1. Review Factors that influence how reference price is formed purchase context cost current prices past prices 1

2. Lecture 3 Prospect theory Value creation 2

3. Prospect Theory 20" iMac MA876LL/A $999.99 with $200 mail-in rebate $799.99 3 Option AOption B

4. Prospect Theory Theory Consumers evaluate purchases as ______ and ______ relative to reference price ______ and _____ have a diminishing effect as they grow larger Consumers are more sensitive to _____ than to _____ 4

5. Shape of the Value Function (According to Prospect Theory) -x x V(-x) V(x) gains Utility(+) 0 losses Disutility(-) Value function 5 yw

6. An Illustrative Example 6 $200 $400 $600 $800 $1000 GainLoss Change in Utils $200 $400 $600 $800 $1000 -80 -60 -40 Change in Utils -20 -10 +40 +30 +20 +10 +5 What is the Utility for Option A? What is the Utility for Option B?

7. Value Creation 7

8. Transaction Utility Price consumer is willing to pay Economic Value For the consumer Price Transaction Utility $0 Reference price 8

9. Value Creation Defining VALUE Use Value (Utility) Savings gained from using a product/service offering Monetary gain from using a product/service offering Satisfaction received from using a product/service offering Economic Value/Exchange Value Value based on substitutes/alternatives in marketplace Calculated using reference value and differentiation value Economic value is highly contingent on perceptions (or perceived value). Marketing plays a large role in shaping consumer perceptions of a firm’s products/services, as well as those of competitors. 9

10. Illustration of Value: the case of Market Research Valuable market research helps to provide information and ___________ in decision making 10

11. 11 Value of Information How much should you pay for such information?  As much as the information is worth, but no more  Value of information is based on improved decision. Value of perfect information vs. value of imperfect information:  Value of _________ information will be LESS!

12. Example 3M company is considering a new product that targets outdoorsy college students. The estimated R&D cost is $5 million and the marketing cost is $5 million. 12

13. Market Research 3M company is considering a new product that targets college students. The estimated R&D cost is $5 million and the marketing cost is $5 million. Consider two cases (1) there is no uncertainty in the revenue. (2) there is uncertainty in the revenue. 13

14. Case 1: No uncertainty in revenue The estimated R&D cost is estimated to be $10 million and the marketing cost is $5 million. Should 3M approve the project if the revenue is $10 million? Should 3M approve the project if the revenue is $25 million? 14

15. Case 2.1: Uncertainty in revenue Suppose with 50% of chance, the product will be very popular, bringing $30 million in revenue; and 50% of chance it will be so-so, bringing $20 million. Notice that the expected revenue is $ 25 million A market research can ascertain which outcome is going to arise. The cost of doing research is $1 million Should the research be done? Why? 15

16. Case 2.2: Uncertainty in revenue Suppose with 50% of chance, the product will be a great success, bringing $40 million in revenue; and 50% of chance it will be a failure, bringing $10 million. Notice that the expected revenue is again $ 25 million A market research can ascertain which outcome is going to arise. The cost of doing research is $1 million Should the research be done? Why? 16

17. Value Creation by Market Research In case 2.1, what is the value, or the maximal amount of money that the company is willing to pay for the market research? In case 2.2, what is the value, or maximal amount of money that the company is willing to pay for the market research? 17

18. 18 An important concept: Expected Value of Perfect Information (EVPI) Value of Perfect Information

19.  Frequently, information is available that can improve the probability estimates for the states of nature.  The expected value of perfect information (EVPI) is the increase in the expected profit that would result if one knew with certainty which state of nature would occur.  The EVPI provides an upper bound on the expected value of any sample or survey information. Expected Value of Perfect Information (EVPI)

20. 20  The expected value of perfect information is defined as EVPI = |EMVwPI – EMVwoI| EVPI = expected value of perfect information EMVwPI = expected value with perfect information about the states of nature EMVwoI = expected value without information about the states of nature where: Expected Value of Perfect Information (EVPI)

21. 21 0 -10 Success 0.5 Failure 0.5 25 0 Approve Disapprove Approve Disapprove EMV(the best alternative with free perfect info) = 12.5 With perfect information Approve Disapprove Success 0.5 Failure 0.5 25 0 -5 EMV(the best alternative without new info) = 10 Without information Suppose with 50% of chance, the product will be a great success, bringing $40 million in revenue; and 50% of chance it will be a failure, bringing $10 million. EVPI = EMVwPI - EMVwoI =  The most you are willingness to pay for any information

22. Another way to look at it… Remember: market research can only be valuable when it can change the status quo course of action when there is no information. 22

23. Calculation 1. Identify the status quo course of action when no market research is available, by calculating expected revenue and/or expected cost.  2. Identify the scenario in which market research can change the course of action.  3. Determine the gain conditional on that scenario.  4. Multiply the conditional gain and the probability for the occurrence of the scenario. 23

24. A Worked Example The estimated R&D cost is estimated to be $10 million and the marketing cost is $5 million. Suppose with 50% of chance, the product will be a great success, bringing $18 million in revenue; and 50% of chance it will be a failure, bringing $10 million. 24

25. Calculation 1. Identify the status quo course of action when no market research is available, by calculating expected revenue and/or expected cost.  2. Identify the scenario in which market research can change the course of action.  3. Determine the gain conditional on that scenario.  4. Multiply the conditional gain and the probability for the occurrence of the scenario. 25

26. A Final Example (with answer) The estimated R&D cost is estimated to be $20 million and the marketing cost is $5 million. Suppose with 1/3 of chance, the product will be a great success, bringing $90 million in revenue; with chance of 1/3 it will be a failure, bringing $15 million revenue, and with 1/3 it will be a disaster and will generate zero revenue. What is the value of the market research here? The answer is $11.67 million Hint: there are 2 scenarios in which the research has the potential to change status quo course of action. 26

27. EVA - based on product differentiation Reference Value or Reference Price Positive Differentiation Value Negative Differentiation Value Total Economic Value +$ - $ Final $ 27

28. Importance of Differentiation Value Selling hot dogs at the street corner of NYC Your cost Competitor cost Case ACase B Your cost Competitor cost WTP 28

29. Importance of Having Differentiation Value NetflixCleanfilms.com InventoryApprox. 100,000Approx. 1,000 # of distribution center 40+1 Price charged For 2 at a time $17.99$19.99 Secret of survival? Happy together thereafter? 29

30. A not-so-fairy-tale ending In 2006, Judge Richard P. Matsch of the United States District Court for the District of Colorado ruled that it was a copyright violation to distribute re- edited movies without the consent from the movie studios. Cleanfilms.com notified its subscribers the loss of the battle while ensuring them that they commit to rent only the “clean” films. Cleanfilms.com went out of business soon after. The Directors Guild of America and the Motion Picture Association of America sued most of these industry players for copyright infringement and claims regarding derivative works. 30

31. Next Lecture More on Value Creation Value Measurement & Communication 31