Network Effects Increasing Returns Pricing Strategies 1 Learning Objectives Standards ownership Increasing returns Winner takes most Positive feedback Pricing Strategies for Information Goods 2 Metcalf s Law The value of a network increases with the square of the number of users Externality the behavior of an individual affects the utility of another Negative Externalities Smoking Pollution Positive Externalities Online games Web 2 0 Why 3 Information Goods Information Goods almost always end up as near monopoly markets Network effects drive these markets 4 Standards Standards help promote network effects The more people agree to build something using a common standard the more likely the item will benefit from network effects Ex Blu Ray vs HD DVD NOTE the owner of the standard usually obtains the most benefit 5 Standards Ownership If you can develop a standard and get others to use your standard you should be able to get large rewards License fees etc Ex cell phone CDMA standard QUALCOMM iTunes music format IBM failed with SNA vs TCP IP 6 Increasing Returns As network effects build the value of the network increases at an increasing rate Increasing cell phone bills Housing prices and restaurant prices in Bethesda Why do people keep wanting to crowd into NYC London Hong Kong 7 Winner Take Most Whenever network effects lead to increasing returns the industry moves toward a winner take all position Windows eBay VHS Essentially natural monopolies Not illegal if they avoid predatory policies 8 Positive Feedback Increasing returns often lead to expanding the network more positive feedback For the network to build the additional investment must increase the value of the network noticeably Monopoly build hotels 9 Tight Links If the feedback from additional investment is tight positive feedback results and the network grows If it is loose the network may not grow or grow very slowly Ex US Interstate system big volume purchasing stores 10 The Result Once a player gets positive feedback going it is likely you will have a winner take most result Initially anyone can win First mover always tries Sometimes a late mover or inferior product becomes the standard and wins VHS Windows OS 11 Pricing Strategies Pricing is difficult more so for digital goods The information like goods problem Lack of clear market definitions Lack of robust willingness to pay WTP data Lack of comparables 12 Traditional Pricing Strategies Traditional Cost based Pricing Cost Plus Price cost some defined profit margin Also Price based Costing Guess at what the customer will pay and work backwards to see if you can build it 13 What is Price Discrimination Price discrimination occurs when the same product is sold at more than one price Purpose Increase firm s profits Impact on consumers Reduces welfare value they get Types of price discrimination First degree Second degree Third degree 14 Requirements for Price Discrimination Firms must have some monopoly power Price setting is not possible in perfectly competitive markets There must be at least two classes of consumers who have different WTP willingness to pay The product cannot be resold 15 First Degree Price Discrimination Perfect price discrimination Each consumer pays the maximum he or she is willing to Traditionally Seller negotiates with each buyer pay Difficult Illegal Example 16 Personalized pricing The ideal economic scenario For a single product find out what each customer is willing to pay and set price WTP p PRICE p vs REVENUE REVENUE DEMAND q q 17 Personalized pricing Implementation Strategy sucker evil smile So how much are you willing to pay Five dollars sucker happy smile Issues Too many customers Customers don t tell you their true WTP when asked Sellers can t always trust the WTP that customers reveal to them 18 Third Degree Price Discrimination Market separated into two or more segments Examples airlines frequent flyer programs students seniors staying through Saturday buy in advance Most common Why Market segments must have different valuations or WTPs price sensitivities Peak load pricing redistribute usage avoid congestion phone transportation 19 Second Degree Price Discrimination Seller gives consumer a schedule of prices Quantity discounts The more the buyer purchases the lower her average cost Reduces consumer surplus compared to fixed prices More common than first degree price discrimination 20 Versioning Multiple versions multiple prices Self selection of version no need for active customer data based pricing Example Airline seats Seat 3 week advance 50 penalty less legroom lousy food Seat fully refundable book anytime more legroom lousy food 21 Versioning Guidelines Offer versions tailored to the needs of different segments Design these versions to accentuate the differences in the needs of the segments Choose a pricing structure that is consistent with and or highlight the differences between segment needs Value subtract Design for your high end market then remove features Be prepared to discount your premium product When in doubt offer three versions Goldilocks model 22 Bundling Bundling is the practice of selling two or more products together It s a pricing strategy Pure Bundling ex cable channels Two goods A and B are only sold together They are not available for individual purchase Also in a pure bundle the two goods are typically offered in some fixed proportion Mixed Bundling ex Microsoft Office Products A and B are sold as a A B bundle Products A and B are also available individually Bundle is sold at a discount relative to the components 23 Bundling Incentives Incentives to Bundle Efficiency Reasons Non competitive Reduce Costs Improve Quality More Efficient Pricing Strategic Reasons Undercut Rivals Entry Deterrence Mitigate Competition Gain an advantage over consumers 24 Bundling Incentives Reduce Cost Cheaper to deliver a bundle of components A bundle of songs on a CD Software suite Most valuable when consumers valuations for the various components are positively correlated Ease of decision making Giving consumers a choice not always a good thing 25 Bundling Incentives Improve Quality Improved Functionality Better Performance MS Windows IE Better Service Quality e g Same firm providing local and long distance and wireless telecom services 26 Bundling Incentives Pricing Efficiency Bundling as a price discrimination device Bundled pricing can increase firm profits No need to charge different price to different consumer segments Just
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