Thursday, March 7, 2013

Pricing Digital Products

Pricing digital products is tricky. The cost of copying something digital is essentially zero, so in a competitive market, there are pressures that push the market price to 0. However, producing something digital requires large upfront costs in idea generation and creation of the product. Therefore, if the price was actually 0, you would never see that product in the first place! This is why copyrights, patents, proprietary formats, or some other market power for some amount of time may be efficient. Companies get to charge consumers non-zero prices to recoup their investment and make a profit while consumers benefit because the product is actually produced.

Pricing gets even trickier when there are digital and physical versions of the "same" product (I will use "same" here to denote same underlying intellectual property that is the basis for the product). For example, you can buy a CD or an mp3 or iTunes format of the same album. Video games can be downloaded or purchased on a disk or cartridge. You can buy books or eBooks. Here's the tricky part: Being exposed to one version of the product may make consumers more likely to purchase the other version. For example, downloading a song may expose you to new music and may make you more likely to purchase a physical album. This would lead to prices on digital products that are below the price a company would set in the case where there is no relation between the products. Maybe it should even be free -- or maybe the company should pay consumers to take the digital copy! On the other hand, having one version may make you less likely to purchase the other. For example, if you have a digital copy of a song, you may decide you don't need the physical copy. In this case, assuming it has control over the distribution of the digital copy, the company may have to optimally price the digital version higher than it otherwise would in order to prevent cannibalization of its physical products. So it's not clear how a company should set its prices without understanding the market and how consumers use the products.

Industry examples:

Board Games:
Ticket to Ride is a very popular (and very fun) board game in which players use train cards to build railway lines across the country to connect destination cities. It won the Spiel Des Jahres (Game of the Year) in 2004. Recently, Days of Wonder, the publisher, decided to produce digital versions of the board game on iPhone, iPad, for browsers, etc. According to the WSJ, Ticket to Ride has sold more than 2 million physical copies and 1.8 million digital copies. Would Days of Wonder have sold so many physical copies without the presence of the digital version? Penny Arcade reports that the board game industry may be ripe for physical and digital versions complementing each other (read the whole article, it's great).
The game was once again developed in-house, with the graphics and presentation being treated with great care, and the $6.99 app quickly became another huge success. Sales of the board game jumped 30 percent.

The model doesn’t end there, as Days of Wonder then released a version of the game for the iPhone. This version sold for only $0.99. In a surprise twist, the release of the iPhone version of the game caused sales of the more expensive iPad version of the game to quadruple. So gamers were making an impulse buy of the iPhone game, liking it enough to want the $7 iPad version, and they would then decide they wanted to own a copy of the actual board game to play with their friends.
Other board game companies are getting into the digital realm, too. Rio Grande Games sold the rights to produce digital versions of Dominion and its expansions to Goko. The price of buying all the digital expansions is about the price of purchasing one physical expansion.

However, not all board game companies target the same consumers or make the same decisions. Pogo uses a combination of advertising and a subscription model to play popular board games like Monopoly and Risk. Magic the Gathering (a collectable card game) prices its digital cards at about the same price as its physical cards in order to prevent cannibalization. In order to keep the parity, they even allow you to redeem your digital cards as physical cards when you collect a whole set (e.g. see this interview).

Movies and music are at the heart of the storm, because media companies have been unable to fully control and protect their IP (or market power) which results in widespread piracy. Thus it's important to know whether these free downloads actually increase sales for the firms or do in fact harm the companies. Via the WSJ this morning, Danaher and Smith find that illegitimate free digital copies of movies cannibalize sales of legitimate digital sales and rentals.
The shutdown of Megaupload [a piracy website] caused weekly digital sales of movies from the two studios to grow by between 10,500 and 15,300 from what would otherwise have been expected, the study said. Rentals grew between 13,700 and 24,000 units a week.
Mickey Ferri is working on this, too. Hopefully in the future, he can tell us about the effect on DVD sales. One thing he notes is that movie studios also try to increase sales of expensive physical versions (movies in theaters) by windowing when products become available for rental or purchase. Ferri suggests the way studios are handling this currently is not necessarily profit maximizing because consumers time-shift consumption to the cheaper products. Also, piracy erodes the ability of media companies to employ windowing strategies. 

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