Lecture 11 Pricing Information Goods

Lecture Plan: HW3 Pricing Information Goods Cost structure Network Externalities Information Laws Long Tail Required background reading : HBS case “Freemium Pricing at Dropbox” Required reading for next class: HBS case Merck: Pricing Gardasil.

The Information Economy 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 Unique cost structure Properties of experience goods Properties of public goods 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 Fixed and Variable Costs AC P AVC Total Fixed AFC q1 Q

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

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

2. Properties of Experience Goods 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.

3. Properties of Public 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.

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.

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:

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 (2006-2008) Why a war? Why not coexist peacefully? Other format wars?

Laws of the Information Age Moore’s Law Metcalfe’s Law Power Law

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

"Web 2.0, Library 2.0, and Copyright 2.0" 1. Moore’s Law Graphics Source: http://www.intel.com/research/silicon/mooreslaw.htm Eric Flower

Information Capacity Constraints (or lack thereof) 2017: 15 GB free space Future: trend towards unlimited space (curiously – the same for the last 3 years) (Remember“Your mailbox is full”? What was that about?)

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.

2. Metcalfe’s Law

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.

2. Metcalfe’s Law n(n-1) = n2 – n. 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) = n2 – n.

The total value of the network of a technology is proportional to n2 2. Metcalfe’s Law If n is large, as it will be for most information products, then n will be small relative to n2 and Metcalfe’s Law becomes: The total value of the network of a technology is proportional to n2

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

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.

2. Metcalfe’s Law Implications INCREASE SWITCHING COSTS! Investing to build an installed base through promotions and by offering up-front discounts. Designing the products and pricing to get customers to invest in technology, thereby raising their own switching costs. Maximizing the value of installed base by selling customers complementary products and by selling access to installed base.

2. Metcalfe’s Law Implications “ Positive feedback makes the strong grow stronger . . . and the weak grow weaker.” Examples of Battles: QWERTY vs DVORAK Betamax vs VHS Blue Ray vs HD DVD

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.

Power Law

The Long Tail The internet vs. brick-and-mortar A changing economy 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”

The Long Tail Marginal costs approaching zero, nearly unlimited capacity, and global distribution channels give rise to a market in which firms can generate significant (in some cases the bulk of) revenues by selling a small number of millions of niche products as opposed to relying on selling millions of a small number of “hits.”

Wal-Mart vs. Rhapsody Wal-Mart Itunes/Rhapsody/Spotify 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

Long Tail Examples: Travel

Netflix Long Tail

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

Pricing Information Goods: Differentiation of Products and Services Strategies used: a) Mass Customization b) Differential Pricing c) Personalized Content d) Versioning

Versioning Extremely low marginal costs rule out many traditional pricing strategies: the only viable option is to price the product according to how much value customer places on it. Individualized pricing is difficult, and the only practical way to do it is to sell different versions at different prices. The version the customer chooses will reveal the valuation she places on the product.

Versioning Need to identify the necessary versions. Several dimensions to consider: time (or delay) of the product release hardcovers are released before paperback, movies are first shown at the cinema, convenience The more a customer needs information, the more freedom they’ll want in accessing it. comprehensiveness newspapers allow access to their recent articles, but charge for access to archives.

Versioning Several dimensions to consider:. annoyance speed allowing some users to avoid seeing advertising, speed common among software makers, with different versions running at different speeds. data processing limit the capabilities or number of data that can be processed in different versions, interface from sophisticated to simple intuitive ones; support providing different levels of support for different products.

Optimal Number of Versions The optimal number of versions of a product offered should be equal to the number of types of customers in the market. But what happens if there is no obvious choice? Or if the number of types is huge. A common choice is to have 2 versions: “Standard” and “enhanced/premium” However, recent behavioral research suggests that the optimal number is not two but three.

Extremeness aversion Extremeness aversion: if the only two sizes of drink that you offer are small and large, then some consumers will be on the margin between choosing one extreme or the other. Some of these consumers will choose the small version, thereby reducing producer revenues. Suppose the producer adds a ‘‘jumbo’’ version, and renames the sizes ‘‘small,’’ ‘‘medium,’’ and ‘‘large,’’ with the current medium being the same size as the previous large version. In this case, the medium size serves as a focal point for the indecisive: those who would have chosen small, end up compromising on medium, thereby increasing revenues

Evidence Simonson and Tversky describe a marketing experiment in which two groups of consumers were asked to choose microwave ovens. One group was offered a choice between two ovens: an Emerson priced at $109.99 and a Panasonic priced at $179.99. The second group was offered three options: an Emerson priced at $109.99, a Panasonic priced at $179.99 plus a high-end Panasonic priced at $199.99

Implications By offering the high-end oven, Panasonic increased its market share from 43% to 73%. More remarkably, the sales of the mid-priced Panasonic oven increased from 43% to 60% apparently because it was now the‘‘middle’’ choice.

Goldilocks effect Adding a “premium” version to the product line actually boosts the sales of the mid-priced version. The newly-introduced premium version steals market share from the mid-range version, This is more than offset by the market share that the mid-range version gains at the expense of the low-end. Note that this is purely the result of a cognitive bias – there is no objective rationale for such trading-up. The Goldilocks principle states that something must fall within certain margins, as opposed to reaching extremes.

A bit off topic. Wine! Similarly, we see the goldilocks principle in place in restaurants that optimize the wine list Research shows that a lot of customers order second cheapest wine on the menu. Restaurants tend to mark up the second cheapest wine the most (the largest margin of wines on the wine list)

Case: Freemium Pricing at Dropbox

Freemium Pricing Model Concept Importance of Referral Offer limited access to a company’s service for free Charge for anything above Increasing the number of consumers is key for business success Free upgrades for referral increase the network size and revenue 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

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

What drives the prices?

How is Dropbox differentiated from its competitors?

DropBox Overview Referral 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 pricing model 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)

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

Market to Corporate Customers Consumer Share (%) Price $800 per year for five users +$125 for each additional user Product 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