Lecture 11: Pricing Information Goods

1. Lecture 11: Pricing Information Goods AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

2. Lecture Plan Overview of digital and information goods Cost Structure Market Structure of Information Industries Network externalities Information Laws Long Tail HW 4

3. The Information Economy • Information: • Essentially, anything that can be digitized—encoded as a stream of bits—is information. E.g. baseball scores, 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

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). • As high fixed costs are also usually sunk, producers design pricing schemes that reflect a high degree of differentiation of goods along many dimensions, such as time, convenience and format

6. Cost Structure of Information Goods • The cost of producing the first unit of a digital good is generally not small, and can be substantial. • 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.

7. Traditional Product Total Fixed Total Fixed Fixed and Variable Costs AC P AVC AFC Q q1

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

9. 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 the see highly competitive market structures.

10. 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, email addresses, news, stock price quotes, etc.)

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 have a hard time determining how much they’re willing 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: • bundling a good with an excludable good (physical means), • DRM - digital rights management (IT means) or • Encryption and licensing • Intellectual property law (legal means), can be used to modify the property. • Auditing and user tracking • Embrace copying and bundle with content that benefits from wide distribution (e.g. ads) • Network TV does this – problem: maximizing revenue does not maximize consumer surplus

15. 3. Properties of Public Goods • While there are ways to limit non-excludability, the pertinent question is whether sharing of information goods or piracy are actually always damaging to the revenue of the digital goods producer.

16. 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).

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

18. 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

19. Moore’s Law

20. Information Capacity Constraints (or lack thereof) 2012:“Over 7,687,881,264 megabytes (and counting) of free storage so you'll never need to delete another message” 2013: 10.350.051.462 megabytes (Remember“Your mailbox is full”? What was that about?)

21. 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.

22. Metcalf’s Law

23. 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.

24. 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.

25. 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

26. Network Effect • The more users of a technology there are, the more useful it becomes. • Examples: • E-mail • MS Windows • MS Office

27. 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.

28. Power Law

29. 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”

30. The Long Tail

31. 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

32. 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

33. Netflix Long Tail

34. Long Tail Examples: Travel