Lecture 12: Pricing Information Goods
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
1
Information Goods

3 Strategies for Information Goods:
1 Differentiation of Product and Services.
2 Lock – In.
2 Positive feedback and network externalities
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



convenience


hardcovers are released before paperback,
movies are first shown at the cinema,
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


speed


limit the capabilities or number of data that can be processed in
different versions,
interface


common among software makers, with different versions running
at different speeds.
data processing


allowing some users to avoid seeing advertising,
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 $109.99 and
 a Panasonic priced at $179.99.
The second group was offered three options:
 an Emerson priced at $109.99,
 a Panasonic priced at $179.99 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-ofmouth 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 qt.

At any time t and for any given consumer in the population, let
the probability of purchase be P

When qt consumers have already bought the product, then (Q
- qt) have not yet purchased (i.e., this is the untapped market).
The Model

The expected sales at any time t are
St  P (Q  qt )  i (Q  qt )  cqt (Q  qt )

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-ofmouth (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
3000000
2500000
2000000
1500000
1000000
500000
0
0
Case 2: Innovation with weak innovation but strong
imitation effect
3000000
2500000
2000000
1500000
1000000
500000
0
0
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: $0.22-0.25 (depends on subscription)
Yahoo!: $0.79
Music Download Costs

Labels
$0.60 - $0.70
Financial Transaction
$0.10 - $0.15
Marketing
$0.05 - $0.10
Staff
$0.03 - $0.05
Bandwidth and Hosting
$0.02 - $0.05
Start-up Costs
$0.02 - $0.03
Total Costs
$0.82 - $1.03
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
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