PRICING OF DIGITAL GOODS

LEARNING OBJECTIVES
• Understand Basic Economic Properties of Digital
Goods.
• Understand Strategies for Pricing Digital Goods:
• What personalized pricing is and how it is used.
• What group pricing is, and how it is used.
• Versioning as a differentiation strategy
• How digital piracy and DRM can affect versioning.
• Familiarize yourself with other commonly used pricing
strategies:
• Bundling
• Usage-based pricing
DIGITAL (“INFORMATION”)
GOODS: EXAMPLES
• Information Goods: Products that can be digitized

• eBooks, Movies, TV programs

• Newspaper, magazines
• CD, DVD
• Software, Customized cellular ringtones
• Online content (video, web sites)
• Online application services
• Online information services
PROPERTIES OF DIGITAL
GOODS: EASY TO COPY
PROPERTIES OF DIGITAL
GOODS: EASY TO DISTRIBUTE
Title User Speed
song1.mp3 beasiteboy DSL
song2.mp3 beasiteboy DSL
song3.mp3 beasiteboy DSL
song4.mp3 kingrook T1
song5.mp3 kingrook T1
song5.mp3 slashdot 28.8
song6.mp3 kingrook T1
song6.mp3 slashdot 28.8
song7.mp3 slashdot 28.8

s ong5

“beastieboy” “kingrook” “slashdot”

•song1.mp3 •song4.mp3 •song5.mp3
•song2.mp3 •song5.mp3 •song6.mp3
•song3.mp3 •song6.mp3 •song7.mp3
•song5.mp3
 PRODUCTION COSTS
Costly to produce but cheap to reproduce
• Sunk costs: Costs paid upfront before production.
• Plus marketing and promotion costs.
• Usually not recoverable even if production is halted (no resale of flop movie, low price
for dud CD)
Variable costs small
• Total cost does not increase much with production quantity.
No capacity constraints
• Can make and distribute unlimited number of copies.
This leads to significant economies of scale
• Marginal cost less than average cost
• Declining average cost with production
• For instance, Microsoft has 92% gross profit margins.

What does this mean for competition?

COST STRUCTURE OF DIGITAL
GOODS
High fixed cost to develop the first copy
Marginal cost of additional copy is low or zero (negligible cost to
duplicate)
Distribution costs fall so first copy cost is a large proportion of total cost

Cost

Average Cost

Marginal Cost

Quantity
0
CONSUMER AND PRODUCER SURPLUS

Consumer surplus is the difference between the price paid and the
higher price that consumers would have been willing to pay for the
product.

Producer surplus is the difference between the payment received and

the minimum payment that producers would have accepted.
CONSUMER AND PRODUCER SURPLUS

1
3
Pe
4
2

Q1 Qe
CS = 1 PS = 2 DWL = 3+4
MARKET STRUCTURES FOR
DIGITAL GOODS
• Threat of sequential price cutting (example: CD telephone books)
• When many firms sell very similar digital goods, marginal cost
pricing is inevitable
• Digital goods have very low or zero marginal costs

• What are the implications?

COMMODITIZED INFORMATION:
CD-ROM PHONE BOOKS
1986: Nynex charged $10,000 per disk for NY directory &
sold to govt. agencies
ProCD and Digital Directory Assistance for national
directories
• Phone companies would not give CDs
• Internationally outsourced at $3.50 daily
Low barrier to entry (6 companies)  more supply than
demand  Bertrand competition
• Start at $200 each, now at < $20.
• Once several firms have sunk costs, then price is forced close to
marginal cost
• (Think what happens if one competitor cuts prices)
VIABLE MARKET STRUCTURES FOR DIGITAL GOODS
Viable “market structure”: Cost leadership
• Dominant firm: Monopolist (?) with economies of scale
• The firm with lowest costs gets the market
Achieving Cost leadership

• How does one become a cost leader when variable costs are zero?
• Supply chain, workflow analysis, low assembly costs do not help

• As quantity sold goes up, average costs go down

• Sell and resell as many versions as you can
• “Long tail”
• Syndication
VIABLE MARKET STRUCTURES FOR DIGITAL GOODS
Viable “market structure”: Product differentiation
• Differentiated products: Many firms, each producing a
differentiated variety of the product

Achieving Product differentiation

• Unique capabilities
• E.g., editorial resources, talent
• Intellectual property protection
West Publishing
• Few firms in collecting statutes and legal opinions. Now they can be scanned.
• Key number system of legal references citation index. (Copyright and content)
• Technological quality, resolution, speed (Google Video)
STRATEGIES FOR AN EXISTING MARKET LEADER
“Don’t be greedy”
• Price as high as you can without making it profitable for a potential
entrant to come into your market (“limit pricing”)
• Low prices take your customers out of the market for a while
• Achieve “lock-in”
• Limit price is lower than the “monopoly” price
• Example: Microsoft Windows

“Play tough”
• Be willing to signal that you will cut prices if necessary
• Costly in the short term, but can be profitable in the long run
• Discourage future entry
• Imitation as a strategy
• Constant innovation (search engines)

Example: Google vs. MSFT

PRICING STRATEGIES
Pricing information (digital) goods (products)
• Personalized pricing (First-degree price
discrimination)
• Group pricing (Third-degree price discrimination)
• Versioning (Second-degree price discrimination)
• Bundling
• Usage-based and unlimited usage pricing
 PERSONALIZED PRICING
p p

vs.
PRICE

REVENUE REVENUE

DEMAND q q

• The idealized economic scenario (ideal for the seller)

• Find out what each customer is willing to pay, and charge
them as close as possible to this
• Can work in conjunction with increasing product fit
• Made more easily feasible by a web-based sales channel
 PERSONALIZED PRICING:
IMPLEMENTATION ISSUES
sucker! So, how much
Five bucks sucker!
are you willing
to pay for my
information?

• Typically requires more information than may be realistic:

customers will not reveal their true willingness to pay
• Requires preventing arbitrage
• Customers don’t like paying different prices
Solution: use indirect methods, e.g. targeted coupons
REAL WORLD PERSONALIZED
PRICING
Approximate examples: Automobile dealers, Lexis-Nexis, Airlines
Opportunities online: Amazon, Virtual Vineyards
• Gather demographic information
• Monitor clickstreams
• Easy to adjust prices on-the-fly
Other Concepts
• Pricing based on ROI or total cost of customer
• Behavior-based pricing (clickthroughs/purchases)
Personalized vs. Group Pricing
• Real-world instances of personalized pricing are usually some
type of group pricing (zip, gender, reaction to offers…)
 GROUP PRICING
Same product, different prices for different groups
• Identify groups willing to pay less, offer them lower prices
• Need to be able to identify group membership easily
• What types of groups are systematically willing to pay
less?

p p
SEGMENT 1 SEGMENT 2

PRICE 1
PRICE
vs.
REVENUE PRICE 2
REVENUE

DEMAND q q
DEMAND
GROUP PRICING
Examples of group pricing
• Wall Street Journal, Microsoft Office, movie tickets,
magazines, software, airlines, trains

Group pricing and digital piracy

• Piracy lowers a consumer’s willingness to pay
• Identify ‘high-piracy’ groups, offer them lower
prices
• What would these groups be for digital music, for
example?
 VERSIONING
p p
High-end version

Single version

PRICE 1

Low-end version
PRICE
vs.
REVENUE
PRICE 2
REVENUE
DEMAND q q
DEMAND

• Different versions, different prices

• Segmentation based on self-selection based on
willingness to pay for different versions
VERSIONING
Key idea: get customers to self-select
Different than customization: all customers prefer the high-
end version
Key challenges:
• Analyzing what dimensions segment your customers
• Designing pricing based on these dimensions
Non-digital example: Airline seats
Seat + 3-week advance + $100 penalty + less legroom
+ lousy food
OR Seat + fully refundable + book anytime + more
legroom + lousier food
VERSIONING DIMENSIONS
EXAMPLE: NEED FOR DISCOUNT AT HIGH-END
100 total consumers; 2 versions of a software program

40 type As (impatient): WTP $100 for fast, $40 for slow version

60 type Bs (patient): WTP $50 for fast, $30 for slow version
Offer only fast: best price is $50, revenues=$5000

Offer only slow: best price is $30, revenues = $3000

Perfect price discrimination: 40*100+60*50= $7000 in revenues

Making Self-Selection Work

• May need to cut price of high end
• May need to cut quality at low end
• Value-subtracted versions
• it may cost more to produce the low-quality version!
• In design, make sure you can turn features off!
 ONE POSSIBLE VERSIONING
SOLUTION
Try fast for $100, slow for $30
• Will this work? Compare benefits and costs to consumers
• Surplus value for A’s: 100-100=0, but 40-30=10 > 0
• Revenues = 100x$30 = $3000
• Discount the fast version: 100-p=40-30
• So, p=90
• Revenues = $5,400 = $90x40 + $30x60
p
High-end version

Discount
PRICE 1 Low-end version

High-end surplus
for low-end version
PRICE 2
REVENUE
WTP: Willingness to pay
DEMAND q
 COMMON VERSIONING
DIMENSIONS
Comprehensiveness (all vs. selected features)
Timeliness (current vs. delayed stock quotes)
Convenience (interface, search capabilities)
Resolution or sound quality (selling images and songs)
Annoyance (selling shareware software, fast vs slower version)
Support (24/7 on-site vs. toll-free calls vs. pay-per-call)
Access (online books vs. physical copies)

Others?
VERSIONING EXAMPLE:
BRITANNICA ONLINE
Possible versioning options
• In-depth vs. summary, real-time vs. once-a-year
updates, resolution of graphics, search and organizing
capability, ability to print or copy,..

• Other possibilities?

How many versions would you create?

• One, two, three…?
• The Goldilocks principle
VERSIONING AND PIRACY
Versioning based on digital rights
• Number of times one can render
• Number of devices one can render on
• Number of copies one can create for personal use
• Permission to rent and/or resell
• For software: # of clients one can install software on, #
of clients that can use software concurrently.

Versioning and digital piracy

• A pirated good is often like a free low-end version
• Therefore, price your product as the high-end version
• Identify those features that are degraded the most in the
pirated version, and highlight those in the legal version
OTHER PRICING STRATEGIES
Usage-based (and unlimited usage) pricing
• Similar to versioning based on usage
• When tracking/billing usage is costly, unlimited-
usage pricing is often profitable (some examples:
AOL, telephony)

Bundling
• Different customers value different features
differently
• If you can’t figure out who values what, bundling
may be useful
• Bundling digital goods has special benefits
• However, may have piracy concerns
BUNDLING: A SIMPLE
EXAMPLE
Product 1 Product 2
Word Processor Spreadsheet

Alice $60 $40

Bob $40 $60

Optimal prices
• $40 for product 1
• $40 for product 2
• $100 for the bundle of product 1 and product 2
BUNDLING DIGITAL GOODS
Why does it make sense?
Because the valuations for the bundle converge around the mean.
[Law of Large Numbers]
 PROFITS FROM
INDIVIDUAL GOODS

Why does it make sense? Profits from

Bundle
Profits from Individual Profits from
Goods Bundle
BUNDLING EXAMPLES FOR
DIGITAL GOODS
Albums vs. singles
Cable television bundles vs. a la carte programs or
channels
Wall Street Journal Online (US+Europe+Asia+…) vs.
pay per story for research archives
Subscription services vs. pay per use
Office suites versus individual components Microsoft
Office: 90% market share
TAKE-AWAYS
1. Three types of Price Discrimination
• First degree (personalized pricing)
• Second and Third degree (versioning and group
pricing)
• Result: Increased profits, decreased inefficiency
2. Can use data about customers to increase profits and
even total efficiency
• To price discriminate or not
3. Other strategies for digital goods
• Usage-based (or unlimited use) pricing
• Bundling