Welcome

1. Welcome Strategies of Network Companies Jonathan D. Wareham wareham@acm.org

2. Agenda • Pricing • Standards • Auctions • Bundling

3. Price Levels • Assumption that electronic markets have less friction than comparable markets. • Search costs lower • Competition increases • Average prices should fall, converging on market level • Study of prices of books and CDs and software sold on internet: • Higher prices & greater variance in electronic channel !!!!!

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6. Possible Causes • Superior disc. pricing techniques: lower registration and menu costs • Heterogeneity: wine in store or restaurant • Versioning • Temporal preference: consumer behavior and types • Imperfect information: bait and switch • Neural real estate: 5% sites/75% traffic • Market immaturity: eMarkets too young

7. Fixed Prices P $1.00 1 Coke Q

8. Fixed Prices Consumers Surplus Dead Weight Loss MC

9. Get a little more revenue

10. 2nd Degree Price Discrimination • “product line pricing”, “market segmentation”, “versioning” • Gold Club, Platinum Club, Titanium Club, Synthetic Polymer Club • First Class, Business Class, World Traveler Class • Professional Version, Home Office

11. 3rd Degree Price Discrimination • The practice of charging different groups of consumers different prices for the same product • Examples include student discounts, senior citizen’s discounts, regional & international pricing, coupons

12. Maximize the Revenue ! Perfect (1st degree) Price Disc.

13. Perfect Price Discrimination Price $ Profits: .5(4-0)(10 - 2) = $16 10 8 6 4 Total Cost 2 MC D 1 2 3 4 5 Quantity

14. Prefect Price Discrimination • Practice of charging each consumer the maximum amount he or she will pay for each incremental unit • Permits a firm to extract all surplus from consumers • Difficult: airlines, professionals and car dealers come closest

15. Caveats: • In practice, transactions costs and information constraints make this is difficult to implement perfectly (but car dealers and some professionals come close). • Price discrimination won’t work if you cannot control three things: • Preference profiles • Personalized billing; (anonymous transactions lesson seller’s discriminatory power over consumers) • Consumer arbitrage

16. What is different about this site?

17. Conclusions • Internet double edged sword: • Consumers enjoy lower search costs, but… • eMarketers have superior tools to register your consumption patterns and price sensitivity • The end of fixed pricing??? • Fixed pricing as an institution only 100 years old!! • Developed in response to large scale economies/production models….with standard products !!!!

18. But lets mix things up a bit more.. • Product heterogeneity, Make the products different!!!! • Available from different locations and time periods (wine served in store or restaurant) • Levels of customer service, “Mass Customization” • Search engines, product reviews, samples may create stickiness - charge price premium. • Outstanding product information or compelling web design. Colors, wall paper, or exposure cycles may also influence buying behavior.

19. Customer Info and Economic Effects • Personalized product => highest price charged. • Price comparison is impossible. • Sellers may be in a better position to bargain. • All consumers’ needs are met. • Some configurations of industrial goods may not be feasible. • All consumers may be served efficiently.

20. Market Segmentation through Quality Differentiation • Different classes of service (1st class, 2nd class) • Basic, expanded basic and premium cable services • Economy, family and luxury automobiles • Standard, professional subscription plans • Educational, professional, enterprise versions of software The key consideration is how to charge high-income group more without making them switch to lower-class goods

21. Differentiated Products • Homogeneous products in the industrial age • Competition through differentiation • Horizontal differentiation (brand proliferation) • Vertical differentiation (quality) • Reasons for differentiation • Reduce substitutability • Segment the market • Entry into the market • “price control” Market power

22. Horizontal Differentiation • The game of location (proximity to customer’s tastes) Alice Bob 1/2 Alice Bob

23. Vertical Differentiation High Price Low Quality

24. How??? • Versions • Timing and delays • Ease of use • Pathways into site • Segregation of markets and users • Analysis of click stream and previous purchasing history

25. Making Self-Selection Work • May need to cut price of high end • May need to cut quality at low end • Value-subtracted versions • May cost more to produce the low-quality version. • In design, make sure you can turn features off!

26. How Many Versions? • One is too few • Ten is (probably) too many • Two things to do • Analyze market • Analyze product

27. Analyze Your Market • Does it naturally subdivide into different categories? AND • Are their behaviors sufficiently different? • Example: Airlines • Tourists v. Business travelers

28. Analyze Your Product • Dimensions to version • High and low end for each dimension • Design for high end, reduce quality for low end • Low end advertises for high end in service industries – Cheap rates • High end – Flagship products -advertises for low end in many products.

29. Goldilocks Pricing • Mass market software (word, spreadsheets) • Network effects • User confusion • Default choice: 3 versions • Extremeness aversion • Small/large v. small/large/jumbo

30. Extremes Aversion • Bargain basement at $109, midrange at $179 • Midrange chosen 45% of time • High-end at $199 added • Mid-range chosen 60% of time • Wines • Second-lowest price • “Framing effects”-example

31. Cross-Subsidies • Prices charged for one product are subsidized by the sale of another product • May be profitable when there are significant demand complementarities effects • Examples • Browser and server software • Drinks and meals at restaurants • Long distance and local access • Auto spare parts • Razor & Blades • Burger, fries, drinks • Auto financing

32. Lessons • Version your product • Delay, interface, resolution, speed, etc. • Add value to online information • Use natural segments • Otherwise use 3 • Control the browser, access, comparisons, etc. • Bundling & cross subsidies may reduce dispersion

33. Down & Dirty • First degree (perfect) price discrimination • “market of one” • Second degree price discrimination • “product line pricing”, “market segmentation”, “versioning” • Third degree price discrimination • “different prices to different groups” • Other definitions in literature…

34. Standards: Examples • RR gauges • Edison v. Westinghouse • NBC v. CBS in color TV • 3Com v. Rockwell/Lucent • Qwerty • What is going on now in wireless???

35. Rival evolution Video machines Rival revolutions DVD-A v. SACD Evolution v. Revolution Examples

36. AM stereo Auto industry invested, radio didn’t Digital wireless phones Europe: GSM US: GSM, TDMA (cousin of GSM), CDMA TDMA: 5 million CDMA: 2.5 million GSM: 1 million Recent Standards Wars

37. Ericsson (TDMA) has AT&T, SBC , Bellsouth Qualcom (CDMA) has Bell Atlantic, US West, etc Performance play strategy How big are the network externalities? Geographic scope Investment is sunk, systems interconnect Standards Wars

38. Key Assets • Control over an installed base • Intellectual property rights • Ability to innovate • First-mover advantages • Manufacturing • Strength in complements • Reputation and brand name

39. Network Externalities • Direct Network Effects Xn • The value of a product is a direct function of the number of others that own the product • Telephones, Fax machines • Indirect Network Effects • Your DVD player is not interdependent with my DVD player. However, more people who demand DVD players will increase the number of DVDs available.

40. Demand & Supply for a Network Good

41. Diffusion and Price

42. What is an auction ? • A method for allocating scarce resources based on competition • Bidding mechanism: • the seller (auctioneer) defines the auction rules: • how the winner is determined • how much he must pay • each buyer chooses a bidding strategy • The auction rules define a game among buyers • should use game-theoretic concepts to analyze auctions

43. Examples • Ancient cases: • 500BC: Herodotus mentions about auctions in Babylon • Ancient Rome: commercial trading, selling war booty • 193 A.D.: auction for the entire empire • More recent cases: auctions • for rare collective items • in wholesale markets of fish, flowers, etc. • for public contracts • in stock market • Very recent cases: auctions • over Internet (E-bay, ONSALE, etc.) • for bandwidth (Interxion, RateX, etc.) , spectrum

44. Auctions and resource allocation • An auction is a market mechanism that • allocates resources (goods) to buyers • generates value for the consumers • generates revenue for the seller • generates revenue for the producer • Is used where traditional market mechanisms (e.g. fixed price) can not be used • can serve as an internal mechanism value Seller buyers revenue

45. seller Performance Measures • When choosing an auction design, a variety of assessment criteria and measures may be used: • social efficiency (maximize the total value to buyers: Vickrey) • revenue (seller profit) • bidder profit • time, complexity, susceptibility to collusion • Why is it hard to design? Due to lack of information! • Auction: incentive mechanism • buyer: maximizes expected profit • seller: maximizes performance measure

46. Buyer i i Bidder and seller characteristics • Valuation • private values • common values • correlation • Risk assessment • risk neutral • risk averse • Symmetry • symmetric • asymmetric

47. Auctions • Uses • Major types of Auction • English • First-price, sealed-bid • Second-price, sealed-bid (Vickrey) • Dutch

48. English Auction • An ascending sequential bid auction. • Bidders observe the bids of others and decide whether or not to increase the bid. • The item is sold to the highest bidder.

49. English Auction • ascending bid, open-outcry • item is sold at least at the reserve price • best strategy for bidder • bid a small amount more than the previous high bid until bidder’s valuation is reached, then stop • auctioneer has great influence • most emotional and competitive of auctions • much information regarding demand is revealed

50. First-Price, Sealed-bid • An auction whereby bidders simultaneously submit bids on pieces of paper. • The item goes to the highest bidder. • Bidders do not know the bids of other players.