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Pricing Information

Hal R. Varian

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Britannica v. Encarta

• Britannica: 200 years, $1,600 for set• 1992: Microsoft purchased Funk & Wagnalls

to create Encarta• Britannica response

– Sales dropped 50% between 1990 and 1996– Online subscription at $120– CD first for $200, then $70-$125– Free access, Summer 1999– Offer subscriptions to libraries– Adopt Wikipedia model

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Wikipedia v Encarta• Wiki – developed by Ward Cunningham circa

1994-95• Wikipedia started 2001 by Larry Sanger and

Jimmy Wales– Currently 2.7 million articles (in English)– 256 other languages, 21 with more than 50

thousand articles

• Microsoft’s response: “looking for volunteers to keep Encarta up to date.”– "Microsoft offers cash"– "Paid entries in Wikipedia?“

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Production Costs of Information

• First-copy (fixed) costs dominate– Sunk costs: not recoverable

• Variable costs small; no capacity constraints– Microsoft profit margins of 92%

• Leads to significant supply-side economies of scale and scope

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Economies of Scale and Scope

• Traditional supply-side economies (cost effects)– Economies of scale

• cost of incremental units less than average cost• equivalently: average cost is declining in units produced• often due to fixed costs

– Economies of scope• cost of producing additional products reduced• often due shared resource • E.g., Google infrastructure allows them to offer additional

services at relatively low cost (e.g., Google Scholar)

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Economies of Scale and Scope

• Demand side (revenue effects)– Economies of scale

• value of product increases with number of users• often due to network externalities

– Economies of scope• value of product depends on availability of other products • systems effects: DVD player + disk, hardware + software • Interoperability/compatibility

– Windows + MS Office– Google calendar + Gmail

• due to branding, reputation, etc– Virgin Air, Virgin phone, etc.

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Implications for Market Structure

• Scale + scope on cost/revenue sides imply: market cannot be "perfectly competitive”– bidding wars lead to downward price spirals

• Britannica, Encarta, Wikipedia• spreadsheet wars in mid-80s

• Two sustainable structures– Dominant firm/monopoly with entry barrier such as

cost advantage, network effects (e.g., Microsoft)– Differentiated product (e.g., magazines)

• …and combinations of above

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Example of commoditized information

• CD ROM phonebooks: 1986: Nynex charged $10,000 per disk for NY directory

• Nynex employee + consultant started rival product– Hired Chinese workers at $3.50 daily wage– Partnership broke up– Bidding war between ProCD and Digital

Directory Assistance (Bertrand competition)• Competitive price reductions• Price forced to marginal cost

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Other examples of commoditization?

• What are some other examples of information commoditization?

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What to do to achieve sustainability

– Exploit economies of scale and scope on demand side and supply side

– Supply side/cost strategy• …but if everyone tries to do it, watch out• …first-mover (really best-mover) advantage

– Demand side strategy• build a network/community: eBay, YouTube• move to advertising model• differentiate your product

– add value to the raw information to distinguish yourself from the competition

– target specific markets (as with social networking sites)– compare MySpace, Facebook

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Cost Strategies for Commodity Business

• Reusability: sell the same thing over again– Baywatch, Reuters, FoodTV, SciFi channel– Reduces average cost

• Look for supply-side economies– scale: natural in info business– scope: often arises

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Revenue Strategies for Commodity Business

• Differentiate your product– West Publishing and page numbers– Google API to Maps: User Created Content

• Look for demand-side economies– scale: network effects (e.g., via community)– scope: interoperability, branding,

reputation, bundling

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First-mover Advantages• Avoid greed

– Respond to threat quickly and decisively• Example: Intuit and Microsoft

– Limit pricing to discourage entry• highly credible with high sunk costs to entry

• Play tough– Discourage future entry– Microsoft: “Embrace and extend…”– Engage in constant innovation (Amazon, Google)

• Value to incumbent of controlled experiments• Example of MSN search

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Hard to do for Incumbent

• May not recognize threat till too late– CP/M– Wordstar– VisiCalc– AOL

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Personalize Your Product

• Personalize product, personalize price• Search-based advertising

– Google, Yahoo, MSN chief players– Pay per click model – Auction off the best positions

• Very effective ads due to high relevance• Very high margins due to low marginal cost• Will explore in detail later…

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Know Your Customer

• Registration– Required: NY Times– Billing: Wall Street Journal– Yahoo/Microsoft: collect addresses– Allows demographic targeting via ZAG

• Know user behavior– Observe queries– Observe clickstream– Yahoo and Microsoft: behavioral targeting

– "Online retailers are watching you"

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Logic of Pricing

• Quicken example– 1 million wtp $60, 2 million wtp $20

Quantity (Millions)

$20

$40

$60

1 2 3

Price(Dollars)

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Quicken example

– Assumes only one price• Charging different prices gives $100 million• But how do you get at extra value?

– Answer: market segmentation/price differentiation• Quicken Basic• Quicken Deluxe• Quicken Premier• Quicken Home and Business

– But how to segment?

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Forms of Differential Pricing

• Personalized pricing– Sell to each user at a different price

• Versioning– Offer a product line and let users choose

• Group pricing– Based on group membership/identity

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Personalized Pricing inTraditional Industries

• Airlines and yield management• Direct mail and catalogs

– Britannica experiment– Victoria’s Secret

• Supermarket scanners– Profit margin more than doubled 1993-1996– More effective than newspaper advertising due to

targeting

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Promotional Pricing

• Sales, coupons, rebates• Only worthwhile if these segment

market – some use, some don’t• Offer credible signal of price sensitivity

– By proving you are price sensitive, get a lower price

– But by same token are a nuisance– "Rebates expiring"

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Personalized Pricing: new techniques on the Internet

• Auctions– Ebay, Priceline, Dovebid,etc.– Will discuss in later lecture

• Huge lock-in for auction markets due to network effects– Buyers want to be where sellers are and vice

versa– Compare eBay US and Yahoo Japan auctions

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Group Pricing

• Price sensitivity: traditional– low price to more elastic (sensitive) demand

• Network effects, standardization– value of good goes up if your group adopts– significant switching costs for organization– site licenses offer big discount because of this

• Product endorsement/viral market– “click here to email to a friend”

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Group pricing: price sensitivity

• International pricing– US edition textbook: $70– Indian edition textbook: $5

• Problems raised by Internet– Localization as partial solution– Keyboards, languages, etc.– Grey market in cameras and warantees

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Sharing as group pricing

• Transactions cost of sharing– History of video rental

• Only video sales• Rise of video rental• Pricing for ownership• Revenue sharing model

– Academic journals• Library price (for shared copies)• Individual price • Now: bundling

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Summary

• Understand cost structure• Commodity market: be aggressive, not

greedy• Avoid commoditization if you can:

differentiate product and price• Understand consumer• Continual experimentation• Personalize products and prices