Information and Pricing

Supply and Demand in Two Minutes Producers have a limited set of items to sell –Each item has a marginal cost This is the cost of manufacturing, plus salary, R&D, etc. Consumers have a demand for items –Amount they’re willing to pay Prices serve to moderate demand –High prices reduce demand; low prices increase demand Prices also control production –If price is less than marginal cost, firms enter

Supply and Demand in Two Minutes This all leads to the efficient market hypothesis Once supply and demand have equalized –Profits are maximized –Social welfare is maximized In some sense, this produces an “optimal” solution. There may be other criteria not met –Fairness, moral issues, universal access This theorem is the primary argument for laissez- faire capitalism –Let the markets work, things will equilibrate on their own –The role of the government is to correct market failures

But … The “invisible hand” requires a number of assumptions –Low barriers to entry –Informed consumers –Scarcity –Excludability –Etc … What happens when these assumptions are violated?

Information goods One unique feature of (digital) electronic commerce is the ability to buy and sell information goods. No physical good purchased; only bits are transferred. Changes many of the rules of the game. Avoids direct competition with brick-and- mortar vendors

Examples of Information Goods News articles Mp3s, movies Stock quotes Software Journal articles Weather reports More …

Features of Information Goods Information goods have a relatively high fixed cost –This is the cost to make the first copy of a good. $300 million for Lord of the Rings –Can be amortized over the number of goods sold. Can discourage new entrants

Features of Information Goods Information goods have little or zero marginal cost. –This is the cost of making additional copies. Low marginal cost implies lots of consumers wanted. –Absorb high fixed costs. This is called increasing returns to scale –As you sell more items, your profit per item increases. Advantages to being a large producer.

Low Marginal Cost Classical theory predicts that items in a competitive market will be sold at marginal cost. –Competitors will undercut until margin is reached. If marginal cost is zero, information goods will be sold for no cost! –No incentive to sell then. –Obviously not the way things actually work. In the “real world”, information is not usually sold in a competitive market. –Copyright allows producers to hold a monopoly. –Cartel structures inflate prices (e.g. music industry)

Features of Information Goods Information goods are nonrival –This means that the amount one person consumes does not affect the amount available to other people. 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.

Nonrivalry Nonrivalry leads us back to the problem of selling at zero cost –If goods aren’t scarce, no one will pay for them –If no one will pay for them, how do you get people to manufacture them? “Traditional” solution: allow the government to create a “natural monopoly” –Prices are regulated so as to meet social goals –E.g. telephone service before the AT&T breakup, NSF/DARPA control of Internet

Nonrivalry Today, natural monopolies are seen as counterproductive –Corporations exert undue influence in pricing and policy Content providers are still able to maintain partial monopolies through copyright –This allows them to set prices above marginal cost. –Appealing to producers, but inefficient –Some people would buy the good if it were available at a competitive price.

Features of Information Goods Information goods are often nonexcludable –This means that you can’t prevent someone from getting the good without paying. –File-sharing is the most obvious example. Workarounds include indirect taxes –Britain has a set tax on televisions This means that information is sometimes thought of as a public good –Universally available, funded indirectly –Like streetlights, police, highways, PBS –Relationship between producer and consumer based on reciprocity rather than need

Excludability There are several strategies for dealing with the problem of excluding non-purchasers: –Couple information to a physical medium (such as a book) –Encryption and licensing –Auditing and user tracking (e.g. ASCAP) –Embrace copying and bundle with content that benefits from wide distribution (e.g. ads) Network TV does this – problem: maximizing revenue does not maximize consumer surplus

Features of Information Goods Information goods are experience goods (transparency) –This means that a consumer doesn’t know exactly how much she values an information good until after it is consumed. –Example: I don’t know how much I’ll like the new Lord of the Rings movie until I see it. –Compare this to a traditional good, like a car. Problem: consumers have a hard time determining how much they’re willing to pay. Recommendations, reviews, try-before-purchase, reputation become important.

Open Source as a Solution Open Source solves the transparency problem –Full product is available for evaluation Excludability is the main weakness –Solutions: gift economy, pay for service, increase in “status” in labor market Some incentive for vendors to add proprietary solutions on top of open source projects –E.g Microsoft’s Java.

Pricing and Packaging All of these issues open the door for new ways to price, package, and distribute information. Solutions that might not make sense in a physical economy become possible when items being sold are digital. However, old rules and laws may not apply –New rules and laws are needed

Bundling Information goods can be easily bundled and unbundled –Different packages can be easily created. When marginal cost is very low, bundling is an attractive strategy –If any consumers will pay for a particular good, producers may as well include it. –Advertising or subsidized products can be bundled to increase revenue. –Example: Cable TV, Microsoft Office, BonziBuddy

Bundling Bundling is also a nice way to deal with heterogeneous consumer preferences. Example: two items: i 1 and i 2, two consumers c 1 and c 2 c 1 values i 1 at $5 and i 2 at $3 c 2 values i 2 at $5 and i 1 at $3 Assigning separate prices to each item, the best a seller can do is charge $3 and make $12 total. If a seller can bundle the two items together, he can charge $8 and make $16 total. –(there are similar examples in which consumers do better with bundling)

Value-added bundling Bundling can be used to add value to an existing product. A seller filters, bundles and organizes existing information goods. –RedHat –AP news wire –Brokerages –Cable packages Helps consumers deal with the glut of information Takes advantage of complementarity (two things are more valuable together than separately)

Price Schedules Bundling is just one of a number of price schedules that are possible when marginal cost is very low. This makes a number of new schemes possible for the sale of information goods. Gives producers more flexibility to distinguish themselves from each other. –Specialists (searchers) often prefer single items –Generalists (browsers) want larger quantities

Price Schedules Per-article pricing (linear pricing): Every item costs $p. –Example: mp3 sales, back-dated NYT articles Bundling: Consumers pay a fixed price $b for access to all goods. –Example: cable packages, Salon, Netflix (sort of) Two-part tariff (subscription + fee) – Consumers pay an entry fee $f, plus a per-item price $p. –Buying clubs, rebates (fee is negative), amusement parks, shared computer resources

Price Schedules Mixed Bundling: Consumers are offered a choice between a linear price and a bundle. –Microsoft Office vs Word, Excel Block pricing (discount pricing): Consumers pay a price $p1 for the first n items, and $p2 for each additional item. –Grain, electricity, bandwidth

Price Schedules Nonlinear pricing –Consumer pays a different price for each item. –Logical extension of block pricing. –Power consumption, water usage Each of these schedules implements a form of price discrimination.

Price Schedules More complex schedules are able to fit consumer demand more exactly.

Price Discrimination Goal: Charge different prices to different consumers. –Extract more surplus (consumer $$) –Make it possible for more consumers to buy. First-degree price discrimination: explicitly charge different prices to different consumers. –Hard to do, potentially illegal

Price Discrimination Second-degree price discrimination –Different prices are charged for different quantities. Third-degree price discrimination –Consumers are grouped into different classes, which are charged different rates. Different versions of software Airlines Senior discounts

Issues with Schedule Complexity In theory, a more complex schedule is better for the producer –Allows him to match consumer demand more precisely. Problems –Complex schedules are difficult and confsing for people Agents may help with this –If producers must learn what prices to offer, a tradeoff develops Extra profit from a more complex schedule vs the cost of learning more parameters.

Fixed Price Schedules Simpler schedules can be learned more easily, but extract lower long-run profit

Summary Information goods have a number of characteristics that differentiate them from physical goods –Nonrivalry, nontransparency, nonexcludability, zero marginal cost Sellers of information goods need to account for the fact that traditional market rules may not apply.

Summary Information goods can be easily packaged and bundled. More complex pricing schedules are also available –Trade off the ability to precisely meet consumer demand against number of parameters needed.