USING SAMPLES TO DECREASE UNCERTAINTY WHEN PRICING EXPERIENCE INFORMATION GOODS

Transcription

1 USING SAMPLES TO DECREASE UNCERTAINTY WHEN PRICING EXPERIENCE INFORMATION GOODS Jesse Bockstedt Carlson School of Management University of Minnesota Minneapolis, MN Frederick J. Riggins Carlson School of Management University of Minnesota Minneapolis, MN May 4, 2006

2 USING SAMPLES TO DECREASE UNCERTAINTY WHEN PRICING EXPERIENCE INFORMATION GOODS ABSTRACT We develop a model for pricing experience information goods that exhibit initial uncertainty in the marketplace. We show how a combination of heterogeneous consumer valuations of the good and an increasing, but concave, word-of-mouth effect that decreases uncertainty results in an inverted U-shaped willingnessto-pay function for the buyers. With a fixed-price strategy the uncertainty in the market may prevent any sales from occurring, however, initial adoption may occur for well-known producers of the good due to lower uncertainty. This is contrasted with a variableprice strategy where the seller may initially price higher for wellknown producers, but may need to price lower for unknown producers of the good. In addition to the word-of-mouth effect, the seller is able to reduce uncertainty by providing a free sample of the good. We show how the sample decreases uncertainty leading to a greater likelihood of initial adoption, but a stand-alone value from the sample may cannibalize sales of the good. While a variableprice strategy captures more consumer surplus, allowing the consumers to retain much of this surplus under a fixed-price strategy may be necessary due to competition from a pirate market. However, if the seller controls the format standard it can make up the difference by selling a complementary hardware device. On the other hand, in a virtual environment a variable-price strategy allows the seller to take advantage of the long tail effect by selling a large number of niche products. 2

3 INTRODUCTION When teenager Shawn Fanning gave copies of the beta version of his Napster peer-to-peer (P2P) file share software to thirty friends and relatives in June 1999 he initiated what was to become a radical transformation of the music distribution industry [Moon, 2002]. Within months many colleges and universities were reporting massive consumption of bandwidth as students sought to fill up their computer hard drives with free music files downloaded in the MP3 format from other Napster users. For those individuals with broadband Internet connections, the prospects of a zero price point for their favorite music songs coupled with an ambiguous legal environment represented a value proposition that was too good to be true. Indeed it was, and in December 1999, just six months after Napster s launch, the Recording Industry Association of America (RIAA) filed suit to stop Napster from aiding the download of pirated MP3 files. In July 2001, a U.S. District Court judge ruled that Napster must shut down its P2P file sharing system. The popularity of downloadable music files is emblematic of a broader move to an online market for downloadable culture goods. Hughes and Lang [2006] define culture goods as goods for which their meaning and value are created only by their audience. Therefore, the value of culture goods is realized as a social process. They note that digitization presents new opportunities to transmute culture goods so that consumers and producers can create derivative works in the post-purchase environment. Online word of mouth promotion of transmuted information-based culture goods represents another challenge for 3

4 those seeking to protect the intellectual property rights of creators of original works of art such as music and video products. Bockstedt, Kauffman and Riggins [2006] assert that the digitization of music potentially enables artist-led music production and distribution that leverages new digitization tools and the Internet. This is particularly attractive for artists who have established strong brand recognition in the marketplace. However, unknown artists may find it difficult to establish a following since these types of information goods are also experience goods that present considerable uncertainty in the pre-purchase environment. For information goods that exhibit uncertainty in the market, uncertainty may be reduced in several ways including providing free samples or copies of the music, word of mouth from existing fans, personalized recommender systems, and expert reviews. The fact that these culture goods may exhibit considerable uncertainty, yet may be copied and distributed essentially free over the Internet further explains the demand in peerto-peer piracy networks. For a legitimate seller of these goods, providing a free sample may help to reduce uncertainty, yet if the sample is too good it may cannibalize potential sales [Riggins, 2002]. Clearly managing the uncertainty associated with the release of new culture goods creations is an important issue that directly affects a consumer s demand. In addition to the zero price point, the Napster experience illustrates the market demand for easily downloadable music files that can be conveniently loaded on an easy to use, portable player device. In 2001, Apple took advantage of this demand when they launched their popular ipod device, which was 4

5 followed with the opening of the itunes online music store in April 2003 which allowed users to purchase individual music files legitimately for 99 [Yoffie, 2005]. Within three years itunes was celebrating the sale of its one-billionth song on itunes. The highly successful combination of the popular player device and the easy to use storefront has encouraged Apple to branch out into the sale of other culture goods including music videos, television shows, and individual comedy skits (all for $1.99). In an effort to avoid losing control of the downloadable movie market, the major production studios have banded together to launch MovieLink.com where consumers can buy or rent digitized versions of new and old movies. Indeed, the popularity of the ipod/itunes combination has led to legal filings that allege Apple is acting as a monopolist due to an 80% market share in downloadable music files and 90% market share in the portable digital music player market [Higgins, 2005]. Because of the market dominance of Apple itunes in the downloadable music market there is considerable rigidity in the pricing of legitimate online music sales. While Wal-mart.com sells downloadable music files for 88 per song download and other services such as Rhapsody by RealNetworks employ a variety of revenue models, the 99 price per song by itunes continues to be the standard. This has caused record labels to put pressure on Apple to impose a variable pricing scheme whereby they could charge more for hit songs and less for songs that have run through much of their promotion cycle [Kafka, 2005; Chaffin, 2006]. 5

6 In this paper, we develop an analytical model for the pricing of downloadable digital information goods such as MP3 music files. We can summarize our main research questions as follows: How does a fixed-price strategy impact the adoption of digital information goods exhibiting consumer uncertainty and how does this compare to a variable-price strategy? What effect does offering a sample version of the good have on these strategies? Does the format of the sample make a difference? To what extent can the seller benefit from varying the quality of the sample as the population adopts the good, and how does this impact adoption and profits? Our main goal is to develop a model of pricing of information goods under uncertainty with the option of providing samples of the good. We show how a combination of heterogeneous consumer valuations of the good, coupled with an increase concave word-of-mouth effect on decreasing uncertainty results in an inverted U-shaped willingness-to-pay function for the buyers. For a fixed-price strategy, such at Apple itunes, the uncertainty in the market may prevent any sales from occurring, especially for unknown producers of the good. However, for a variable-price strategy the seller may be able to price higher for well-known producers, but may need to price lower for unknown producers. The seller may be able to reduce uncertainty offering a free sample of the good, but if the sample has stand-alone value it may end up cannibalizing sales of the good itself. While a variable-price strategy can capture much more consumer surplus than a fixed-price strategy, allowing the consumers to retain much of this surplus under fixed pricing may be necessary due to the competition from a pirate market. If the seller controls the standard, such as the Apple ipod, 6

7 the seller can more than make up the difference by selling the complementary player device. This strategy is an interesting twist on the sale of complementary goods where the seller essentially is giving away the blades to sell the razor. Further, we show how a variable price strategy allows the seller to take advantage of the long tail effect which posits that in a virtual environment free from physical inventory constraints sellers can potentially earn more revenue from the sales of obscure niche products than the sales of popular products simply because the number of niche products far outweighs the number of popular products [Anderson, 2006]. REFERENCES Anderson, Chris, The Long Tail: The Radical New Shape of Culture and Commerce, Hyperion, Bockstedt, Jesse, Kauffman, Robert J., and Frederick J. Riggins, The Move to Artist-Led Online Music Distribution: A Theory-Based Assessment and Prospects for Structural Changes in the Digital Music Market, forthcoming in the International Journal of Electronic Commerce, Chaffin, Joshua, Apple Sets Tune for Pricing of Song Downloads, FinancialTimes.com, May 2, 2006, available at Higgins, Donna, Antitrust Suit Against Apple Over ipod, itunes to Proceed, FindLaw Legal News and Commentary, September 22, 2005, Thomson 7

8 West, available at andrews/bt/cmp/ / slattery.html Hughes, Jerald and Karl Reiner Lang, Rip, Mix and Burn Strategies as a new Source of Value in the Production and Consumption of Culture Goods, forthcoming in the Journal of Management Information Systems, Kafka, Peter, EMI Says Apple s Jobs will Change itunes Pricing, Forbes.com, November 16, 2005, available at Moon, Youngme, Online Music Distribution in a Post-Napster World, Harvard Business School Case, 2002, Harvard Business School Publishing, Boston MA, Revised September 13, Riggins, Frederick J., Market Segmentation and Information Development Costs in a Two-Tiered Information Web Site, Journal of Management Information Systems, Fall Yoffie, David B., Apple Computer, Harvard Business School Case, 2005, Harvard Business School Publishing, Boston, MA, Revised August 4,