Lecture 12: Pricing Information Goods AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 1

Information Goods 3 Strategies for Information Goods: Differentiation of Product and Services. Lock – In. Positive feedback and network externalities 1 2 2

1. 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 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” 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 $ and a Panasonic priced at $ The second group was offered three options: an Emerson priced at $109.99, a Panasonic priced at $ 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.

Other (non information goods) examples The Starbucks menu uses the "rule of three." Tall, Grande, and Venti (12, 16, and 20 ounces respectively) Note that Grande = 2 cups of regular 8 oz coffee!!! TIP: Many Starbucks will serve you eight ounces of coffee, but you have to ask for a "Short" coffee (which isn't listed on the menu). You do have to remember that password "Short," though: Company policy says that a customer who asks for a "small" coffee is to be given a "Tall" one.

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 version - this is the Goldilocks effect. 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.

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)

2. Managing Lock-In for Sellers 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.

3. Positive Feedback and Network Externalities “ Positive feedback makes the strong grow stronger... and the weak grow weaker.”

Positive Feedback How it Helps? Consumers value information technologies that are widely used, just as they value communications networks with broad reach. - NETWORK EXTERNALITY. QWERTY vs DVORAK Betamax vs VHS Blue Ray vs HD DVD Positive feedback works to the advantage of large networks and against small networks.

Network Effects When the value of a product is affected by how many people buy/adopt it Example: Phone System Types of Network Effects Direct Indirect Post-purchase

Network Effects All these strategies encourage faster circulation of the good (more people find an offer that is attractive to them) -> encourage network effects -> increase value of the product

Direct Network Effects The number of users directly impacts the value of the system Based on interaction between members of a network Metcalfe’s Law: Network of size N has value O(N^2) Facebook IPO valuation partially based on a version of Metcalfe’s law 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.

Indirect Network Effects Do not directly affect the value of the product Indirect influence Credit cards: More adopters of the card  more merchants accept it  higher value for the card

Post-Purchase Network Effects Mostly support related Examples Software user groups (LINUX Users Group) Consumer networks

Bass Diffusion Model The Bass diffusion model describes the process of how new products get adopted as an interaction between users and potential users. It has been described as one of the most famous empirical generalizations in marketing,

Innovations: Demand Side Bass Diffusion Model Describes the first purchase and diffusion of innovative new durables. Postulates two distinct types of influences on potential consumers The intrinsic desire to adopt an innovation: the innovation effect. Consumer characteristics. Marketing-mix activities. The influence of social interactions (e.g., through word-of- mouth WOM) with consumers who have already bought: the imitation effect.

The Model Let the potential market for a new innovation such as HDTV be Q and the number of consumers who have already bought the product at any time t be q t. At any time t and for any given consumer in the population, let the probability of purchase be P When q t consumers have already bought the product, then ( Q - q t ) have not yet purchased (i.e., this is the untapped market).

The Model The expected sales at any time t are In this i is the coefficient of innovation: people who are not affected by how many others have adopted. This effect is highest in the initial periods. Captures the fact that early buyers are less affected by word-of- mouth (i.e., WOM). c measures the coefficient of imitation. This effect increases with the number of people who have already adopted. Later buyers are more influenced by WOM.

Sales Patterns Case 1: Innovation with strong innovation but weak imitation effect Case 2: Innovation with weak innovation but strong imitation effect

Summary The original model fits data quite well at the category level in numerous new product markets. Given initial sales data it is a good tool to estimate total market potential peak of the innovation Ignores the strategic effect of firm competition in shaping the product diffusion of innovations.

Online Music Industry and Long Tail

Online Music Industry Product: music files (in single or album format) available for personal download over the internet Basic technology: File format (iTune’s AAC, Microsoft’s WMA, MP3) DRM technology Distribution: retailers’ websites

The Beginning of Napster June 1, 1999 – Napster, the first free, online file sharing service is launched Specialized exclusively in music in the form of MP3 files, which could then be burned onto CDs Resulted in sharp decline in the number and dollar amount of pre-recorded music sales in 2000

Digital Rights Management (DRM) DRM is software that can detect, monitor and block the use of copyrighted material Limits or prevents the sharing of downloaded music Opened the door for new ways of legally distributing digital content Different versions of DRM allow different access to files

Product Differentiation A la carte vs. subscription services Compatibility with portable music devices Ease of use Terms of use Ability to burn to a CD Computer accessibility Additional products or services Streaming video Radio Related products (iPod accessories, concert tickets)

First mover advantage iTunes moves first Apple negotiates contracts with Big 4 record labels As implicit monopoly, can secure wholesale discounts and favorable pricing Sets price of $0.99 per downloaded song Competitors follow Undercut to drive price to MC? No! Don’t have Apple’s purchasing power or wholesale discounts, so can’t be profitable by undercutting Competitors match the leader

Results and Exceptions Apple profit margin: 5-10% Exceptions to the rule Wal-Mart: $0.88 eMusic: $ (depends on subscription) Yahoo!: $0.79

Music Download Costs Largely sunk or fixed costs Copyright deals with record labels Technology development Potential savings from volume on bandwidth and financial transaction costs Low MC of adding an additional song to library Labels$ $0.70 Financial Transaction$ $0.15 Marketing$ $0.10 Staff$ $0.05 Bandwidth and Hosting$ $0.05 Start-up Costs$ $0.03 Total Costs$ $1.03

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”

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” Rhapsody Over 1 million songs for sale Cost of storing one more song is essentially zero Top 400,000 songs streamed once a month 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: 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

A La Carte Downloading Effectively “unbundles” CD Allows for significant consumer surplus