Welcome

Strategies of Network Companies

Jonathan D. Warehamwareham@acm.org

Agenda

Pricing Standards Auctions Bundling

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 !!!!!

Price Levels

                                    

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1. Superior disc. pricing techniques: lower registration and menu costs

2. Heterogeneity: wine in store or restaurant• Versioning

3. Temporal preference: consumer behavior and types

4. Imperfect information: bait and switch

5. Neural real estate: 5% sites/75% traffic

6. Market immaturity: eMarkets too young

Possible Causes

P

Q

$1.00

1 Coke

Fixed Prices

P

Q

P

Q

Fixed Prices

Consumers Surplus

Dead Weight Loss MC

P

Q

P2

Q2

P3

P1

Q1 Q3

Get a little more revenue

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

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

P

Q

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

Perfect Price Discrimination

Price $

Quantity

D

10

8

6

4

2

1 2 3 4 5

Profits:.5(4-0)(10 - 2)

= $16

Total Cost

MC

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

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

What is different about this site?

1. Internet double edged sword:

• Consumers enjoy lower search costs, but…

• eMarketers have superior tools to register your consumption patterns and price sensitivity

2. 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 !!!!

Conclusions

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.

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.

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 ishow to charge high-income

group more without making themswitch to lower-class goods

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

Horizontal Differentiation

The game of location (proximity to customer’s tastes)

Alice

Bob

1/2A

lice

Bob

Vertical Differentiation

Price

Quality

High

Low

1. Versions

2. Timing and delays

3. Ease of use

4. Pathways into site

5. Segregation of markets and users

6. Analysis of click stream and previous

purchasing history

How???

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!

How Many Versions?

One is too few Ten is (probably) too many Two things to do

Analyze market Analyze product

Analyze Your Market

Does it naturally subdivide into different categories? AND

Are their behaviors sufficiently different?

Example: Airlines Tourists v. Business travelers

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.

Goldilocks Pricing

Mass market software (word, spreadsheets) Network effects User confusion

Default choice: 3 versions Extremeness aversion Small/large v. small/large/jumbo

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

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

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

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…

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???

Examples

Rival evolution Video machines

Rival revolutions DVD-A v. SACD

Evolution v. Revolution

Recent Standards Wars

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

Standards Wars

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

Key Assets

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

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.

Demand & Supply for a Network Good

Diffusion and Price

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

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

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

Seller iV

value

revenuebuyers

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!

10

20

seller

Auction: incentive mechanism buyer: maximizes expected profit seller: maximizes performance

measure

Performance Measures

Valuation private values common

values correlation

Risk assessment risk neutral risk averse

Symmetry symmetric asymmetric

Bidder and seller characteristics

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iV

Buyer iii VU iii xVVVU ,

)(hU

pVh

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1V 2V

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Auctions

Uses Major types of Auction

English First-price, sealed-bid Second-price, sealed-bid (Vickrey) Dutch

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.

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

English Auction

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2V

3V

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r

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.

first price wins sealed (each bidder is ignorant of other

bids) usually each participant is allowed one

bid two parts

bidding period resolution (winner determination)

phase bidder’s strategy: shade bids

to generate positive profit to avoid winner’s curse (for common

value) little information on demand is revealed

First price, sealed-bid

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2b

3b

nb

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1V

2V

3V

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Second Price, Sealed-bid

The same bidding process as a first price auction.

However, the high bidder pays the amount bid by the 2nd highest bidder.

Developed for Social Efficiency: Vickrey auction

second price wins, sealed the item is awarded to the highest bidder at a

price equal to the second highest bid dominant strategy: submit a bid equal to

true valuation incentive compatibility less fear of winner’s curse (for common

value)

1b

2b

3b

nb

p

1V

2V

3V

nVV bb b

Vbb b

Why???? Asymmetric Cases

Different distributions for bidders’ valuations

Revenue equivalence does not apply First price auctions not socially optimal Public authorities should use second price

auctions for efficiency purposes otherwise, possibility for inefficiency

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Intuition

1. Aggressive bidders receive sure and certain awards but pay a price closer to market consensus.

2. The price that winning bidder pays is determined by competitors' bids alone and does not depend upon any action the bidder undertakes

3. Hence, closer to real market valuation and socially optimal

4. Less bid shading or collusion occurs because people don't fear winner's curse.

5. Hence, they may adjust bid upwards.6. Bidders are less inclined to compare notes

before an auction.

Dutch Auction

A descending price auction.

The auctioneer begins with a high asking price.

The bid decreases until one bidder is willing to pay the quoted price.

Strategically equivalent to a first-price auction

descending price (often by “Dutch clock”), open-outcry

first price wins auctioneer usually has no influence little information on demand is revealed

Dutch Auction

1V

2V

3V

4V

1b2b3b4b

price

Information Structures

Independent private values Bidders know their own valuation of the item, but not other

bidders’ valuations Bidders’ valuations do not depend on those of other

bidders Affiliated (or correlated) value estimates

Bidders do not know their own valuation of the item or the valuations of others

Bidders use their own information to form a value estimate Value estimates are affiliated: the higher a bidder’s

estimate, the more likely it is that other bidders also have high value estimates.

Common values is the special case in which the true (but unknown) value of the item is the same for all bidders

Optimal Bidding Strategy in an English Auction

With independent private valuations, the optimal strategy is to remain active until the price exceeds your own valuation of the object.

Optimal Bidding Strategy in a First-Price, Sealed-Bid Auction

If there are n bidders who all perceive valuations to be evenly (or uniformly) distributed between a lowest possible valuation of L and a highest possible valuation of H, then the optimal bid for a risk-neutral player whose own valuation is v is

b vv L

n

.

Example

Two bidders with independent private valuations (n = 2)

Lowest perceived valuation is unity (L = 1)

Optimal bid for a player whose valuation is two (v = 2) is given by

b vv a

n

2

2 1

250$1.

Optimal Bidding Strategy in a Second-Price Sealed-Bid Auction

The optimal strategy is to bid your own valuation of the item.

This is a dominant strategy. You don’t pay your own bid, so bidding

less than your value only increases the chance that you don’t win.

If you bid more than your valuation, you risk buying the item for more than it is worth to you.

Optimal Bidding Strategies with Affiliated Value Estimates

Difficult to describe because Bidders do not know their own valuations

of the item, let alone the valuations others.

The auction process itself may reveal information about how much the other bidders value the object.

Optimal bidding requires that players use any information gained during the auction to update their own value estimates.

The Winner’s Curse

In a common-values auction, the winner is the bidder who is the most optimistic about the true value of the item.

To avoid the winner's curse, a bidder should revise downward his or her private estimate of the value to account for this fact.

The winner’s curse is most pronounced in sealed-bid auctions.

Common value auctions

Value of bidder is not fixed before the auction True value of item is not known ex-ante, although

defined Value to bidder i depends on other bidder’s values examples: sealed box with coins, oil-lease

Complex strategies, no general results Winner’s curse: the winner discovers that he

overestimated the value of the item Strategic approach: shade the bid to account

for the adverse selection bias

Expected Revenues in Auctions with Risk Neutral Bidders

Independent Private Values English = Second Price = First Price =

Dutch Affiliated Value Estimates

English > Second Price > First Price = Dutch

Bids are more closely linked to other players information, which mitigates players’ concerns about the winner’s curse.

Collusion

Bidders make collusive agreements to get the item at a lower price: they select their designated winner (the one

with the highest valuation) others promise to follow a specific strategy

(abstain from bidding) Which auctions are more collusive than

others ? Enforcement issue: incentives for non-winners

to keep their promise

Collusion (cont.)

First price sealed bid and Dutch auctions: not self-enforcing! no possibility for punishment In FP: winner places bid = other

bidders may abstain or break the ring by bidding slightly higher

In Dutch: one of the others may shout “mine” and win!

English and Second price auctions: self-enforcing! In English: if one of the others bids higher than

promised, then the winner may overbid again In SP: winner’s bid = valuation of others’ bid

,min p

What would you pay for all this stuff?

                                         

Desired Revenue

3.5

3.5

3.5 3.5

3.5 3.5

3.5 3.5 3.5

3.5

= 35

Your Valuation

2

3

4 3

3 4

4 6 3

3

= 35

But If Price = 3.5

Revenue = 14

Solution: Bundle it!!!

= 35

Revenue = 35

Someway, somehow, you will find a combination of products equal to 35

2

3

4 3

3 4

4 6 3

3

Why Bundle?

Technological complementarities in production, distribution, and consumption

Sunday newspaper A bundle of articles – we do not read

them all, but which ones?? Economies of scale in production and

distribution

Why Bundle?

Price discrimination Intuition different Price discrimination based on ability to

identify and segregate customers But we can’t always do that – hence 2nd

degree price discrimination But when marginal costs are low –

bundling may be better!

Bundling

Price discrimination Increases the menu of prices to better

match heterogeneous distribution of consumers

Bundling reduces the effective heterogeneity of consumers’ willingness to pay.

Someway, somehow – out of these 10 goods, you will find some combination that you will value at 20$ - we just do not know which ones.

Key Variables

Production Costs: cost of producing additional units for the bundle

Distribution Costs: Costs of distributing a bundle

Transaction Costs: Costs of administrating the transaction – arranging for payment

Binding Costs: cost of binding components together as a bundle

Menu Costs: Costs of administering multiple prices of bundle

Production Costs

When production costs – specifically marginal costs are low – bundle.

The inclusion of an additional product does not cost much, so why not do it anyway and increase your chances of addressing consumers valuation profile.Software, magazines, cable packages

Hi marginal costs: un-bundle

Distribution Costs

When distribution costs are high - bundle.Newspapers

Low distribution costs: un-bundlePay per view TVBuying single articles on internet

Transaction Costs

If cost of administering small payments is sufficiently low – use micro-paymentsPay per view

Buying single articles on internet

If cost of administering payments is high-use long term payment/subscriptionsMagazines, Cable TV

Binding and Menu Costs

If binding costs are high – don’t bundle

High menu costs may make discriminatory pricing difficult and may favor bundling by default –

Neither of these are as determinative as the others.

To Bundle or to Un-Bundle?

It depends on a combination of all factors

Marginal cost most important Distribution costs secondary Transaction costs: are micro

payments feasible? Binding and Menu costs peripheral

but an issue.