The Market for Digital Goods
An Overview
Information Commodities
• Economic characterization of commodities
– A good or service is completely characterized by its
physical description, the place in which it is available,
the date at which it is available, and any contingencies
under which it is available.
– Like other commodities, digital commodities can be
durable (in which case we call them goods) or
perishable (in which case we call them services).
• Digital goods typically exist in code (software)
• Digital services typically involve processing information
without the process itself having any permanent existence.
Characteristics of Information Products
• Physical characteristics
– Indestructibility
• Coase problem
• Obsolescence issues: What is a used information good?
– Transmutability
• Intellectual property right issues
– Reproducibility
• Excludability
• Pricing: Product differentiation and market segmentation
• Property right issues
Characteristics of Information Products
• Spatial and Temporal Characteristics
– The internet is everywhere and it never sleeps
• Enhancement to competition
– Arbitrage opportunities across different market locations or across
different time periods.
– Global markets available to all potential sellers or buyers
– Applications of technology to enhance competition: auctions, search.
• Breaking of local market power
– Information allows replacement of distribution networks with just in
time delivery systems.
Characteristics of Information Products
• Contingent characteristics
– Real-time, or near real-time, interactivity can reduce the
need to anticipate (and write contracts contingent on)
unforeseen random events.
– Networked interactions themselves introduce new
random events that can increase or decrease the value
of a digital product (new sources of uncertainty
associated with technology, new problems of
information asymmetries leading to problems of moral
hazard or adverse selection.
– Real-time financial transactions also significantly
expand the scope for contingent trades.
Markets for Information
• Complements or Substitutes?
– Information generated in any transaction will have
value, at least to the parties to the transaction. This
information is complementary to the transaction, and
can itself be viewed as a commodity with economic
value.
– Information and related digital goods having value in
and of themselves will compete with other substitute
goods or services in the market directly, rather than as
an adjunct good or service to some other transaction.
Markets for Information, cont.
• We focus on both aspects of the market for
information, beginning with an analysis of
markets for pure digital goods or services,
then turning to adjacent markets.
Strategic Issues in Markets for Digital Goods
• Indestructibility
– Innovation or Standardization?
• “If you don’t cannibalize your own market, someone else
will.”
– Related issues of pricing and market organization
• Cost structure
• Market segmentation
Strategic Issues in Markets for Digital Goods
• Reproducibility
– Can you even make a market?
• Excluding non-payers
• Copy protection versus customer annoyance
• Pricing in the face of easy reproducibility
– Copyright and Intellectual Property
• How to keep rivals from mimicking your success
• How to ensure that added value gets compensated
Pricing Digital Goods
Microsoft vs. Britannica
• Pre-internet: 32 volume set of Encyclopedia
Britannica cost $1600 in hardback.
• Microsoft’s strategy for marketing electronic
encyclopedic services:
– purchase Funk & Wagnalls Encyclopedia
– use the content of F&W to produce a CD with
multimedia enhancements and a user friendly search
facility
– market the result as MS Encarta for $49.95
Microsoft vs. Britannica
• Result:
– Britannica loses significant market share to the search
features and multimedia enhancements of Encarta and
other electronic encyclopedia’s.
– Britannica fights back:
• Online version for libraries (cost: $2000)
– But households, smaller schools and libraries continue to defect
to cheaper electronic encyclopedias and online encyclopedia
services
• Britannica offers an online subscription for individuals for
$120/yr and CDROM for $200.
– Households still not willing to pay 4 times the cost of Encarta
Microsoft vs. Britannica
– Shake out
• Jacob Safra purchases Britannica’s parent company,
disbands sales network, and begins aggressive pricecutting.
• Britannica’s CDROM version currently sells for
$49.95 after mail-in rebate
The Coase Experiment
• Analysis of the data
Round 1: Monopoly Seller (73-469)
1000
500
Transaction
31
28
25
22
19
16
13
10
7
4
0
1
Price
1500
The Coase Experiment
Round 1 (45-857)
Price
4000
3000
2000
1000
0
1
2
3
4
5
6
Transaction
7
8
9
The Coase Experiment
Round 2 (73-469)
Price
800
600
400
200
0
1
2
3
4
5
6
7
8
Transaction
9
10 11 12
The Coase Experiment
Round 2 (45-857)
2000
1000
Transaction
34
31
28
25
22
19
16
13
10
7
4
0
1
Price
3000
The Coase Experiment
Round 3 (73-469)
Price
1500
1000
500
0
0
2
4
6
Quantity Sold
8
10
The Coase Experiment
Round 3 (45-857)
3000
2000
1000
Transaction
25
23
21
19
17
15
13
11
9
7
5
3
0
1
Price
4000
Experiment
• Supply and Demand Analysis
• Conclusion: With even a small
amount of competition, prices are
driven down to marginal cost.
The Cost of Information
• The cost of producing the first unit of a digital good is
generally not small, and can be substantial.
• As we have seen, the indestructibility and reproducibility
of digital goods means that the marginal cost of producing
an additional unit of the good is close to zero.
• Because the cost of storing and transmitting stored
information is cheap (and continues to get cheaper), there
are also no effective capacity constraints on the production
of digital goods.
Cost Diagram
Implications
• Globally declining average costs imply
significant economies of scale.
• Minimum efficient scale can be on the order
of the whole market
• We should not expect the see highly
competitive market structures.
Implications
• What market structures should be expect to see?
– Markets with a dominant firm
• Microsoft comes to mind
– Differentiated Product Markets
– Commoditized information markets
• Digital goods selling at marginal cost
• Free information products (maps, telephone information, email
addresses, news, stock price quotes, etc.)
• We examine models of each of these structures in
turn.