1 Digital Products Pricing Switching Costs Network Externalities

2 Digital Goods Definition Can be digitized Books, music, movies, data, software, games, … Entertainment value, business value, … Cost Structure Costly to produce, cheap to reproduce High sunk cost of producing the 1st copy Cost of each additional copy is small + uniform Almost unlimited capacity to replicate Price > Production Cost Set Price = Value

3 Market Structure 1. Information commodity market pushes price to 0 Example: CD Phone Book 1990: Transcribe phone books, price > $100 Competition: Copies idea, price ~ $20 Present: Free on the Internet 2. Add value to raw information in to differentiate Personalize: Learn about customers through registration, billing and observation 3.Reduce average cost through reuse and resale TV Shows (prime time, summer reruns, overseas markets, syndicated channels)

4 Group Pricing Price sensitivity Offer different prices to different groups (seniors, students) Network effects Standardize on a single product (MS Office) Lock-in Induce customers early (newspapers in education) Sharing Low transaction costs favor rentals (movie video)

5 Designing Information Product Line Product DimensionUsers/Uses Delay User impatience (Stock Quote) User interfaceNovice/Experienced Convenience Daily/Weekly rental Image resolution Newsletter/Glossy Speed of operation Slow/Fast (Mathematica)

6 Designing Information Product Line Product DimensionUsers/Uses Format Raw/Organized Capability Special use (Voice recognition) Features Additional functions ComprehensivenessDepth of information Annoyance Hi price, no ads Support Hi/Lo

7 Price vs. Quality – High end version: Keep price reasonable to make it attractive. – Low end version: Reduce quality so users would seek high end. – Can users (hackers) turn low end version to high end? – Does on-line version help or deter off-line one? – How many versions? How many segments?

8 Bundling Examples: Microsoft Office Suite, Cable TV, News Paper Reasons for bundling Technical: compatibility across applications in the bundle Economic: Reduce dispersion in consumer valuation of products P(Word)=$75, P(Excel)=$75, Revenue=75*2+75*2=$300 P(Bundle)=$175, Revenue=175*2=$350

9 Implications of Low Distribution Costs Digital distribution is easy, cheap and quick. Give away free samples to sell content (information = experience good) A “bitlegger” must advertise for business to his peril

10 Digital Products Pricing Switching Costs Network Externalities

11 Switching Costs Examples: Switching from PC to Mac? Windows to Unix? Access to Oracle? How much did Microsoft pay to acquire Hotmail.com? Total switching costs = Costs to customers and new suppliers Even small switching costs are critical in mass market How much would it take for you to switch your telephone service? Profit from current customer = Customer’s total switching costs + Supplier’s quality/cost advantage (if any) Charge a premium from existing customers while offering discounts to new customers.

12 The Lock-In Cycle Brand Selection (trial) Entrenchment (complementary investment) Lock-in (Switching costs) Sampling (e.g., Music club)

13 Lock-Ins and Switching Costs Type of Lock-InSwitching Costs Contractual Compensatory or liquidated damages Durables Replacement of equipment; declines as durable ages Brand-specificLearning a new software, both direct costs and lost productivity; tends to rise over time Information/databasesConverting data to new format; tends to rise over time as collection grows (VHS to DVD) Specialized suppliersFinding of new supplier; may rise over time if capabilities are hard to find/maintain Search costsCombined buyer and seller search costs; includes learning about quality of alternatives (agents) Loyalty programs Any lost benefits from incumbent supplier, plus possible need to rebuild cumulative use (discounts)

14 Buyer’s Lock-in Strategies 1. Bargain for discounts or support for switching 2. Reason your benefits (costs) from switching are small (large) 3. Leverage future purchases or your ability to influence others 4. Seek protection from monopolistic exploitation down the road 5. Keep your options open via second sourcing. 6. Watch out for creeping lock-in

15 Seller’s Lock-in Strategies Invest Leverage Entrench

16 Seller’s Lock-in Strategies Investing in an Installed Base – Look ahead the whole cycle (how long?) – Get influential customers (government) – Structure a life-cycle deal (service contract) – Large market share is not a guarantee (Netscape) – Attract buyers with increasing switching costs (growth potential) – Exploit divergent interests of multiple parties (frequent flyers)

17 Encourage Customer Entrenchment – Offer value-added services (custom reports) – Use loyalty programs and cumulative discounts Leverage Your Installed Base – Sell complementary products (additional software) – Sell access to your installed base (AOL) – Set differential prices (introductory offer to low end version) – Exploit 1st mover advantage (stagger termination dates) – Control cycle length (premature renewal & update) Seller’s Lock-in Strategies (Contd.)

18 Digital Products Pricing Switching Costs Network Externalities

19 Network Externalities The value of a product is affected by the number of users Positive Externalities: Telephone, , File sharing, debugging Negative externalities: over-crowding, congestion, pollution Winner Loser Time Market Share VHS, Windows Beta, Apple

20 Adoption Pattern Key Characteristics User expectations are important 1.Early adopters jump start adoption 2.Intermediate adopters are critical 3.A bandwagon may emerge 4.Ultimately diminishing returns Expected number of adopters Number willing to adopt

21 Managing the Adoption Pattern Create momentum through marketing Leveraging reputation (e.g., Intel, IBM) Winning over an influential customer Advance sign-ups to create confidence Wink at pirates at the outset Leasing to reduce customer adoption risk Price commitments to reduce lock-in risk

22 Positive Feedback Positive Feedback can be due to – Networks connecting users, allowing mobility – Compatibility among users Demand side economy of scale: Market size Supply side economy of scale: Cost of production Combine supply-side, demand-side economies of scale

23 Market Tipping Economy of scale Low demand for variety High demand for variety LowHigh Low Unlikely High Depends Number of Compatible Users Value to User Virtuous Cycle Vicious Cycle Eventually may create negative effects

24 Invoking Positive Feedback Strategy 1. Evolution Technical: Backward (One-way) Compatibility: MS Office 97 Legal: Incumbent’s Intellectual Property Rights: CD Strategy 2. Revolution Improve performance by ten times Appeal to Early Adopters Risky unless a growing market Performance Compatibility Revolution Evolution Improved Design

25 Openness versus Control Do you encourage others to develop components? Or, do you leverage your position to control components? Full Openness: Int’l Telecom Union Open: Java Alliance: MS + Intel Control: AT&T before break-up Return = Total industry value * Your share Total value added to the industry Your Share Your Reward Optimum Proprietary Open

26 Generic Network Strategies

27 Impact of Standards on Competition Expanded network externalities Reduced Uncertainty Competition for the market vs competition in the market Competition on price versus features Competition to offer proprietary extension Component versus systems competition

28 Consumers Innovators Incumbents Complementors Standards: Winners and Losers

29 Key Assets in Network Markets Installed base of customers Complements Ability to innovate Intellectual Property First mover advantage Reputation + Brand name

30 Key Points Unique cost structure Network effect Bundle and Lock-in