Pricing information goods. The economics of ICT. The Economics of Information Technology Varian Farrel and Shapiro (2004); Comino and Manenti ch.

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1 3/04/06 The Economics of Information Technology Varian Farrel and Shapiro (004); Comino and Manenti ch. ICT is a general purpose technology; it refers to the set of technologies used to manage information. Information: anything that can be digitalised Internet allows to store/retrieve, send/receive, produce/consume information The development of the economics of information and the Internet boom The economics of ICT Technology and market structure Scale economies Search costs Switching costs Firms strategies in digital markets: price discrimination Network Externalities and Two sided networks Innovation and Intellectual Property Cost structure of information goods Production in digital markets is characterised by high fixed costs and low marginal costs (economies of scale) Fixed costs are sunk No capacity constraints Pricing information goods For information goods, the price cannot be set as a mark-up on MC, since in many cases MC is almost zero. The price can be determined looking at consumers willingness to pay for the good. But consumers differ in their willingness to pay (the more so, for information goods). price discrimination is very common for information goods.

2 3/04/06 Price discrimination CW: ch. 5; CM: ch Selling the same good at different prices, adjusted for differences in costs examples Aim: extract surplus from consumers Conditions: Market power No arbitrage Price discrimination Types of price discrimination I degree (Personalised pricing ) III degree (Group pricing) II degree Non-linear pricing Versioning Bundling Dynamic pricing First-degree price discrimination An example c p M B A C MR D Each consumer pays a price equal to his willingness to pay The firm extracts all CS Monopoly: TS=A+B First-degree PD: TS=A+B+C Max efficiency but equity? Seller has 5 unitsof the good Consumers willingness to pay, as in table Max revenue with uniform pricing:.. Max revenue with first-degree PD: Total surplus in the two situations Willingness to pay C C 8000 C C C5 000 q M q MD Quantità

3 3/04/06 First-degree price discrimination First-degree price discrimination is highly profitable but requires detailed information ability to avoid arbitrage Leads to the efficient choice of output First-degree price discrimination The information requirements appear to be insurmountable but not in particular cases tax accountants, doctors, No arbitrage is less restrictive but potentially a problem 9 Chapter 6: Price Discrimination: Nonlinear Pricing 0 Third-degree PD Consumers differ by some observable characteristic(s) that affect their willingness to pay (age, income, status, nationality ) Market segmentation A uniform price is charged to all consumers in a particular group Different prices are charged to different groups Firm sets higher prices in inelastic markets since demand is less responsive to prices: p p A monopolist selling to two groups/markets q P q q P q TC( q q ) Max p p Third-degree PD MR p MC MR p MC 3

4 3/04/06 Third-degree PD (linear demand) Welfare effects Two groups: p A bq p a bq A>a MC=c Profits increase Consumers in the market with lower demand elasticity are worse off, since the price in this market has increased. Consumers in the market with higher elasticity are better off, since price in this market has decreased Second-degree price discrimination Offer a menù of options and let consumers self-select. Information technology helps collect information to help design menù options Non-linear pricing Versioning Bundling Pricing conditioned on purchase history Second-degree price discrimination Characteristics of second-degree price discrimination extract all consumer surplus from the lowestdemand group leave some consumer surplus for other group(s) the incentive compatibility constraint Second-degree price discrimination converts consumer surplus into profit less effectively than first-degree Some consumer surplus is left on the table in order to induce high-demand groups to buy large quantities 4 4

5 3/04/06 Two-part pricing The simplest form of non linear pricing is two-part pricing where consumers pay a fixed fee T plus a variable charge per unit: T+pq Examples: Two-part pricing with heterogeneous consumers and perfect information Suppose two types of consumers D (p)>d (p) Knowing the consumers type the firm can offer each group a non-linear price p =c & T =SC (p ) to type (low-demand) p =c & T =SC (p )> T to type (high demand) Two-part pricing with heterogeneous consumers and imperfect information If you cannot distinguish between buyers: offer a menù and let consumers choose High-income buyer will pretend to be a low-income buyer and no one would buy Option The incentive compatibility constraint: Any offer made to high demand consumers must offer them as much consumer surplus as they would get from an offer designed for low-demand consumers. Two-part pricing with heterogeneous consumers and imperfect information Design a pricing scheme that makes buyers reveal their true types self-select the quantity/price package designed for them Firm will offer Option I: p >c & T Option II: p =c & T >T Consumers of type will choose Option Consumers of type will choose Option 5

6 3/04/06 Versioning Versioning:an example firms produces several versions of its product, each targeted at a specific market segment. hard-back versus paper back books first-class versus economy airfare Crimp the product to make lower quality products e.g. Mathematica Loyal readers N=40 Normal readers N=60 Hardcover 0 60 Paperback Versioning Identify the characteristics and the price of the low-end version (Pp=40) Determine the characteristics and the price of the high-end version so that targeted consumers are indifferent between the two versions the incentive compatibility constraint (Ph=00) Versioning to increase the market One version (high quality) of the product Quality indexed by m θε 0, represents consumers preferences over m assumed to be uniformly distributed k indicates basic willingness to pay Utility from version of quality m is: U = k + θm p The indifferent consumer is characterised by θ such that U = 0 θ = p k m Profit maximisation p = k+m and q = m k m 6

7 3/04/06 Versioning to increase the market Two versions of the product Quality indexed by m with m > m Prices of the two versions must be such that consumers with high θ are induced to select the high quality version while those with low θ are induced to select the low quality version Utility from version of quality mi is: U = k + θm i p i Versioning to increase the market Two versions of the product 0 θ θ do not buy buy low quality buy high quality The consumer indifferent between version and not buying is characterised by θ such that U = U 0 = 0 θ = p k m The consumer indifferent between version and version is characterised by θ such that U = U θ = p p m m Versioning to increase the market Two versions of the product Profit maximisation p = k+m and p = k+m Result: If the monopolist offers two versions of the product, sales increase and profits are larger Bundling Firms often bundle the goods that they offer Sky offers packages Microsoft bundles Windows and Explorer Office bundles Word, Excel, PowerPoint, Access Aim: extract consumers surplus by reducing heterogeneity in preferences Bundled package is usually offered at a discount 36 7

8 3/04/06 Bundling: an example Two television If the stations films are sold are How considering much can two films Harry Potter separately and Lord total of the Ring How much can be charged for revenue is $9,000 be charged for HP? Willingness to pay is: Lord of the Ring? $7,000 Station A Willingness to pay for Harry Potter $8,000 Willingness to pay for Lord of the Ring $,500 $,500 Station B How much can Bundling: an example be charged for Now suppose the package? that the two films are bundled Willingness If and the sold films are to sold Willingness Bundling is profitable to Total as a package as pay a package for HP total pay because for Lord it exploits Willingness revenue is $0,000 aggregate of the Ring willingness to pay pay Station A $8,000 $,500 $0,500 $7,000 $3,000 $0,000 Station B $7,000 $3,000 $0, An Example Four consumers; two products; MC = $00, MC = $50 Consumer A B C D Reservation Price for Good Reservation Price for Good Sum of Reservation Prices $50 $450 $500 $50 $75 $55 $300 $0 $50 $450 $50 $500 The example Good : Marginal Cost $00 Price Quantity Total Consider revenue simple Profit $450 $450 monopoly pricing $350 $300 $600 $400 Good should be sold $50 3 $750 $450 at $50 and good at $50 4 $00 -$00 $450. Total profit Good : Marginal is $450 Cost $50 + $300 Price Quantity = Total $750 revenue Profit $450 $75 $0 3 $450 $550 $660 $300 $00 $0 $50 4 $00 -$400 4 Chapter 8: Commodity Bundling and Tie-In Sales 4 8

9 3/04/06 Consumer A B C D The example 3 Now consider pure bundling Reservation Reservation Sum of Price for The highest Price bundle for Reservation Good price that Good can be Prices All four $50 consumers considered $450 will is buy $500 the bundle and profit is $500 4x$500 $50-4x($50 + $75 $00) = $,000 $55 $300 $0 $50 $450 $50 $500 The example 5 Try instead the prices p = $450; p = $450 and a bundle price p B = $50 This is actually Reservation the best that Reservation the All four consumers buy Sum of Consumer Price for firm can Price do and profit is $300 + for Reservation Good Good Prices $70x + $350 = $,90 A $50 $450 $500 B C D $50 $75 $55 $50 $300 $0 $50 $450 $50 $500 Chapter 8: Commodity Bundling and Tie-In Sales 43 Chapter 8: Commodity Bundling and Tie-In Sales 45 Pricing conditioned on purchase history The model by Acquisti and Varian On-line, vendors can store information on customers characteristics, behaviour, purchases and condition price on these information. Consider an on-line monopolist operating in two periods. Consumers vistit the firm s website in each period and decide whether to buy or not Pricing conditioned on purchase history The model by Acquisti and Varian k indicates basic valuation of the good m i is additional benefit from purchase in period i with m > m θε 0, represents consumers preferences over m i assumed to be uniformly distributed Utility from purchase in period i is: U = k + θm i p i 9

10 3/04/06 Pricing conditioned on purchase history No price discrimination The indifferent consumer is characterised by θ such that U = 0 θ = p k m i Profit maximisation p = k + m m m +m Pricing conditioned on purchase history Dynamic pricing Firm must determine three prices: p0, pb, pnb Consumers who bought in the first period have high θ charge pb high, some will buy also in the second period Myopic consumers do not recognise that price tomorrow may depend on price paid today «Smart» consumers : if pnb too low no-one would buy in the first period set pnb extremely large Pricing conditioned on purchase history Dynamic pricing, SMART consumers 0 θ L θ H do not buy buy first visit buy both visits The consumer indifferent between buying only at first visit and not buying is characterised by θ such that U = U 0 = 0 θ L = p 0 k m The consumer indifferent between buying in both periods and buying only at first visit is characterised by θ such that U + U = U θ H = p b k m Pricing conditioned on purchase history Dynamic pricing, SMART consumers Profit maximisation p 0 = k+m and p b = k+m Result: The firm profitably discriminates consumers by conditioning prices on purchase history 0

11 3/04/06 Search costs Consumers are not fully informed on the price N consumers willing to pay v to buy a good Consumers may search at a cost s If s=0 and all the assumption of Bertrand model are satisfied, then firms price at MC If s>0 equilibrium price exceed MC (p=v) All firm set the same price and consumers are better off by not searching. Reducing price is not convenient since no additional demand can be obtained (if consumers buy at first visit) Internet can lower search costs Switching costs and lock-in Two periods N consumers willing to pay v to buy a good Two producers with MC=c Let s be the switching cost such that v>c but v+s<c HIGH s LOCK-IN Second period: NE price equal to v First period: firms are willing to pay v-c for an additional consumer; Bertrand competition p=c-v Price dispersion Antitrust and of Price Discrimination Assuming consumers differ in search costs price dispersion If search costs are negligible, (e.g. on-line) then other explanations are needed for price dispersion. Varian (980) argues that it may be optimal for retailers to randomly choose prices consumers cannot be informed on prices even if search costs are null

12 3/04/06 Additional Readings Axelrod (98) The evolution of Cooperation Besen and Farrell (994) CM ch.3 Boldrin and Levine (008) CM ch.7 One to be chosen from the following: Acquisti and Varian (005) CM ch. Arthur (989) CM ch. 3 Katz and Shapiro (986) CM ch. 3 Farrel and Shapiro (008) CM ch. 6 Bessen and Maskin (009) CM ch. 7