Digital Products

1
Digital Products

• Pricing
• Switching Costs
• Network Externalities

2
Digital Goods

• Definition
• Can be digitized
• Books, music, movies, data, software, games,
• Entertainment value, business value,
• Cost Structure
• Costly to produce, cheap to reproduce
• High sunk cost of producing the 1st copy
• Cost of each additional copy is small uniform
• Almost unlimited capacity to replicate
• Price gt Production Cost
• Set Price Value

3
Market Structure

• 1. Information commodity market pushes price to
  0
• Example CD Phone Book
• 1990 Transcribe phone books, price gt 100
• Competition Copies idea, price 20
• Present Free on the Internet
• 2. Add value to raw information in to
  differentiate
• Personalize Learn about customers through
  registration, billing and observation
• Reduce average cost through reuse and resale
• TV Shows (prime time, summer reruns, overseas
  markets, syndicated channels)

4
Group Pricing

• Price sensitivity
• Offer different prices to different groups
  (seniors, students)
• Network effects
• Standardize on a single product (MS Office)
• Lock-in
• Induce customers early (newspapers in education)
• Sharing
• Low transaction costs favor rentals (movie video)

5
Designing Information Product Line
Product Dimension Users/Uses
Delay User impatience (Stock Quote)
User interface Novice/Experienced
Convenience Daily/Weekly rental
Image resolution Newsletter/Glossy
Speed of operation Slow/Fast (Mathematica)
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Designing Information Product Line
Product Dimension Users/Uses
Format Raw/Organized
Capability Special use (Voice recognition)
Features Additional functions
Comprehensiveness Depth of information
Annoyance Hi price, no ads
Support Hi/Lo
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Price vs. Quality

• High end version Keep price reasonable to make
  it attractive.
• Low end version Reduce quality so users would
  seek high end.
• Can users (hackers) turn low end version to high
  end?
• Does on-line version help or deter off-line one?
• How many versions? How many segments?

8
Bundling

• Examples Microsoft Office Suite, Cable TV, News
  Paper
• Reasons for bundling
• Technical compatibility across applications in
  the bundle
• Economic Reduce dispersion in consumer valuation
  of products
• P(Word)75, P(Excel)75, Revenue752752300
• P(Bundle)175, Revenue1752350

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Implications of Low Distribution Costs

• Digital distribution is easy, cheap and quick.
• Give away free samples to sell content
• (information experience good)
• A bitlegger must advertise for business to his
  peril

10
Digital Products

• Pricing
• Switching Costs
• Network Externalities

11
Switching Costs

• Examples Switching from PC to Mac?
• Windows to Unix? Access to Oracle?
• How much did Microsoft pay to acquire
  Hotmail.com?
• Total switching costs
• Costs to customers and new suppliers
• Even small switching costs are critical in mass
  market
• How much would it take for you to switch your
  telephone service?
• Profit from current customer
• Customers total switching costs
• Suppliers quality/cost advantage (if any)
• Charge a premium from existing customers while
  offering discounts to new customers.

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The Lock-In Cycle
Brand Selection (trial)
Lock-in (Switching costs)
Sampling (e.g., Music club)
Entrenchment (complementary investment)
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Lock-Ins and Switching Costs

• Type of Lock-In Switching Costs
• Contractual Compensatory or liquidated damages
• Durables Replacement of equipment declines as
  durable ages
• Brand-specific Learning a new software, both
  direct costs and lost productivity tends to
  rise over time
• Information/databases Converting data to new
  format tends to rise over time as collection
  grows (VHS to DVD)
• Specialized suppliers Finding of new supplier
  may rise over time if capabilities are hard to
  find/maintain
• Search costs Combined buyer and seller search
  costs includes learning about quality of
  alternatives (agents)
• Loyalty programs Any lost benefits from
  incumbent supplier, plus possible need to
  rebuild cumulative use (discounts)

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Buyers Lock-in Strategies
1. Bargain for discounts or support for switching
2. Reason your benefits (costs) from switching
are small (large) 3. Leverage future purchases
or your ability to influence others 4. Seek
protection from monopolistic exploitation down
the road 5. Keep your options open via second
sourcing. 6. Watch out for creeping lock-in
15
Sellers Lock-in Strategies
Invest
Leverage Entrench
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Sellers Lock-in Strategies

• Investing in an Installed Base
• Look ahead the whole cycle (how long?)
• Get influential customers (government)
• Structure a life-cycle deal (service contract)
• Large market share is not a guarantee
  (Netscape)
• Attract buyers with increasing switching costs
  (growth potential)
• Exploit divergent interests of multiple parties
  (frequent flyers)

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Sellers Lock-in Strategies (Contd.)

• Encourage Customer Entrenchment
• Offer value-added services (custom reports)
• Use loyalty programs and cumulative discounts
• Leverage Your Installed Base
• Sell complementary products (additional
  software)
• Sell access to your installed base (AOL)
• Set differential prices (introductory offer to
  low end version)
• Exploit 1st mover advantage (stagger
  termination dates)
• Control cycle length (premature renewal
  update)

18
Digital Products

• Pricing
• Switching Costs
• Network Externalities

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• Network Externalities
• The value of a product is affected by the number
  of users
• Positive Externalities Telephone, Email, File
  sharing, debugging
• Negative externalities over-crowding,
  congestion, pollution

Winner
VHS, Windows
Market Share
Loser
Beta, Apple
Time
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Adoption Pattern

• Key Characteristics
• User expectations are important
• Early adopters jump start adoption
• Intermediate adopters are critical
• A bandwagon may emerge
• Ultimately diminishing returns

4
3
Number willing to adopt
1
2
1
1
Expected number of adopters
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Managing the Adoption Pattern

• Create momentum through marketing
• Leveraging reputation (e.g., Intel, IBM)
• Winning over an influential customer
• Advance sign-ups to create confidence
• Wink at pirates at the outset
• Leasing to reduce customer adoption risk
• Price commitments to reduce lock-in risk

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• Positive Feedback
• Positive Feedback can be due to
• Networks connecting users, allowing mobility
• Compatibility among users
• Demand side economy of scale Market size
• Supply side economy of scale Cost of production
• Combine supply-side, demand-side economies of
  scale

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Market Tipping
Economy of scale
Low
High

• Low demand for variety
• High demand for variety

Low Unlikely
High Depends
Virtuous Cycle
Value to User
Eventually may create negative effects
Vicious Cycle
Number of Compatible Users
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• Invoking Positive Feedback
• Strategy 1. Evolution
• Technical Backward (One-way) Compatibility MS
  Office 97
• Legal Incumbents Intellectual Property Rights
  CD
• Strategy 2. Revolution
• Improve performance by ten times
• Appeal to Early Adopters
• Risky unless a growing market

Improved Design
Evolution
Compatibility
Revolution
Performance
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Openness versus Control Do you encourage others
to develop components? Or, do you leverage
your position to control components? Full
Openness Intl Telecom Union Open
Java Alliance MS Intel Control ATT before
break-up Return Total industry value Your
share
Proprietary
Optimum
Your Share
Your Reward
Open
Total value added to the industry
26
Generic Network Strategies
27

• Impact of Standards on Competition
• Expanded network externalities
• Reduced Uncertainty
• Competition for the market vs competition in the
  market
• Competition on price versus features
• Competition to offer proprietary extension
• Component versus systems competition

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Consumers
Standards Winners and Losers
Innovators
Complementors
Incumbents
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Key Assets in Network Markets
Installed base of customers
Intellectual Property
Ability to innovate
Complements
First mover advantage
Reputation Brand name
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Key Points

• Unique cost structure
• Network effect
• Bundle and Lock-in