Create and answer a case study similar to Memo 3 from Time Warner (Most Relevant Chapters 3, and 13) that looks at pricing strategies for related goods. James Mohr
Final Paper
Memo 3 discusses pricing implications and strategies for two related goods, HD televisions and HD programming. These two goods are provided by separate companies. There are a number of different HDTV manufacturers. Time Warner is the HDTV programming provider. This case specifically discusses future profitability of the HDTV programming sector of Time Warner. They believe that HTDV programming provides superior services to basic analog television and the value it can add to their customers can be a great revenue source going forward. There are a few roadblocks ahead for them to be successful in the market. The two main issues revolve around the expensive nature of HDTV's at the time. Prices for basic sets ranged from $1,000 to $7,000. Studies showed that consumers were unwilling to spend that much money for an HDTV set, mainly due to a lack of HDTV programming available at the time. Program producers and distributors, like Time Warner, were unwilling to spend large amounts of money on the programming when consumers didn't have the sets to view it properly. This creates a catch-22 of sorts.In Baye's answer, it is proposed that Time Warner sharply increase their production of quality HDTV programming as an incentive to get consumers to purchase new sets. Surveys have shown that consumers would be willing to pay to view sporting programs specifically in high definition. It is also proposed that Time Warner penetrate this market with low starting HDTV subscription prices. Once they reach a "critical mass" of customers and they can begin offering a greater variety of programming and charge subscription prices more in line with the value derived from the programming - aka - at a higher price. It seems Time Warner is developing a "penetration pricing" strategy. They are going to eat a lot of initial equipment and production costs now in order to penetrate the market more than competitors and come out ahead 3 years plus down the road when the sets become more affordable. Currently, Comcast and other programming providers use bundling techniques and introduction promotional pricing to get customers hooked on their products, then raise prices after 6 months. Oregon Live.com goes even further stating "Death. Taxes. And cable TV rate increases. All sure bets." (http://www.oregonlive.com/business/index.ssf/2010/11/comcast_sets_annual_rate_hike_1.html). Programming purchasers across the country are all experiencing these same price increases. Comcast is banking on consumers getting hooked on their products and will be willing to pay extra each year to keep them.
Programming providers also routinely force customers into contracts, claiming to keep prices down during the life of the contract. For instance, Comcast currently offers HBO, ShowTime, and Cinemax as promotional "free" complements to their basic HD programming guide for six months. Afterwards, when the customer has become accustom to having these premium channels, the prices will go to $5.99 and up for those single channels. Comcast also bundles their HDTV programming with their high speed internet. With bundling, the internet will only cost you $42.99/month, compared to $59.99/month on its own. Bundling is a great way for companies to get power in the buying decision back from the seller. This Harvard Business Review article ( http://blogs.hbr.org/tjan/2010/02/the-pros-and-cons-of-bundled-p.html), gives more insight into bundling pros and cons. It's easy to understand why companies profit more with bundling services and gives them more power though. Bundling allows them to force unwanted products (at a price) onto customers who would normally bypass purchasing them. They force customers to take product B in order to purchase product A (the one customers really want). Here is another case where the use of bundling is examined; this time within the agriculture industry http://www.aae.wisc.edu/pubs/sps/pdf/stpap529.pdf.
Types of Goods Much like the programming examples above, how related goods are priced relative to each other and to consumers depend on what type of goods they are and the environment of the consumer. Complementary goods are the first type of related goods needing mentioned here. When pricing complements, it's important to remember that demand a good will increase or decrease as the price for the other good does. The two complementary products in the Time Warner case illustrate this fact. As the price of HDTVs decreased over the next decade there will be a steep increase in the demand for HDTV programming. These goods are also normal goods, which are they are going to be in more demand as consumer income increases. The more money a consumer has, the easier to buy one of those expensive HDTVs and programming to go with it.
Another great complementary pricing example customers routinely encounter are concession prices at arenas and movie theaters. After paying gate prices for movies, sporting events, or concerts, consumers are subjected to insane concession prices. In this Stanford Business School Review, "Why Does Movie Popcorn Cost So Much?" (http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html), concession prices are examined relative to gate prices. The article claims that these exorbitant prices are actually beneficial to movie goers, keeping the gate prices down and allowing the frugal spender to keep seeing films on the big screen. The facts seem to back up these claims, as it’s noted that 20 percent of a theater's gross revenue comes from concessions, but 40 percent of their net profit comes from concessions. This is due to the fact that theaters have to share ticket revenues but not concession revenues.
It's always going to be a struggle and fine line that companies need to walk when thinking about how to price two complementary goods. Especially if one of them is only appealing after the first good is bought. In the movie theater case, there's no profit on unsold concession food if the gate price is too high to get lots of consumers through the door.
Lock-In
“Customer Lock-In” is defined as when companies force consumers to use their products without spending substantial money on switching costs. Joachim Buschken, of Catholic University explains a profitable consumer is not satisfied, but locked-in http://www.abebooks.com/Profitable-Consumer-Satisfied-Locked-Joachim-Buschken/742977251/bd). The razor blade market is infamous for using this type of economic principle. In fact, when people talk about pricing related products in today’s terms they often refer to the model as the razor blade model (http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw). The razorblade business model is defined when a firm offers a one-time product at no cost or below cost (loss leader). Then the consumer is forced to repeatedly buy a complementary product to use the initial purchase. In this case, the razor is the loss leader product, and the blades are the repeat purchase. An analysis of the industry is below, and really shows how companies in the industry use the “Customer Lock-In” principle to their advantage.
There are two main players in the disposable razor blade market; Gillette and Schick. Their products are the classic example of hooking consumers with a low cost entry item (razor) and then providing a complementary item (blades) that consumer must continually return to purchase in order to keep using the original item.
In all likelihood, Gillette and Schick are selling razors at a loss. They do that because they know that once a customer has purchased a particular razor, they will continue to buy disposable blades that only fit that particular razor. They may be able to charge more for the blades than their competitor and the customer will pay that price because they don’t want to pay the costs associated with switching to another brand razor, even if the blades are a little cheaper. This proves the “Lock-In” principle works. Here, consultant Rafi Mohammad explains why it and the razor blade model works: http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm.
So manufactures take this loss b/c they know once consumers have bought one particular they can sell their higher margin complementary good (the blades) over and over again. Once a razor has been on the shelves for a while, both these companies will come out with a razors with “more blades!” that claim they make shaving more comfortable. Once consumer upgrade they require different blades that starts this whole process again.
Yet another example of this model mentioned in the link above was when the next generation gaming consoles (Xbox, PlayStation) were first being manufactured and sold. These consoles were costly to manufacture and were sold at massive losses. However, the best feature was the online gaming capabilities. To make up for early losses, Microsoft specifically charged monthly subscription fees to players. The costs associated with these purchases locked consumers into the Xbox gaming console. This became very important down the road a when Sony launched their free online gaming community through the PlayStation. Xbox customers were unwilling to switch over even though Sony offered a free online platform because of all the money already invested into Microsoft products.
Maybe the most economically interesting case of related goods and lock-in during the last 5 years is seen when examining the market for iPhones. Until the past year, iPhones were available to purchase only for AT&T wireless network customers. They offered iPhones at huge discounts when switching networks or signing new 2 year contracts. They then (and still do) forced large monthly data subscription fees on consumers to take full advantage of all the iPhone’s best features.
The iPad has been AT&T’s latest weapon used to lure consumers to their network. In this WSJ article (http://blogs.wsj.com/digits/2010/01/28/att-on-ipad-economics-new-york-and-san-francisco/) from two years ago, they discuss why the iPad went unsubsidized by AT&T, unlike the iPhone. They also discussed how they would have a differently priced monthly subscription plan from the iPhone, mainly because they envision the iPad being used in the home more.
Just like the examples earlier, AT&T has used their iPhone/iPad exclusivity for half a decade to lure customers away from competing networks (Sprint, Verizon). They were able to substantially improve their position in the carrier market, despite having one of the worst networks for reception around. They are well known for dropped calls and poor overall poor service. Essentially, AT&T was a complementary good to the iPhone. AT&T’s iPhone monopoly is explained here: http://www.thestreet.com/story/10777804/1/atts-iphone-monopoly-todays-outrage.html, with AT&T’s response to those claims found here: http://www.thestreet.com/stock-market-news/10777969/att-responds.html.
The iPhone market is changing however (http://www.econtech.com/newsletter/january2011/january2011a2.php). In January 2011, it was announced that Verizon (and since Sprint) would begin selling and carrying the iPhone on their networks, along with AT&T. This adds much needed competition to the market and will allow consumers to eventually change carriers if they feel Verizon or Sprint offers better service without having to give up the iPhone. This change will force AT&T to either improve their network, or make it cheaper to the point consumers wouldn’t jump to a better performing competitor. Because the AT&T/iPhone exclusivity is gone, Verizon and Sprint have become substitute complementary goods to the iPhone. There are different pricing strategies these companies now face due to the entrance of competitors in the iPhone market, one of them being pricing the phones extremely low to prevent other entrants into the market.
By definition, a substitute good is any good in which an increase or decrease in price leads to a correlating increase or decrease in demand for another good; such as brand name and generic products. Grocery items and prescription drugs are common products that consumers must make daily pricing decisions on between brand name and generic offerings. Many times, patents on new prescription drugs make substitutes impossible, forcing insurance companies to pay higher prices for their customers drug related needs. A year or two later when the patent expires, the same insurance companies will refuse payment on brand name drugs, forcing their customers to lower cost generics. This is an example of the higher price leading to a greater demand for the generic.
Other tech industry examples of substitute goods are the ever popular e-readers. Barnes and Nobles Nook and Amazon’s Kindle are definitely substitutes, where initial pricing is ultra-important. This is because once consumers pick one or the other, the lock-in principle comes into play once more. These e-readers are upwards of $150, and that is a lot of switching costs for someone wanting to go from one to the other. So even though these two products are substitutes, it’s important to price them accordingly because their individual complementary items attached to them most likely have a higher profit margin. Economic scholars have even posted journals describing the how having substitutes for these complementary goods is important in how firms price complementary goods and how they lead to perfect competition or monopolies in some cases (Apple) (http://jcle.oxfordjournals.org/content/2/3/333.short) . The apps, books, magazines, etc. purchased on one product can’t be transferred to the other. They can attach higher price tags though because of this and not fear consumers switching as easily. Here, Dan Costa at PCMAG.com explains how the lock-in principal affects e-readers: http://www.pcmag.com/article2/0,2817,2386266,00.asp.
Summary
In general, related goods can be summarized into two categories. They can either be substitutes or complements. In review, remember that substitutes are goods for which in increase in the price for good A causes an increase in the demand for good B, and vice versa. Complements are goods in which a decrease in price for good A will cause an increase in the demand for good B. It is imperative that companies research the market for their good and its complements, relative to its competition. It's also important to note that many of the goods discussed here have very elastic demands. This is evident when viewing how pricing of goods effects the demand of another good; or cross-price elasticiy. It is also beneficial to view these demands against income, or income elasticity. Only after analyzing all these facots can pricing decisions be made.
This discussion has mainly concentrated on the effects pricing can have on complements, especially the technology industry in which there are millions of complementary items. Companies such as Apple, Barnes and Noble, Amazon, Microsoft, Sony, Comcast, etc. have created complementary services as well to go along with their main products. Apple has monthly subscription fees to go along with their iPhones and iPads. They also have apps to go with these products, and the best ones also generate heavy advertising revenues. Many other products mentioned here have similar complements.
All these products can generate an interesting discussion on another interesting economic principle, known as consumer lock-in. This principle concerns companies locking consumer into their products by offering higher priced items as steep discounts only to charge premium prices for complementary add-ons later. Consumers have a hard time switching products at this point because they’ve already invested upfront costs in the original item.
The Nook vs. Kindle and Xbox vs. PlayStation tech wars also show why substitutes are so closely priced. If any of these products were prices significantly higher than the other, the companies would not only lose the initial investment from consumers, but the book, app, and game purchases that follow. These complementary items can also rarely be shared between substitute goods either. Gaming console, phone, and tablet manufactures are also beginning to come out with cloud services, allowing customers to access their information from anywhere, while also promoting related goods. It’s now “cooler” to be able to buy an e-book on your iPhone and that book automatically appearing on your iPad at home. Technically, you’re just paying for rental space on the web, with these companies storing your purchases for you. All at a hefty price of course.
Dari-Mattiacici. Guiseppe. And Parisi. Francesco. “Substituting Complements”. Oxford Journals. Journal of Competition Law and Economics. Web. November 2011. http://jcle.oxfordjournals.org/
Multiple Choice 1. Consumer Lock-In happens when consumers are unwilling to switch products due to:
Brand loyalty
High switching costs
Product satisfaction
Return Policies
2. A complementary good is:
A similar good from a competing firm
A similar good from the same firm
Any good whose demand increases or decreases inversely with the price of another good
A good that only works when paired with another
3. AT&T claims that their exclusive relationship with the Apple has in fact stimulated competition in the market because:
AT&T subsidizes iPhones and lower prices creates competition between carriers
Dozens of devices have been introduced in response to the iPhone, thus giving consumers more options
Multi-Touch technology in wireless handsets has expanded.
All of the above
4. Which method is not an example of a firm utilizing the razorblade model of business:
Next gen gaming consoles selling monthly subscriptions to use an online multiplayer platform
Cable companies giving away DVRs for free but charging a monthly fee for use
Shoe companies selling charging extra for replacement shoe laces
Brita selling replacement filters for their water purifiers
5. In a December 2009 Stanford Graduate Business School Review, it was found that extremely high concession prices at movie theaters was actually beneficial because:
Keeps gate prices down
Customers get more for their money – portion sizes are larger
Theaters are more profitable
A and C
All of the above
Multiple Choice Answers 1. Consumer Lock-In happens when consumers are unwilling to switch products due to:
Brand loyalty
High switching costs
Product satisfaction
Return Policies
Answer – 2. Consumers are locked-in to a firm’s products when switching costs are too high. This means the consumer has spent significant money to buy into a certain product up front and is unwilling eat those expenses to switch to a better product.
2. A complementary good is:
A similar good from a competing firm
A similar good from the same firm
Any good whose demand increases or decreases inversely with the price of another good
A good that only works when paired with another
Answer– 3. Complementary goods are goods whose demand rise and fall with the price of another good. For instance, as the price of hot dogs increases, the demand for hot dog buns will decrease.
3. AT&T claims that their exclusive relationship with the Apple has in fact stimulated competition in the market because:
AT&T subsidizes iPhones and lower prices creates competition between carriers
Dozens of devices have been introduced in response to the iPhone, thus giving consumers more options
Multi-Touch technology in wireless handsets has expanded.
All of the above
Answer – 4. AT&T claims that their exclusive contract has actually increases competition because other firms have increased their consumer options and performance in response to the iPhone and in an attempt to lure customers away from AT&T. Also – the touchscreen technologies introduced with the iPhone have expanded research and product availability since. They claim all this gives consumer more options, the definition of competition.
4. Which method is not an example of a firm utilizing the razorblade model of business:
Next gen gaming consoles selling monthly subscriptions to use an online multiplayer platform
Cable companies giving away DVRs for free but charging a monthly fee for use
Shoe companies selling charging extra for replacement shoe laces
Brita selling replacement filters for their water purifiers
Answer – 3. The razorblade model is utilized when a firm sells a one-time product that is complemented by another product that customers are forced to buy repeatedly. The initial product is usually a loss leader (sold for less than cost or just given away). In this example shoes are not a one-time purchase. Shoe laces are also not repeat business products.
5. In a December 2009 Stanford Graduate Business School Review, it was found that extremely high concession prices at movie theaters was actually beneficial because:
Keeps gate prices down
Customers get more for their money – portion sizes are larger
Theaters are more profitable
A and C
All of the above
Answer – 4. It was found that higher concession prices both kept gate prices down and allowed the theater to make more profit at the same time. This is because theaters must share the gross revenues earned from gate prices, but get to keep 100% of the revenue from concessions. Concessions only counted for 20% of gross revenue, but 40% of their profit. Keeping the gate prices lower also allows for more price conscience, frugal spenders to still see movies.
Summaries
Auctions including English auction, First price sealed bid auction, second price sealed bid auction, Dutch auction, winners curse
By Kristin Westerfield
By definition, auctions are places where “potential buyers compete for the right to own a good, service, or, more generally, anything of value. There are four different types of auctions summarized in Kristin’s paper. First, an English auction is a sequential bid auction where players observe other bids and then decide whether to increase the bid or not. The auction doesn’t end until there is only one bidder left and they pay that amount. Second, a first-price sealed bid auction is an auction where all bidders submit a bid on a piece of paper and the highest bid wins immediately. Third, a second-price sealed bid auction is the same as the first price except the highest bidder doesn’t pay his/her bid, but the bid of the second highest. Lastly, a Dutch auction is when the auctioneer starts the process with a high price and gradually decreases the price of an item until someone is willing to pay. That type of auction then ends immediately.
Kristin gave good real world examples of each of these types of bid, as well as many variations of each type. English auctions are the most popular, as well as a popular timed variation, the silent auction. Auction houses such as Sotheby’s immediately come to mind. The sealed bid auction types differ greatly from English and silent auctions because the bidder must evaluate their willingness to pay up front and only get once chance to place a bid on an item instead of incrementally increasing their bid in an English auction and possibly getting an item for less than their value. Contracts are good examples of sealed bid auctions. Second price sealed bid auctions are also called “Vickrey” auctions, and prompt bidders to bid their real personal value, though disadvantages of this also promote collusion between bidders. Ebay is considered an online version of a second price auction.
There are plenty of advantages and disadvantages of auction listed. Auctions are great ways for sellers to quickly get market value for their items, as well as quickly bring together qualified buyers. They are also the fastest way available to convert assets into cash. Sellers are able to set the parameters of the sale and buyers prefer this as well because they normally get a better deal. Disadvantages include that fact that all information about an item and bidders’ preferences are not fully shared. It’s also hard to appropriately price items when bidders’ have different personal opinions.
Comparative advantage and trade (How do you determine your comparative advantage?)By Regina Gauger
It’s obvious from Regina’s research that comparative advantage can mean different things, as well as have very different definitions. An economic definition says that comparative advantages exists when two or more parties such as individuals and firms can both gain from trading if they have different relative costs for producing the same goods. Comparative advantage can also be defined as having the lowest opportunity cost between different individuals or firms in producing a particular good. Also, David Ricardo, an early influential economist, also described comparative advantage as “mutually beneficial exchange is possible whenever relative production costs differ prior to trade”.
There are several examples of comparative advantage. Regina focuses on two industries. First, the technology industry and Apple in particular is examined. One cited source claimed there is a three version rule in the technology industry. This means that a tech firm will usually need three versions of a product before they really get it to where the consumer likes their product. However, Apple seems to get consumers behaviors and wants after only one version. But it’s Apple’s marketing that really gives them a comparative advantage. They master their vision and excel at promoting features consumer want in their marketing campaigns.
The apparel industry is the second industry Regina focuses on. Another source claims that Pakistan has a large comparative advantage in this industry. This is due to the quality of the cotton grown inside their borders. Due to this, they can produce denim, flannels, fleece, and knits as a significantly cheaper cost than others.
The next section tackles the question of how to assess if a firm or individual possesses a comparative advantage. Consumer preferences and cost metrics seem to be the best way to determine if someone owns a comparative advantage over their competitors. Plus, an individual or firm’s natural surroundings are a great place to look for one as well.
Lastly, Regina discusses some opposition to the defined terms of comparative advantage, or more a different way to view it. Economic principle tells us that comparative advantage exists when someone can product a product more cost effectively than another. Her sources claim though this may be true, there are many times when firms or individuals still choose to outsource those activities. This is because though an advantage may exist, that particular party may have an even greater advantage at something else, and freeing up labor and resources is more beneficial.
Monopolistic CompetitionBy Dan Kreitl
Dan describes monopolistic competition as “the middle ground between perfect competition and a monopoly”. Essentially, a perfectly competitive firm sells identical products to its competitors and a monopoly sells a unique products. This makes the perfect competition firms price takers and the monopoly firm a price setter. Everything in between these two markets is called monopolistic competition.
Dan next further defines the two markets described above, a monopoly and perfect competition, because the two of them combined are what make monopolistic competition. A monopoly, on top of being a price setter, owns nearly all of the market for a given product or service. Barriers to entry allow a monopoly to operate without competition. Barriers to entry can include economies of scale and governmental regulation. Firms with monopolies will usually produce less an amount less than socially efficient.
At the other end of the spectrum, perfect competition allows for a free flow of information, helping keep barriers to entry out of the market. This produces a large number of sellers. This means heavy competition allowing buyers to set prices they’re willing to pay.
Monopolistic competition therefore, is characterized by many sellers that produce similar, but not identical products. A degree of differentiation exists that allows each supplier to set their own price. They can’t completely control price though, because at a certain level, consumer preference will cease driving purchasing decisions and they’ll switch products.
Dan then goes into more depth on the properties of monopolistic competition. These include free entry, product differentiation, many buyers and sellers, limited pricing power, and a downward sloping demand curve. All of these characteristics are explained above except the downward demand curve. This shows where and why a monopolistic firm produces supply where marginal revenue equals marginal cost.
Oligopoly
By Kevin McNutt
Oligopoly is a certain type of market where there are many buyers and few sellers. Because of this, each firm is large in size compared to the industry as a whole. This market is described by no barriers to entry for buyers, but there are barriers for sellers. Oligopoly firms are normally well known too, preventing any new entrants from severely threatening their market power. Such industries and firms include Satellite TV providers (Dish, Direct TV), auto manufacturers (GM, Ford, Chrysler), oil companies (BP, Shell, Chevron) and soda manufacturers (Coke, Pepsi).
Kevin explains how an oligopoly structure brings a lot of game theory into play between the competing market firms. This is because with so few firms, the pricing decisions that firm A makes will have a profound effect of firms B’s profits. But this works both ways, as firm B knows firm A’s decision will affect it, it will have contingencies for any decision firm A makes. These reactions correlate into reaction functions. This leads to multiple types of oligopoly pricing models.
Cournot oligopoly is the first model. In this type of model, firms can produce either the same of different products. However, the main principle of this model is that firm B will maintain the same level of output regardless of what firm A does. This leads to equilibrium where neither firm will ever change their output because it does not better their profits. The Stackelberg model has similar characteristics as the Cournot model but differs in that the market will develop into a leader-follower situation. In short, firm A will set output and only then will firm B and C etc. set output. Their output will reflect how they can maximize profit based on firm A’s decisions. The Bertrand model also has similar market structure and characteristics as the first two. However, these participants compete on price by setting their price equal to marginal cost.
Collusion is also a major factor in oligopolies because of the few number of firms. By working together, or colluding, firms can eliminate all consumer surpluses and completely maximize their profits. End the end, oligopolies are somewhere between free trade and a monopoly. Market structure will create higher prices than free trade but not quite as high as monopoly prices.
Supply and Demand (Also, include private goods vs. public goods, marginal analysis, producer and consumer surplus and how it applies to perfect competition)
By Thaddeus Bogardus
Thaddeus started this topic by listing in detail many different economic principles needed to have a basic understanding of economics. These included: law of demand, market demand curve, market supply curve, consumer and producer surplus, equilibrium price, private and public goods, marginal benefit, marginal cost, and price floor and ceilings.
Next, he went into reasons for demand and supply curves shifting. Reasons for demand shifts are consumer income, prices of related goods, advertising, population, and consumer expectation. Concerning consumer income, demand will shift inward or to the left for an inferior good. This means that as income rises, demand will fall. Demand will shift outward or to the right for a normal good. This means as income rises demand rises as well. Prices of related goods will have the same effect as consumer income. As substitutes rise in price, this will cause demand for an item to shift outward, or to the right. As prices for complements rise, demand for a particular good will shift inward, or to the left.
There are five supply shifters as well. These are: prices of inputs, the level of technology, number of firms in the market, taxes, and producer expectations. These will also shift the supply curve inward to the left or outward to the right. For instance, as the price of inputs increases, supply will decrease, or shift inward to the left and vice versa. Technology is a big shifter, and as it advances and makes products cheaper to manufacture, supply will increase by shifting outward to the right.
Thaddeus gave great real world examples of both shifting of supply and demand. He used tablet technology, the wine market, gasoline, and water and energy to illustrate the economic principles in play.
Weekly Posts Week of 10/3 - Baye's Case Answer and Overview Before jumping straight into a weekly discussion about real world pricing strategies and stories for related goods, I'd like to take a moment to discuss Baye's answer to Memo 3 of the Time Warner Case.
Memo 3 discusses pricing implications and strategies for two related goods, HD televisions and HD programming. These two goods are provided by seperate companies. There are a number of different HDTV manufacturers. Time Warner is the HDTV programming provider. This case specifically discusses future profitability for the the HDTV programming sector of Time Warner. They believe that HTDV programming provides superior services to basic analog television and the value it can add to their customers can be a great revenue source going forward.
There are a few roadblocks ahead for them to be successful in the market. The two main issues revolve around the expensive nature of HDTV's at the time. Prices for basic sets ranged from $1,000 to $7,000. Studies showed that consumers were unwilling to spend that much money for an HDTV set, mainly due to a lack of HDTV programming available at the time. Program producers and distributors, like Time Warner, were unwilling to spend large amounts of money on the programming when consumers didn't have the sets to view it properly. This creates a catch 22 of sorts.
In Baye's answer, it is proposed that Time Warner sharply increase their production of quality HDTV programming as an incentive to get sonsumers to purchase net sets. Survery's have shown that consumers would be willing to pay to view sporting programs specifically in high definition. It is also proposed that Time Warner penetrate this market with low starting HDTV subscription prices. Once they reach a "critical mass" of customers and they can begin offering a greater variety of programming and charge subscription prices more in line with the value derived from the programming - aka - at a higher price.
It seems Time Warner is proposing to eat a lot of initial equipment and production costs now in order to penetrate the market more than competitors and come out ahead 3 years plus down the road when the sets become more affordable.
In the coming weeks, I'll discuss the different types of related goods, and how demand for each changes based on their own price, and the price of other goods.
Week of 10/10 - TV Cont...
Continuing with the television provider theme, Comcast and other companies use bundling techniques and introductional promotional pricing to get customers hooked on their products, then raise prices after 6 months. Oregon Live.com goes even further stating "Death. Taxes. And cable TV rate increases. All sure bets." (http://www.oregonlive.com/business/index.ssf/2010/11/comcast_sets_annual_rate_hike_1.html). Programming consumers across the country are all experiencing these same price increases. Comcast is banking on consumers getting hooked on their products and will be willing to pay extra each year to keep them. Programming providers also routinely force customers into contracts, claiming to keep prices down during the life of the contract. For instance, Comcast currently offers HBO, SHowtime, and Cinemax as promotional "free" compliments to their basic HD programming guide for six months. Afterwards, when the customer has become accustom to having these premium channels, the prices will go to $5.99 and up for those single channels. Comcast also bundles their HDTV programming with their high speed internet. With bundling, the internet will only cost you $42.99/month, compared to $59.99/month on its own.
Week of 10/17 - Complementary Goods How related goods are priced relative to each other and to consumers depend on what type of goods they are and the environment of the consumer. Complementary goods are the first type of related goods needing mentioned here. When pricing complements, it's important to remember that demand a good will increase or decrease as the price for the other good does. The two complementary products in the Time Warner case above illustrate this fact. As the price of HDTVs decreased over the next decade there will be a steep increase in the demand for HDTV programming. These goods are also normal goods, which are they are going to be in more demand as consumer income increases. The more money a consumer has, the easier to buy one of those expensive HDTVs and programming to go with it.
Week of 10/24 – Movie Theaters Another great complementary pricing example customers routinely encounter are concession prices at arenas and movie theaters. After paying gate prices for movies, sporting events, or concerts, consumers are subjected to insane concession prices. In this Stanford Business School Review, "Why Does My Popcorn Cost So Much?" (http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html), concession prices are examined relative to gate prices. The article claims that these exorbitant prices are actually beneficial to movie goers, keeping the gate prices down and allowing the frugal spender to keep seeing films on the big screen. The facts seem to back up these claims, as it’s noted that 20 percent of a theater's gross revenue comes from concessions, but 40 percent of their net profit comes from concessions. This is due to the fact that theaters have to share ticket revenues but not concession revenues. It's always going to be a struggle and fine line that companies need to walk when thinking about how to price two complementary goods. Especially if one of them is only appealing after the first good is bought. In the movie theater case, there's no profit on unsold concession food if the gate price is too high to get lots of consumers through the door. References and Links Stanford Graduate School of Business. Web. Accessed Nov 2011. http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html
Week of 10/31 – Lock-In and the Razor Blade Model
“Customer Lock-In” is defined as when companies force consumers to use their products without spending substantial money on switching costs. The razor blade market is infamous for using this type of economic principle. In fact, when people talk about pricing related products in today’s terms they often refer to the model as the razor blade model (http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw). An analysis of the industry is below, and really shows how companies in the industry use the “Customer Lock-In” principle to their advantage.
There are two main players in the disposable razor blade market; Gillette and Schick. Their products are the classic example of hooking consumers with a low cost entry item (razor) and then providing a complementary item (blades) that consumer must continually return to purchase in order to keep using the original item. In all likelihood, Gillette and Schick are selling razors at a loss. They do that because they know that once a customer has purchased a particular razor, they will continue to buy disposable blades that only fit that particular razor. They may be able to charge more for the blades than their competitor and the customer will pay that price because they don’t want to pay the costs associated with switching to another brand razor, even if the blades are a little cheaper. This proves the “Lock-In” principle works. Here, consultant Rafi Mohammad explains why it and the razor blade model works: http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm. So manufactures take this loss b/c they know once consumers have bought one particular they can sell their higher margin complementary good (the blades) over and over again. Once a razor has been on the shelves for a while, both these companies will come out with a razors with “more blades!” that claim they make shaving more comfortable. Once consumer upgrade they require different blades that starts this whole process again. Yet another example of this model mentioned in the link above was when the next generation gaming consoles (Xbox, PlayStation) were first being manufactured and sold. These consoles were costly to manufacture and were sold at massive losses. However, the best feature was the online gaming capabilities. To make up for early losses, Microsoft specifically charged monthly subscription fees to players. The costs associated with these purchases locked consumers into the xBox gaming console. This became very important down the road a when Sony launched their free online gaming community through the PlayStation. Xbox customers were unwilling to switch over even though Sony offered a free online platform because of all the money already invested into Microsoft products. Resources and Links http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw Mohammad. Rafi. Web. Accessed Nov 2011. http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm
Week of 11/7 – The iPhone! Maybe the most economically interesting case of related goods and lock-in during the last 5 years is seen when examining the market for iPhones. Until the past year, iPhones were available to purchase only for AT&T wireless network customers. They offered iPhones at huge discounts when switching networks or signing new 2 year contracts. They then (and still do) forced large monthly data subscription fees on consumers to take full advantage of all the iPhone’s best features. The iPad has been AT&T’s latest weapon used to lure consumers to their network. In this WSJ article (http://blogs.wsj.com/digits/2010/01/28/att-on-ipad-economics-new-york-and-san-francisco/) from two years ago, they discuss why the iPad went unsubsidized by AT&T, unlike the iPhone. They also discussed how they would have a differently priced monthly subscription plan from the iPhone, mainly because they envision the iPad being used in the home more. Just like the examples earlier, AT&T has used their iPhone/iPad exclusivity for half a decade to lure customers away from competing networks (Sprint, Verizon). They were able to substantially improve their position in the carrier market, despite having one of the worst networks for reception around. They are well known for dropped calls and poor overall poor service. Essentially, AT&T was a complementary good to the iPhone. AT&T’s iPhone monopoly is explained here: http://www.thestreet.com/story/10777804/1/atts-iphone-monopoly-todays-outrage.html, with AT&T’s response to those claims found here: http://www.thestreet.com/stock-market-news/10777969/att-responds.html. Week of 11/14 – iPhone market changing… The iPhone market is changing (http://www.econtech.com/newsletter/january2011/january2011a2.php). In January 2011, it was announced that Verizon (and since Sprint) would begin selling and carrying the iPhone on their networks, along with AT&T. This adds much needed competition to the market and will allow consumers to eventually change carriers if they feel Verizon or Sprint offers better service without having to give up the iPhone. This change will force AT&T to either improve their network, or make it cheaper to the point consumers wouldn’t jump to a better performing competitor. Because the AT&T/iPhone exclusivity is gone, Verizon and Sprint have become substitute complementary goods to the iPhone. There are different pricing strategies these companies now face due to the entrance of competitors in the iPhone market, one of them being pricing the phones extremely low to prevent other entrants into the market.
Week of 11/21 – Substitute Goods and Pricing
By definition, a substitute good is any good in which an increase or decrease in price leads to a correlating increase or decrease in demand for another good; such as brand name and generic products. Grocery items and prescription drugs are common products that consumers must make daily pricing decisions on between brand name and generic offerings. Many times, patents on new prescription drugs make substitutes impossible, forcing insurance companies to pay higher prices for their customers drug related needs. A year or two later when the patent expires, the same insurance companies will refuse payment on brand name drugs, forcing their customers to lower cost generics. This is an example of the higher price leading to a greater demand for the generic.
Another tech industry example of substitute goods are the ever popular e-readers. Barnes and Nobles Nook and Amazon’s Kindle are definitely substitutes, where initial pricing is ultra-important. This is because once consumers pick one or the other, the lock-in principle comes into play once more. These e-readers are upwards of $150, and that is a lot of switching costs for someone wanting to go from one to the other. So even though these two products are substitutes, it’s important to price them accordingly because their individual complementary items attached to them most likely have a higher profit margin. The apps, books, magazines, etc purchased on one product can’t be transferred to the other. They can attach higher price tags though because of this and not fear consumers switching as easily. Here, Dan Costa at PCMAG.com, explains how the lock-in principal affects e-readers: http://www.pcmag.com/article2/0,2817,2386266,00.asp.
James Mohr
Final Paper
Memo 3 discusses pricing implications and strategies for two related goods, HD televisions and HD programming. These two goods are provided by separate companies. There are a number of different HDTV manufacturers. Time Warner is the HDTV programming provider. This case specifically discusses future profitability of the HDTV programming sector of Time Warner. They believe that HTDV programming provides superior services to basic analog television and the value it can add to their customers can be a great revenue source going forward. There are a few roadblocks ahead for them to be successful in the market. The two main issues revolve around the expensive nature of HDTV's at the time. Prices for basic sets ranged from $1,000 to $7,000. Studies showed that consumers were unwilling to spend that much money for an HDTV set, mainly due to a lack of HDTV programming available at the time. Program producers and distributors, like Time Warner, were unwilling to spend large amounts of money on the programming when consumers didn't have the sets to view it properly. This creates a catch-22 of sorts.In Baye's answer, it is proposed that Time Warner sharply increase their production of quality HDTV programming as an incentive to get consumers to purchase new sets. Surveys have shown that consumers would be willing to pay to view sporting programs specifically in high definition. It is also proposed that Time Warner penetrate this market with low starting HDTV subscription prices. Once they reach a "critical mass" of customers and they can begin offering a greater variety of programming and charge subscription prices more in line with the value derived from the programming - aka - at a higher price. It seems Time Warner is developing a "penetration pricing" strategy. They are going to eat a lot of initial equipment and production costs now in order to penetrate the market more than competitors and come out ahead 3 years plus down the road when the sets become more affordable. Currently, Comcast and other programming providers use bundling techniques and introduction promotional pricing to get customers hooked on their products, then raise prices after 6 months. Oregon Live.com goes even further stating "Death. Taxes. And cable TV rate increases. All sure bets." (http://www.oregonlive.com/business/index.ssf/2010/11/comcast_sets_annual_rate_hike_1.html). Programming purchasers across the country are all experiencing these same price increases. Comcast is banking on consumers getting hooked on their products and will be willing to pay extra each year to keep them.
Programming providers also routinely force customers into contracts, claiming to keep prices down during the life of the contract. For instance, Comcast currently offers HBO, ShowTime, and Cinemax as promotional "free" complements to their basic HD programming guide for six months. Afterwards, when the customer has become accustom to having these premium channels, the prices will go to $5.99 and up for those single channels. Comcast also bundles their HDTV programming with their high speed internet. With bundling, the internet will only cost you $42.99/month, compared to $59.99/month on its own. Bundling is a great way for companies to get power in the buying decision back from the seller. This Harvard Business Review article (
http://blogs.hbr.org/tjan/2010/02/the-pros-and-cons-of-bundled-p.html), gives more insight into bundling pros and cons. It's easy to understand why companies profit more with bundling services and gives them more power though. Bundling allows them to force unwanted products (at a price) onto customers who would normally bypass purchasing them. They force customers to take product B in order to purchase product A (the one customers really want).
Here is another case where the use of bundling is examined; this time within the agriculture industry http://www.aae.wisc.edu/pubs/sps/pdf/stpap529.pdf.
Types of Goods
Much like the programming examples above, how related goods are priced relative to each other and to consumers depend on what type of goods they are and the environment of the consumer. Complementary goods are the first type of related goods needing mentioned here. When pricing complements, it's important to remember that demand a good will increase or decrease as the price for the other good does. The two complementary products in the Time Warner case illustrate this fact. As the price of HDTVs decreased over the next decade there will be a steep increase in the demand for HDTV programming. These goods are also normal goods, which are they are going to be in more demand as consumer income increases. The more money a consumer has, the easier to buy one of those expensive HDTVs and programming to go with it.
Another great complementary pricing example customers routinely encounter are concession prices at arenas and movie theaters. After paying gate prices for movies, sporting events, or concerts, consumers are subjected to insane concession prices. In this Stanford Business School Review, "Why Does Movie Popcorn Cost So Much?" (http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html), concession prices are examined relative to gate prices. The article claims that these exorbitant prices are actually beneficial to movie goers, keeping the gate prices down and allowing the frugal spender to keep seeing films on the big screen. The facts seem to back up these claims, as it’s noted that 20 percent of a theater's gross revenue comes from concessions, but 40 percent of their net profit comes from concessions. This is due to the fact that theaters have to share ticket revenues but not concession revenues.
It's always going to be a struggle and fine line that companies need to walk when thinking about how to price two complementary goods. Especially if one of them is only appealing after the first good is bought. In the movie theater case, there's no profit on unsold concession food if the gate price is too high to get lots of consumers through the door.
Lock-In
“Customer Lock-In” is defined as when companies force consumers to use their products without spending substantial money on switching costs. Joachim Buschken, of Catholic University explains a profitable consumer is not satisfied, but locked-in http://www.abebooks.com/Profitable-Consumer-Satisfied-Locked-Joachim-Buschken/742977251/bd). The razor blade market is infamous for using this type of economic principle. In fact, when people talk about pricing related products in today’s terms they often refer to the model as the razor blade model (http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw). The razorblade business model is defined when a firm offers a one-time product at no cost or below cost (loss leader). Then the consumer is forced to repeatedly buy a complementary product to use the initial purchase. In this case, the razor is the loss leader product, and the blades are the repeat purchase. An analysis of the industry is below, and really shows how companies in the industry use the “Customer Lock-In” principle to their advantage.
There are two main players in the disposable razor blade market; Gillette and Schick. Their products are the classic example of hooking consumers with a low cost entry item (razor) and then providing a complementary item (blades) that consumer must continually return to purchase in order to keep using the original item.
In all likelihood, Gillette and Schick are selling razors at a loss. They do that because they know that once a customer has purchased a particular razor, they will continue to buy disposable blades that only fit that particular razor. They may be able to charge more for the blades than their competitor and the customer will pay that price because they don’t want to pay the costs associated with switching to another brand razor, even if the blades are a little cheaper. This proves the “Lock-In” principle works. Here, consultant Rafi Mohammad explains why it and the razor blade model works: http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm.
So manufactures take this loss b/c they know once consumers have bought one particular they can sell their higher margin complementary good (the blades) over and over again. Once a razor has been on the shelves for a while, both these companies will come out with a razors with “more blades!” that claim they make shaving more comfortable. Once consumer upgrade they require different blades that starts this whole process again.
Yet another example of this model mentioned in the link above was when the next generation gaming consoles (Xbox, PlayStation) were first being manufactured and sold. These consoles were costly to manufacture and were sold at massive losses. However, the best feature was the online gaming capabilities. To make up for early losses, Microsoft specifically charged monthly subscription fees to players. The costs associated with these purchases locked consumers into the Xbox gaming console. This became very important down the road a when Sony launched their free online gaming community through the PlayStation. Xbox customers were unwilling to switch over even though Sony offered a free online platform because of all the money already invested into Microsoft products.
Maybe the most economically interesting case of related goods and lock-in during the last 5 years is seen when examining the market for iPhones. Until the past year, iPhones were available to purchase only for AT&T wireless network customers. They offered iPhones at huge discounts when switching networks or signing new 2 year contracts. They then (and still do) forced large monthly data subscription fees on consumers to take full advantage of all the iPhone’s best features.
The iPad has been AT&T’s latest weapon used to lure consumers to their network. In this WSJ article (http://blogs.wsj.com/digits/2010/01/28/att-on-ipad-economics-new-york-and-san-francisco/) from two years ago, they discuss why the iPad went unsubsidized by AT&T, unlike the iPhone. They also discussed how they would have a differently priced monthly subscription plan from the iPhone, mainly because they envision the iPad being used in the home more.
Just like the examples earlier, AT&T has used their iPhone/iPad exclusivity for half a decade to lure customers away from competing networks (Sprint, Verizon). They were able to substantially improve their position in the carrier market, despite having one of the worst networks for reception around. They are well known for dropped calls and poor overall poor service. Essentially, AT&T was a complementary good to the iPhone. AT&T’s iPhone monopoly is explained here: http://www.thestreet.com/story/10777804/1/atts-iphone-monopoly-todays-outrage.html, with AT&T’s response to those claims found here: http://www.thestreet.com/stock-market-news/10777969/att-responds.html.
The iPhone market is changing however (http://www.econtech.com/newsletter/january2011/january2011a2.php). In January 2011, it was announced that Verizon (and since Sprint) would begin selling and carrying the iPhone on their networks, along with AT&T. This adds much needed competition to the market and will allow consumers to eventually change carriers if they feel Verizon or Sprint offers better service without having to give up the iPhone. This change will force AT&T to either improve their network, or make it cheaper to the point consumers wouldn’t jump to a better performing competitor. Because the AT&T/iPhone exclusivity is gone, Verizon and Sprint have become substitute complementary goods to the iPhone. There are different pricing strategies these companies now face due to the entrance of competitors in the iPhone market, one of them being pricing the phones extremely low to prevent other entrants into the market.
By definition, a substitute good is any good in which an increase or decrease in price leads to a correlating increase or decrease in demand for another good; such as brand name and generic products. Grocery items and prescription drugs are common products that consumers must make daily pricing decisions on between brand name and generic offerings. Many times, patents on new prescription drugs make substitutes impossible, forcing insurance companies to pay higher prices for their customers drug related needs. A year or two later when the patent expires, the same insurance companies will refuse payment on brand name drugs, forcing their customers to lower cost generics. This is an example of the higher price leading to a greater demand for the generic.
Other tech industry examples of substitute goods are the ever popular e-readers. Barnes and Nobles Nook and Amazon’s Kindle are definitely substitutes, where initial pricing is ultra-important. This is because once consumers pick one or the other, the lock-in principle comes into play once more. These e-readers are upwards of $150, and that is a lot of switching costs for someone wanting to go from one to the other. So even though these two products are substitutes, it’s important to price them accordingly because their individual complementary items attached to them most likely have a higher profit margin. Economic scholars have even posted journals describing the how having substitutes for these complementary goods is important in how firms price complementary goods and how they lead to perfect competition or monopolies in some cases (Apple) (http://jcle.oxfordjournals.org/content/2/3/333.short) . The apps, books, magazines, etc. purchased on one product can’t be transferred to the other. They can attach higher price tags though because of this and not fear consumers switching as easily. Here, Dan Costa at PCMAG.com explains how the lock-in principal affects e-readers: http://www.pcmag.com/article2/0,2817,2386266,00.asp.
Summary
In general, related goods can be summarized into two categories. They can either be substitutes or complements. In review, remember that substitutes are goods for which in increase in the price for good A causes an increase in the demand for good B, and vice versa. Complements are goods in which a decrease in price for good A will cause an increase in the demand for good B. It is imperative that companies research the market for their good and its complements, relative to its competition. It's also important to note that many of the goods discussed here have very elastic demands. This is evident when viewing how pricing of goods effects the demand of another good; or cross-price elasticiy. It is also beneficial to view these demands against income, or income elasticity. Only after analyzing all these facots can pricing decisions be made.
This discussion has mainly concentrated on the effects pricing can have on complements, especially the technology industry in which there are millions of complementary items. Companies such as Apple, Barnes and Noble, Amazon, Microsoft, Sony, Comcast, etc. have created complementary services as well to go along with their main products. Apple has monthly subscription fees to go along with their iPhones and iPads. They also have apps to go with these products, and the best ones also generate heavy advertising revenues. Many other products mentioned here have similar complements.
All these products can generate an interesting discussion on another interesting economic principle, known as consumer lock-in. This principle concerns companies locking consumer into their products by offering higher priced items as steep discounts only to charge premium prices for complementary add-ons later. Consumers have a hard time switching products at this point because they’ve already invested upfront costs in the original item.
The Nook vs. Kindle and Xbox vs. PlayStation tech wars also show why substitutes are so closely priced. If any of these products were prices significantly higher than the other, the companies would not only lose the initial investment from consumers, but the book, app, and game purchases that follow. These complementary items can also rarely be shared between substitute goods either. Gaming console, phone, and tablet manufactures are also beginning to come out with cloud services, allowing customers to access their information from anywhere, while also promoting related goods. It’s now “cooler” to be able to buy an e-book on your iPhone and that book automatically appearing on your iPad at home. Technically, you’re just paying for rental space on the web, with these companies storing your purchases for you. All at a hefty price of course.
References
Rogoway. Mike. “Comcast hikes rates for Oregon cable TV, Internet access”. OregonLive.com. Web. November 2011. <http://www.oregonlive.com/business/index.ssf/2010/11/comcast_sets_annual_rate_hike_1.html>
Tjan. Anthony. "The pros and cons of bundled pricing". Harvard Business Review. Web. December 2011. <http://blogs.hbr.org/tjan/2010/02/the-pros-and-cons-of-bundled-p.html>
Shi, Guanming. Chavas, Jean-Paul. and Stiegert, Kyle. “An Analysis of Bundle Pricing: The Case of the Corn Seed Market”.
University of Wisconsin-Madison Department of Agricultural & Applied Economics. Staff Paper No. 529. Revised, December 2008. Web. December 2011. http://www.aae.wisc.edu/pubs/sps/pdf/stpap529.pdf
Rigoglioso. Marguerite. “Why Does Movie Popcorn Cost So Much?” Stanford Graduate School of Business. Web. November 2011. <http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html>
Buschken. Joachim. “Higher Profits Through Customer Lock-In”. First Edition. SWEP. Copyright 2005. Web. November 2011. <http://www.abebooks.com/Profitable-Consumer-Satisfied-Locked-Joachim-Buschken/742977251/bd>
Bynum. Justin. “What is the Razor/Razorblade model?”. Investopedia. Web. November 2011. <http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw>
Mohammad. Rafi. “The REAL Reason to Use the Razor/Razor Blade Price Strategy”. Pricingforprofit.com. Web. November 2011. <http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm.
LaVallee. Andrew. “AT&T on iPad Economics, New York and San Franciso. WSJ.com. Web. November 2011. <http://blogs.wsj.com/digits/2010/01/28/att-on-ipad-economics-new-york-and-san-francisco/>
LaCapra. Lauren Tara. “AT&T’s iPHone Monoply: Today’s Outrage”. Thestreet.com. Web. November 2011. <http://www.thestreet.com/story/10777804/1/atts-iphone-monopoly-todays-outrage.html>
Siegel. Mark. Memo. Thestreet.com. Web. November 2011. <http://www.thestreet.com/stock-market-news/10777969/att-responds.html>
Weir. Colin B. “Verizon to start offering iPhones: A big deal, or a big so what?”. econtech.com. Web. November 2011. <http://www.econtech.com/newsletter/january2011/january2011a2.php>
Costa. Dan. “Nook, Kindle and the Perils of Lock-in”. pcmag.com. Web. November 2011. <http://www.pcmag.com/article2/0,2817,2386266,00.asp>
Dari-Mattiacici. Guiseppe. And Parisi. Francesco. “Substituting Complements”. Oxford Journals. Journal of Competition Law and Economics. Web. November 2011. http://jcle.oxfordjournals.org/
Multiple Choice
1. Consumer Lock-In happens when consumers are unwilling to switch products due to:
2. A complementary good is:
3. AT&T claims that their exclusive relationship with the Apple has in fact stimulated competition in the market because:
4. Which method is not an example of a firm utilizing the razorblade model of business:
5. In a December 2009 Stanford Graduate Business School Review, it was found that extremely high concession prices at movie theaters was actually beneficial because:
Multiple Choice Answers
1. Consumer Lock-In happens when consumers are unwilling to switch products due to:
Answer – 2. Consumers are locked-in to a firm’s products when switching costs are too high. This means the consumer has spent significant money to buy into a certain product up front and is unwilling eat those expenses to switch to a better product.
2. A complementary good is:
Answer – 3. Complementary goods are goods whose demand rise and fall with the price of another good. For instance, as the price of hot dogs increases, the demand for hot dog buns will decrease.
3. AT&T claims that their exclusive relationship with the Apple has in fact stimulated competition in the market because:
Answer – 4. AT&T claims that their exclusive contract has actually increases competition because other firms have increased their consumer options and performance in response to the iPhone and in an attempt to lure customers away from AT&T. Also – the touchscreen technologies introduced with the iPhone have expanded research and product availability since. They claim all this gives consumer more options, the definition of competition.
4. Which method is not an example of a firm utilizing the razorblade model of business:
Answer – 3. The razorblade model is utilized when a firm sells a one-time product that is complemented by another product that customers are forced to buy repeatedly. The initial product is usually a loss leader (sold for less than cost or just given away). In this example shoes are not a one-time purchase. Shoe laces are also not repeat business products.
5. In a December 2009 Stanford Graduate Business School Review, it was found that extremely high concession prices at movie theaters was actually beneficial because:
Answer – 4. It was found that higher concession prices both kept gate prices down and allowed the theater to make more profit at the same time. This is because theaters must share the gross revenues earned from gate prices, but get to keep 100% of the revenue from concessions. Concessions only counted for 20% of gross revenue, but 40% of their profit. Keeping the gate prices lower also allows for more price conscience, frugal spenders to still see movies.
Summaries
Auctions including English auction, First price sealed bid auction, second price sealed bid auction, Dutch auction, winners curse
By Kristin Westerfield
By definition, auctions are places where “potential buyers compete for the right to own a good, service, or, more generally, anything of value. There are four different types of auctions summarized in Kristin’s paper. First, an English auction is a sequential bid auction where players observe other bids and then decide whether to increase the bid or not. The auction doesn’t end until there is only one bidder left and they pay that amount. Second, a first-price sealed bid auction is an auction where all bidders submit a bid on a piece of paper and the highest bid wins immediately. Third, a second-price sealed bid auction is the same as the first price except the highest bidder doesn’t pay his/her bid, but the bid of the second highest. Lastly, a Dutch auction is when the auctioneer starts the process with a high price and gradually decreases the price of an item until someone is willing to pay. That type of auction then ends immediately.
Kristin gave good real world examples of each of these types of bid, as well as many variations of each type. English auctions are the most popular, as well as a popular timed variation, the silent auction. Auction houses such as Sotheby’s immediately come to mind. The sealed bid auction types differ greatly from English and silent auctions because the bidder must evaluate their willingness to pay up front and only get once chance to place a bid on an item instead of incrementally increasing their bid in an English auction and possibly getting an item for less than their value. Contracts are good examples of sealed bid auctions. Second price sealed bid auctions are also called “Vickrey” auctions, and prompt bidders to bid their real personal value, though disadvantages of this also promote collusion between bidders. Ebay is considered an online version of a second price auction.
There are plenty of advantages and disadvantages of auction listed. Auctions are great ways for sellers to quickly get market value for their items, as well as quickly bring together qualified buyers. They are also the fastest way available to convert assets into cash. Sellers are able to set the parameters of the sale and buyers prefer this as well because they normally get a better deal. Disadvantages include that fact that all information about an item and bidders’ preferences are not fully shared. It’s also hard to appropriately price items when bidders’ have different personal opinions.
Comparative advantage and trade (How do you determine your comparative advantage?)By Regina Gauger
It’s obvious from Regina’s research that comparative advantage can mean different things, as well as have very different definitions. An economic definition says that comparative advantages exists when two or more parties such as individuals and firms can both gain from trading if they have different relative costs for producing the same goods. Comparative advantage can also be defined as having the lowest opportunity cost between different individuals or firms in producing a particular good. Also, David Ricardo, an early influential economist, also described comparative advantage as “mutually beneficial exchange is possible whenever relative production costs differ prior to trade”.
There are several examples of comparative advantage. Regina focuses on two industries. First, the technology industry and Apple in particular is examined. One cited source claimed there is a three version rule in the technology industry. This means that a tech firm will usually need three versions of a product before they really get it to where the consumer likes their product. However, Apple seems to get consumers behaviors and wants after only one version. But it’s Apple’s marketing that really gives them a comparative advantage. They master their vision and excel at promoting features consumer want in their marketing campaigns.
The apparel industry is the second industry Regina focuses on. Another source claims that Pakistan has a large comparative advantage in this industry. This is due to the quality of the cotton grown inside their borders. Due to this, they can produce denim, flannels, fleece, and knits as a significantly cheaper cost than others.
The next section tackles the question of how to assess if a firm or individual possesses a comparative advantage. Consumer preferences and cost metrics seem to be the best way to determine if someone owns a comparative advantage over their competitors. Plus, an individual or firm’s natural surroundings are a great place to look for one as well.
Lastly, Regina discusses some opposition to the defined terms of comparative advantage, or more a different way to view it. Economic principle tells us that comparative advantage exists when someone can product a product more cost effectively than another. Her sources claim though this may be true, there are many times when firms or individuals still choose to outsource those activities. This is because though an advantage may exist, that particular party may have an even greater advantage at something else, and freeing up labor and resources is more beneficial.
Monopolistic CompetitionBy Dan Kreitl
Dan describes monopolistic competition as “the middle ground between perfect competition and a monopoly”. Essentially, a perfectly competitive firm sells identical products to its competitors and a monopoly sells a unique products. This makes the perfect competition firms price takers and the monopoly firm a price setter. Everything in between these two markets is called monopolistic competition.
Dan next further defines the two markets described above, a monopoly and perfect competition, because the two of them combined are what make monopolistic competition. A monopoly, on top of being a price setter, owns nearly all of the market for a given product or service. Barriers to entry allow a monopoly to operate without competition. Barriers to entry can include economies of scale and governmental regulation. Firms with monopolies will usually produce less an amount less than socially efficient.
At the other end of the spectrum, perfect competition allows for a free flow of information, helping keep barriers to entry out of the market. This produces a large number of sellers. This means heavy competition allowing buyers to set prices they’re willing to pay.
Monopolistic competition therefore, is characterized by many sellers that produce similar, but not identical products. A degree of differentiation exists that allows each supplier to set their own price. They can’t completely control price though, because at a certain level, consumer preference will cease driving purchasing decisions and they’ll switch products.
Dan then goes into more depth on the properties of monopolistic competition. These include free entry, product differentiation, many buyers and sellers, limited pricing power, and a downward sloping demand curve. All of these characteristics are explained above except the downward demand curve. This shows where and why a monopolistic firm produces supply where marginal revenue equals marginal cost.
Oligopoly
By Kevin McNutt
Oligopoly is a certain type of market where there are many buyers and few sellers. Because of this, each firm is large in size compared to the industry as a whole. This market is described by no barriers to entry for buyers, but there are barriers for sellers. Oligopoly firms are normally well known too, preventing any new entrants from severely threatening their market power. Such industries and firms include Satellite TV providers (Dish, Direct TV), auto manufacturers (GM, Ford, Chrysler), oil companies (BP, Shell, Chevron) and soda manufacturers (Coke, Pepsi).
Kevin explains how an oligopoly structure brings a lot of game theory into play between the competing market firms. This is because with so few firms, the pricing decisions that firm A makes will have a profound effect of firms B’s profits. But this works both ways, as firm B knows firm A’s decision will affect it, it will have contingencies for any decision firm A makes. These reactions correlate into reaction functions. This leads to multiple types of oligopoly pricing models.
Cournot oligopoly is the first model. In this type of model, firms can produce either the same of different products. However, the main principle of this model is that firm B will maintain the same level of output regardless of what firm A does. This leads to equilibrium where neither firm will ever change their output because it does not better their profits. The Stackelberg model has similar characteristics as the Cournot model but differs in that the market will develop into a leader-follower situation. In short, firm A will set output and only then will firm B and C etc. set output. Their output will reflect how they can maximize profit based on firm A’s decisions. The Bertrand model also has similar market structure and characteristics as the first two. However, these participants compete on price by setting their price equal to marginal cost.
Collusion is also a major factor in oligopolies because of the few number of firms. By working together, or colluding, firms can eliminate all consumer surpluses and completely maximize their profits. End the end, oligopolies are somewhere between free trade and a monopoly. Market structure will create higher prices than free trade but not quite as high as monopoly prices.
Supply and Demand (Also, include private goods vs. public goods, marginal analysis, producer and consumer surplus and how it applies to perfect competition)
By Thaddeus Bogardus
Thaddeus started this topic by listing in detail many different economic principles needed to have a basic understanding of economics. These included: law of demand, market demand curve, market supply curve, consumer and producer surplus, equilibrium price, private and public goods, marginal benefit, marginal cost, and price floor and ceilings.
Next, he went into reasons for demand and supply curves shifting. Reasons for demand shifts are consumer income, prices of related goods, advertising, population, and consumer expectation. Concerning consumer income, demand will shift inward or to the left for an inferior good. This means that as income rises, demand will fall. Demand will shift outward or to the right for a normal good. This means as income rises demand rises as well. Prices of related goods will have the same effect as consumer income. As substitutes rise in price, this will cause demand for an item to shift outward, or to the right. As prices for complements rise, demand for a particular good will shift inward, or to the left.
There are five supply shifters as well. These are: prices of inputs, the level of technology, number of firms in the market, taxes, and producer expectations. These will also shift the supply curve inward to the left or outward to the right. For instance, as the price of inputs increases, supply will decrease, or shift inward to the left and vice versa. Technology is a big shifter, and as it advances and makes products cheaper to manufacture, supply will increase by shifting outward to the right.
Thaddeus gave great real world examples of both shifting of supply and demand. He used tablet technology, the wine market, gasoline, and water and energy to illustrate the economic principles in play.
Weekly Posts
Week of 10/3 - Baye's Case Answer and Overview
Before jumping straight into a weekly discussion about real world pricing strategies and stories for related goods, I'd like to take a moment to discuss Baye's answer to Memo 3 of the Time Warner Case.
Memo 3 discusses pricing implications and strategies for two related goods, HD televisions and HD programming. These two goods are provided by seperate companies. There are a number of different HDTV manufacturers. Time Warner is the HDTV programming provider. This case specifically discusses future profitability for the the HDTV programming sector of Time Warner. They believe that HTDV programming provides superior services to basic analog television and the value it can add to their customers can be a great revenue source going forward.
There are a few roadblocks ahead for them to be successful in the market. The two main issues revolve around the expensive nature of HDTV's at the time. Prices for basic sets ranged from $1,000 to $7,000. Studies showed that consumers were unwilling to spend that much money for an HDTV set, mainly due to a lack of HDTV programming available at the time. Program producers and distributors, like Time Warner, were unwilling to spend large amounts of money on the programming when consumers didn't have the sets to view it properly. This creates a catch 22 of sorts.
In Baye's answer, it is proposed that Time Warner sharply increase their production of quality HDTV programming as an incentive to get sonsumers to purchase net sets. Survery's have shown that consumers would be willing to pay to view sporting programs specifically in high definition. It is also proposed that Time Warner penetrate this market with low starting HDTV subscription prices. Once they reach a "critical mass" of customers and they can begin offering a greater variety of programming and charge subscription prices more in line with the value derived from the programming - aka - at a higher price.
It seems Time Warner is proposing to eat a lot of initial equipment and production costs now in order to penetrate the market more than competitors and come out ahead 3 years plus down the road when the sets become more affordable.
In the coming weeks, I'll discuss the different types of related goods, and how demand for each changes based on their own price, and the price of other goods.
Week of 10/10 - TV Cont...
Continuing with the television provider theme, Comcast and other companies use bundling techniques and introductional promotional pricing to get customers hooked on their products, then raise prices after 6 months. Oregon Live.com goes even further stating "Death. Taxes. And cable TV rate increases. All sure bets." (http://www.oregonlive.com/business/index.ssf/2010/11/comcast_sets_annual_rate_hike_1.html). Programming consumers across the country are all experiencing these same price increases. Comcast is banking on consumers getting hooked on their products and will be willing to pay extra each year to keep them.
Programming providers also routinely force customers into contracts, claiming to keep prices down during the life of the contract. For instance, Comcast currently offers HBO, SHowtime, and Cinemax as promotional "free" compliments to their basic HD programming guide for six months. Afterwards, when the customer has become accustom to having these premium channels, the prices will go to $5.99 and up for those single channels. Comcast also bundles their HDTV programming with their high speed internet. With bundling, the internet will only cost you $42.99/month, compared to $59.99/month on its own.
References and Links
Oregon Live.com, Web. Accessed Nov 2011. http://www.oregonlive.com/business/index.ssf/2010/11/comcast_sets_annual_rate_hike_1.html
Week of 10/17 - Complementary Goods
How related goods are priced relative to each other and to consumers depend on what type of goods they are and the environment of the consumer. Complementary goods are the first type of related goods needing mentioned here. When pricing complements, it's important to remember that demand a good will increase or decrease as the price for the other good does. The two complementary products in the Time Warner case above illustrate this fact. As the price of HDTVs decreased over the next decade there will be a steep increase in the demand for HDTV programming. These goods are also normal goods, which are they are going to be in more demand as consumer income increases. The more money a consumer has, the easier to buy one of those expensive HDTVs and programming to go with it.
Week of 10/24 – Movie Theaters
Another great complementary pricing example customers routinely encounter are concession prices at arenas and movie theaters. After paying gate prices for movies, sporting events, or concerts, consumers are subjected to insane concession prices. In this Stanford Business School Review, "Why Does My Popcorn Cost So Much?" (http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html), concession prices are examined relative to gate prices. The article claims that these exorbitant prices are actually beneficial to movie goers, keeping the gate prices down and allowing the frugal spender to keep seeing films on the big screen. The facts seem to back up these claims, as it’s noted that 20 percent of a theater's gross revenue comes from concessions, but 40 percent of their net profit comes from concessions. This is due to the fact that theaters have to share ticket revenues but not concession revenues.
It's always going to be a struggle and fine line that companies need to walk when thinking about how to price two complementary goods. Especially if one of them is only appealing after the first good is bought. In the movie theater case, there's no profit on unsold concession food if the gate price is too high to get lots of consumers through the door.
References and Links
Stanford Graduate School of Business. Web. Accessed Nov 2011. http://www.gsb.stanford.edu/news/research/hartmann.popcorn.html
Week of 10/31 – Lock-In and the Razor Blade Model
“Customer Lock-In” is defined as when companies force consumers to use their products without spending substantial money on switching costs. The razor blade market is infamous for using this type of economic principle. In fact, when people talk about pricing related products in today’s terms they often refer to the model as the razor blade model (http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw). An analysis of the industry is below, and really shows how companies in the industry use the “Customer Lock-In” principle to their advantage.
There are two main players in the disposable razor blade market; Gillette and Schick. Their products are the classic example of hooking consumers with a low cost entry item (razor) and then providing a complementary item (blades) that consumer must continually return to purchase in order to keep using the original item.
In all likelihood, Gillette and Schick are selling razors at a loss. They do that because they know that once a customer has purchased a particular razor, they will continue to buy disposable blades that only fit that particular razor. They may be able to charge more for the blades than their competitor and the customer will pay that price because they don’t want to pay the costs associated with switching to another brand razor, even if the blades are a little cheaper. This proves the “Lock-In” principle works. Here, consultant Rafi Mohammad explains why it and the razor blade model works: http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm.
So manufactures take this loss b/c they know once consumers have bought one particular they can sell their higher margin complementary good (the blades) over and over again. Once a razor has been on the shelves for a while, both these companies will come out with a razors with “more blades!” that claim they make shaving more comfortable. Once consumer upgrade they require different blades that starts this whole process again.
Yet another example of this model mentioned in the link above was when the next generation gaming consoles (Xbox, PlayStation) were first being manufactured and sold. These consoles were costly to manufacture and were sold at massive losses. However, the best feature was the online gaming capabilities. To make up for early losses, Microsoft specifically charged monthly subscription fees to players. The costs associated with these purchases locked consumers into the xBox gaming console. This became very important down the road a when Sony launched their free online gaming community through the PlayStation. Xbox customers were unwilling to switch over even though Sony offered a free online platform because of all the money already invested into Microsoft products.
Resources and Links
http://www.investopedia.com/ask/answers/08/razor-blade-model.asp#axzz1fODa98rw
Mohammad. Rafi. Web. Accessed Nov 2011. http://www.pricingforprofit.com/pricing-strategy-blog/real-reason-to-use-razor-razor-blade-price.htm
Week of 11/7 – The iPhone!
Maybe the most economically interesting case of related goods and lock-in during the last 5 years is seen when examining the market for iPhones. Until the past year, iPhones were available to purchase only for AT&T wireless network customers. They offered iPhones at huge discounts when switching networks or signing new 2 year contracts. They then (and still do) forced large monthly data subscription fees on consumers to take full advantage of all the iPhone’s best features.
The iPad has been AT&T’s latest weapon used to lure consumers to their network. In this WSJ article (http://blogs.wsj.com/digits/2010/01/28/att-on-ipad-economics-new-york-and-san-francisco/) from two years ago, they discuss why the iPad went unsubsidized by AT&T, unlike the iPhone. They also discussed how they would have a differently priced monthly subscription plan from the iPhone, mainly because they envision the iPad being used in the home more.
Just like the examples earlier, AT&T has used their iPhone/iPad exclusivity for half a decade to lure customers away from competing networks (Sprint, Verizon). They were able to substantially improve their position in the carrier market, despite having one of the worst networks for reception around. They are well known for dropped calls and poor overall poor service. Essentially, AT&T was a complementary good to the iPhone. AT&T’s iPhone monopoly is explained here: http://www.thestreet.com/story/10777804/1/atts-iphone-monopoly-todays-outrage.html, with AT&T’s response to those claims found here: http://www.thestreet.com/stock-market-news/10777969/att-responds.html.
Week of 11/14 – iPhone market changing…
The iPhone market is changing (http://www.econtech.com/newsletter/january2011/january2011a2.php). In January 2011, it was announced that Verizon (and since Sprint) would begin selling and carrying the iPhone on their networks, along with AT&T. This adds much needed competition to the market and will allow consumers to eventually change carriers if they feel Verizon or Sprint offers better service without having to give up the iPhone. This change will force AT&T to either improve their network, or make it cheaper to the point consumers wouldn’t jump to a better performing competitor. Because the AT&T/iPhone exclusivity is gone, Verizon and Sprint have become substitute complementary goods to the iPhone. There are different pricing strategies these companies now face due to the entrance of competitors in the iPhone market, one of them being pricing the phones extremely low to prevent other entrants into the market.
Week of 11/21 – Substitute Goods and Pricing
By definition, a substitute good is any good in which an increase or decrease in price leads to a correlating increase or decrease in demand for another good; such as brand name and generic products. Grocery items and prescription drugs are common products that consumers must make daily pricing decisions on between brand name and generic offerings. Many times, patents on new prescription drugs make substitutes impossible, forcing insurance companies to pay higher prices for their customers drug related needs. A year or two later when the patent expires, the same insurance companies will refuse payment on brand name drugs, forcing their customers to lower cost generics. This is an example of the higher price leading to a greater demand for the generic.
Another tech industry example of substitute goods are the ever popular e-readers. Barnes and Nobles Nook and Amazon’s Kindle are definitely substitutes, where initial pricing is ultra-important. This is because once consumers pick one or the other, the lock-in principle comes into play once more. These e-readers are upwards of $150, and that is a lot of switching costs for someone wanting to go from one to the other. So even though these two products are substitutes, it’s important to price them accordingly because their individual complementary items attached to them most likely have a higher profit margin. The apps, books, magazines, etc purchased on one product can’t be transferred to the other. They can attach higher price tags though because of this and not fear consumers switching as easily. Here, Dan Costa at PCMAG.com, explains how the lock-in principal affects e-readers: http://www.pcmag.com/article2/0,2817,2386266,00.asp.