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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:


Pricing Information Goods






Price Matching
Cost structure
Network Externalities
Information Laws
Long Tail
Required reading for next class: HBS case “Freemium
Pricing at Dropbox”
HW2
Tacit Coordination

Spontaneous cooperation resulting from strongly
perceived interdependence.




Repeated interaction provides firms with strategic leverage
over each other that may encourage cooperation.
Difficult to achieve with lots of firms.
Hard to find/prove/correct.
Facilitating practices:




Price matching
Most Favored consumer clause
Price leadership
Advance announcement of price changes
Tacit Collusion: Example

Mechanisms
Homogeneous
Products
Industry is an oligopoly

Top four firms dominate almost the entire
market

Same phone (e.g. iPhone from AT&T or
Verizon?), data services (text, e-mail, etc)
Agreement on price is easier to come by
and cheating is easier to catch

Tacit Collusion:
Pre-Announced Rate Changes

Service providers typically pre-announce rate changes
they plan on implementing


Advanced notice gives competing firms time to respond
Can test the market and competitors
Tacit Collusion:
Infrequent High Changes in Rates

Rate changes in the industry have been high and
infrequent, yet coordinated across all four firms

FOCUS: Text Messages

No capacity constraints = unlimited supply => in a competitive
market prices should decrease not increase over time


Since 2005 price per text has doubled. [IBISworld, 2012]
Service providers do not claim that these increases were driven by higher
costs so other methods must be at work.
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





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





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





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
6
The Information Economy

Information:

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

Microsoft, Facebook

Differentiated Product Markets

Commoditized information markets



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

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

Non-rival goods:


one person’s consumption doesn’t diminish the amount
available to other people
Non-excludable goods:

one person cannot exclude another person from
consuming the product.
Non-Rivalrly

This has issues for sellers of information goods



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:


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


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:


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",


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

High definition optical disc format war:

Between Blu-ray Disc and HD DVD (2006-2008)
Why a war? Why not coexist peacefully?

Other format wars?

Laws of the Information Age



Moore’s Law
Metcalfe’s Law
Power Law
1. Moore’s Law

In 1965 Gordon Moore observed an exponential
growth in the number of transistors per integrated
circuit and predicted that this trend would continue

What it means to us today—computing power
doubles about every 18 to 24 months

It is also common to cite Moore's Law to refer to the
rapidly continuing advance in computing power per unit
cost, because increase in transistor count is also a rough
measure of computer processing power
1. Moore’s Law
Information Capacity Constraints (or lack thereof)
2015: 15 GB free space
Future: trend towards unlimited space
(Remember“Your mailbox is full”?
What was that about?)
2. Metcalfe's Law:

Metcalfe's Law: attributed to Robert Metcalfe, originator
of Ethernet and founder of 3COM:


The value of a network is proportional to the square of the
number of nodes;
So, as a network grows, the value of being connected to it
grows exponentially, while the cost per user remains the same
or even reduces.
2. Metcalf’s Law
400
350
Value of network
300
250
Individual network value
Community network value
200
150
100
50
0
1
2
3
4
5
6
7
8
9
10
11
12
Size of network
13
14
15
16
17
18
19
20
40
The Network Effect

The usefulness of information products is often
dependent on the number of other users of that
technology.

For example, e-mail is quite useless if there are only a few
others that use e-mail.
41
2. Metcalfe’s Law

According to Metcalfe’s Law, if there are n users of a
technology, then the usefulness of that technology is
proportional to the number of other users of that
technology (n-1 in this case). The total value of the
network of the technology is therefore proportional
to the usefulness to all users, which is:
n(n-1) = n2 – n.
42
2. Metcalfe’s Law
If n is large, as it will be for most information products, then
n will be small relative to n2 and Metcalfe’s Law becomes:
The total value of the network of a
technology is proportional to n2
43
2. Metcalfe’s Law


The more users of a technology there are, the more
useful it becomes.
Examples:



Facebook,
E-mail
MS Windows/MS Office
44
2. Metcalfe’s Law: Critique



Facebook’s IPO and valuation of a lot of tech
companies is rationalized based on some variant of
Metcalfe’s law of network effects
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.
3. Power Law


On the Web a few pages have a huge number of other
pages linking to them, and a very large number of pages
have only a few pages linking to them.
In short, the Web has many small elements, and few large
ones.
Power Law
1000
1200
900
1000
800
700
Relative popularity
800
600
500
600
400
400
300
200
200
100
0
0
1
50
Relative popularity
Search referrals
Page views
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”
The Long Tail
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”
Itunes/Rhapsody/Spotify


Millions of songs in archives
Cost of storing one more song is essentially zero


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
Long Tail Examples: Travel
Netflix Long Tail
Case: Freemium Pricing at Dropbox
AEM 4160: Strategic Pricing
Prof. Jura Liaukonyte
Freemium Pricing Model
Concept
Importance of Referral

Offer limited access to a
company’s service for free

Increasing the number of consumers is
key for business success

Charge for anything above

Free upgrades for referral increase the
network size and revenue
Industries using Freemium

Apple’s App store – 2013: 77% of top 100 grossing Apps

LinkedIn – 0.8% of users

Evernote – 1% of users

Spotify – 20% of users
Industry Overview
Global Market

Value in 2011: $ 4bn

Expected Value in 2018: $ 46bn

What are value drivers in the industry?

What drives the price in the industry?
Direct Competitors
Provider
Price (per year
per GB)
Platform

Microsoft

SkyDrive

$2

Apple

iCloud

$2

Google

Google Drive

$1.2

Amazon

Simple Storage

$.095
Actual Usage
Others
17%
Apple
33%
Google
Drive
12%
Amazon
18%
Dropbox
20%
DropBox
Overview

Founded by Drew Houston and Arash Ferdowsi in 2007

Provides remote storage and file sharing, accessible online or as folder on your
computer

Total number of users: 200 million – 1.6 – 4 percent actually generate revenue

The company targets both, private consumers and corporations
Freemium
Referral

500 MB storage for both sender and receiver

Maximum of 16 GB

Additional 2.8 million Referrals, which is a referral rate of 70 percent

12 percent conversion rate *
*(individuals who install dropbox/individuals who click on the invitation link)
Approach
Problem
1.
The cloud storage market was fragmented with small competitors
2.
Bureaucracy prevented business customers from purchasing cloud storage
3.
Consumers were not willing to pay for the service, as they have not adapted to
the product at that time
Approach
1.
Faster file backup and retrieval service – Combination between users’ own
storage and remote storage (i.e. dropbox folder)
2.
Focus on individual consumers to avoid business bureaucracy
3.
Freemium Pricing
Result

200 million users by November 2013

Valued at $ 4bn in 2013

After capturing individual consumers, focus on corporate customers
Market to Corporate Customers
Corporate
Price

$800 per year for five users

+$125 for each additional user
Consumer Share (%)
100
90

Unlimited storage

Administrative controls to manage
documents
Product

Single-Sign-On option

14-day free trial period
80
70
60
50
40
30
20
10
0
Business Users all Paid
Impact

40% of 400 million revenue

96-98 % use product for free
Consumer Business Paid
Consumer Business Unpaid

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