangerous acquisition model. Subscriptions might be highly unprofitable. I hear plenty of doomsday scenarios. Still, if AI startups follow best practices, then pricing their products may not be that scary after all.

Pricing costly software

Let's address the cost issue right out of the gate. How much should you consider your costs when setting your prices? Pretty much not at all. 

Imagine I run a lemonade stand. I'm trying to set the price for a glass of lemonade. Now, I'm not just a lemonade entrepreneur but also a mind reader. My superpower is that I know exactly what my customers are willing to pay for my lemonade. There are 10 people waiting in line for my lemonade: the first customer's willingness to pay—or the maximum price they’re willing to pay for a product or service—is $9, the second customer's is $8, and so on and so forth, until we get to the last customer's willingness to pay of $0 for my lemonade. I have perfect market knowledge. So what's the optimal price for my lemonade?

Assuming that I can't charge different customers different amounts, the optimal price is $5. You can do the math yourself, but if I charge $5, five customers make a purchase, and I pocket $25.

What if I told you that my lemonade costs me $1 per glass to make? Does that change your answer? It shouldn’t. The optimal price is still $5. What if the lemonade cost $4.50 per glass to make? You might tell me I have a bad business, but the optimal price is still $5. Cost has no bearing on what my price should be.

An astute reader might point out that it makes a difference whether we are trying to optimize revenue or profit. Let's take that objection seriously. I did the math, and your costs have to be $2 per glass before our "revenue optimal price" and our "profit optimal price" diverge. Put another way, you have to have 60% or lower gross margins before cost starts making a difference.

Does your generative AI product have 60% or lower gross margins? I hope not.