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Lecture 10:
Pricing Information Goods
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
2
Lecture Plan:


HW3
Pricing Information Goods




Network Externalities
Information Laws
Long Tail
Required reading for next class: HBS case “Merck: Pricing
Gardasil”
Laws of the Information Age



Moore’s Law
Metcalfe’s Law
Power Law
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
1. Moore’s Law
Information Capacity Constraints (or lack thereof)
2015: 15 GB free space
Future: trend towards unlimited space
(Remember“Your mailbox is full”?
What was that about?)
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.
2. Metcalfe’s Law
400
350
Value of network
300
250
Individual network value
Community network value
200
150
100
50
0
1
2
3
4
5
6
7
8
9
10
11
12
Size of network
13
14
15
16
17
18
19
20
10
The Network Effect

The usefulness of information products is often
dependent on the number of other users of that
technology.

For example, e-mail is quite useless if there are only a few
others that use e-mail.
11
2. Metcalfe’s Law

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.
12
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
13
2. Metcalfe’s Law


The more users of a technology there are, the more
useful it becomes.
Examples:



Facebook,
E-mail
MS Windows/MS Office
14
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.
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.
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
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.
Power Law
1000
1200
900
1000
800
700
Relative popularity
800
600
500
600
400
400
300
200
200
100
0
0
1
50
Relative popularity
Search referrals
Page views
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”
The Long Tail
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”
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
Long Tail Examples: Travel
Netflix Long Tail
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
Pricing Information Goods:
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



allowing some users to avoid seeing advertising,

common among software makers, with different versions
running at different speeds.
speed
data processing



limit the capabilities or number of data that can be processed
in different versions,
interface

from sophisticated to simple intuitive ones;

providing different levels of support for different products.
support
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.
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.
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.
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)
Case: Freemium Pricing at Dropbox
Freemium Pricing Model
Concept
Importance of Referral

Offer limited access to a
company’s service for free

Increasing the number of consumers is
key for business success

Charge for anything above

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
Industry Overview
Global Market

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
Price (per year
per GB)
Platform

Microsoft

SkyDrive

$2

Apple

iCloud

$2

Google

Google Drive

$1.2

Amazon

Simple Storage

$.095
Actual Usage
Others
17%
Apple
33%
Google
Drive
12%
Amazon
18%
Dropbox
20%
What drives the prices?

How is Dropbox differentiated from its competitors?
DropBox
Overview

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)
Approach
Problem
1.
The cloud storage market was fragmented with small competitors
2.
Bureaucracy prevented business customers from purchasing cloud storage
3.
Consumers were not willing to pay for the service, as they have not adapted to
the product at that time
Approach
1.
Faster file backup and retrieval service – Combination between users’ own
storage and remote storage (i.e. dropbox folder)
2.
Focus on individual consumers to avoid business bureaucracy
3.
Freemium Pricing
Result

200 million users by November 2013

Valued at $ 4bn in 2013

After capturing individual consumers, focus on corporate customers
Market to Corporate Customers
Corporate
Price

$800 per year for five users

+$125 for each additional user
Consumer Share (%)
100
90

Unlimited storage

Administrative controls to manage
documents
Product

Single-Sign-On option

14-day free trial period
80
70
60
50
40
30
20
10
0
Business Users all Paid
Impact

40% of 400 million revenue

96-98 % use product for free
Consumer Business Paid
Consumer Business Unpaid