Market Segmentation and Information Development Costs in a Two-Tiered Information Web Site

Transcription

1 Market Segmentation and Information Deveopment Costs in a Two-Tiered Information Web Site Frederick J. Riggins Carson Scoo of Management University of Minnesota, Minneapois, MN friggins@csom.umn.edu Pone: Fax: February 00 An earier version of tis paper was nominated for te Best Paper award at te Tirty- Fift Annua Hawaii Internationa Conference on Systems Sciences, January 00. 1

2 Market Segmentation and Information Deveopment Costs in a Two-Tiered Information Web Site Abstract We deveop an anaytica mode of a separating equiibrium for a two-tier fee-based and sponsored-based information Web site. We examine te monopoist s coice of content quaity and price for a feebased site targeted at ig type consumers and te content quaity eve for a sponsored site offered free to a consumers. We sow ow a reduction in te potentia for advertising revenues resuts in ower content quaity on te free site, but permits te seer to raise te fee carged to ig type consumers. We aso sow ow differences in consumer toerances to ads impacts content quaity, banner ad voume, and usage fees. In particuar, te seer can increase profits by making ads more attractive to eiter ig type consumers or ow type consumers, but never bot at te same time. We sow te conditions tat determine wic consumer segment te seer soud seek to improve ad reevancy.

3 1. Introduction Market Segmentation and Information Deveopment Costs in a Two-Tiered Information Web Site Te Internet and te Word Wide Web ave atered te way many peope gater various types of information, ranging from daiy news stories, to contact information for od ig scoo cassmates, to igy tecnica consutancy reports. In teir searc for a pat to profitabiity, information providers ave attempted various combinations of free sponsored sites and fee-based sites. Daiy news stories, sports scores, and stock price information can be found on numerous sponsored sites suc as CNN.com, Yaoo!, and BusinessWeek onine. Due to te coapse of te dot-com economy, tese sites ave strugged as teir potentia for revenues from banner advertisers as pummeted. Oter sites suc as Cassmates.com, Britannica.com, and AOL.com provide some content for free on a sponsored site, but seek to entice users to pay a subscription fee for unique content not easiy found esewere. For exampe, Cassmates.com aows te non-paying user to read a sort bio of od cassmates, but requires a $9.95 annua God Membersip fee to be abe to actuay contact od friends and engage in cat and discussion board community features. Britannica.com offers some free content on a sponsored site, but continuousy prompts te user to pay a $50 annua membersip fee in order to receive fu use of Britannica s unique information arcive. AOL.com functions as a competitive Web porta, but offers various monty pricing options wereby te user can upgrade to te proprietary AOL interface wit its many unique features. A variation of te two-tier site mode incude companies suc as Gartner and Forrester Researc wo provide some free information on teir advertisement-free company ome pages, wit te opes of enticing users to pay for oter expensive services suc as tecnica witepapers and industry-specific consutancy reports. In a sense, te ome page functions as an advertisement for te company itsef, wit te goa of buiding brand image and promotion of unique information products. For two-tier sites ike Britannica.com and Cassmates.com, te caenge is to provide enoug free content to keep users coming back in order to increase banner ad revenues, but at te same time, imit te free content suc tat ig end users wi sti be 3

4 wiing to pay to access te premium services and information. Simiary, te consuting firms desire to provide enoug free content on teir ome pages suc tat visitors wi tink igy of te firm wereby guests can be converted to cients. Wat tese information providers are essentiay doing is degrading teir information product to create a free version of te good tat satisfies ow type consumers, but oding back enoug content so tat ig type consumers are not entirey satisfied and terefore are wiing to pay for te fee-based site [1, 13]. In tis paper, we consider an information monopoist tat markets its web site to ow type consumers wo are not wiing to pay for content on te Web, but may toerate some degree of banner advertising, and ig type consumers wo are wiing to pay for ig quaity content but ave ess toerance for onine advertising. We deveop an anaytica mode of a separating equiibrium were te monopoist provides a free sponsored site to bot ig and ow type consumers and a fee-based portion targeted at ig type consumers. Te seer must seect content quaity and price eves for te feebased portion of te site, and te degraded quaity eve for te free sponsored site. Firms tat simutaneousy cater to ig-end and ow-end cientee ave been te focus of muc anaytica modeing by researcers empoying economic modeing tecniques. Based on work by Spence [14], Tiroe [15], and Varian [16], information systems researcers ave anayzed te use of second degree price discrimination were firms operate witin te Internet economy to se a ig quaity, expensive product to ig type consumers and a ow quaity, inexpensive product to ow type consumers simutaneousy [, 4, 5, 6, 10]. Because te seer is not abe to know te type of a given consumer, te seer is forced to create a separating equiibrium by setting price and quaity eves so tat consumers sef-seect into te appropriate categories. Muc of tis researc examines te impications of te so-caed cannibaization probem were ig type consumers may be tempted to purcase te product aimed at te ow type consumers. Moorty and Png [8] sow ow tis distortion in te marketpace may resut in ow type consumers being under-served or in some cases not being served at a. Riggins and Narasiman [10] extend tese resuts to mode a firm tat ses to ig and ow type consumers in onine canne and uses personaization tecnoogy, community access imitations, and intertempora price discrimination to segment te 4

5 market. Bot of tese studies examine te cannibaization probem for te sae of pysica goods. Wie severa studies ave examined te onine pricing poicies of information goods, te impications of cannibaizing ig-end information goods ave not been torougy examined. Te current anaysis examines te cannibaization probem as it appies to information goods witin te onine canne. If a firm operates a two-tier Web site were a free, sponsored portion is offered to a consumers and a fee-based portion is targeted at ig types, te seer may face te cannibaization probem if ig type consumers receive sufficient vaue from te free content. We examine tis probem in igt of two trends regarding onine advertising. First, due to te coapse of te dot-com economy te amount of money sites can carge for ad pacement as decined in recent years, tereby putting pressure on te revenue generating potentia of banner ads. Indeed, tis trend casts some doubt on te very efficacy of te sponsored site business mode. We sow ow a reduction in revenue potentia from ads on te sponsored site resuts in ower quaity of information on te free site, an increase in price or fees on te fee-based portion of te site, and ower tota profits. Second, personaization toos aow Web sites to manage te pacement of banner ads by providing impressions of ads tat are more reevant and interesting to te specific user. Terefore, it coud be tat users discomfort from aving banner ads dispayed migt be essened as personaization increases. We sow ow information quaity, banner ad voume, and fees cange as ig and ow type consumers toerance for onine banner ads cange. In particuar, we sow te conditions under wic te seer wi seek to make ads more reevant to eiter ow type consumers or ig type consumers. In, we discuss te reevant iterature concerning te pricing of goods wen te cannibaization probem potentiay exists, and recent work on te pricing of information goods. In 3, we present a styized exampe of te cannibaization probem to iustrate its impications on te seer and bot types of consumers. Tis is foowed in 4 wit te deveopment of our mode of a separating equiibrium for a two-tier Web site were a free, sponsored site is offered to a consumers, and a fee-based portion of te site is aimed at ig type consumers. We deveop severa propositions reated to information 5

6 quaity and pricing eves as te potentia for banner ad revenue decines and as consumers toerances for banner ads cange. We concude te discussion in 5.. Background Literature A seer may practice first-degree price discrimination wen it faces eterogeneous consumers and can distinguis te particuar type of a given consumer. Wen tis occurs te seer may potentiay extract a consumer surpus by carging at eac consumer s wiingness-to-pay. However, in most cases te seer is not abe to know te type of a given consumer. In addition, tese consumers may not be incined to trutfuy revea teir type. In tis situation, te seer may resort to second-degree price discrimination by offering a range of goods were consumers may be induced to revea teir preferences by sef-seecting into te appropriate category. To investigate tis probem, researcers commony incorporate anaytica modes tat investigate te pricing strategy of seers tat practice intertempora price discrimination or tat se mutipe products to mutipe types of customers witin a given canne. For exampe, Conner [3] sows ow a firm may spend aggressivey on researc and deveopment to create a new product, ony to set tis new product aside unti te od one is caenged by a competitor. Bensanko and Winston [1] and Levinta and Puroit [7] bot examine intertempora price discrimination were prices of products today are infuenced by te expectations of a new product tomorrow. Te expectation of an improved product in te future can cannibaization saes in te current market. Puroit [9] furter deveops a two-period mode of a manufacturer tat offers a product in a renta market and a saes market. Dewan, et a. [4] deveop a mode tat sows ow an eary entrant into te onine saes canne can use te personaization and customization features of te Internet to create a barrier to entry discouraging oter onine seers from entering te market. Indeed, te eary entrant may over-customize in an effort to bock entry. In a foow-up anaysis, Dewan, et a [5] extent Saop s circuar city mode [11] to deveop a mode of a firm tat ses a range of customized products in addition to a standard product. Te autors deveop pricing and product-positioning strategies for a monopoist and a duopoy in igt of canging customization and personaization capabiities. 6

7 Moorty and Png [8] deveop an anaytica mode of a seer tat ses a product tat can be differentiated aong some measure of quaity to bot ig and ow types consumers witin a singe canne. Hig type consumers are distinguised from ow types in tat ig type consumers are wiing to pay more for a given eve of quaity tan are ow type consumers. Because te monopoist seer is not abe to know a given consumer s type, it must create a separating equiibrium by setting prices and quaity eves so tat consumers sef-seect into te appropriate category. Te probem is tat in order to se to ow type consumers at a price eve tey are wiing to pay, ig type consumers wi view te ow product as an attractive aternative to te ig quaity good. Tis potentia for cannibaization is a distortion tat utimatey arms te ow type consumers as te monopoist is forced to ower te quaity of te ow type product to make it ess attractive to te ig type consumers. Te autors furter deveop te mode by considering intertempora price discrimination were te seer can segment te market using deay in addition to quaity differences. Riggins and Narasiman [10] extend tis mode to examine te case were a monopoist markets a pysica product to two types of consumers in te onine canne. Tey sow ow te seer may use personaization tecnoogy to imit or peraps eiminate te distortion caused by te cannibaization probem. Terefore, te seer may provide iger product quaity eves and earier product introductions for goods aimed at ow type consumers. Tey sow ow personaization tecnoogy aso essens te adverse effects caused wen te seer cannot crediby commit to future actions. In addition, because te seer overcomes te cannibaization probem by making sure te ig type consumer buys te correct product te seer soud focus a of its personaization efforts on ig type consumers, and must concern itsef wit te eve of patience of ig type consumers and not ow types. Tey aso examine tree different seer strategies for bunding te sae of te pysica good wit customer access to a seer-sponsored onine community. Wen personaization capabiities are reativey ow, te seer soud segment consumers into two communities by aowing consumers to ave access to te community associated wit te type of pysica good tat was actuay purcased. Wen personaization capabiities are sufficienty ig, te seer soud switc from te 7

8 segmented communities strategy and merge a consumers into one community to take advantage of externaity effects. Te modes considered above examine te pricing strategies of traditiona pysica goods. In tese modes, te margina cost of producing a product of iger quaity in convex as sown in Figure 1. Because ig type consumers ave a iger reservation vaue for a given eve of quaity, te seer wi create two versions of te product and se te iger quaity version to te ig types and te ower quaity version to ow type consumers. Segment $ Segment Costs q * quaity q * Figure 1. Consumer Reservation Vaues and Margina Costs [from (8)] Recent anaytica modeing as examined te unique caracteristics of information goods. Information goods are goods were te main vaue is derived from digitized content []. Te major portion of te costs associated wit information goods is in te deveopment pase, rater tan te production pase. Works of iterature, music recordings, software programs, and fu-production movies a require a significant up front-cost to produce te first copy of te good, but can ten be dupicated for a minima 8

9 cost [13]. Indeed, te presence of te Internet aows near costess downoad of countess copies of an information good tat as aready been produced. In tis sense te margina cost of producing anoter copy for sae is essentiay zero. In contrast to te function in Figure 1, muc of tis iterature assumes a concave margina cost function or simpy assumes a margina cost of zero. In tis context, Bargava and Coudary [] sow tat te firm s optima product ine is dependent upon te benefit-to-cost ration of quaities in te coice menu. Terefore, product differentiation is not an optima strategy and te seer soud produce and se ony te igest quaity product feasibe. Repacing te convex function in Figure 1 wit a concave function wi ceary resut in te seer maximizing profits by increasing quaity as muc as possibe. In a simiar approac Jones and Mendeson [6] sow tat te seer soud offer ony one product quaity eve. Ceary, for information goods, te margina cost is zero for producing additiona quantity. But wat about creating a iger eve of quaity in te second unit? Is tat costess? Consider a vendor of a software product of a certain quaity. If a different customer desires a iger eve of quaity, producing a perfected version of te program can become very costy. Indeed, te cost function associated wit improving te quaity of software woud ikey be convex as it becomes arder and arder to perfect te program. Tis is because creating a iger quaity version of an information good requires te seer to return to te deveopment pase rater tan te production pase. Indeed, te very concept of a production pase is miseading wen considering information goods. Any deviation from te continuous dupication of te origina copy of an information good coud be considered a return to deveopment. On te oter and, a manufacturer of a pysica good need not return to te product deveopment pase wen a customer desires a iger quaity product. Rater, te production ine continues as before, abeit wit iger quaity raw materias. As anoter exampe, consider te writing of a mystery nove. One coud create a version wit saow caracters and a straigtforward pot (Copy 1), but te costs to create a iger quaity version wit wedeveoped caracters and an intricate pot ine (Copy ) can become a very daunting task. Te same can be said of writing academic conference and journa papers were te cost of improving te quaity of te manuscript is certainy convex. 9

10 Te Bargava and Coudary [] anaysis ets te seer coose quaity eves and sows ow te seer woud coose te one of igest quaity. Suppose a software maker as aready deveoped two versions of a software product (one of iger quaity tan te oter) and te software can be costessy downoaded from te seer s Web site. If a consumer is wiing to pay for iger quaity, and one version is no more costy to provide tan te oter, ten ony te iger quaity version soud be sod. Terefore, if we disregard te initia deveopment costs te ower quaity version wi not be deveoped in te first pace. Ony te igest quaity feasibe wi be offered, were te autors assume te quaity imit is exogenousy given. By disregarding convex deveopment costs and considering zero or concave margina costs, tey avoid te issue of coosing te appropriate eve of quaity to deveop in te first pace. In reaity, seers serve a variety of consumers wo ave differing vauations of quaity and terefore wiing to pay different amounts for a given product. In order to meet tis demand, information providers typicay provide versions of teir information products were a free or ow priced version may be a time-imited tria version, ave imited functionaity, or may contain some time deay to make it ess vauabe [1, 13]. Wat information providers typicay do is deveop te ig-end good and ten purposey degrade te quaity of te ow-end good. In our mode in Section 4, we examine tis particuar probem were an information monopoist deveops a ig end information good based on a convex deveopment cost function, ten incurs some degradation cost to create te ow end good. Te seer s task is to seect te two quaity eves and te ig quaity price eve tat maximizes te firm s profit. 3. An Exampe of te Cannibaization Probem Te current anaysis examines te impications of te cannibaization probem as outined by Moorty and Png [8] and furter expanded upon by Riggins and Narasiman [10]. In our mode, we consider te impications of a monopoist offering a Web-based information good. However, before considering te information good case, it woud be instructive to iustrate te cassic cannibaization probem by considering an exampe of a simpe pysica good. 10

11 Consider te foowing exampe: a monopoist seer of a new type of teevision set seeks to se its teevision sets in a market comprised of 75 ow type consumers and 100 ig type consumers. Witin tis new product ine, teevisions differ according to te number of ines of resoution (LOR) of te set. Market studies ave sown tat ow type consumers are wiing to pay $0.60 per LOR, wie ig type consumers are wiing to pay $0.80 per LOR. In addition, te cost to manufacture and deiver a particuar set to market is C = $ LOR. Tese market conditions are igigted in Tabe 1. To Low Types To Hig Types LOR Unit Cost $ Vaue $ Profit $ Vaue $ Profit $ Tabe 1. Iustration of te Cannibaization Probem Inspection of Tabe 1 indicates tat te seer woud maximize its profits by seing a 600 LOR set to ow type consumers wit a price tag of $ per set and an 800 LOR set to ig type consumers wit a price tag of $ per set. If te seer were abe to price its goods in tis manner by pricing eac type of set at eac type s wiingness-to-pay te seer coud acieve profits of $45,500 as sown in Tabe. However, consider a ig type consumer s purcase decision wen te seer doesn t know te consumer s type. A ig type consumer must coose weter to pay $ for te 800 LOR set tat se vaues at $640.00, or pay $ for te 600 LOR set tat se vaues at $ Wie te ig type consumer paces a ig vaue on quaity and wi view te 800 LOR set as a reasonabe vaue for $640.00, se wi view te 600 LOR set as a bargain tat is too good to pass up. In purcasing te 800 LOR set, te consumer gets zero excess surpus, but by purcasing te 600 LOR set, te ig type consumer gains a $10.00 surpus. Ceary, a 175 consumers wi purcase te 600 LOR set! Tis resuts in a profit of $31,500 for te seer (Strategy ). 11

12 Seer s Strategy 1. A Consumers Buy at Teir WTP (Best-Case). A Consumers Buy 600 LOR Set 3. Seer Ses Ony 800 LOR Set 4. Lower p of Hig Good By $ Lower p of Hig Good and q, p of Low Good Profit $45,500 31,500 3,000 33,500 36,166 Tabe. Seer s Profits For Five Different Strategies Tis distortion in te market tat costs te seer $14,000 is te cannibaization probem tat a seers face wen trying to service mutipe types of consumers in te same canne wen te seer can t know a given consumer s type. Indeed, Moorty and Png [8] cacuate a measure of cannibaization n v R = 1, were n and n are te n v number of ig and ow type consumers respectivey, and v and v are te respective vauations of a unit eve of quaity for eac type of consumer. Wen R = 0, tere is no potentia for cannibaization. Tis is because tere are eiter no ig types in te market or ig and ow types ave te same vauation of quaity. Note tat in te teevision exampe, R =. 44, wic is aso te percentage different between te actua profits (Strategy ) and te best-case profits (Strategy 1). Inspection of Tabe sows tree oter strategies te seer coud pursue. Wat is particuary interesting about tis styized exampe is tat te seer coud improve its profits using Strategy 3 by removing te ow quaity good from te market entirey and ony seing te ig quaity good to te ig type consumers! Reca from Tabe 1 tat wen te ig type consumer buys te 600 LOR set, se receives a $10.00 surpus. Te seer coud consider reducing te price of te ig good by $10.00 to $50.00, tereby making te ig type consumers indifferent (Strategy 4). Tis wi resut in a consumers buying te rigt product, but it wi aso reduce profits on te more profitabe ig-end good. Te fact is tat wen trying to se to ow type consumers in te same canne as ig types, te ig type consumers wi need to get a reduced price, suc tat te seer cannot extract te entire surpus from te ig type consumers. However, te seer can reduce te required discount for te ig quaity good by making te ow quaity good 1

13 ess attractive to te ig type consumers. Moorty and Png [8] sow tat te seer soud set prices at ( ) q v = and q = ( 1 R) c v c p = v q v v q and p = v q, and set quaity eves at, wereby te optima soution is to ower te price of te ig-end good, but aso reduce te quaity and price of te ow-end good (Strategy 5). Here te 800 LOR set soud be priced at $573.33, wie a LOR set is priced at $00.00 for te ow type consumers. Notice tat te seer extracts te entire surpus from te ow type consumers and prices just to ensure tat tey participate in te market. On te oter and, te seer knows te ig type consumers wi participate in te market. Te seer just needs to make sure se buys te rigt good. 4. A Mode of Separating Equiibrium for a Two-Tiered Web Site We consider a monopoist producer and seer of an onine information good tat can be differentiated aong some dimension of quaity, q. Te producer ses to a market tat is made up of two types of consumers a ig type,, and a ow type,, wit market sizes n and n respectivey. Te two consumer types vaue a product of quaity q at v q and v q respectivey, were v > v > 0. For tis particuar mode we impose an additiona imitation in tat wie ow type consumers ave a positive vaue for te information good, ow type consumers are unwiing to actuay pay for access to te information. Instead, tey are wiing to incur te inconvenience of viewing banner advertising at a discomfort rate of d a, were a is a unit measure of advertisement and te discomfort rate is convex in a. Simiary, ig types ave a discomfort rate of d a, were d > d > 0. Eac time a consumer accesses te good from te sponsored site, te seer receives advertising revenue of ra were r > 0 and is exogenousy given. Aso, we assume tat te cost of producing te first copy of te good wit quaity q is cq, were c > 0, and it is costess to produce additiona copies of te same good. In addition, te seer can create a degraded version of te good at a fixed cost k, were q is te origina good and q is te degraded version. Given tis scenario, te seer may produce two versions of te product to be targeted at te two consumer segments. Specificay, a product of ig quaity, q, wi be targeted at te ig type consumers for an access fee 13

14 of p, and a product of ow quaity, q, wi be avaiabe for free to a consumers wit revenues of ra for eac consumer tat accesses te good. Because of te ack of information about a specific consumer s type, te seer must practice second-degree price discrimination and price te ig quaity good and set quaity eves so tat te ig type consumers sef-seect by subscribing to te fee-based content. Te cannibaization probem arises because te seer is not abe to proibit te ig type consumer from accessing te free content and avoiding te fee-based site. In our mode, te potentia for cannibaization forces te seer to give te ig type consumer a fee discount and ower te quaity of te ow quaity good to te point tat te ig type consumer sti finds te ig quaity site desirabe. Te seer s probem is to set te quaity, price, and advertising eves in order to max q, q, p, a ra ( n + n ) + n p cq k (1) subject to: vq da () vq da (3) v q v q v q p (4) v q p (5). Constraints () and (3) are te participation constraints for te two consumer segments tat ensure tat a consumers visit te sponsored site. Constraints (4) and (5) are te sef-seection constraints to ensure tat te ow type consumer wi not subscribe to te fee-based content, but te ig type consumer wi do so. Te mode is different from te Moorty and Png [8] and Riggins and Narasiman [10] anaysis in tat te cost terms are not margina costs but rater te deveopment cost associated wit producing te first copy of te good at tat particuar quaity eve. Eac additiona copy of tat version is costess to produce and is not incuded in te objective function. Terefore, [ra(n + n ) - k] represents te tota profit potentia to be generated from te sponsored site and [n p cq ] is te tota profit potentia from te fee-based site. Furter notice tat 14

15 (4) and (5) take into account a unique aspect of information goods aving aready consumed te free content, te fee-based site user receives te incrementa benefit of te difference between q and q wen paying te subscription fee. In oter words, aving consumed a certain amount of information once, consuming te same information a second time resuts in zero additiona benefit. Terefore, aving aready visited te free sponsored site, a subscriber to te fee-based site receives an additiona quaity of ony q q. We can cacuate te efficient quaity eve of te fee-based portion of te site as te quaity tat te seer woud provide if first-degree price discrimination were possibe. Tis woud occur if te seer were abe set p = v q. Soving te objective function resuts in nv q * = (6) c for te ig quaity good. Tis eads us to Proposition 1. PROPOSITION 1. For information goods on a fee-based site, te optima eve of quaity produced in te deveopment stage is proportiona to te expected size of te market for tat good. Tis is in contrast to te pysica good case were quaity eves are based on te margina cost of producing anoter unit. For information goods te major cost, or in many cases te ony cost, is te deveopment cost, wereas production costs are essentiay zero. Terefore, te size of te potentia market must be strongy considered before embarking on costy information product deveopment. Returning to te probem in (1) - (5), consider te participation constraints () and (3). Te seer wants to make sure te ow type consumer participates via (). Te seer woud aso ike to make sure te ig type consumer visits te free site using (3) in an effort to promote te fee-based site. Suppose te seer binds () so tat v q = d a. Ten (3) is satisfied provided tat δ δ, were δ i = v i /d i is te consumer s vaue-discomfort 15

16 index. However, if δ < δ ten te seer woud bind (3) and ave () be satisfied. Te seer wi bind te participation constraint of te consumer wit te ower vauediscomfort index. Since te seer wi set te eve of advertising to make tis consumer indifferent between visiting or not visiting te sponsored site, we ca tis consumer type te advertising target of te sponsored site. Tis is te margina consumer type from wom te seer is abe to extract a consumer surpus regarding te sponsored site. Now consider (4) and (5). If we assume tat () and (3) are satisfied, ten a consumers wi visit te sponsored site. Ten (5) assures tat ig type consumers wi subscribe to te fee-based site and (4) ensures tat ow type consumers wi not subscribe. Te seer wi bind (5) suc tat p = v q v q. Note tat te ig type consumers receive a discount from teir wiingness to pay, v q. Given tat v < v, ten v q v q v q v q = p (7) suc tat (4) wi be satisfied if we bind (5). Case 1: d > d. Bind () and (5). In tis case, te advertising target is te ow type consumer. Binding () to ensure te ow type visits te sponsored site gives v q a = (8) d as te appropriate amount of advertising for a given eve of quaity on te free portion of te site. As ow type consumers discomfort wit banner ads increases, te number of ads soud decrease. On te oter and, wen ow type consumers vaue quaity content more, te seer can increase ads on te free site. Binding (5) and using (8) aows us to sove te objective function wit respect to te two eves of quaity, suc tat 16

17 q nv = (9) c and q ( n n ) r + = δ (10) vn were te seer s profits for case 1 are ( n + n ) r v n Π1 = δ + k. (11) 4v n 4c Case : d < d. Bind (3) and (5). Here, te ig type consumer is te advertising target wo as te ower vauediscomfort index suc tat te seer extracts a of te ig type consumer s vaue from te sponsored site. Using te same procedure, binding (3) gives vq a = (1) d as te appropriate amount of advertising tat keeps te ig type consumer interested in te sponsored site. As ig type consumers discomfort wit banner ads increases, te number of ads soud decrease. On te oter and, wen ig type consumers vaue quaity content more, te seer can increase ads on te free site. Binding (5) and using (1) in te objective function resuts in q nv = (13) c and 17

18 q ( n n ) r + = δ (14) vn were te seer s profits for case are ( n + n ) r v n Π = δ + k. (15) 4v n 4c Notice tat in bot cases, te quaity of te ig good is at te efficient amount sown in (6). On te oter and, te ow quaity good is degraded to an amount tat is proportiona to te vaue-discomfort index of te margina consumer type. For bot cases, we are interested in knowing te impications of canges in r, wic is exogenousy given. Due to te coapse of te dot-com economy providers of free sponsored sites ave strugged to find a profitabe business mode based on advertising revenues. Tis is because te fees tese sites can carge advertisers ave decreased as cas-strapped dot-com companies ave exited te marketpace or cut back on teir advertising expenditures. In our mode, tis woud correspond to a reduction in r. As sown in (10) and (14), q is increasing in r, so tat wen r decreases te seer owers te quaity of te content on te free site since tere is ess revenue potentia from ow type consumers visiting tat portion of te site. Stated more formay, PROPOSITION. Wen fees carged for onine advertising decrease, te seer decreases te quaity of content on te sponsored portion of te Web site. Provided tat r is sufficient suc tat r ( n + n ) 4v n δ k i were δ i = min {δ,δ } (16) 18

19 te seer wi degrade te ig quaity product to create te ow quaity good and offer te sponsored site. Wie Proposition is not particuary surprising, we see from (7) tat a reduction in q impacts te fee carged to ig type consumers. Specificay, wen te seer as ess revenue from ads on te sponsored portion of te site, te seer reduces te quaity of te free content tereby making it ess attractive to ig type consumers. Te seer is ten free to increase te fee carged to tese premium customers. PROPOSITION 3. Wen fees carged for advertising on te sponsored portion of te Web site decrease, te seer is abe to raise te access fee carged to consumers of te fee-based portion of te site. Wen te advertising revenues are reduced, te seer is abe to make up some of Π te oss by raising subscription fees, owever, from (11) and (15) we see tat 0 r suc tat profits are reduced wit r is reduced. Terefore, a reduction in advertising potentia resuts in ower quaity on te sponsored site, ig access fees for te fee-based site, and overa ower profits for seer. Te opposite woud occur if r were to increase. We are aso interested in examining te impications of canges in te vauediscomfort index. Wie te seer needs to take te reative quaity vauations, v i, as given, te seer may be abe to cange a given consumer s discomfort due to banner ads. For exampe, one sponsored site mentioned earier not ony paces a banner ad at te top of eac Web page, but aso uses Fas-based mutimedia advertisements to pop-up and move across te screen even to te point of bocking content. To many users, tis increases te discomfort eve, d i, associated wit accesses te free information. On te oter and, Web-based personaization toos aow te information provider to dispay ads tat are based on te particuar user s persona interests, tereby owering te user s discomfort eve. Wat, ten, are te impications in canges to d i? Reca tat δ i = v i /d i. From (10) q q and (14) we see 0 for Case 1 and 0 for Case. In oter words owering te d d 19

20 discomfort eve for te advertising target consumer segment aows te seer to increase te quaity of te content on te sponsored site and tereby increase te amount of advertising on te sponsored site. Furter, we know tat tis forces te seer to ower te fee for te ig quaity content, but resuts in overa iger profit eves. Specificay, we can state Proposition 4 as PROPOSITION 4. If te seer can use personaization tecnoogy to improve ad reevancy and tereby ower te discomfort rate of visitors to te sponsored site, te seer soud seek to make ads more reevant to te consumer type wit te ower vauediscomfort index, δ i = v i /d i, ony. Of course, it soud be noted tat wie owering d i wi resut in increased profit, it woud aso increase δ i. In oter words, for Case 1, efforts to ower d may resut in δ becoming greater tan δ, causing a switc to Case (and vice versa). Te reader soud notice from (11) and (15) tat Π 1 = Π wen te two consumer segments ave te same vaue-discomfort index. A continuous effort to improve ad reevancy may reac a steady state point were δ = δ, and te seer focuses on making ads reevant for bot types of consumers simutaneousy. 5. Concusion We ave anayzed te seer s information quaity deveopment probem wen te majority of costs are associated wit deveopment and not production. Tis is common wit most information goods offered troug te onine canne incuding music, iterary works, software, and video presentations. Unike te conventiona production of pysica goods we ave sown tat te optima eve of quaity for te fee-based content is proportiona to te expected size of te market. Tis indicates tat providers of unique information product must consider te overa size of te potentia market in order to recover te uge fixed deveopment costs. We ave aso sown tat a reduction in te potentia for advertising revenues from onine banner ads resuts in a reduction in quaity of free information offered on sponsored sites and an increase in fees carged for ig quaity information services. 0

21 Tis is because a reduction in quaity of te free information makes tat content ess attractive to ig type consumers and terefore decreases te ikeiood te seer wi cannibaize te fee-based content. Wit te continued decine of te dot-com economy and a depressed onine advertising market, we soud expect to see ess unique information offered on free Web sites and iger fees for ig quaity content. Tese reductions in advertising rates aso resut in reduced profits for te information provider. We ave aso sown tat wen personaization toos can be used to make banner ads more reevant, tereby decreasing user discomfort associated wit te sponsored site, te seer can raise te quaity of te sponsored site content and increase te amount of advertising on te site resuting in iger profits. Te seer must correspondingy ower te price for te fee-based content to avoid cannibaization. Aso, we ave sown tat te seer wi focus suc efforts on te advertising target consumer, tat is, te consumer wit te ower vaue-discomfort index, v i /d i. Furter extensions of tis anaysis currenty underway incude consideration of te seer s probem wit future commitment is not possibe and te incusion of a product degradation cost. In particuar, te strategy many information providers empoy is to deveop te ig quaity good first, and ten purposey degrade tat product to create te ow quaity version. 1

22 References [1] Bensanko, D., W.L. Winston. Optima Price Skimming by a Monopoist Facing Rationa Consumers, Management Science, 36, 5, (May 1990), [] Bargava, H.K., V. Coudary, Information Goods and Vertica Differentiation, Journa of Management Information Systems, 18, 3, (Fa 001). [3] Conner, K.R., Strategies for Product Cannibaization, Strategic Management Journa, 9, (Specia Issue 1988), 9-6. [4] Dewan, R., B. Jing, A. Seidmann, Adoption of Internet-based Product Customization and Pricing Strategies, Journa of Management Information Systems, 17,, (Summer 000), 9-8. [5] Dewan, R., B. Jing, A. Seidmann, Product Customization and Price Competition on te Internet, working paper, Simon Scoo of Management, University of Rocester, 001. [6] Jones, R., H. Mendeson, Product and Price Competition for Information Goods, working paper Stanford University, [7] Levinta, D.A., D. Puroit, Durabe Goods and Product Obsoescence, Marketing Science, 8, 1, (Winter 1989), [8] Moorty, K.S., I.P.L. Png, Market Segmentation, Cannibaization, and te Timing of Product Introductions, Management Science, 38, 3, (Marc 199), [9] Puroit, D., Dua Distribution Cannes: te Competition Between Renta Agencies and Deaers, Marketing Science, 16, 3, (Summer 1997), [10] Riggins, F.J., S. Narasiman, Overcoming Product Cannibaization in te Onine Canne Using Personaization Tecnoogy, Community Access, and Intertempora Price Discrimination, working paper, Carson Scoo of Management, University of Minnesota, 001. [11] Saop, S., Monopoistic Competition wit Outside Goods, Be Journa of Economics, 10, 1, (January 1979), [1] Sapiro, C., H. R. Varian, Versioning: Te Smart Way to Se Information, Harvard Business Review, (Nov-Dec 1998). [13] Sapiro, C., H. R. Varian. Information Rues, Harvard Business Scoo Press, Boston, MA, (1999). [14] Spence, A.M., Muti-Product Quantity-Dependent Prices and Profitabiity Constraints, Review of Economic Studies, 47, 5, (October 1980),

23 [15] Tiroe, J. Te Teory of Industria Organization, MIT Press, Cambridge, MA, [16] Varian, H. Microeconomic Anaysis, 3 rd Edition, Norton,