Decreasing returns

• Traditional models had decreasing returns• Works for bulk processing manufacturing

industries– Coffee plantation

• Equilibrium was predictable and orderly• Therefore winning meant operational

excellence, differentiation, and reasonable margins. No one could dominate.

Increasing returns

• Upfront costs

• Network effects

• Customer groove-in

Leads to:

• Market instability – winner takes all

• Unpredictable

• Fat profits for the winner

A comparison

Traditional – production• Production is repetitive

• Products remain same

• Keep products flowing, improve quality, lower costs

• Need control and planning

• Need hierarchy

• Optimization is possible

Internet – Casino• Winner takes all• Quest for next cash cow• Mission oriented not

production oriented• Flat organizations• Give free rein• Reinvent, restructure,

reposition, reorganize• Adapt – games changing

constantly

So what to do ?

• Pioneer

• Develop superb technology

• Build installed base – discount heavily at first

• Get partners to complement

• Link and leverage across markets and products

Psychological positioning

Scare rivals – Pre-announcements– Threatened alliances– Technology preening– Future partnerships– Vaporware

The Importance of Pricing Decisions

Hyper-Competition on Price

PriceConcerns ofE-MarketingManagers

PriceConcerns ofE-MarketingManagers

Loss Leader Pricingto build Installed Base

Consumer Price Sensitivity on the Net

Cost Transparency

Determinants of Price(1) Product Quality

- e.g. Lexus versus Corolla

(2) Service level

- e.g. Merrill Lynch vs. E*Trade

(3) Purchase conditions (Cash vs. Credit)

- e.g. gasoline, automobile financing, etc.

(4) Location and Transportation

- e.g. hypermarche’s in France, warehouse stores.

(5) Brand Image

- e.g. McAfee versus Command.com

Most visit only 1 site prior to purchase

Books 89%

Toys 84%

Music 81%

Electronics 76%

Computers 65%

Travel 55%

McKinsey Marketing Solutions

Big difference between what people say and what they do.

McKinsey Marketing Solutions, April 2000

Simplifiers 29%

Connectors 36%

Bargainers 8%

Routiners 15%

Surfers 8%

Sportsters 4%

•29 percent of users are “Simplifiers,” looking more for the promise of superior “end-to-end” convenience rather than price.

•The 36 percent who use the Internet primarily to connect with friends and family generally default to their offline brand preferences if they do buy online.

•Only 8 percent of users are “Bargainers,” finding entertainment

3 ways to profit from flexible pricing

• Precision in price levels and price communication– Better understanding of zone of price indifference

• Engg. products – 10%, financial product – 0.2%• Testing is easy - every 50th customer gets a different price.

– More precise communication to influence customer choice

• For clearance items observe faster sales rate if you show scheduled price reductions

• If you show available quantity, customers likely to delay purchases

– Greater precision in setting optimal price

• Faster adaptiveness in response to market changes– B2B – faster price changes– B2C – tickets are priced far in advance and

cannot be changed dynamically– Faster response to competitive and cost changes

• Segmentation– Ability to choose creative and accurate

segmentation dimensions– Ease of identifying which segment a buyer

belongs to– Ability to create barriers between segments

Pricing

Internet has the feature that has high fixed costs and low or zero marginal costs

A and B develop software spending $500 million a year in marketing, R&D, and promotion.

Variable cost is $5 to sell each copy.

Price = $200

Firm A has 80% market share and firm B has 20% share

Market size is 10 million units in 1999.

Profit for Firm A = 200*8M - (500M+8M*5) = 1060M

Profit for Firm B = 200*2M - (500M+2M*5) = -110M

Market share is key!

Margins and growth rates are also important in determining the profits.

Why cannot B reduce the price?

There are a number of lock-in factors:• Switching costs• Complementary products that are not compatible• Network externalities• Inertia and lack of differentiation• B has to recover high fixed costs too.

Types of pricing : Menu pricing

• It does not extract the entire value that the customers may be willing to pay.

• It may cut off some buyers with a high price.• Once set, these prices are sticky? Why?

Costs to implement price changes - Time- Money - Confusion to customers

• Not easy to detect changes in customer's preferences quickly to change prices

One-to-one bargaining

• Not practical for regular stores• Seller not sure that it has the buyer willing to pay

the worth of the product• Buyer not sure that seller wants to sell at the price

he/she wants - uncertainty 

Auctions

 Most efficient mechanism from a welfare point of view • Need to bring together a number of bidders to one

location.• Sellers could collude to hold down the price of an item• Need to establish reputation of the bidders. Internet overcomes some of the problems associated with the

above pricing strategies.

Auctions

Ebay revenue 88 million/qtrSmall operators – liquidators, small retail shops, entrepreneurs4 million items listedTop 20 sellers 72000 listingsTop 38000 – 2.7 million items listed15.8 million registered userscommissions 1.25 – 5% of the value of the item sold

 

Yahoo has 2.5 million items listedPower seller Bronze $ 2,000 per month

Silver $10,000 Gold $25,000

Must have received 100 comments from customers and 98 % positive.

Ebay has 20-25K power sellersPower sellers get full time customer service

support and permission to display an official power seller logo.

 10% of sellers sold 80% of salesSellers made a 40% marginAmazon spent 25% sales on marketing

Pricing environments

Buyers

Many

One

SellersOne Many

Auction Exchange

Bargaining / Menu pricing Reverse auction

Key players

Buyers

Many

One

SellersOne Many

Auction Exchange

Bargaining / Menu pricing Reverse auction

Free MarketsPriceline

BarterTrust, BigVineIntellibarter, UbarterSwap.com, SwitcHouse

Amazon.com, EbayFob.com, MercataMobShop, Yahoo auctions

Altra Energy, CheMatchE-Steel, GofishMetalSite, PaperExchange

Technology providers

Source of AuctionEngine Technology

3rd Party

Proprietary

Degree of CustomizationLow High

MoaiOpenSite

AribaCommerceOne

Amazon.com AuctionseBayYahoo! Auctions

Bots cooking !

• Software that aggregates information from multiple sources into one easy to use interface.

Buyer’s Perspective

•800 auction sites, 3-7 million items listed•Time constraints for searching•Buyers gain access to larger # of sellers, auction trends, bids•If unavailable, a bot will inform when item is available. •Can also make bids on your behalf

Seller’s Perspective

•Can list seller’s items across multiple auction sites•Keeps track of their auctions•Sellers gain access to larger base of buyers•Manages post sale track of transactions

Bot Landscape

MarketSector

B2B

B2C

Auction Management ServicesLimited Extensive

Bizbots.com

AndaleBidder’s Edge

AuctionRoverAuction Watch

Why auctions succeed on the web?

• Easy to get many bidders to participate - raises price and profits for the auctioneer

• Efficient mechanism to extract all the surplus from the consumer.

• Easy to provide in-depth information to consumers about the product making them more realistic in bidding prices.

• Different locations reduces collusive behaviors

Auction types

• English auction: Price starts low and goes up. Highest bidder gets the item and pays his bidE.g., eBay, Ubid

• Dutch auction: Price starts high and gradually declines. The first bidder gets the item and the quantity desired. Used for flower auctions and perishable items. The entire consignment has to be cleared. E.g., Basement.com, Outletzoo.com

• Reverse auctions : You specify the price and firms will decide whether to serve you at that price– e.g. Lendingtree.com (loans)– Priceline.com (airline tickets)

• First price sealed bid - Submit sealed bids. Highest bidder wins, pays his price. – E.g. Mineral rights

• Second price sealed bid – Submit sealed bids. Highest bidder wins, pays second highest bidder’s price.

Yield management

• Matching of prices and available capacity as in airline tickets pricing. – higher returns to airlines – mitigated ruinous direct price competition.

This works if:– There is fixed and perishable capacity– There is a high level of fixed cost and relatively

small variable costs– Clearly Identifiable segments– Uncertain demand and availability of

sophisticated information technology systems

Demand uncertainty

• Cross (1997) identifies several reasons for demand uncertainty: – Perishable products or opportunities– Seasonal demand and peaks– Different segments value products differently– Product waste– Competition between individual and bulk

purchasers– Discounting to meet competition– Rapidly changing market conditions.

Price elasticity

= Price Elasticity of Demand - % change in quantity due to 1% change in price.

= (dQ/dp)*p/Q • = (Q1-Q0) * P0 • Q0 (P1-P0)•  • Price elasticity > 1 means demand is elastic• Price elasticity < 1 means demand is

inelastic

• Inverse elasticity rule

 

• CMR* = (p* -c)/ p* = -1/(p*)

 

• p* = profit maximizing price

• c = incremental cost of the next unit

• CMR* = Optimal contribution margin ratio

What factors affect Price elasticity ?

Unique value or features

• Differentiation– can achieve this by doing the following

• Provide hard facts of quality• Testimonials• Hands-on trial usage

• It is better to get customers to your own web-site rather than let others control the information about your firm. The price comparisons on other web-sites may be unfair to your product as they may omit relevant information.

Availability of substitutes

e.g. Non differentiated products Awareness of local restaurants

• Internet increases consumer's awareness of alternatives.– e.g. Computers - Price Watch (www.

pricewatch.com)– Mortgage rates - Quicken Financial Network

(www.quicken.com/mortgage)– Books - ACSES (www.acses.com)

Difficulty in comparison of quality

e.g. Technical products

Different pack sizesExperience goods

• On the web, quality cues are missing. Some solutions are:– Co-branding– Testimonials

Who is paying?

Business expense or personal ? • Web sites should decide which

segment to target and provide information accordingly.– Hyatt versus HoJo

Versioning

• The practice of offering different varieties of products at different price points.

Benefits:

- Segment consumers by their price-consciousness;

- keep the sales within the company;

- allow consumers to trade-up.

Types of Versioning

• Delay – 20 min delayed stock quotes versus real time quotes

• User interface – professional version vs free• Convenience – high price version easy to use• Image resolution• Speed of operation• Capability, features• Annoyance – “Nagware”• Level of technical support

Policy Issues

• Versioning involves making the complete product and degrading it?

• Is this OK?

• Yes, if it improves consumer welfare

Loyalty programs

• Need to build loyalty –– Freebies

– Customer service

– Community

– Other products

– Frequency programs

• Frequency programs must be non-linear i.e., as a consumer uses more, he should get proportionately greater rewards

Price competition

• With shopbots will prices rise on the internet?

• No. Why?

• There is no incentive to price discount.