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Lecture 9: Tacit Collusion; Pricing Information Goods AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 2

Lecture Plan:  Tacit Collusion  Facilitating Practices:  Price Matching  Pricing Information Goods  Cost structure  Network Externalities  Information Laws  Long Tail  Required reading for next class: HBS case “Freemium Pricing at Dropbox”  HW2

Price Matching Guarantees  Price matching guarantees  Helps a firm to protect its consumers and charge a high price.  It makes your competitor “soft.”  Takes away the benefit for your competitor to undercut your price.

Counter-Intuitive?  Price matching guarantee is simply a mechanism for tacit collusion or competition reduction between firms.  Any offer of the price matching guarantee means effectively taking away any gains that its competitor might get from cutting price.  If a firm offers a price matching guarantee, then a search consumer will buy from it because the consumer knows that in the event that there is a lower price offered in the market the consumer is insured that it will match that price.  Since price matching takes away the gain from price cutting, no firm cuts price and price competition is reduced.

Example  Two firms: Firm 1 and Firm 2  Two prices: low ($4) or high ($5 )  3000 captive consumers per firm  4000 floating go to firm with lowest price  Payoffs = revenue Firm 2 LowHigh Firm 1 Low,, High,,

Example  Two firms: Firm 1 and Firm 2  Two prices: low ($4) or high ($5 )  3000 captive consumers per firm  4000 floating go to firm with lowest price  Payoffs in thousands of $ (revenue)  Both low = 5000*4 = $20K  Both high = 5000*5 = $25K  One high = 3000*5=$15K  Another low = 7000*4=$28K Firm 2 LowHigh Firm 1 Low 20,20 28,15 High 15,28 25,25

Contracting with Customers  The game is a prisoner’s dilemma  Both firms prefer: {High, High}  Only equilibrium: {Low, Low}  Cannot credibly promise to play High  Even if committed to High, other firm would still respond with Low  How to resolve this?  Third party contracts with customers – e.g. price matching guarantee

Price Matching  If one firm charges low, it does not gain any additional customers, since the competitor “automatically” matches it.  What is the effect on the game?

Price Matching Firm 2 LowHigh Firm 1 Low 20, 20 28, 15 High 15, 28 25, 25 Firm 2 LowHigh Firm 1 Low 20, 20 High 20, 20 25, 25

Price Matching  Literature focusing on price-matching guarantee typically finds that it supports higher equilibrium prices and profits.  Intuition: This is because when all firms are committed to match the lowest price, no firm has incentive to undercut others  In practice, if you read fine print, there are quite a few restrictions:  price-matching generally applies to products that are homogeneous across stores  Firms often match lower prices of only some competitors, typically their close competitors.

Pricing Information Goods 12

The Information Economy  Information:  Essentially, anything that can be digitized—encoded as a stream of bits—is information.  E.g. books, databases, magazines, movies, music and web pages are all information goods.  Cost of Producing Information:  Information is costly to produce but cheap to reproduce.

Properties of Information goods 1. Unique cost structure 2. Properties of experience goods 3. Properties of public goods 4. Network effects and externalities

1. Unique Cost Structure  Information goods have high fixed costs of production but near-zero or zero marginal costs.  Developmental costs of producing the first unit of an information product are generally high, but producing each additional unit costs virtually nothing.  the estimated costs of developing the popular computer game Gran Turismo 5 were around $80 million (DigitalBattle, 2010);  the costs of replicating additional copy range from negligible (production of DVDs) to essentially zero (downloadable files).

1. Unique Cost Structure  Cost of storing and transmitting stored information is cheap (and continues to get cheaper)  there are no effective capacity constraints on the production of digital goods.

Traditional Product AVC AC Fixed and Variable Costs AFC Total Fixed P Q q1

Typical Digital Product AVC AC Fixed and Variable Costs AFC P Q q1

1. Unique Cost Structure: Implications  Declining average costs imply significant economies of scale.  Minimum efficient scale can be on the order of the whole market  We should not expect to see highly competitive market structures  Natural monopolies may arise

1. Unique Cost Structure: Implications  What market structures should we expect to see?  Markets with a dominant firm  Microsoft, Facebook  Differentiated Product Markets  Commoditized information markets  Digital goods selling at marginal cost  Free information products (maps, telephone information, addresses, news, stock price quotes, etc.)  Freemium pricing

 Certain characteristics of a product or service cannot be observed or verified prior to consumption, but these characteristics can be ascertained upon consumption.  Problem: Consumers cannot determine their willingness to pay  Recommendations, reviews, try-before-purchase, reputation or word of mouth become important. 2. Properties of Experience Goods

 Non-rival goods:  one person’s consumption doesn’t diminish the amount available to other people  Non-excludable goods:  one person cannot exclude another person from consuming the product. 3. Properties of Public Goods

Non-Rivalrly  This has issues for sellers of information goods  Traditional price competition is based on scarcity  If there are a limited number of widgets, people who want widgets more will pay more for them.  Luxury cars, houses, stock  If there is no limit to the number of widgets available, no one will want to pay more than the lowest price.

 While the non-rival property is inherent to digital goods, the non-excludable one is the question of technology or strategy: 3. Properties of Public Goods

 While the non-rival property is inherent to digital goods, the non-excludable one is the question of technology or strategy:  Bundling a good with an excludable good (physical means),  DRM - digital rights management (IT means)  Encryption and licensing  Intellectual property law (legal means), can be used to modify the property.  Auditing and user tracking 3. Properties of Public Goods

 While there are ways to limit non-excludability, the pertinent question is:  Is sharing of information goods or piracy are actually always damaging to the revenue of the digital goods producer?

Embrace copying  Embrace copying and bundle with content that benefits from wide distribution (e.g. ads)  E.g., Network TV, YouTube, Free Apps  Directly connected with the next property of information goods: network externalities.

4. Network effects and externalities  Many digital products increase in value with wider distribution, as the network of users increases.  Positive network effects and externalities explain a wide range of empirical regularities common to digital goods:  high quality digital goods are released for free to increase platform penetration and value of the platform for third-party advertisers (e.g., Google search engine),  high incidence of technological tie-ins and pricing of one component at a loss (e.g., digital e-readers and content libraries specific to those e-readers).

Hardware vs. Content  Amazon and Google sell their hardware (Kindle and Nexus tablets) "at cost",  Some analysts say that it can even be below cost  The point is: hardware is a discounted tying product with profit coming from sales of online content.

Increasing Platform Penetration  High definition optical disc format war:  Between Blu-ray Disc and HD DVD ( )  Why a war? Why not coexist peacefully?  Other format wars?