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Summary: Information Rules: A Strategic Guide to the Network Economy

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Key Points

Summary

This book discusses the principles behind the economics of “information goods”.

Prices

In the language of economics, information involves high sunk costs, and very low marginal costs - in other words, information is expensive to create, but costs next to nothing to reproduce, and there are virtually no limits to the amount of copies that can be produced. Information commodoties trend towards the marginal cost: zero, meaning that selling information commodities is not likely to be successful in the long run. There are two sustainable structures for an information market:

  1. In the dominant firm, the largest company in the market has a cost advantage through economics of scale.

  2. A differentiated product market, like the film industry, involves a number of firms producing the same type of information, with many different varieties.

This leads to the conclusion that the strategies to follow are to either differentiate your product, or be the cost leader in your market. A price war may lead to a victory that isn’t worth winning because of the extremely slim margins. If you are the dominant player in the market, don’t be greedy - it’s often better to sacrifice some of your margins in order to keep out competitors. Don’t start a price war unless you are sure you can win, but if you are, be seen as willing to “drop the bomb” and slash prices. By sending this signal, you make other companies wary of encroaching on your territory, knowing that they won’t recoup their investments if you cut prices to the bone.

You have some room to maneuver with regards to pricing and your product if you are fortunate enough to have a unique source of information. To capture as much value as possible, personalize your product to its target as closely as possible. Targeted on-line advertising is an example of this.

Whatever your business, knowing your customer is valuable, and need their feedback in order to improve, and better target your product. The internet makes it much easier to collect current and pertinent data about your customers.

Price discrimination is the art of attempting to match as closely as possible the curve describing what people will pay for your product. A few people will be willing to pay a lot, but if your price is high, you exclude all the people willing to pay less money. On the other hand, too low a price, and you lose out on the money the high spenders would have been willing to pay. There are three ways of implementing differential pricing:

Many web sites, especially airlines, and even amazon.com, change prices for each individual on the site based on their behavoir. Information products sold on the internet offer a great deal of flexibility in setting individual prices.

Reasons why it may make sense to target groups rather than individuals.

Versioning

The concept of versioning refers to the practice of creating different versions of the same product at different price points. In the world of books, hardback versions are usually released some time prior to paperbacks. Those who are willing to pay more will purchase the hardback, while those who are more price sensitive may choose to wait for the paperback. In this way, the publisher maximizes revenues, because customers self-select into groups who are willing to pay more or less.

The key to versioning is to select the aspects of your product that are important to some users, and less so to others. Several strategies that may prove effective are:

Customers may find the concept of versioning annoying, but remember that that segment of the market might not have been served at all were it not for a cheaper, reduced feature version.

Another useful tactic is to utilize people’s “extremeness aversion” in order to steer them away from a cheaper product. By creating three versions, people will naturally tend towards the middle one as the “safe” choice, even in cases where the low end version would meet their needs.

Bundling can be an effective strategy, where one of the included products is not something the customer would have been likely to buy by itself. An example is the Wall Street Journal on-line edition, which is offered at a low price to people who are already print subscribers. If, on the other hand, the customer would likely buy both products at their full price, bundling is likely to lose money.

Promotional pricing is a technique used for price discrimination that works because of the “inconvenience” involved. A sale might only last a few days, and you may have to wait for it to occur. Rebate coupons are often not redeemed. Through this inconvenience, people self-select - those who can pay the full price do, but there is still an opportunity to collect money from those who can’t or won’t and are willing to put up with the inconvenience to get the better price.

Be wary of getting into a competition based only on price, though, because you risk turning your product into a very low margin commodity.

Intellectual Property

Content publishers have traditionally had to content with two costs that are significantly changed by digital technology: reproduction and distribution.

Rather than fighting lower distribution costs, you need to make them work for you. By giving away free samples, you are likely to increase sales. Make sure the free samples direct customers back to you, though. Information that is time-sensitive is more naturally easier to defend against illicit copying. By the time it has been copied and illegally distributed, it may not be relevant any more.

Lower reproduction costs are not an entirely new phenomenon, either, despite the fact the digital reproductions aren’t just good, but perfect copies of the original. Once upon a time, in the 1800’s, libraries were viewed with suspicion by the publishing industry. However, the availability of books to read at a low cost drove many people to learn to read, thus expanding the market for books. Video rentals in the 1980s followed a similar pattern, with videos being expensive to purchase, and vcr’s costing hundreds of dollars, video rental stores made the technology available to more people. Initially, Hollywood was unenthusiastic about this development, but eventually reaped huge benefits.

In order to determine the ideal rights management program, an analysis of the demand curve is in order. The more liberal terms, the more copying and sharing there will be, but it will also be more valuable for your customers, moving the demand curve up. Tighter restrictions will reduce demand, but also reduce illicit use of your product.

It’s also important to take transaction costs into consideration for the “hassle” they create for customers. The lower they are (the easier it is to purchase your product), the better.

Lock Lock-in in

Lock-in is the rule, rather than the exception in information industries. Think about changing cars vs changing operating systems. Buying a new car is easy, even if you purchase a Toyota instead of a Ford. Moving to Linux from Windows is a significant challenge even for an expert. To understand the potential for lock-in, “look ahead and reason back”. Even small switching costs can have a large effect. Consider changing email addresses, for example - even though hotmail and gmail are both free, you may not wish to change from one to the other even if you like the service better, because your old email is stored with the other account, and in any case, that’s the email address that most people have for you. “Switching costs measure the extent of a customer’s lock-in to a given supplier”. Companies need to look at the total switching costs - what the customer pays, and what the company pays to acquire a new customer. For instance, with long distance carriers, simply offering a customer 10 dollars to change merely transfers the costs from the client to the company, meaning there is no net reduction. Offering free minutes, on the other hand, where the client values them more highly than the company, creates a net reduction in switching costs. If a business has high margins, this kind of offer is an attractive way of reducing switching costs. If you can easily measure the switching costs, you can calculate your expected profits from a customer as equal to the total switching costs, plus the value of the value of other competitive advantages in terms of a superior product or lower costs, with regards to rivals.

Types of lock in include: contractual commitments, durable purchases (purchasing expensive, durable equipment that can be used for many years), training specific to a particular product, data conversion costs for information and databases, specialized suppliers, search costs (finding other suppliers) and loyalty programs.

The product cycle for lock-in looks like this:

  • Brand selection - looking at what options are available.
  • Sampling - testing out a particular option.
  • Entrenchment - switching would be expensive.
  • Lock-in - switching costs are prohibitevely expensive.

As a customer, you must understand lock-in in order to deal with it effectively. The two key elements in your strategy are to strike a tough bargain at the beginning of the lock in cycle when your choices are still open, and throughout the lock-in cycle, to attempt to minimize switching costs. By bargaining initially when you have levarage, you improve your situation further down the road.

Sellers desire locked in customers, and to acquire them, need to:

  • Be prepared to invest to build the initial customer base. Smart clients will know that they face lock in, and your competitors will also want locked-in clients, so competition is fierce to offer attractive terms for the initial purchase.

  • Aim to entrench customers by creating products that your customers will have a stake in and be prepared to invest in.

  • Leverage your existing user base. For instance, influential buyers are worth even more, and should be offered corresponding discounts. Consider selling complementary products, as well as access to others to your installed base (be careful not to irritate your users by going too far, though).

Network effects

Cooperation strategies

Control strategies

Links

Hal Varian His columns in the New York Times are good reading if you liked the book.

Carl Shapiro

Back to Information Rules: A Strategic Guide to the Network Economy summary history

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