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

3. 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

4. Tacit Coordination  Spontaneous cooperation resulting from strongly perceived interdependence.  Repeated interaction provides firms with strategic leverage over each other that may encourage cooperation.  Difficult to achieve with lots of firms.  Hard to find/prove/correct.  Facilitating practices:  Price matching  Most Favored consumer clause  Price leadership  Advance announcement of price changes

5. Tacit Collusion: Example  Industry is an oligopoly  Top four firms dominate almost the entire market  Same phone (e.g. iPhone from AT&T or Verizon?), data services (text, e-mail, etc)  Agreement on price is easier to come by and cheating is easier to catch Mechanisms Homogeneous Products

6. Tacit Collusion: Pre-Announced Rate Changes  Service providers typically pre-announce rate changes they plan on implementing  Advanced notice gives competing firms time to respond  Can test the market and competitors

7. Tacit Collusion: Infrequent High Changes in Rates  Rate changes in the industry have been high and infrequent, yet coordinated across all four firms  FOCUS: Text Messages  No capacity constraints = unlimited supply => in a competitive market prices should decrease not increase over time  Since 2005 price per text has doubled. [IBISworld, 2012]  Service providers do not claim that these increases were driven by higher costs so other methods must be at work.

8. 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.

9. 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.

10. 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,,

11. 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

12. 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

13. 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?

14. 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

15. 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.

16. Pricing Information Goods 16

17. 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.

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

19. 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).

20. 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.

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

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

23. 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

24. 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, email addresses, news, stock price quotes, etc.)  Freemium pricing

25.  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

26.  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

27. 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.

28.  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

29.  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?

30. 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.

31. 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).

32. 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.

33. Increasing Platform Penetration  High definition optical disc format war:  Between Blu-ray Disc and HD DVD (2006-2008)  Why a war? Why not coexist peacefully?  Other format wars?

34. Laws of the Information Age  Moore’s Law  Metcalfe’s Law  Power Law

35. 1. Moore’s Law  In 1965 Gordon Moore observed an exponential growth in the number of transistors per integrated circuit and predicted that this trend would continue  What it means to us today—computing power doubles about every 18 to 24 months  It is also common to cite Moore's Law to refer to the rapidly continuing advance in computing power per unit cost, because increase in transistor count is also a rough measure of computer processing power

36. 1. Moore’s Law

37. Information Capacity Constraints (or lack thereof) 2015: 15 GB free space Future: trend towards unlimited space (Remember“Your mailbox is full”? What was that about?)

38. 2. Metcalfe's Law:  Metcalfe's Law: attributed to Robert Metcalfe, originator of Ethernet and founder of 3COM:  The value of a network is proportional to the square of the number of nodes;  So, as a network grows, the value of being connected to it grows exponentially, while the cost per user remains the same or even reduces.

39. 2. Metcalf’s Law

40. The Network Effect  The usefulness of information products is often dependent on the number of other users of that technology.  For example, e-mail is quite useless if there are only a few others that use e-mail. 40

41. 2. Metcalfe ’ s Law  According to Metcalfe ’ s Law, if there are n users of a technology, then the usefulness of that technology is proportional to the number of other users of that technology (n-1 in this case). The total value of the network of the technology is therefore proportional to the usefulness to all users, which is: n(n-1) = n 2 – n. 41

42. 2. Metcalfe ’ s Law If n is large, as it will be for most information products, then n will be small relative to n 2 and Metcalfe ’ s Law becomes: The total value of the network of a technology is proportional to n 2 42

43. 2. Metcalfe ’ s Law  The more users of a technology there are, the more useful it becomes.  Examples:  Facebook,  E-mail  MS Windows/MS Office 43

44. 2. Metcalfe ’ s Law: Critique  Facebook’s IPO and valuation of a lot of tech companies is rationalized based on some variant of Metcalfe’s law of network effects  However recent research suggests that it produces over-valuation  The real value is closer to Zipf’s law: N*log N  linguist George Zipf: in any system of resources, there exists declining value for each subsequent item. 44

45. 3. Power Law  On the Web a few pages have a huge number of other pages linking to them, and a very large number of pages have only a few pages linking to them.  In short, the Web has many small elements, and few large ones.

46. Power Law

47. The Long Tail  The internet vs. brick-and-mortar  Nearly unlimited capacity  Distribution and shelving costs approaching zero  Global distribution channels  A changing economy  Popularity no longer has a monopoly on profitability  Can generate significant revenues by selling small number of millions of niche products vs. selling millions of a small number of “hits”

48. The Long Tail

49. Wal-Mart vs. Rhapsody  Wal-Mart  39,000 songs on CDs in average store  Must sell at least 100,000 copies of a CD to cover its retail overhead and make a sufficient profit  Less than 1 percent of CDs sell that much  Therefore, can carry only “hits”  Itunes/Rhapsody/Spotify  Millions of songs in archives  Cost of storing one more song is essentially zero  More streams each month beyond its top 10,000 than in the top 10,000  Therefore, no economic reason not to carry almost everything

50. Long Tail: Good News for Consumers  Brynjolfsson, Hu, and Smith (2003):  consumer surplus is 10x higher from access to increased product variety vs. access to lower prices in online stores  Consumers as individuals  Satisfaction of very narrow interests  Mass customization as an alternative to mass-market fare

51. Long Tail Examples: Travel

53. Netflix Long Tail

54. Case: Freemium Pricing at Dropbox AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

55. Freemium Pricing Model Concept Importance of Referral Increasing the number of consumers is key for business success Free upgrades for referral increase the network size and revenue Offer limited access to a company’s service for free Charge for anything above Industries using Freemium Apple’s App store – 2013: 77% of top 100 grossing Apps LinkedIn – 0.8% of users Evernote – 1% of users Spotify – 20% of users

56. Industry Overview Direct Competitors Microsoft Apple Google Amazon Global Market Value in 2011: $ 4bn Expected Value in 2018: $ 46bn What are value drivers in the industry? What drives the price in the industry? ProviderPlatform Price (per year per GB) SkyDrive iCloud Google Drive Simple Storage $2 $1.2 $.095 Actual Usage

57. DropBox Overview Founded by Drew Houston and Arash Ferdowsi in 2007 Provides remote storage and file sharing, accessible online or as folder on your computer Total number of users: 200 million – 1.6 – 4 percent actually generate revenue The company targets both, private consumers and corporations Freemium Referral 500 MB storage for both sender and receiver Maximum of 16 GB Additional 2.8 million Referrals, which is a referral rate of 70 percent 12 percent conversion rate * *(individuals who install dropbox/individuals who click on the invitation link)

58. Approach Problem Approach 1. The cloud storage market was fragmented with small competitors 2. Bureaucracy prevented business customers from purchasing cloud storage 3. Consumers were not willing to pay for the service, as they have not adapted to the product at that time 1. Faster file backup and retrieval service – Combination between users’ own storage and remote storage (i.e. dropbox folder) 2. Focus on individual consumers to avoid business bureaucracy 3. Freemium Pricing Result 200 million users by November 2013 Valued at $ 4bn in 2013 After capturing individual consumers, focus on corporate customers

59. Market to Corporate Customers CorporateConsumer Share (%) Product Price $800 per year for five users +$125 for each additional user Unlimited storage Administrative controls to manage documents Single-Sign-On option 14-day free trial period Impact 40% of 400 million revenue 96-98 % use product for free