Version 10/13/01
You will note that there are links from many of the words and phrases in this text (hyperlinked.) By clicking on these links, an additional browser window will open. Many of these links will take you to a Dictionary of Terms, in order to explain the word/phrase (other links take you to other relevant documents.) The purpose of the Dictionary of Terms is to allow many users, with different levels of knowledge, to benefit from the text. If there is a term in the text you feel should be better explained, please email me at alex@udel.edu and I will include it.

The internet has changed some fundamental economic principles, especially with respect to digital products. Economics clearly still plays a key role in understanding the business environment. The rules are changing. Understanding these new rules will allow us to better understand the principles of a networked economy.
This material looks at:

Reach, Richness, Flexibility Trade-off.

Traditionally there is a trade off between richness of communication, the reach of the communication and the flexibility of the communication. For instance, if one wants to communicate a message to a large audience, quickly, then perhaps running a TV commercial makes sense (high reach, low richness). This medium is, however fairly limiting in the quality of message that can be conveyed in a 30 second commercial. At the other end of the scale, a salesperson is able to spend a significant amount of time with each customer, tailoring the marketing message to the individual customers needs. The salesperson is also able to execute a transaction with the customer. However the salesperson is only able to communicate with one person at a time (high richness, low reach). This trade-off in communucation is very accepted.

The web is the first medium that allows for a rich, unique and flexible communication, to many people simultaneously. Each customer controls the type of information he or she receives, based of his/her needs. The unique path each customer takes through a web-site presents a unique set of information for that person. Complementing this, a site is able to tailor its presentation based on the individual's previous experiences with the site, using information from the cookie file. If you have not experienced this, you will if you make a purchase from Amazon.com. Thus a website is able to offer a rich set of information to the entire audience of the marketer, simultaneously, at little marginal cost to the marketer. Not only is the website able to do this, it is also able to facilitate many activities that are vital to the marketing of a product or service (high flexibility). This includes not only the marketing literature, but customer service needs, transaction needs and community building. As you review the Wharton MBA Admissions Website note that it is designed to accomplish many things to satisfy many types of customers' information and transaction needs (regardless of their stage in the "purchasing" process). A business school candidate can:

No other medium is as flexible and therefore able to accomplish so much, at significantly reduced costs. Marketers should consider the web as the central component of their marketing program, reducing costs AND increasing marketing effectiveness, simultaneously. This destroys the paradigm that increased marketing initiatives necessarily increase marketing costs!

**Discussion Topic: Evaluate your company's web-site with respect to communications, transactions, customer service and community building efforts. Identify one area that you believe can be improved. Make sure to cite the web address. (Note: You may have already done this from a previous session.)

Cost Structures

Cost structures of digital products are very different from the traditional manufactured good. Costs are typically made of up Fixed costs and Variable costs. Fixed costs (such as rent on a manfacturing site) are fixed over a given number of units produced. Therefore the more units that are sold, the lower the average cost per unit. Variable costs are fixed per unit produced. Examples include materials for the product.

With digital products a large component of the cost structure is fixed, and sunk. Sunk costs are non-recoverable fixed costs, including research and development and human capital. Since these costs are sunk costs, they should not be considered in future decisions about the marketing of the product. Digital products typically have small variable costs, and can have zero variable costs, assuming the product (software for instance) is being marketed directly from the web-site, with no distribution or packaging costs. Thus with a cost structure that is mostly fixed (and sunk) and not variable, it effects the decisions one can make about marketing the product.

A few factors that support the ability to have zero marginal costs include:

In competitive markets, where more than one firm/product compete for the same consumer needs, this competition will tend to drive the price of the products close to the marginal cost of the product, since any revenue over the margin will contribute directly to recovering the sunk costs and contribute to the profit. Thus, if two competing software packages are competing for the same market, accounting packages for lawyers, for example, and assume they are the only competing players in this niche market. Their products have identical functionality. Firm A spent $2 million developing the package, and retails it over its website. It has marginal costs of $1.50 per unit. Firm B spent $4 million and retails the package over its web-site, and its marginal cost per unit is $1. All fixed costs are considered sunk costs, in this case. Each dollar gained from the price (over the marginal cost) of the product contributes to the company, contributing to the fixed costs and then profit.

**Discussion Topic: Which company, A or B is likely to be the stronger competitor in the marketplace? What are the long term implications of these costs structures to the competitive nature of the marketplace? What assumptions do you need to make?

**Discussion Topic: Think of your own examples of products that have zero marginal costs?

Product Differentiation

Due to the unique cost structures of digital products (high fixed costs, close to zero marginal costs,) this allows for some interesting possibilities for differentiating products in the marketplace. If one wanted to introduce multiple products into the marketplace, to satisfy different needs of different customers --- and one is producing automobiles, then there is significant fixed and variable costs associated with each style of product introduced. For digital products this is not the case. The research and development is applied to developing the core product, this product is then altered to satisfy different markets. For the most part, the core product will be the most sophisticated product offered to the market (high end spreadsheet package for tax people) and the low end product uses the same code-base, with limitations ADDED. This is interesting to note, as the low end product (sold at the lower price) is actually the most expensive of the products to produce (given the additional work required to limit its capabilities). Clearly, this work could be avoided, to increase the margins on the low end product, but this would allow the high end market to purchase the low end product, if the functionality was not reduced.

A simple example can illustrate how this works. The goal is to maximize the revenue generated for the product, therefore maximizing the profits (assuming zero marginal costs):

Software version casual user: Sold at $50, size of market 10,000
Software version student user: Sold at $30, size of market 50,000
Software version professional user: Sold at $150, size of market 50,000

This gives a total revenue of: $500,000 + $1,500,000 + $7,500,000 = $9.5M
Assume zero variable costs and fixed costs of : $1M
Thus gross profit = $9.5M - $1M = $8.5M

Assume that instead, the firm decided to launch the product, without differentiation, the high-end product at $150. What are the consequences? Fixed costs (sunk) will be reduced because there will be less development costs associated with developing only one version, thus, fixed costs are reduced to: $900,000. However, due to the high price point, there is only demand from the professional user, generating revenue if $7,500,000 (150 x 50,000). Thus the product generates a profit of $6.6M.
Now assume the firm introduces the product at $30, but again, with all the functionality in place. This saves $100,000 for fixed costs (similar to last example.) The entire market will demand the product, but will have access to the product at $30. Revenue = 30 x 110,000 = $3.3 M. Profit = $3.3M - 900,000 = $2.4M.

Thus both scenarios leave the company with less opportunity to be as successful.

**Discussion Topic: What other assumptions are required to support the above examples?

Product Differentiation to Market Products

Given that digital products have small (or zero marginal costs) it is possible to give-away (or significantly discount) a version of the product in order to entice people to purchase a paid version of the product in the future, as they become more sophisticated users of the product. In the above scenario, if the marketer reduced the student version to zero, it would lose $1.5M in revenue, but still realise a profit of $7M. If this strategy increases the number of student users, which in turn increases the likelihood of increased conversion to professional users, then in the long term, this may make sense.

The only revenue the company is losing with this strategy is the opportunity cost. This works if the company can establish lock-in and the consumer upgrades to paid versions in time. Prospero.com has adopted this strategy. It has a very basic version (delphi) that is free to use for all web users. The problem marketers can face by doing this, is that if the free version is very limited in its functionality (has to be somewhat limited or there is no incentive to upgrade to the paid version) this may create a poor perception of the product in the consumers' mind.

**Discussion Topic: Can you think of other examples of product differentiation? Can you think of other examples of free products that are used to encourage users to upgrade?

Installed-Base

Installed-base is the term used to reflect the marketer's customer base. The value of the installed-base to the marketer is essentially the value that can be placed on the company. Thus as marketers build their installed-base, they will consider the following issues: Lock-in refers to the strategies/tactics in place to more closely align the customer with the particular product in the marketplace. A marketer will lock the customers into their product when costs (switching costs) are associated with the customer selecting another product. In its most basic form, lock-in can come from the marketer having data on the customer, such that the marketer can use this data to better present their products to the customer on return visits. Ebay is a great example of establishing lock-in for its customer base. Its customers are essentially both the buyers and the sellers that trade on Ebay. Once you have performed a transaction on Ebay, you have a historical record that other users can use to determine whether they want to trade with you (building a reputation). Once you have built up a good reputation on Ebay, you have created a cost that is associated with you moving to another online auction service. Your established reputation, which in turn will translate into dollars, becomes your cost to switch to another online auction system.

Switching Costs refer to the costs of a customer (or entire customer base) switching from one competing product to another. Telephone companies are an good example of companies that estimate the switching costs of consumers, and then develop an incentive program to encourage consumers to switch from one competitor to another. (Surely you have experienced the phone calls to encourage you to switch!) Once the telephone company estimates that switching cost, and calculates the life-time value of a customer then the company will try to grow its installed base by trying to encourage customers to switch. As long as the switching cost is less than the life-time value, there is incentive available to encourage a switch. If lock-in can be established within the customer base after the switch, this clearly increases the life-time value of the customer as it increases the switching costs.

The Life-Time Value of a customer, is the value placed on a customer, to the company, for the life-time that customer will remain with the company. This calculation is often used to estimate the overall value of a company. It increases as alternative revenue streams are established from the installed-base. For example, if the telephone company is able to sell additional services to its installed-base, on top of the traditional phone service, then they are able to increase this value. They may also sell the data of their installed-base to third party marketers who are interested in selling additional products. etc.

Is the auto industry able to establish high switching costs? Why or why not? How about the airline industry? What do they do to create switching costs?

Network Effects

Digital products that benefit from connectivity may experience network effects. The idea behind network effects is that as the number of users of the network increases, the value of the network to each user also increases. This is also known as increasing returns to scale or demand-side economies of scale. This is clearly a different phenomena that we are used to with the industrial age, the notion of diminishing returns to scale. Diminishing returns holds that as the number of users increases, the value to each user diminishes. (Imagine if everyone owned a Porsche motor car, the prestige of being a Porsche owner loses value to each owner).

The Fax effect is an excellent illustration of network effects (and increasing returns). When the fax machine was first introduced, it was an expensive product, and the product needed additional owners for it to be useful. Thus, the buyer of the first fax machine had no use for it, since there was no one to communicate (no value). As more fax machines were purchased, the value of each fax machine to each user increased. This also drove down the costs of developing the fax machines (economies of scale and learning curve effect) which reduced the price of the fax machines, which increased the demand for fax machines, which increased the value of each machine for each user (and so it goes on.) The positive spiral that occurs enabled the fax machine to become an industry standard for transmitting digital documents.

This is also known as Metcalfe's Law: The value of the network to each user is proportional to the number of other users. The total value of the network is proportional to n x (n-1) = n squared - n. (n is the number of users in the network.)

Network effects are one of the reasons first-mover advantage can occur. As the first player in a new market, if the marketer can take advantage of network effects and create a positive spiral, they can make it very difficult for other marketers to enter into the market. The first mover will also move down the learning curve very quickly, and this will reduce the average cost of the product, creating margins that later entries into the market will find difficult to compete with. It is important that the first-mover tries to establish lock-in. Clearly this does not always work effectively. Microsoft has done a wonderful job of never being the first to a market! (netscape, mac)

The combination of network effects (the more users, the more valuable the product to each user) and the learning curve effect (the more units developed/experience developing the product, the lower the average costs of the product) leads to a "winner takes all" scenario, where markets work more effectively if one company (standard) controls the entire market. In fact as competing companies in the market go head to head, as one company reaches its tipping point and experiences increasing returns due to positive spirals etc., the competing company will experience a negative spiral as it loses customers and increases its average costs per unit. One can also argue that it is economically inefficient to have more than one company compete in a marketplace for digital products, where all costs are fixed and sunk. Each competing firm would be adding to the total investment made in development costs of creating the product.

These same effects are not relevant for industrial goods, whose organizations typically experience diminishing returns once they reach a certain size. Thus we see many traditional industries operating as ologopolies (car industry for example) as they discover their optimal size of operation.

**Discussion Topic: Cite examples of other products that exhibit network effects.

Standards

Digital marketplaces are much more efficient once a standard for the marketplace is established. Standards are able to increase the overall size of the market as the market itself increases its utility for each consumer.

Standards typically evolve in different ways:

WINTEL (Windows and Intel) is an example of a proprietary-standard that has helped consumers communicate with each other. It is comforting to know that the receiver of a document will be able to read the document a sender emails. Imagine if there were several competing software vendors, marketing incompatable software, competing in the office suite market. It would create a fragmented market, which would undoubtedly reduce our ability to communicate efficiently. While traditional market thinking suggests several competing players would create a better marketplace creating more choice for consumers, here we see developing a standard actually creates a more robust market (a function of a networked market place, where connectivity between consumers is a function of the product). In the above case, the standard is propietary. (Controlled by commercial organizations.) This does not have to be the case.

TCP/IP is a communications standard, that allows any computer to talk to any other computer on the internet. Without this communications protocol, we would not have the internet. Thus TCP/IP is a non-proprietary standard that has enabled the worldwide internet. A non-proprietary standard (unlike the Wintel proprietary standard) is open to the public, and not owned by one company.

A couple of examples of Open Standards, that are overseen by industry bodies include the language of the web, html, overseen by the w3c.org, and the development of 3D on the internet, overseen by www.web3d.org. The Internet Engineering Task Force oversees much standard setting related to internet architecture.

A couple of examples of standard setting to establish markets a few years ago can help illustrate some interesting points.

The standard railway gauge in the United States was not always so. Many years ago, for goods to pass all the way across the country, they had to travel by one rail track, then be unloaded and reloaded to another train, to continue travel, due to the different rail gauges being used (at one point, there were seven different gauges in use!) Clearly this limited trade, and created industries within communities whose work relied on transferring goods from one railway line to another. Once the railway gauges were consistent, trade immediately increased.

** Discussion Topic: Standards can evolve in strange ways. What is the history of the now adopted standard 4 foot 8 1/2 inch railway track gauge? Where did this gauge originate, and why? Can you think of other examples of the evolution of a standard.

The QWERTY example is an interesting case study of an entrenched standard. The keyboard layout that we are used to was developed many years ago, in order to slow down our ability to type (also allowed early salespeople to impress their costomers, since they could type the brand name, typewriter, using the top row of the keyboard only!) Typewriter keys at the time were prone to get stuck together, if the typist typed too fast. Soon, typewriters overcame this technical glitch, but QWERTY has stayed. In fact, a more effective keyboard design (Dvorak layout) was introduced, but never had a chance to become a standard. Even if it is easier to teach new users to type using the new layout, companies would not be encouraged to adopt the new design since its current employers were familiar with the old design, and new users would rather learn a keyboard layout that gave them skills that they could transfer from one organization to another. Thus while learning the new design may have been easier, it had much less value to the user. The collective switching costs of users from one standard to another was too high. A detailed review of the evolution of the QWERTY standard appears in the essay: Clio and the Economics of QWERTY

The development of the internet is another interest case study in standards. Many proprietary companies attempted to develop the standard for online networks. These included compuserve, genie and prodigy (no longer living!) and aol and microsoft (now gateways to the internet). From the early 1980s to the mid 1990s these companies competed with propietary standards to develop their online communities. Each developed their effort with a blind eye turned to the internet. This changed in the mid 1990s when realization set in that the open standard internet was going to become the network. Even subsequent to this, Microsoft believed that it had the power to force Word to become the standard language of the web (replacing html). This clearly did not happen. This is a good example of an open standard becoming more robust, more quickly than many competing proprietary standards.

Setting Standards

When developing a new product, in a new market place, a significant consideration a company is faced relates to the standard setting for the market. Should the company try to establish a proprietary standard (as Front Page did for web authoring tools) or develop an open standard that competing companies would have access. The second strategy assumes that this will allow the market place to grow faster, and the pioneer is able to take first mover advantage. Clearly decisions will be a function of the current nature of the marketplace (does a standard already exist ... does it make sense to join a current standard or develop a competing standard etc.) What is clear, however, is the success of an individual firm, in a networked marketplace is dependant on its relationships with other firms within that marketplace. It is unlikely that one firm can provide a full end-to-end solution for a consumer, that does not rely on other vendors. This dependance on other companies means there is considerable likelihood of the need to develop alliances in order to help establish standards and interfaces across products that improve interoperability. Much work in game theory can be applied to business alliance forming, and the Prisoner's Dilemma framework has been used to explain how businesses should behave in terms of cooperation in developing interoperable marketplaces.

**Discussion Topic: Identify a company which developed an open standard, successfully. Identify a company that has developed a (business / consumer) solution that does not require dependance on other firms within the marketplace.