1. Lecture 11 Pricing Information Goods

2. 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.

3. 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.

4. Properties of Information goods
Unique cost structure
Properties of experience goods
Properties of public goods
Network effects and externalities

5. 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).

6. 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.

7. Traditional Product Fixed and Variable Costs AC P AVC Total Fixed AFCq1 Q

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

9. 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

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

11. 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.

12. 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.

13. 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.

14. 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:

15. 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

16. 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?

17. 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.

18. 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).

19. 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.

20. Increasing Platform Penetration
High definition optical disc format war:
Between Blu-ray Disc and HD DVD ( )
Why a war? Why not coexist peacefully?
Other format wars?

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

22. 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

23. "Web 2.0, Library 2.0, and Copyright 2.0"
1. Moore’s Law
Graphics Source:
Eric Flower

24. 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?)

25. 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.

26. 2. Metcalfe’s Law

27. The Network Effect
The usefulness of information products is often dependent on the number of other users of that technology.
For example, is quite useless if there are only a few others that use .

28. 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.

29. 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

30. 2. Metcalfe’s Law
The more users of a technology there are, the more useful it becomes.
Examples:
Facebook,
MS Windows/MS Office

31. 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.

32. 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.

33. 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

34. 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.

35. Power Law

36. 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”

37. 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.”

38. 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

39. Long Tail Examples: Travel

41. Netflix Long Tail

42. 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

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

44. 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.

45. 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.

46. 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.

47. 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.

48. 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

49. 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

50. 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.

51. 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.

53. 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)

54. Case: Freemium Pricing at Dropbox

55. 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

56. 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

57. What drives the prices?

58. How is Dropbox differentiated from its competitors?

59. 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)

60. 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

61. 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