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Digital Products

Digital Products. Pricing Switching Costs Network Externalities . Digital Goods. Definition Can be digitized Books, music, movies, data, software, games, … Entertainment value, business value, … Cost Structure Costly to produce, cheap to reproduce

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Digital Products

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  1. Digital Products • Pricing • Switching Costs • Network Externalities

  2. Digital Goods • Definition • Can be digitized • Books, music, movies, data, software, games, … • Entertainment value, business value, … • Cost Structure • Costly to produce, cheap to reproduce • High sunk cost of producing the 1st copy • Cost of each additional copy is small + uniform • Almost unlimited capacity to replicate • Price > Production Cost • Set Price = Value

  3. Market Structure • 1. Information commodity market pushes price to 0 • Example: CD Phone Book • 1990: Transcribe phone books, price > $100 • Competition: Copies idea, price ~ $20 • Present: Free on the Internet • 2. Add value to raw information in to differentiate • Personalize: Learn about customers through registration, billing and observation • Reduce average cost through reuse and resale • TV Shows (prime time, summer reruns, overseas markets, syndicated channels)

  4. Group Pricing • Price sensitivity • Offer different prices to different groups (seniors, students) • Network effects • Standardize on a single product (MS Office) • Lock-in • Induce customers early (newspapers in education) • Sharing • Low transaction costs favor rentals (movie video)

  5. Designing Information Product Line

  6. Designing Information Product Line

  7. Price vs. Quality • High end version: Keep price reasonable to make it attractive. • Low end version: Reduce quality so users would seek high end. • Can users (hackers) turn low end version to high end? • Does on-line version help or deter off-line one? • How many versions? How many segments?

  8. Bundling • Examples: Microsoft Office Suite, Cable TV, News Paper • Reasons for bundling • Technical: compatibility across applications in the bundle • Economic: Reduce dispersion in consumer valuation of products • P(Word)=$75, P(Excel)=$75, Revenue=75*2+75*2=$300 • P(Bundle)=$175, Revenue=175*2=$350

  9. Implications of Low Distribution Costs • Digital distribution is easy, cheap and quick. • Give away free samples to sell content • (information = experience good) • A “bitlegger” must advertise for business to his peril

  10. Digital Products • Pricing • Switching Costs • Network Externalities

  11. Switching Costs • Examples: Switching from PC to Mac? • Windows to Unix? Access to Oracle? • How much did Microsoft pay to acquire Hotmail.com? • Total switching costs = • Costs to customers and new suppliers • Even small switching costs are critical in mass market • How much would it take for you to switch your telephone service? • Profit from current customer = • Customer’s total switching costs • + Supplier’s quality/cost advantage (if any) • Charge a premium from existing customers while offering discounts to new customers.

  12. The Lock-In Cycle Brand Selection (trial) Lock-in (Switching costs) Sampling (e.g., Music club) Entrenchment (complementary investment)

  13. Lock-Ins and Switching Costs Type of Lock-In Switching Costs Contractual Compensatory or liquidated damages Durables Replacement of equipment; declines as durable ages Brand-specific Learning a new software, both direct costs and lost productivity; tends to rise over time Information/databases Converting data to new format; tends to rise over time as collection grows (VHS to DVD) Specialized suppliers Finding of new supplier; may rise over time if capabilities are hard to find/maintain Search costs Combined buyer and seller search costs; includes learning about quality of alternatives (agents) Loyalty programs Any lost benefits from incumbent supplier, plus possible need to rebuild cumulative use (discounts)

  14. Buyer’s Lock-in Strategies 1. Bargain for discounts or support for switching 2. Reason your benefits (costs) from switching are small (large) 3. Leverage future purchases or your ability to influence others 4. Seek protection from monopolistic exploitation down the road 5. Keep your options open via second sourcing. 6. Watch out for creeping lock-in

  15. Seller’s Lock-in Strategies Invest Leverage Entrench

  16. Seller’s Lock-in Strategies • Investing in an Installed Base • Look ahead the whole cycle (how long?) • Get influential customers (government) • Structure a life-cycle deal (service contract) • Large market share is not a guarantee (Netscape) • Attract buyers with increasing switching costs (growth potential) • Exploit divergent interests of multiple parties (frequent flyers)

  17. Seller’s Lock-in Strategies (Contd.) • Encourage Customer Entrenchment • Offer value-added services (custom reports) • Use loyalty programs and cumulative discounts • Leverage Your Installed Base • Sell complementary products (additional software) • Sell access to your installed base (AOL) • Set differential prices (introductory offer to low end version) • Exploit 1st mover advantage (stagger termination dates) • Control cycle length (premature renewal & update)

  18. Digital Products • Pricing • Switching Costs • Network Externalities

  19. Network Externalities • The value of a product is affected by the number of users • Positive Externalities: Telephone, Email, File sharing, debugging • Negative externalities: over-crowding, congestion, pollution Winner VHS, Windows Market Share Loser Beta, Apple Time

  20. Adoption Pattern • Key Characteristics • User expectations are important • Early adopters jump start adoption • Intermediate adopters are critical • A bandwagon may emerge • Ultimately diminishing returns 4 3 Number willing to adopt 1 2 1 1 Expected number of adopters

  21. Managing the Adoption Pattern • Create momentum through marketing • Leveraging reputation (e.g., Intel, IBM) • Winning over an influential customer • Advance sign-ups to create confidence • Wink at pirates at the outset • Leasing to reduce customer adoption risk • Price commitments to reduce lock-in risk

  22. Positive Feedback • Positive Feedback can be due to • Networks connecting users, allowing mobility • Compatibility among users • Demand side economy of scale: Market size • Supply side economy of scale: Cost of production • Combine supply-side, demand-side economies of scale

  23. Market Tipping Economy of scale Low High • Low demand for variety • High demand for variety Low Unlikely High Depends Virtuous Cycle Value to User Eventually may create negative effects Vicious Cycle Number of Compatible Users

  24. Invoking Positive Feedback • Strategy 1. Evolution • Technical: Backward (One-way) Compatibility: MS Office 97 • Legal: Incumbent’s Intellectual Property Rights: CD • Strategy 2. Revolution • Improve performance by ten times • Appeal to Early Adopters • Risky unless a growing market Improved Design Evolution Compatibility Revolution Performance

  25. Openness versus Control Do you encourage others to develop components? Or, do you leverage your position to control components? Full Openness: Int’l Telecom Union Open: Java Alliance: MS + Intel Control: AT&T before break-up Return = Total industry value * Your share Proprietary Optimum Your Share Your Reward Open Total value added to the industry

  26. Generic Network Strategies

  27. Impact of Standards on Competition • Expanded network externalities • Reduced Uncertainty • Competition for the market vs competition in the market • Competition on price versus features • Competition to offer proprietary extension • Component versus systems competition

  28. Consumers Standards: Winners and Losers Complementors Innovators Incumbents

  29. Key Assets in Network Markets Installed base of customers Intellectual Property Ability to innovate Complements First mover advantage Reputation + Brand name

  30. Key Points • Unique cost structure • Network effect • Bundle and Lock-in

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