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Unformatted text preview: MGCR 331 Information Systems IT Impacts on Organizations
Sessions 23, 24 and 25 Economics of IS Today's class Economics of digital goods Shapiro & Varian Ch. 2. Pricing information Ch. 3. Versioning information (Overview, Designing Your Product Line, Adjusting Price and Quality, Bundling; pp.53-63 & pp.73-78) 2 Learning objectives Understand the unique economic properties of digital goods Understand the market structures for digital goods Understand the pricing and differentiation strategy of versioning and some common dimensions for product versions Understand what group pricing is, and how it is used
3 Examples of Digital Goods? 4 Properties of digital goods
1. Digital goods can be easily replicated 5 Properties of digital goods
2. Digital goods can be easily distributed
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 o n g 5 "beastieboy"
song1.mp3 song2.mp3 song3.mp3 song5.mp3 6 song4.mp3 song5.mp3 song6.mp3 "kingrook" song5.mp3 song6.mp3 song7.mp3 "slashdot" Properties of digital goods
3. Digital goods have an unusual cost structure High cost of producing the first copy (high fixed costs) Low or zero costs of producing the second, third,... (low variable costs) Creation costs are `sunk' (and not easily recoverable) No capacity-based limitations on production So, digital goods are costly to product but cheap to reproduce!
7 Recap: Basic economics
Consumers Consumers prefer more to less (higher quality, higher quantity, better `fit'), and are willing to pay more for more For a given product, consumers prefer lower prices Different consumers like different things Some consumers are systematically willing to pay more than others (the `wealth effect') Producers Profits = Revenues Costs; Revenues = S(price X quantity) Producers prefer higher profits Higher profits require higher revenues and/or lower costs A producer with lower costs can charge the same (or lower) prices for the same product and still make higher profits A producer who sells `better' products can charge a higher price and still sell the same quantity
8 Britannica v. Encarta Britannica: 200 years, $2,000 for a printed set 1992: Microsoft purchased Funk & Wagnalls to make Encarta Britannica response Online subscription at $2,000 per year Sales dropped 50% between 1990 and 1996 Online subscription at $120 CD for $200, after1996 $70-$125, now: $50 Sunk costs by firstmover competitors drive price to marginal costs of making additional copy must "uncommoditize" product (dominance; differentiation)
9 Market structures for digital goods
"Commodity" goods (perfect competition) not viable Threat of sequential price cutting (example: CD telephone books) Inevitability of marginal cost pricing when many firms sell very similar digital goods Dominant firm with economies of scale Differentiated products: Many firms, each producing a differentiated variety of the product
10 Viable market structures The two generic strategies revisited
Cost leadership How does one become a cost leader when variable costs are zero? As quantity sold goes up, average costs go down (but unit margin decreases) Sell and resell as many versions as you can (examples?) Drive others out of the market Technological quality, resolution, speed, comprehensiveness Personalization: (1) organize information is useful ways; (2) requires information on customers (registration; observation); (3) personalize both product and price Intellectual property protection (copyright)
11 Product differentiation Forms of Differential Pricing
Personalized pricing Sell to each user at a different price (e.g., coupons) IT can better enable personalized pricing (e.g., purchasing patterns) Offer a product line and let users choose Based on group membership/identity (e.g., student discounts) Versioning Group pricing 12 Lessons on Personalized Pricing Know your customer Directly (e.g., registration) and indirectly (e.g., clickstream) Easy to do on Internet Market research in cheap on the Internet Personalize both product and pricing Use promotions to measure demand 13 Versioning
Different products, different prices Different products with varying product quality (offer full product line with different versions matching different needs) Maximize both value to customer (y-axis) and your share of this value (x-axis) Self-selection
Highend version Single version p PRICE REVENUE DEMAND vs.
q PRICE 1 Lowend version PRICE 2 REVENUE DEMAND q 14 Group Exercise: Different prices, different versions? 1. 2. 3. 4. In groups of 3-5 On a separate sheet of paper, estimate the revenue from the following pricing models: Sell one product which will give you the highest unit price Sell only the speedy product Sell only the slow product Personalized pricing: sell more expensive product at two prices
15 Versioning example
Consumers' willingness-to-pay 40 type As: $100 for speedy, $40 for slow 60 type Bs: $50 for speedy, $30 for slow
$4,000 revenue $5,000 revenue $3,000 revenue (not as profitable) $7,000 revenue (will this work)? Pricing without versioning Sell highest unit price Offer only speedy Offer only slow Personalized pricing (sell speedy at two
prices But can we do better?
16 Versioning example
Consumers' willingness-to-pay 40 type As: $100 for speedy, $40 for slow 60 type Bs: $50 for speedy, $30 for slow Pricing with versioning Try speedy for $100, slow for $30 40x$100 + 60x$30 = $5,800? Will this work? Compare benefits and costs Surplus for type A: 100-100=0, but 40-30=10 > 0 100x$30 = $3,000! Discount the fast version: 100-p=40-30 So, offer speedy for $90 and slow for $30 Revenues = $5,400 = $90x40 + $30x60
17 Making Self-Selection Work May need to cut price of high end (to avoid cannibalization) May need to cut quality at low end (to avoid cannibalization) Value-subtracted versions May cost more to produce the low-quality version (e.g., slower printers) In design, make sure you can turn features off and that they can't be turned back on! (e.g., hack Vista Basic to Vista Premium with Aero effects) So you need to produce a worse version to make it attractive enough for lowend customers but unattractive for highend customers
Common dimensions of versioning Comprehensiveness (all vs. selected features; v. low incremental cost) Timeliness (current vs. delayed stock quotes; hard-cover vs. paperback; early adopters willing to pay more) Access channel (web-based vs. offline) Convenience (full-week rental vs. two days) Resolution or sound quality (e.g., basic vs. gold subscription to networking site) Annoyance (nagware in shareware to remember to pay) Speed (IBM installed chip to slow printers!) Support (commercial OSS vs. free OSS) So you need to version and price information products according to factors that discriminate among customers
19 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
SEGMENT 1 SEGMENT 2 p PRICE REVENUE DEMAND vs.
q PRICE 1 PRICE 2 REVENUE DEMAND
20 q Group Pricing
Examples of group pricing Wall Street Journal, Microsoft Office, movie tickets, magazines,... Group pricing and digital piracy Piracy lowers a consumer's willingness to pay Identify `high-piracy' groups, offer them lower prices 21 Other Pricing Strategies
Personalized pricing Group pricing with `groups of one' Problems due to comparing Usage-based (and unlimited usage) pricing Analogous to versioning based on usage When tracking/billing usage is costly, unlimited-usage pricing is often profitable (some recent examples: AOL, telephony) Bundling Offering two or more products where at least one product is provided at an incremental price less than its stand-alone price Different customers value different features differently - willingness to pay for the bundle is less dispersed than the willingness to pay for the components If you can't figure out who values what, bundling is useful... Examples?
22 A Simple Bundling Example
Product 1 Financial news feed Product 2 Live stock quotes Alice Bob $6 $4 $4 $6 Optimal prices Optimal for company: $6 for each product Optimal for customers: $4 for each product $10 for the bundle of product 1 and product 2 23 Today's class Network effects Shapiro & Varian Ch. 7 Network Effects: Cingular and AT&T 24 Learning objectives Understand the idea of positive feedback and describe the role it has played in some prior technology industries (railroad, electricity, telephony) Define network effects and understand how they lead to positive feedback Describe the difference between supply-side and demand-side economies of scale Understand the typical sources of network effects in information technology industries Be able to recognize these sources for specific technology products or in specific business contexts Understand the trade-offs between performance and compatibility, and between openness and proprietary control of a technology
25 Positive feedback: Overview
What is positive feedback? when a firm becomes successful, its past and current success make it likely to succeed in the future `...success feeds on itself, the strong get stronger...' When does this happen? More customers -> lower unit cost (supply-side economies of scale) More customers -> larger `network' -> more valuable product (demand-side economies of scale caused by network effects) 26 Positive feedback: Overview
Possible consequences of positive feedback Dominance of a single firm or technology Dominance of an inferior technology that got an early lead Historical examples Railroad gauges, AC versus DC power, telephone networks 27 Network effects: Overview Real networks Telephone, railroad, airline networks Network of compatible instant messaging SW Network of email users Network of Macintosh users Metcalfe's Law: Value of a network of size n is proportional to n2
28 Virtual networks Value of a network Network effects: Overview More units consumed > higher value per unit Success feeds on itself, `winner takes all' Inferior products that move first may dominate Expectations are important
Virtuous cycle Vicious cycle value to each user number of compatible users 29 Lock-In and Switching Costs Network effects lead to substantial collective switching costs Even worse than individual lock-in (investments, social norms, psychological effects) Due to coordination costs Example: QWERTY (slow typing to reduce jam) But some web-based software can actually reduce network effects by decreasing switching costs (e.g., PDF and Adobe Reader)
30 Scale: Supply-side and demand-side
Supply-side economies of scale More units produced lower average cost per unit Spreading fixed costs across more units Manufacturing efficiencies, learning by doing Demand-side economies of scale More units consumed higher value per unit Most commonly caused by network effects 31 Network effects and `tippy' markets PRODUCT A PRODUCT B 32 Network effects and `tippy' markets PRODUCT A PRODUCT B 33 Network effects and `tippy' markets PRODUCT A PRODUCT B 34 Network effects and `tippy' markets
PRODUCT A PRODUCT B 35 Demand-side economies of scale? 36 Network Effects: Sources of Value
Person-to-person communication feature Telephones, fax machines, email, Instant Messenger Value from trading volume, number of partners eBay, B2B e-marketplaces Value from user-generated content The Web, online communities, p2p network 37 Network Effects: Sources of Value
Value from complementary assets Software -> System (platform): Windows, PlayStation Medium -> Device: CD's, DVD's Value from more `nodes' in a network Social networking sites (Facebook, LinkedIn) 38 Network effects and competitiveness
Increasing network effects... Reduces the bargaining power of buyers Reduces the bargaining power of suppliers over time by reducing # of firms in the main industry Reduces rivalry among existing competitors Reduces the threat of new entrants Reduces competitiveness, increases industry profits 39 Tradeoff: Performance vs. Compatibility
The performance of a new technology is likely to be better if: It is a radical departure from an existing technology It does not attempt to build in compatibility with the existing technology Adoption is more rapid if the technology is backward compatible Network effects aren't much use if nobody migrates to your technology However: Compatibility (value carried over from an existing network) Evolution: Lower performance, but backward compatibility provides easy migration path Revolution: Offers radically superior performance, but creates the need to build an installed base from scratch Performance (quality)
40 Tradeoff: Openness vs. Control
A firm benefits from generating network effects if it: Is the only supplier of the product (control) Tries to get a very large user base rapidly (openness) Adoption is more rapid with open standards Profit margins are much higher with proprietary standards However: Your share of industry value Your reward The place to be? Control: Maintain control over technology. Ensure high profit margins, face an uphill task of getting to critical mass Total value added to industry
41 Openness: Standards are commonly available and vendor-independent. Facilitate rapid adoption, but face difficulty in keeping margins high Generic Network Strategies
Control Compatibility Performance Controlled migration Performance play Openness Open migration Discontinuity Performance play: good if you have breakthrough technology (e.g., Palm Pilot) Controlled mitigation: good if you have secured domination (e.g., Windows XP; Vista?) Open migration: good if you have manufacturing skills; friendly to consumers; little switching costs (e.g., HP's open migration workstations) Discontinuity: good if you have manufacturing skills (e.g., introduction of CD system)
42 Twitter's Struggle to Make Money
You can have up to 1,000 people following you for free, after that, you have to pay. Or viceversa: You can follow up to 1,000 people, but you have to pay after that. Charge developers for access to some APIs. Charge for corporate accounts (like InformationWeek's), personal use is free. Source: http://www.informationweek.com/blog/main/archives/2008/11/would_you_pay_f.html? cid=RSSfeed_IWK_ALL
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- Winter '09