Strategic Pricing AEM 4160

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Transcript Strategic Pricing AEM 4160

Lecture 12: Pricing Information Goods

AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 1

Information Goods

 3 Strategies for Information Goods: 1  Differentiation of Product and Services.

2  Lock – In.

2  Positive feedback and network externalities

1. 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  hardcovers are released before paperback,  movies are first shown at the cinema, 

convenience

 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,

speed

 common among software makers, with different versions running at different speeds.   

data processing

 limit the capabilities or number of data that can be processed in different versions,

interface

 from sophisticated to simple intuitive ones;

support

 providing different levels of support for different products.

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”  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.

Other (non information goods) examples

The Starbucks menu uses the "rule of three."  Tall, Grande, and Venti  (12, 16, and 20 ounces respectively)  Note that Grande = 2 cups of regular 8 oz coffee!!!

 TIP: Many Starbucks will serve you eight ounces of coffee, but you have to ask for a "Short" coffee (which isn't listed on the menu).  You do have to remember that password "Short," though: Company policy says that a customer who asks for a "small" coffee is to be given a "Tall" one.

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 version - this is the Goldilocks effect.

 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.

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)

2. Managing Lock-In for Sellers

 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.

3. Positive Feedback and Network Externalities

“

Positive feedback makes the strong grow

stronger . . . and the weak grow weaker.

”

Positive Feedback

 How it Helps?

 Consumers value information technologies that are widely used, just as they value communications networks with broad reach. - NETWORK EXTERNALITY.

 QWERTY vs DVORAK  Betamax vs VHS  Blue Ray vs HD DVD  Positive feedback works to the advantage of large networks and against small networks.

Network Effects

 When the value of a product is affected by how many people buy/adopt it  Example: Phone System  Types of Network Effects  Direct  Indirect  Post-purchase

Network Effects

 All these strategies encourage faster circulation of the good (more people find an offer that is attractive to them) -> encourage network effects -> increase value of the product

Direct Network Effects

 The number of users directly impacts the value of the system  Based on interaction between members of a network  Metcalfe ’ s Law: Network of size N has value O(N^2)  Facebook IPO valuation partially based on a version of Metcalfe’s law  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.

Indirect Network Effects

 Do not directly affect the value of the product  Indirect influence  Credit cards:  More adopters of the card  more merchants accept it  higher value for the card

Post-Purchase Network Effects

 Mostly support related  Examples  Software user groups (LINUX Users Group)  Consumer networks

Bass Diffusion Model

 The Bass diffusion model describes the process of how new products get adopted as an interaction between users and potential users.

 It has been described as one of the most famous empirical generalizations in marketing,

Innovations: Demand Side

Bass Diffusion Model  Describes the first purchase and diffusion of innovative new durables.

 Postulates two distinct types of influences on potential consumers  The intrinsic desire to adopt an innovation: the

innovation

effect.

 Consumer characteristics.

 Marketing-mix activities.

 The influence of social interactions (e.g., through word-of mouth WOM) with consumers who have already bought: the

imitation

effect.

The Model

 Let the potential market for a new innovation such as HDTV be

Q

and the number of consumers who have already bought the product at any time

t

be

q t

.

 At any time

t

and for any given consumer in the population, let the probability of purchase be P  When

q t

consumers have already bought the product, then (

Q - q t )

have not yet purchased (i.e., this is the untapped market).

The Model

 The expected sales at any time

t

are

S t

P

(

Q

q t

) 

i

(

Q

q t

) 

cq t

(

Q

q t

)  In this

i

is the coefficient of innovation:  people who are not affected by how many others have adopted.  This effect is highest in the initial periods.

 Captures the fact that early buyers are less affected by word-of mouth (i.e., WOM). 

c

measures the coefficient of imitation.  This effect increases with the number of people who have already adopted.

 Later buyers are more influenced by WOM.

Sales Patterns

Case 1: Innovation with strong innovation but weak imitation effect

3000000 2500000 2000000 1500000 1000000 500000 0 0

Case 2: Innovation with weak innovation but strong imitation effect

3000000 2500000 2000000 1500000 1000000 500000 0 0

Summary

 The original model fits data quite well at the category level in numerous new product markets.  Given initial sales data it is a good tool to estimate  total market potential  peak of the innovation  Ignores the strategic effect of firm competition in shaping the product diffusion of innovations.

Online Music Industry and Long Tail

Online Music Industry

 Product: music files (in single or album format) available for personal download over the internet  Basic technology:  File format (iTune ’ s AAC, Microsoft ’ s WMA, MP3)  DRM technology  Distribution: retailers ’ websites

The Beginning of Napster

 June 1, 1999 – Napster, the first free, online file sharing service is launched  Specialized exclusively in music in the form of MP3 files, which could then be burned onto CDs  Resulted in sharp decline in the number and dollar amount of pre-recorded music sales in 2000

Digital Rights Management (DRM)

 DRM is software that can detect, monitor and block the use of copyrighted material  Limits or prevents the sharing of downloaded music  Opened the door for new ways of legally distributing digital content  Different versions of DRM allow different access to files

Product Differentiation

 A la carte vs. subscription services  Compatibility with portable music devices  Ease of use  Terms of use  Ability to burn to a CD  Computer accessibility  Additional products or services  Streaming video  Radio  Related products (iPod accessories, concert tickets)

First mover advantage

 iTunes moves first  Apple negotiates contracts with Big 4 record labels  As implicit monopoly, can secure wholesale discounts and favorable pricing  Sets price of $0.99 per downloaded song  Competitors follow  Undercut to drive price to MC?

 No! Don ’ t have Apple’s purchasing power or wholesale discounts, so can’t be profitable by undercutting  Competitors match the leader

Results and Exceptions

 Apple profit margin: 5-10%  Exceptions to the rule  Wal-Mart: $0.88

 eMusic: $0.22-0.25 (depends on subscription)  Yahoo!: $0.79

Music Download Costs

Labels Financial Transaction Marketing Staff Bandwidth and Hosting Start-up Costs

Total Costs

 Largely sunk or fixed costs  Copyright deals with record labels  Technology development

$0.60 - $0.70

$0.10 - $0.15

$0.05 - $0.10

$0.03 - $0.05

$0.02 - $0.05

$0.02 - $0.03

$0.82 - $1.03

 Potential savings from volume on bandwidth and financial transaction costs  Low MC of adding an additional song to library

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 ”

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

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

A La Carte Downloading

 Effectively “ unbundles ” CD  Allows for significant consumer surplus