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INFORMATION TECHNOLOGY IN BUSINESS AND SOCIETY SESSION 22 – ECONOMICS/PRICING OF DIGITAL GOODS SEAN J. TAYLOR.

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Presentation on theme: "INFORMATION TECHNOLOGY IN BUSINESS AND SOCIETY SESSION 22 – ECONOMICS/PRICING OF DIGITAL GOODS SEAN J. TAYLOR."— Presentation transcript:

1 INFORMATION TECHNOLOGY IN BUSINESS AND SOCIETY SESSION 22 – ECONOMICS/PRICING OF DIGITAL GOODS SEAN J. TAYLOR

2 LEARNING OBJECTIVES Understand Basic Economic Properties of Digital Goods. Understand Strategies for Pricing Digital Goods: What personalized pricing is and how it is used. What group pricing is, and how it is used. Versioning as a differentiation strategy How digital piracy and DRM can affect versioning. Familiarize yourself with other commonly used pricing strategies: Bundling Usage-based pricing

3 DIGITAL (INFORMATION) GOODS: EXAMPLES Information Goods: Products that can be digitizedInformation Goods: Products that can be digitized eBooks, Movies, TV programseBooks, Movies, TV programs Newspaper, magazinesNewspaper, magazines CD, DVDCD, DVD Software, Customized cellular ringtonesSoftware, Customized cellular ringtones Online content (video, web sites)Online content (video, web sites) Online application servicesOnline application services Online information servicesOnline information services

4 PROPERTIES OF DIGITAL GOODS: EASY TO COPY

5 slashdot song5.mp3song5.mp3 song6.mp3song6.mp3 song7.mp3song7.mp3kingrook song4.mp3song4.mp3 song5.mp3song5.mp3 song6.mp3song6.mp3 song5.mp3song5.mp3 Title User Speed song1.mp3 beasiteboy DSL song2.mp3 beasiteboy DSL song3.mp3 beasiteboy DSL song4.mp3 kingrook T1 song5.mp3 kingrook T1 song5.mp3 slashdot 28.8 song6.mp3 kingrook T1 song6.mp3 slashdot 28.8 song7.mp3 slashdot 28.8 song5 beastieboy song1.mp3song1.mp3 song2.mp3song2.mp3 song3.mp3song3.mp3 PROPERTIES OF DIGITAL GOODS: EASY TO DISTRIBUTE

6 PRODUCTION COSTS Costly to produce but cheap to reproduce Sunk costs: Costs paid upfront before production. Plus marketing and promotion costs. Usually not recoverable even if production is halted (no resale of flop movie, low price for dud CD) Variable costs small Total cost does not increase much with production quantity. No capacity constraints Can make and distribute unlimited number of copies. This leads to significant economies of scale Marginal cost less than average cost Declining average cost with production For instance, Microsoft has 92% gross profit margins. What does this mean for competition?

7 COST STRUCTURE OF DIGITAL GOODS High fixed cost to develop the first copy Marginal cost of additional copy is low or zero (negligible cost to duplicate) Distribution costs fall so first copy cost is a large proportion of total cost 0 Cost Quantity Average Cost Marginal Cost

8 CONSUMER AND PRODUCER SURPLUS Consumer surplus is the difference between the price paid and the higher price that consumers would have been willing to pay for the product. Producer surplus is the difference between the payment received and the minimum payment that producers would have accepted.

9 PePe 1 2 CS = 1 PS = 2 QeQe CONSUMER AND PRODUCER SURPLUS Q1Q1 4 3 DWL = 3+4

10 MARKET STRUCTURES FOR DIGITAL GOODS Threat of sequential price cutting (example: CD telephone books)Threat of sequential price cutting (example: CD telephone books) When many firms sell very similar digital goods, marginal cost pricing is inevitableWhen many firms sell very similar digital goods, marginal cost pricing is inevitable Digital goods have very low or zero marginal costsDigital goods have very low or zero marginal costs What are the implications?What are the implications?

11 COMMODITIZED INFORMATION: CD-ROM PHONE BOOKS 1986: Nynex charged $10,000 per disk for NY directory & sold to govt. agencies ProCD and Digital Directory Assistance for national directories Phone companies would not give CDs Internationally outsourced at $3.50 daily Low barrier to entry (6 companies) more supply than demand Bertrand competition Start at $200 each, now at < $20. Once several firms have sunk costs, then price is forced close to marginal cost (Think what happens if one competitor cuts prices)

12 VIABLE MARKET STRUCTURES FOR DIGITAL GOODS Viable market structure: Cost leadership Dominant firm: Monopolist (?) with economies of scaleDominant firm: Monopolist (?) with economies of scale The firm with lowest costs gets the marketThe firm with lowest costs gets the market Achieving Cost leadership How does one become a cost leader when variable costs are zero?How does one become a cost leader when variable costs are zero? Supply chain, workflow analysis, low assembly costs do not helpSupply chain, workflow analysis, low assembly costs do not help As quantity sold goes up, average costs go down As quantity sold goes up, average costs go down Sell and resell as many versions as you can Sell and resell as many versions as you can Long tail Long tail Syndication Syndication

13 VIABLE MARKET STRUCTURES FOR DIGITAL GOODS Achieving Product differentiation Unique capabilitiesUnique capabilities E.g., editorial resources, talentE.g., editorial resources, talent Intellectual property protectionIntellectual property protection West Publishing Few firms in collecting statutes and legal opinions. Now they can be scanned.Few firms in collecting statutes and legal opinions. Now they can be scanned. Key number system of legal references citation index. (Copyright and content)Key number system of legal references citation index. (Copyright and content) Technological quality, resolution, speed (Google Video)Technological quality, resolution, speed (Google Video) Viable market structure: Product differentiation Differentiated products: Many firms, each producing a differentiated variety of the productDifferentiated products: Many firms, each producing a differentiated variety of the product

14 STRATEGIES FOR AN EXISTING MARKET LEADER Dont be greedy Price as high as you can without making it profitable for a potential entrant to come into your market (limit pricing)Price as high as you can without making it profitable for a potential entrant to come into your market (limit pricing) Low prices take your customers out of the market for a whileLow prices take your customers out of the market for a while Achieve lock-inAchieve lock-in Limit price is lower than the monopoly priceLimit price is lower than the monopoly price Example: Microsoft WindowsExample: Microsoft Windows Play tough Be willing to signal that you will cut prices if necessaryBe willing to signal that you will cut prices if necessary Costly in the short term, but can be profitable in the long runCostly in the short term, but can be profitable in the long run Discourage future entryDiscourage future entry Imitation as a strategyImitation as a strategy Constant innovation (search engines)Constant innovation (search engines) Example: Google vs. MSFT

15 PRICING STRATEGIES Pricing information (digital) goods (products) Personalized pricing (First-degree price discrimination) Group pricing (Third-degree price discrimination) Versioning (Second-degree price discrimination) Bundling Usage-based and unlimited usage pricing

16 q p REVENUE q p PRICE DEMAND vs. The idealized economic scenario (ideal for the seller) Find out what each customer is willing to pay, and charge them as close as possible to this Can work in conjunction with increasing product fit Made more easily feasible by a web-based sales channel PERSONALIZED PRICING

17 So, how much are you willing to pay for my information? Five bucks Typically requires more information than may be realistic: customers will not reveal their true willingness to pay Requires preventing arbitrage Customers dont like paying different prices Solution: use indirect methods, e.g. targeted coupons PERSONALIZED PRICING: IMPLEMENTATION ISSUES sucker!

18 REAL WORLD PERSONALIZED PRICING Approximate examples: Automobile dealers, Lexis-Nexis, Airlines Opportunities online: Amazon, Virtual Vineyards Gather demographic information Monitor clickstreams Easy to adjust prices on-the-fly Other Concepts Pricing based on ROI or total cost of customer Behavior-based pricing (clickthroughs/purchases) Personalized vs. Group Pricing Real-world instances of personalized pricing are usually some type of group pricing (zip, gender, reaction to offers…)

19 q p GROUP PRICING REVENUE q p PRICE DEMAND REVENUE SEGMENT 1 SEGMENT 2 PRICE 1 PRICE 2 vs. Same product, different prices for different groups Identify groups willing to pay less, offer them lower prices Need to be able to identify group membership easily What types of groups are systematically willing to pay less?

20 GROUP PRICING Group pricing and digital piracy Piracy lowers a consumers willingness to pay Identify high-piracy groups, offer them lower prices What would these groups be for digital music, for example? Examples of group pricing Wall Street Journal, Microsoft Office, movie tickets, magazines, software, airlines, trains

21 q p REVENUE q p PRICE DEMAND PRICE 1 PRICE 2 vs. Single version High-end version Low-end version REVENUE Different versions, different prices Segmentation based on self-selection based on willingness to pay for different versions VERSIONING

22 Key idea: get customers to self-select Different than customization: all customers prefer the high- end version Key challenges: Analyzing what dimensions segment your customers Designing pricing based on these dimensions Non-digital example: Airline seats Seat + 3-week advance + $100 penalty + less legroom + lousy food OR Seat + fully refundable + book anytime + more legroom + lousier food

23 VERSIONING DIMENSIONS

24 EXAMPLE: NEED FOR DISCOUNT AT HIGH-END 100 total consumers; 2 versions of a software program 40 type As (impatient): WTP $100 for fast, $40 for slow version 60 type Bs (patient): WTP $50 for fast, $30 for slow version Offer only fast: best price is $50, revenues=$5000 Offer only slow: best price is $30, revenues = $3000 Perfect price discrimination: 40*100+60*50= $7000 in revenues Making Self-Selection Work May need to cut price of high end May need to cut quality at low end Value-subtracted versions it may cost more to produce the low-quality version! In design, make sure you can turn features off!

25 ONE POSSIBLE VERSIONING SOLUTION Try fast for $100, slow for $30 Will this work? Compare benefits and costs to consumers Surplus value for As: 100-100=0, but 40-30=10 > 0 Revenues = 100x$30 = $3000 Discount the fast version: 100-p=40-30 So, p=90 Revenues = $5,400 = $90x40 + $30x60 WTP: Willingness to pay q p DEMAND PRICE 1 PRICE 2 High-end version Low-end version REVENUE High-end surplus for low-end version Discount

26 COMMON VERSIONING DIMENSIONS Comprehensiveness (all vs. selected features) Timeliness (current vs. delayed stock quotes) Convenience (interface, search capabilities) Resolution or sound quality (selling images and songs) Annoyance (selling shareware software, fast vs slower version) Support (24/7 on-site vs. toll-free calls vs. pay-per-call) Access (online books vs. physical copies) Others?

27 VERSIONING EXAMPLE: BRITANNICA ONLINE Possible versioning options In-depth vs. summary, real-time vs. once-a-year updates, resolution of graphics, search and organizing capability, ability to print or copy,.. Other possibilities? How many versions would you create? One, two, three…? The Goldilocks principle

28 VERSIONING AND PIRACY Versioning based on digital rights Number of times one can render Number of devices one can render on Number of copies one can create for personal use Permission to rent and/or resell For software: # of clients one can install software on, # of clients that can use software concurrently. Versioning and digital piracy A pirated good is often like a free low-end version Therefore, price your product as the high-end version Identify those features that are degraded the most in the pirated version, and highlight those in the legal version

29 OTHER PRICING STRATEGIES Bundling Different customers value different features differently If you cant figure out who values what, bundling may be useful Bundling digital goods has special benefits However, may have piracy concerns Usage-based (and unlimited usage) pricing Similar to versioning based on usage When tracking/billing usage is costly, unlimited- usage pricing is often profitable (some examples: AOL, telephony)

30 BUNDLING: A SIMPLE EXAMPLE Alice Bob Product 1 Word Processor Product 2 Spreadsheet $60 $40 $60 Optimal prices $40 for product 1 $40 for product 2 $100 for the bundle of product 1 and product 2

31 BUNDLING DIGITAL GOODS Why does it make sense? Because the valuations for the bundle converge around the mean. [Law of Large Numbers]

32 PROFITS FROM INDIVIDUAL GOODS Why does it make sense? Profits from Bundle

33 Profits from Individual Goods Profits from Bundle

34 BUNDLING EXAMPLES FOR DIGITAL GOODS Albums vs. singles Cable television bundles vs. a la carte programs or channels Wall Street Journal Online (US+Europe+Asia+…) vs. pay per story for research archives Subscription services vs. pay per use Office suites versus individual components Microsoft Office: 90% market share

35 TAKE-AWAYS 1.Three types of Price Discrimination First degree (personalized pricing) Second and Third degree (versioning and group pricing) Result: Increased profits, decreased inefficiency 2.Can use data about customers to increase profits and even total efficiency To price discriminate or not 3.Other strategies for digital goods Usage-based (or unlimited use) pricing Bundling

36 NEXT CLASS: Work on G1


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