Transcript Strategic Pricing AEM 4160

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Lecture 9: Tacit Collusion;
Pricing Information Goods
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
2
Lecture Plan:

Tacit Collusion

Facilitating Practices:
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
Pricing Information Goods
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Price Matching
Cost structure
Network Externalities
Information Laws
Long Tail
Required reading for next class: HBS case “Freemium
Pricing at Dropbox”
HW2
Price Matching Guarantees

Price matching guarantees



Helps a firm to protect its consumers and charge a high price.
It makes your competitor “soft.”
Takes away the benefit for your competitor to undercut your
price.
Counter-Intuitive?

Price matching guarantee is simply a mechanism for tacit collusion or
competition reduction between firms.

Any offer of the price matching guarantee means effectively taking away any
gains that its competitor might get from cutting price.

If a firm offers a price matching guarantee, then a search consumer will buy
from it because the consumer knows that in the event that there is a lower
price offered in the market the consumer is insured that it will match that
price.

Since price matching takes away the gain from price cutting, no firm cuts price
and price competition is reduced.
Example
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Two firms: Firm 1 and Firm 2
Two prices: low ($4) or high ($5 )
3000 captive consumers per firm
4000 floating go to firm with lowest price
Payoffs = revenue
Firm 2
Firm 1
Low
High
Low
,
,
High
,
,
Example
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Two firms: Firm 1 and Firm 2
Two prices: low ($4) or high ($5 )
3000 captive consumers per firm
4000 floating go to firm with lowest price
Payoffs in thousands of $ (revenue)




Both low = 5000*4 = $20K
Both high = 5000*5 = $25K
One high = 3000*5=$15K
Another low = 7000*4=$28K
Firm 1
Low
High
Firm 2
Low
20,20
15,28
High
28,15
25,25
Contracting with Customers

The game is a prisoner’s dilemma


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
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Both firms prefer: {High, High}
Only equilibrium: {Low , Low}
Cannot credibly promise to play High
Even if committed to High, other firm would still respond
with Low
How to resolve this?

Third party contracts with customers – e.g. price matching
guarantee
Price Matching


If one firm charges low, it does not gain any additional
customers, since the competitor “automatically”
matches it.
What is the effect on the game?
Price Matching
Firm 2
Firm 1
Low
Low
20 , 20
High
28 , 15
High
15 , 28
25 , 25
Firm 2
Firm 1
Low
High
Low
20 , 20
20 , 20
High
20 , 20
25 , 25
Price Matching

Literature focusing on price-matching guarantee
typically finds that it supports higher equilibrium
prices and profits.

Intuition: This is because when all firms are committed to
match the lowest price, no firm has incentive to undercut
others

In practice, if you read fine print, there are quite a few
restrictions:


price-matching generally applies to products that are
homogeneous across stores
Firms often match lower prices of only some competitors,
typically their close competitors.
Pricing Information Goods
1
2
The Information Economy

Information:
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Essentially, anything that can be digitized—encoded as a stream
of bits—is information.


E.g. books, databases, magazines, movies, music and web pages are all
information goods.
Cost of Producing Information:

Information is costly to produce but cheap to reproduce.
Properties of Information goods
1.
2.
3.
4.
Unique cost structure
Properties of experience goods
Properties of public goods
Network effects and externalities
1. Unique Cost Structure


Information goods have high fixed costs of production but
near-zero or zero marginal costs.
Developmental costs of producing the first unit of an
information product are generally high, but producing each
additional unit costs virtually nothing.


the estimated costs of developing the popular computer game
Gran Turismo 5 were around $80 million (DigitalBattle, 2010);
the costs of replicating additional copy range from negligible
(production of DVDs) to essentially zero (downloadable files).
1. Unique Cost Structure

Cost of storing and transmitting stored information
is cheap (and continues to get cheaper)

there are no effective capacity constraints on the
production of digital goods.
Traditional Product
Fixed and Variable Costs
AC
P
AVC
Total Fixed
AFC
Total Fixed
q1
Q
Typical Digital Product
Fixed and Variable Costs
P
AC
AFC
q1
AVC
Q
1. Unique Cost Structure: Implications

Declining average costs imply significant economies of
scale.

Minimum efficient scale can be on the order of the whole
market

We should not expect to see highly competitive market
structures

Natural monopolies may arise
1. Unique Cost Structure: Implications

What market structures should we expect to see?

Markets with a dominant firm
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Microsoft, Facebook
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Differentiated Product Markets
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Commoditized information markets
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Digital goods selling at marginal cost
Free information products (maps, telephone information, email
addresses, news, stock price quotes, etc.)
Freemium pricing
2. Properties of Experience Goods
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Certain characteristics of a product or service cannot be
observed or verified prior to consumption, but these
characteristics can be ascertained upon consumption.


Problem: Consumers cannot determine their willingness to
pay
Recommendations, reviews, try-before-purchase, reputation
or word of mouth become important.
3. Properties of Public Goods
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Non-rival goods:
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one person’s consumption doesn’t diminish the amount
available to other people
Non-excludable goods:
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one person cannot exclude another person from
consuming the product.
Non-Rivalrly
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This has issues for sellers of information goods
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Traditional price competition is based on scarcity
If there are a limited number of widgets, people who want widgets more
will pay more for them.
 Luxury cars, houses, stock
If there is no limit to the number of widgets available, no one will want
to pay more than the lowest price.
3. Properties of Public Goods

While the non-rival property is inherent to digital
goods, the non-excludable one is the question of
technology or strategy:
3. Properties of Public Goods

While the non-rival property is inherent to digital
goods, the non-excludable one is the question of
technology or strategy:


Bundling a good with an excludable good (physical means),
DRM - digital rights management (IT means)


Encryption and licensing
Intellectual property law (legal means), can be used to modify
the property.

Auditing and user tracking
3. Properties of Public Goods

While there are ways to limit non-excludability, the
pertinent question is:
 Is
sharing of information goods or piracy are actually
always damaging to the revenue of the digital goods
producer?
Embrace copying

Embrace copying and bundle with content that
benefits from wide distribution (e.g. ads)
 E.g., Network TV,
YouTube, Free Apps
 Directly connected with the next property of
information goods: network externalities.
4. Network effects and externalities
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Many digital products increase in value with wider
distribution, as the network of users increases.
Positive network effects and externalities explain a wide
range of empirical regularities common to digital goods:
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high quality digital goods are released for free to increase platform
penetration and value of the platform for third-party advertisers
(e.g., Google search engine),
high incidence of technological tie-ins and pricing of one
component at a loss (e.g., digital e-readers and content libraries
specific to those e-readers).
Hardware vs. Content

Amazon and Google sell their
hardware (Kindle and Nexus
tablets) "at cost",

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Some analysts say that it can even be
below cost
The point is: hardware is a discounted
tying product with profit coming
from sales of online content.
Increasing Platform Penetration
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High definition optical disc format war:
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Between Blu-ray Disc and HD DVD (2006-2008)
Why a war? Why not coexist peacefully?
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Other format wars?
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