23 E-commerce 8 Aaron Schiff ECON 204 2009

Introduction Objectives of this lecture: Understand “versioning” of information goods and how different versions can be created, how versioning can increase profits, and the factors that firms must consider when designing different versions.

Versioning Information goods are often sold in different versions with different quality levels or other characteristics. Examples: 256k DRM-free versus 128k+DRM songs on iTunes. Windows Vista Home, Pro, Ultimate, etc. Flickr free versus paid accounts. Google Apps Standard vs Premier editions.

Example: Windows Vista

Example: Google Apps

Ways to Create Versions Quality 128k vs 256k music files HD vs standard video Delay Movie theatres first, DVD later Amazon shipping Live vs delayed stock quotes User interface Advanced vs basic search

Ways to Create Versions Authorised uses Restricted by DRM vs unrestricted Capacity Pro accounts on Flickr Google Apps premier vs Standard storage Speed Intel Core 2 Quad vs Core 2 Duo

Ways to Create Versions Functionality Windows Vista versions iPod Shuffle vs iPod Nano Annoyance Ads vs no ads Shareware Support Self-support vs assistance Speed and cost of support response

Why Version? Different users have different preferences over various product characteristics. A seller cannot easily identify an individual buyer’s preferences. Offering different versions allows buyers to self-select into different groups based on their preferences. Attempt to extract higher price from those who value certain characteristics more than others.

Designing Versions Need information about consumers’ willingness to pay for different features or characteristics. Profits depend on both the prices and characteristics of the different versions and consumers’ preferences over the characteristics. Objective is to get consumers with high willingness to pay to buy the ‘high-end’ version and consumers with low willingness to pay to buy the ‘low-end’ version.

Designing Versions If done correctly, versioning can extract more revenues from consumers compared to offering a single version. Need to make sure that the low-end version is not so attractive that everyone wants to buy it. Marketing is important. Don’t make low-end buyers feel like they’re buying a crippled product. Creative Labs disabled soundcard features in software. Don’t make high-end buyers feel like they’re getting ripped off. Sony charged extra for laptops without unnecessary software installed.

Versioning Model Suppose there are two consumers, consumer 1 and consumer 2. Consumers differ according to their willingness to pay for ‘quality’. A monopoly sells two different versions of a product to the two consumers, version A (‘high-end’) and version B (‘low-end’). The firm does not know the identity of each consumer.

Versioning Model Each consumer has a different marginal willingness to pay for quality curve. Marginal WTP Shows the extra amount a consumer is willing to pay as the quality level increases. It is like a “demand curve” for quality. Quality level

Versioning Model At a given quality level, the area under the curve shows a consumer’s total willingness to pay for a good of that quality level. Marginal WTP K: Total amount the consumer is willing to pay for a good of quality q0. K+L: Total amount the consumer is willing to pay for a good of quality q1. K Not willing to pay extra for quality increases beyond this level. L q0 q1 Quality level

Versioning Model Assume consumer 2 has relatively low willingness to pay for quality compared to consumer 1. Marginal WTP The firm knows what the curves U1 and U2 look like, but does not know which consumer is 1 and which is 2. U1 U2 Quality level

Versioning Model Sell high-quality version A at price pA and low-quality version B at price pB. Note the prices must be set so that consumer 1 prefers version A over version B. Marginal WTP Y X Z qB qA Quality level

Versioning Model Suppose quality is costless, so the firm sets qA and qB at the highest level where consumers are not willing to pay any extra for higher quality. Charge a price of pB = X for the low quality version. Maximum price that consumer 2 is willing to pay. Consumer 1 gets X + Y + Z – pA from the high-quality version. Consumer 1 gets X + Y – X = Y from the low-quality version. Price of the low-quality version

Versioning Model So to induce consumer 1 to buy the high-quality version, we must have: X + Y + Z – pA ≥ Y Or pA ≤ X + Z, so the highest price we can charge for the high-quality version is pA = X + Z. Total profit given these quality levels is p = pA + pB = X + Z + X = 2X + Z.

Example 1 Consumer 1’s marginal willingness to pay for quality is U1 = 20 – q and consumer 2’s is U2 = 10 – q. Suppose quality is costless and qA = 20 and qB = 10 are chosen. Questions: What is the maximum price that can be charged for version B so that consumer 2 buys it? What is the maximum price that can be charged for version A so that consumer 1 buys version A and not version B? What is the profit at these prices?

Designing the Versions We’ve found the maximum profit given the quality levels qA and qB. But are these the profit-maximising quality levels? We can’t make the consumers pay any more by increasing the quality levels. Marginal willingness to pay for extra quality is already zero. But what if we reduce the low quality level?

Designing the Versions Suppose we reduce qB a little: We have to cut pB by this much: Marginal WTP But we can increase pA by this much: => Profits increase qB’ qB qA Quality level

Designing the Versions Why does this work? Note X1 + X2 = X and Y1 + Y2 = Y Consumer 2’s willingness to pay for version B reduces to X1, so set pB = X1 Consumer 1 gets X1 + X2 + Y1 + Y2 + Z – pA from version A. Consumer 1 gets Y1 + X1 – X1 = Y1 from version B => Max price for version A is pA = X1 + X2 + Y2 + Z = X + Y2 + Z This is greater than the previous maximum price of X + Z Marginal WTP Y1 Profit increases because Y2 > X2 Y2 X1 Z qB’ qB qA Quality level X2

Example 2 As in the previous example, U1 = 20 – q and U2 = 10 – q. Question: Starting from qA = 20 and qB = 10, show that profit can be increased by reducing qB to 5 while keeping qA constant.

Designing the Versions The profit-maximising quality level of the low-end version is where the marginal changes in willingness to pay exactly offset. Marginal WTP At qB*, the gain in willingness to pay of consumer 1 for the high-end version from a reduction in qB exactly equals the loss in willingness to pay of consumer 2 for the low-end version. Gain Loss qB* qA Quality level