Digital Economics II: Why Pricing Is Getting Both Complicated and Critical. (Tech Strategy – Podcast 53)

This podcast is more about the strange but important economics of digital. And on pricing, in particular. It is becoming increasingly complicated with bundling, switching costs and platform business models.

You can listen to this podcast here or at iTunes, Google Podcasts and Himalaya.

This is part of Learning Goals: Level 7, with a focus on:
  • #29: Digital Economics II

Concepts for this class.

  1. Combinatorial Innovation
  2. Price Discrimination
  3. Common Pricing Strategies (Penetration Pricing, Market Skimming, Survival Pricing, Maximize Profit Pricing)
  4. Pricing and Switching Costs
  5. Switching Costs

Companies for this class:

  • n/a


I write, speak and consult about how to win (and not lose) in digital strategy and transformation.

I am the founder of TechMoat Consulting, a boutique consulting firm that helps retailers, brands, and technology companies exploit digital change to grow faster, innovate better and build digital moats. Get in touch here.

My book series Moats and Marathons is one-of-a-kind framework for building and measuring competitive advantages in digital businesses.

Note: This content (articles, podcasts, website info) is not investment advice. The information and opinions from me and any guests may be incorrect. The numbers and information may be wrong. The views expressed may no longer be relevant or accurate. Investing is risky. Do your own research.

——transcription below

Welcome, welcome everybody. My name is Jeff Towson and this is the Tech strategy podcast. And the topic for today, digital economics. Why pricing is getting so complicated and critical, both at the same time. And this is just gonna be kind of some economic theory for today. This is sort of building off previous talks. In particular, there’s a podcast 15, which was about digital economics, which I call the sexy but dangerous economics of digital, and talking about why, you know, software companies can be ridiculously profitable, which is amazing, but at the same time can be absolutely brutal. I mean, most software companies, you have to basically give your stuff away for free. That’s not a great business to be in. So, it’s both awesome, sexy, but it’s also dangerous. This is going to build on that and sort of do a little bit more advanced thinking. But you didn’t have to listen to the previous one to, you know, get something out of this when you can do them in either order. Now, for those of you who are members, the key ideas for you here today are. Price discrimination and common pricing strategies for digital stuff, and then pricing and switching costs, because we’ve talked about switching costs and Pricing is actually a huge part of that. And these two subjects actually tie together. You can’t really separate them very much. And this will all go under learning goal 29, which is digital economics two. And I’ll summarize a little bit what we talked about in digital economics one. But yeah, those are the two ideas to sort of mentally take note of here. Price discrimination and common strategies and pricing and switching costs and how they relate. And for those of you who are not subscribers members, go over to You can sign up there with a free 30 day trial. Try it out, see what you think, and sort of get in full access to all the content, which is quite a large library archive at this point. And the six to seven levels we have that we sort of go through in terms of digital thinking strategy and company specific thinking. Now today’s topic subject is really mostly about Pricing I mean there’s other sort of topics. I’m gonna talk about but really pricing is the big one and Just to you know to be clear and to qualify it. This is not my thinking I don’t want this to come across of you know, oh, this is my thoughts. No. No, I’m summarizing other people’s thoughts This is pretty common Textbook stuff a lot. I mean a lot of what I talk about in this class is new ecommerce Communications media that we’re on the frontier, but the basics of sort of digital economics, which used to be called information economics. I mean, there are textbooks about this in 1990, 1995, 2000. So there are people who really have a lot of thinking on this and it’s kind of a standard topic, but it’s still, you know, turns out it’s becoming more and more important. So a lot of what I’m gonna talk about, this is just taken from textbooks. One person I do follow in this space is a guy named Hal Varian. who you should probably be aware of if you’re not. He’s kind of a huge thinker in this whole space of microeconomics and information economics. He’s an economist, a professor. I think he’s maybe an emeritus at this point. He might be close to retirement at UC Berkeley. He’s a chief economist at Google for a long time. So I mean, he’s in the center of this. And I think he actually founded the… the School of Information, or he was the founding dean of the School of Information at UC Berkeley. So, I mean, these are huge thinkers in this, but he’s definitely the one that I always pay attention to whenever he puts stuff out, which is not as common as it used to be. I think he’s pretty much retired. If he’s not, sorry, I apologize, but I think he’s close to it. So, a lot of this thinking comes from him. I don’t wanna take credit for it. Now, this is, I use the word digital. I often talk about data technology. information technology. It’s mostly the same thing. The line I draw between these is between what I would call a software engineering business and a machine learning business. Because how those businesses play out does look very different. Most of what we talk about when we talk about digital economics, we’re talking about software companies. Engineering, where you That’s generally what we’re talking about. But when you start talking more about machine learning where it’s a lot more about the data and how you process it and tag it and clean it and use it, quality, quantity, all of that, the economics actually do look very different than what I’m gonna be talking about today. But I mean, it’s all blurry at a certain point, but in my mind, that’s how I sort of break it into two zones of thinking. Now in the previous podcast, which I’ll put the detail. the link in the show notes was podcast 15, which was a review of what I called the sexy but dangerous economics of digital. I basically made a couple points there. I’ll just list them for you. But I talked about non-rivalry and zero marginal production costs, which is sort of a hallmark of how the economics of things that are not physical, you know, they’re not made of molecules. You can’t put them in a box and ship them. They’re not a labor or a service. someone cutting your hair. No, these are goods that are made up of bits and bytes, ones and zeros that don’t really exist physically. So they have very different economics and one of their characteristics that people always talk about is zero marginal production costs. The first one takes a lot of time sometimes to create, whether it’s an ebook or an Avengers movie, but the second version, you just hit Control C, Control V, and you’ve got two copies. I talked about versioning. in pricing, I’m going to expand on that. I’m not going to go through this, but a willingness to pay the consumer or the customer surplus supplier surplus is another idea, but I haven’t gone into it. Bundling and cross selling compliments. So we kind of went through those in the previous one worth reviewing if you haven’t. But in this talk, I want to just sort of take apart this question of look, why is Pricing within all of this. Why does pricing cut across almost all of this stuff? And why is it getting so complicated and Kind of super important Now within that I’m gonna basically answer five questions and I’ll tell you what they are Number one, why do innovations in software and digital? happen in clusters Like in waves and why are they happening so fast? The waves are much bigger than we’ve seen before these clusters Number two, why are sort of these standard economic effects like bundling, which have been around forever, why have they become so powerful in an information age when they really weren’t in a more traditional physical products and services age? Question number three, why is price discrimination and these choice of pricing strategies so important? And I’ll give you some standard thoughts on that. Number four, bundling, which I’ve talked about before. You know, you sell two products, you put it together with one price. Why is the pricing so important in that? Well, talk about that. And the last one, question five, is this idea of switching costs. It turns out that switching costs and pricing are tightly intertwined as ideas. And switching costs, people talk about all the time, but you really gotta think about the pricing. in that because it’s half the game. So I’ll talk about that. Okay, and today’s class is really just gonna be me lecturing. We’re not gonna do a case. I’m not gonna go through any particular company. I’m just gonna sort of get through, these are all important ideas. You have to understand this stuff. The best way to understand it is just repeat, repeat, repeat. I go through this stuff all the time and I always catch little subtleties. So that’s kind of sort of standard lecture today. Combinatorial innovation. You’ll hear this term a lot. People kind of mean different things about when they use this term. But it’s basically the idea that a lot of innovation, sometimes I think most all innovation, new products, new services, new business models, are really about taking things that exist and putting them together. It’s like a mix and match exercise. Like South Park, the TV show, and those, the two guys behind it. Trey Parker, Matt Parker, Trey Stone, or the other way around. They’re famous for doing this. I mean, they just take random things and put them together, and it’s something new. So they said, let’s make a musical, and let’s make it about the Mormon religion. Stick those two together. Let’s make an action movie, and let’s make it with puppets, which was Team America. And they do this all the time, is they’re always just mixing and matching random things together. So you see this a lot in the media, you see a lot in the creative world. But it’s this idea that a lot of innovation is really just doing that, but you gotta have, things have to be out there. So there’s this idea of that innovation happens in clusters, it happens in waves. Human history sort of goes along and then we get an innovation wave and a whole bunch of stuff gets created. And… let’s say an example of that would be the industrial age, 1800s mass production, factories making everything from tables to train parts to whatever to tractors. There was kind of a wave of innovation that happened. And one argument for this is you see this sort of combinatorial innovation, these waves, these clusters. They kind of happen when a full suite of components is finally in place. Like the parts are there and the tools are there and people just start using them and putting stuff together. Now in the industrial that age, I mean, the parts you’d think about are, okay, there were gears, there were pulleys, there were cams, there were chains. We had a lot of mechanical components. that all got created, there was a full suite of them, and everyone just started going crazy and making stuff. Sewing machines, refrigerators, appliances, trains. You know, this goes through the late 1800s, and then, you know, really around the time, bicycles, things like that, and then about the time automobiles come around, 1910 to 1920, and then later airplanes. We see, you know, a city of a larger version of this. but you’re really taking mechanical components and putting them together in lots of combinations. And so one, the sort of suite of components are there, and then it sort of unleashes all this creativity by people all over the place, factories all over the world. People start doing this stuff. So that would be one sort of innovation wave. Another one people routinely point to is in the 60s and 70s when microelectronics. really started to emerge and suddenly we went from transistors to CPUs, microprocessors, and people started to put together all sorts of crazy stuff for the first time. We had calculators for the first time and games and all of that. So we sort of saw a microelectronic wave in terms of innovation again, but it was a different suite of components that were now available to everybody. So you hear this discussion a lot, but people use different language. Schumpenter, the famous sort of destructive innovation guy, he talked about innovation happening in clusters. He called it recombinant growth. People talk about general purpose technologies that can be used widely like electricity. So there’s a lot of ways people think about this idea. And I am definitely not one of those thinkers. I’m just citing what other people say. Another explanation you will hear for all of this is the idea of compliments. That certain things compliment each other. That you need, the more compliments that exist, the more it adds value to each other. You know, having a car is not terribly useful unless you have roads. Roads and cars are compliments, as are gas stations. You need road, gas stations, and compliments. let’s say train stations, trains, little towns that are along the train route. And then along the train route, you have these sort of pop-up towns you can get off and stop at and have lunch and stay in a hotel. I mean, these things all sort of add value to each other. Well, you could look at how, you know, at a certain point we see a suite of complements that emerge and usually they all kind of depend on each other, which is why it’s hard to launch new technologies. because you often need all of these compliments in place before a new technology takes hold. And one of the reasons cars became adopted fairly quickly for those times was because the roads and the gas stations already existed by the time that they hit. The roads, people were using them for horses and bicycles and farmers would use gasoline for their tractors and stuff. So that stuff was already there. So the compliments were in place and therefore, then we saw this sort of wave of innovation. So that’s another way to think about all of this. Now, brings me to the point, why did it happen so much faster when we moved from physical stuff, which is what I’ve just been talking about, to information-based goods, software, to some degree hardware, CPUs, everything on your smartphone. We’re seeing these waves of innovation, but they’re happening much, much faster. than we’ve ever seen before. Well, this gets us to the point of digital economics. Why are they happening so fast? Well, there’s a lot of reasons. Let’s say the first internet boom of 1998 to 2000, 2001. I’d say we’re still kind of in the boom. That was more of a stock market boom than an innovation boom. But the obvious reason is there’s nothing physical, right? I mean… You don’t have to make the parts and ship them all over the world. So suddenly everyone has the right component parts in their warehouses, in their factories. I mean, you could just download stuff. It’s all intangible. I mean, the ideas we’re talking about, the components, the complements, they’re mostly ideas. They’re intellectual property. They’re lines of code. They’re standards. They’re protocols. They’re programming languages. There’s APIs, there’s apps you can use. I mean, it’s just sort of all intangible and mostly intellectual property. Well, that’s pretty easy to share and easy to combine. There’s no delays. You don’t have to wait for this technology to slowly make its way across the geography. Once someone loads a nice app, anyone can download it anywhere. Available everywhere, no delays. One of the interesting things about digital economics, which I’ll talk about in a minute, is we don’t have capacity constraints. A factory can only produce so many tires or so many pulleys or so many chassis. If you have a nice API, a nice piece of software, people can load it once, download it once, twice, a million, 10 million. It’s like having a factories that don’t have any limits. So no capacity constraints. Open source was a big, big deal. Open source is powerful for a couple of reasons. One, it’s available everywhere, that’s great. But you can also sort of lift up the hood of the car and see how something was put together. Like you can’t really do that. If you wanna build a jet engine, now you can download some specs, but you really need to be trained and to have someone show you the secrets, all those trade secrets. That’s not really the case with open source. You can just download it and you can take it apart and see the code. And one, it makes things you know, sort of ideas and tools percolate much faster, but it means almost anyone can become a developer. You know, the secrets are out there. You can just sit in any city, look at this stuff and sort of teach yourself, oh, that’s how you make this work. That’s kind of important. And, you know, obviously you can just sort of put things together, software by its nature and technology by its nature. has a lot to do with connectedness and standardization. That things have to fit together. You know, your plugin on WordPress has to work and your email has to be sent and then received by somebody else. Everything you make in this space, there’s a big focus on standardization and making sure stuff all fits together. Well, that makes it a lot easier to combine stuff. So anyways, there’s a lot of reasons, but software is just a super powered version. Software and digital is a super powered version of something we’ve seen before. But it’s pretty amazing when you think about it. Okay, so that’s kind of question number one. Why do innovations in software happen so much faster and why are the clusters so big? I would say we’ve been in pretty much an innovation cluster since about 1990 and it hasn’t really stopped. Slows down and it speeds up, You know, I think it’s full steam ahead, really. Now, question number two, why are economic effects phenomenon attributes that have been around forever, but haven’t been terribly important? Why have certain ones of them become so important in a digital age? And you’ll hear people talk about this all the time. Like one of them is capacity constraints. The fact that there aren’t capacity constraints, that’s amazing. You know, it used to be like, if you want to sell a book, I sold a book, a traditional book once where you hired, you know, you worked with a publisher, you print it, it gets shipped, it goes into, you know, bookstores. And to get that thing all over the world, you basically had to either go with a major publisher that could do sub publishing contracting deals, or you had to do them yourself, but you had to basically have publishing deals in every country in the world. Cause you had to print the thing locally. You had to put it in trucks and then it had to get into the stores and sit on the shelves. And that was just the physical aspect was a total pain. And it made it really uneconomic and unprofitable. Well, and you would which would argue with the publisher is the publisher would only want to print so many in your first run when you release the book, because they don’t want to print a bunch of books that are going to sit somewhere and not sell. So they had to think about those costs. How many can you print? How much does it cost? None of that really applies once you switch over to an ebook. I mean, you put it up on Amazon, you put it up on a couple places. I can put it up on my webpage, and the day I do that, anyone around the world can just download it. All those costs and all of those capacity constraints are just, they’re just gone. I mean, that’s amazing. So that’s one effect. Second one would be the low or zero marginal costs. Obviously a big deal doesn’t exist in physical products. I talked a lot about that before but even even if it’s not software even if it’s actually is a physical product like a smartphone a CPU a GPU a memory chip. Okay. Those are actually physical components in the tech space, but even then The marginal cost of producing that extra memory chip is very very small It’s a very extreme version compared to say the cost structure of developing the thinking and developing the design. When you actually get to punching out that second memory chip, it’s actually very, very small. So it’s not just the intangible sort of digital goods. You can see it in other areas of technology. The constant fixed cost for most things. Now this one I think people get wrong a lot where they say, oh, you have a big, you know, you have a standard fixed cost to… create the marketplace platform. You had to create the code, get it up and running. But once you do that, it’s pretty much a fixed cost. And no matter how much activity is on your marketplace, your cost structure is pretty much the same. That’s true. So we call that a fixed cost sort of economies of scale situation. But I would break that into two bits. There is the upfront cost. and then there is the ongoing fixed costs to keep it running. So let’s say the ongoing operating fixed costs. Depending what type of software digital business you’re in, the first one of those can be very, very important. Developing content is actually quite expensive in either time or labor, effort, thinking. So if you’re gonna create lots of new content, there’s a big upfront cost to that. But once you do that, once it’s on the platform, then you’re in that more common fixed cost scenario. This is the difference between say TikTok and that, how do you say, Quibi? That Jeffrey Katzenberg, Meg Whitman, spectacular flame out that just went public, or they just launched it, they spent 2 billion and they’ve closed it down after six months. The difference between that and TikTok is the difference of those upfront costs. They wanted to to some degree stay in the business of funding content creation, which is that upfront cost, and then own the platform as well, which would be your ongoing fixed costs. TikTok never touched that stuff. They don’t do content creation at all. They just, you do it, you’re the user, you create the content, you upload it, they don’t touch that piece. And that front piece can actually, it can either be a cost, which is just content. That’s a good example of that one. But it can also just be difficulty. Doesn’t have to be a huge expenditure of money. Sometimes it’s just cracking the IT and figuring out how to design the new drug or design the algorithm. Sometimes it’s a matter of difficulty, not just throwing money at the problem. It’s actually making a movie like Frozen. and these animated singing movies, the hardest part of that is not spending the money. I mean, if you wanna make an action movie, you can pretty much throw money at the problem and you’ll have an action movie. But to create these strange animated movies with the songs that drive little kids crazy and they nag their parents to buy it, that’s actually a very difficult skill set to replicate. Very few companies have been able to make… Classic animated movies outside of Disney a lot of people have tried the vast majority can’t do it It’s actually you know John Lasseter and the people at sort of Pixar and Disney animation in the old days That’s a very special thing. It’s you know, so the difficulty is another part of that upfront aspect Okay geographic boundaries Yeah, Netflix has no problem going country to country to country neither does Google neither does Facebook they just rock and roll and then network effects, which have always existed. I talked about this before, shopping malls have a network effect. Universities, famous universities like Harvard have sort of a slow network effect that plays out over really decades. Okay, that became dramatically more important when we moved into digital. So there’s a lot of these sort of economic effects are incredibly powerful. It’s worth keeping in mind. That’s sort of point number two. So let’s start to talk about pricing. The more you think about pricing in the digital world, the more it makes your head hurt. It’s complicated, especially when you start going to platforms where suddenly you can shift pricing from one side to the other, and then, God forbid, you get up into a sort of ecosystem competition where you’re Apple versus Google versus maybe Epic, and you’re trying to figure out what to price all of your many, many platforms and services you create across this entire ecosystem. How do you… figure out the pricing and what are you trying to accomplish. And does your pricing, is it about getting revenue or is your pricing about getting data? Or maybe your pricing, the goal is to get users, to attract users, to keep users. I mean, it gets very complicated very, very quickly. And I guess first way to think about it would be, okay, for common. pricing strategies without getting into the theory. Here’s just four that you’ll hear a decent amount. One would be penetration pricing. This is very common. Look, we’re going for market share. We’re going for users. We’re going for activity. So we’re gonna price this thing low. We’re going for volume. That’s very common if a business is trying to go for a network effect. or they’re building a platform business model. And it’s like, look, we gotta get to critical mass, critical volume in ride sharing in China or Singapore. So let’s just offer this cheap and get people on board. And then once we get on board, we’ll start to get our network effect going. We’ll start to hopefully collapse the market to one or two players. That’ll be us and then we’ll make money, some other place. So that you hear that a lot, Silicon Valley does that a lot. anything where like, you know, you really wanna get a network effect going, or maybe you wanna get a learning curve going, where like we need to get a lot of search engine activity going because as the search engine starts to get more activity, it will get smarter and better. You know, we want you to use TikTok because the more you use it, the smarter it will get and it will improve the product, not only for you as a viewer, but also for others. So the second, you know, there’s a lot of goals going on there. Especially, you see a really extreme version of this when there’s a new standard being created or a new design is coming out. Let’s say, you know, if it’s VHS versus Betamax versus DVD, and we know there’s gonna be one type of sort of format or standard for the next generation of media content. Well then you’ll see very aggressive pricing because if you don’t become the standard and the other person becomes the standard, you’re pretty much out of business. So you see a lot of big stuff happening there sometimes. Sometimes what you’ll see a lot is we want penetration pricing. Let’s say if we’re a business that has a lot of value in the compliments. We sell smartphones. but the big compliments to the smartphone would be all the apps in your app store. So if you’re Apple, what you’re hoping is all the apps that are in the app store are all pursuing penetration pricing where they’re coming in dirt cheap because a compliment by its definition makes your product more valuable, it increases the product unless you’re offering both yourself. If you’re selling hotdog buns, what you really want is the group that sells hotdogs. to be doing penetration pricing and coming in as low as possible because that will really benefit you. So you’ll hear various complimenters trying to get the other users to be as cheap as possible but not yourself. So anyways, penetration pricing, you’ll hear that all the time. It’s a good one to remember. Let’s say the other extreme, survival pricing. Okay, this is when, yeah, look, we’re in a tough market. We’re not in the early days. We’re not in the hey, we’ve got high growth and we’re all making a ton of money. You know, the market is mature. Everyone is slugging it out. There’s not a lot of growth. There’s no network effects protecting us. It’s not winner take all. Look, we’re just in a tough business. We’re making smartphones. Smartphones is a hard business. Not if you’re Apple, that’s different, but if you’re just making the hardware, yeah, you’re slugging it out, trying to get your new phone to get some adoption and make it to next year, and that’s a tough business. So then it’s just survival pricing, which is like, look, we look at our fixed cost structure, we look at our variable cost structure, and we just price right above that. You know, that’s slugging it out for the long term. That’s a good way to think about it. Like you might, you may not be in a business. Everyone wants to be Apple. Everyone wants to be Google. The truth is the vast majority of us are never gonna be that. And you know, we just wanna be the low cost producer. We wanna be the person that makes a fairly standard, unexciting product, but we are so cheap at it that we’re, you know, we’re pretty well protected. You know, that’s sort of your last refuges. My pricing is lower than everybody else’s and that’s how I survive year to year. So survival pricing. It’s a good strategy. It’s great to be the cheapest person in the market. It’s really a good position to be in. Doesn’t make you a rock star, doesn’t make you a tech god, but it’s a great place to be. Walmart, they’re in the we’re really cheap business. So is Costco, so is Sam’s Club. That’s a good business to be in. Okay, so that’s another one, survival pricing. A third common is, people use different words for this, market skimming. where you’re just trying to skim off one little part of the market for yourself. People use different phrases for this. When people mention this, the one I always think about is Tesla. This is one, look, we’re in the tech business, we’re in the information business, we’re in some sort of digital-ish business, and we have something new. We’ve got a new technology, and we wanna signal its value, not by coming in cheap, but pretty much coming in at a high price. And we’re not gonna go for the whole market. We’re gonna go for one little segment of the market. We’re gonna skim off one part of the market. That’s like when Tesla released their first Roadster and they came in at a premium luxury price. The first Teslas were not cheap. But by doing that, by coming in at a high price for a small market, just one little sliver of the market, that accomplished a couple of things. One, it signaled that we have a technology dramatically more valuable than others. Two, it actually gets us some cash flow, because that’s important. We just spent a ton of money on R&D and we’ve got to get some money coming into this business because we are burning R&D. So let’s not try and come in cheap and suck wind. Let’s get some cash flow going here. That’s pretty much what they did. And now after they did that for their first couple of vehicles, then they started moving down market with cheaper cars. But yeah, they did sort of… what we’d call market skimming pricing. And then one more, maximize profit pricing. That’s basically, look, we have a business. Let’s try and milk this thing for everything that it’s worth. Let’s jack up the cash flow. Let’s jack up the return on whatever investment we just made in this thing. And if that hurts us in the long term, that’s fine. We’re just going for the cash flow. You gotta kinda know what game you’re playing. I find those four pretty helpful to think about. So that’s common in terms of just overall where you’re going to price the number. Now one caveat to all the four things I just said is within all of those you can also kind of play with perception and you can play with timing. So timing would be like okay my price is going to be this. I’m going to do a maximized pricing, skimming pricing, but I’m going to stagger the payments. So even though the price is kind of the same, I’m gonna sort of change the timing. So, hey, you can buy this Tesla. It’s a market skimming pricing, but we’re gonna do leased payments. So you’re gonna pay some today, you’re gonna pay some in a year, you’re gonna pay some. So I can play that game. I can give a free trial, which is what I do with my class here. If there’s a lot of uncertainty about the products, okay, the first month try it for free. I’m not really changing the pricing, but I’m changing… the perception of it or the timing of it. And then you can also play with things like freemium and you can step people up. So yeah, we’re gonna have certain prices for certain services, but we will stagger those. We’ll give away the basic one for free, then we’ll give the more advanced one at this price, and then we’ll step it up. So you can play with perception and timing within any of those four. Okay. I find that’s a pretty good first pass. to think about pricing. A lot of times that will get you 80% of the way there. Now, then it gets more complicated. So this gets us into the realm of what they call price discrimination. And this is a big subject, and there’s a lot of theory in this, and economists study this stuff, and there’s all these case studies, and all these journal entries, and journal studies, and blah, blah, blah. But… This is the idea that we’re gonna offer different versions and different prices to maximize these things. The four strategies I just gave you, those are kind of simplified versions of this, of sort of a more robust theory. So if we’re talking about a typical digital good, we’re probably talking about, hey, we’ve got some high fixed costs and then low marginal costs going forward. How do you price against that? And the idea I teared up in the previous podcast was, well, that tees up the idea of versioning. You can’t price a lot of these goods based on cost at all, because it turns out the marginal, in a standard physical product, the way you’d say is, we should have the pricing more or less match the marginal cost of production. Well, if the marginal cost of production is zero, you can’t really do that game. So you start to do versions where we start to set the prices for different versions of the product that maximize against the willingness to pay of each individual customer. If I can’t price based on cost structure, which I can’t for a lot of software, then I look at what is it worth to the buyer? What is the perceived value? What is their willingness to pay? And so my pricing strategy is against that side of the equation, not against the cost structure. Okay, and that was the previous topic of versioning and pricing. And you can actually do that with digital goods because you’re often getting a lot of data. And it’s actually pretty easy to create different versions of the good and offer 20 versions on your website. It’s hard to offer 20 versions of a bottle of shampoo in every store, but you can do that in digital goods. So that gets you to this idea of versioning and pricing. And now I’m gonna sort of… talk about Hal Varian, this is his thinking, completely. He breaks this into first degree, second degree, and third degree price discrimination. Different versions of all of this. So, the most extreme version would be first degree price discrimination, which basically means I’m selling to a market of one. I want to create a product and or a pricing that is specific to every single individual customer. In this case, it would be consumers, not businesses. So people call this mass customization or mass personalization. And now a company like Netflix does this in terms of the versioning of the product. If you’re on Netflix, what you see and what I see are completely different. They tailor the product, the version of the product to each individual person. That’s mass customization, mass personalization. although they do tend to offer the same price to most people. That’s what Amazon does, well, that’s what Netflix does with their subscriptions, that’s what TikTok does, although it’s free for everybody. But they’re doing basically first degree price discrimination. Now that’s pretty awesome because consumers love that. So that’s pretty cool. We would call that enhanced, well, not me, would call this enhanced surplus extraction, which is we are maximizing the sales versus the perceived value on a person by person basis so we can extract the maximum value. Okay, that’s generally pretty good. The bad part about that, you know, this sounds all good, oh, that’s great. Eh, it’s not so good. Because we get what they call the intensified competition effect. You know, it’s one thing when I’m selling shampoo and I’m selling shampoo to everybody, it’s on the Walmart and the boot shelves. And I’ve got a handful of competitors also selling shampoo because it’s kind of a mass market product. Well, if I’m selling to each individual customer individually with their own mass customized product, does that mean I’m competing for every single customer? Am I doing mass competition where every single person who buys my product is different because the product’s different and the version’s different and the price is different? Does that mean I have to compete? customer by customer to customer as opposed to just competing with a handful of competitors. And the answer is kind of yeah, as you get to mass customization, you have to then fight for every individual customer’s attention or sales or dollar or whatever. That’s not great. Now I don’t think that’s actually true. I think that’s theory. I think overwhelmingly mass personalization, mass customization, this sort of first degree price discrimination. The biggest impact of that is I build, if I’m the company, I build a relationship with that customer over time and that long-term value, that is a much bigger phenomenon. So the reason you all do all this is, is probably not to maximize the price for every individual person, and it’s probably not gonna create this mass competition effect. really what you’re going to see is a closer relationship between a customer and a niche audience and that has got a tremendous value over the long term. That’s how I view it. And that’s pretty much what I’m doing. I’m not trying to go for the whole world to do my class or read my stuff. I’m focused on a very relatively small group of people and I’m trying to be the best thing that they’ve ever seen. For them… in this small niche. That’s where I’m going. I’m going for a small niche that thinks my talks or podcasts or whatever are the greatest thing they’ve ever seen. That’s my target, and I’m increasingly gonna personalize. But anyways, okay, so that’s sort of first degree price discrimination. That’s a market of one. Okay, second degree price discrimination, which is far more common. This is like a set menu. This is like when you go and you know, there’s you go to a restaurant and there’s a menu and there’s five items. Now we’re also doing personalization and we’re also doing sort of versioning, but we’re not doing a million versions of it. We’re doing five or 10. So people call this product line pricing or market segmentation or versioning. Basically, we’re gonna create three or four or five versions of the product. I don’t know, maybe it’s Adobe Acrobat, maybe it’s an antivirus program. And by creating four or five set versions of the product at different price points, the market itself is gonna then segment for me against those. I’ll offer four or five versions of, I don’t know, YouTube. One is a paid one, one is a free one. And by choosing four or five very specifically and offering it different features at different prices, the entire market will then sort of self segment against it. And they segment themselves. And that’s pretty much what happens when you offer like an antivirus program or a media product or something like that. Certain people go after one version, certain people go after another based on what features are most valuable to them. And that turns out to be pretty true. And you see lots and lots of software companies doing this second degree price discrimination, which is, you know, five or six versions. Okay, pretty cool. Third degree price discrimination. This is when we’re kinda offering the same thing to everybody, but we’re offering it at different prices. So this is like when you go to the museum or the movie theater, everyone’s watching the same movie. and everyone’s seeing the same museum, but there’ll be a senior’s price and there’ll be a student price. And there’ll be a, you know, if you’re in Thailand, there’ll be a expat price, a foreigner price versus a Thai price, which makes some people kind of angry. But you know, that has a lot to do with the fact of, look, I can create various versions of content and offer them. I can offer various different types of software. Here’s an antivirus, a premier version, a premium version versus a student version. That’s easy to do with software. You can do a lot of versioning. If you’re running a movie theater, you can’t really create different versions of your product. Your cost structure’s pretty much fixed. The service is pretty much fixed. The only thing you can really vary is the price. So a lot of services businesses will do that. So that’s sort of third degree price discrimination. And yeah, I mean, that’s a good first take at pricing and how complicated this all gets. Now, everything I just gave you as an example would buoy you for a product or a service, what we would call a pipeline business, a traditional business. Now think of everything I just said, but now we’re gonna go into the platform business model world where I’m running a dating platform. Dating platforms are big business, by the way. You should look at that business model. It’s pretty attractive and suddenly I’ve got two user groups Let’s say if it’s a male female type of situation. I’m you know, I’m selling services to men and women Well, then the pricing just got a lot into it a lot more interesting because you know I’m probably gonna make it cheaper for women because then they will come on the platform and I will offer them maybe different services and then Depending how I do that, the guys will show up and I might charge them quite a bit more, which is why most bars have ladies night where the drinks are free for women because they know the dudes will show up and they can charge them more. So that whole pricing thing, first degree, second degree, third degree pricing discrimination, survival pricing versus market skimming pricing, well, that just got a lot more complicated because I can shift and do price subsidies across the platform. Well, that’s interesting. Same thing if I’m doing a media platform, I might have advertisers, I might have content creators, and I might have viewers as three different user groups on the same platform. That’s interesting. So you can see that this gets very complicated and like the people who do pricing strategy and analysis for these complicated, you know, these platform business models, man, it’s just, it’s like a PhD in that stuff. It’s really complicated, but it’s pretty amazing. So anyways, that’s kind of question number three for today is just think about this stuff. And I’ve given you a pretty good healthy dose of theory, but it’s great fun to think about. And you can see a lot of people doing clever stuff in this space right now. Okay, we’re in the home stretch now. So if you’re getting tired, wake up. This is, we’re getting, I told you today it was gonna be a lot of theory. Now question number four, what about the intersection of pricing and bundling? I talked about bundling quite a bit in previous talks and articles, and bundling is you basically put two things together and you offer one price. It’s a big deal. It’s really powerful. It’s how cable television made such tremendous profits for such a long time. Netflix is a bundle. They’re bundling content together. Spotify’s a bundle. You walk into a drug store and they have shampoo or conditioner and then they have two smaller bottles that are sort of wrapped together, can shampoo and conditioner, one price. Well, I mean, this has been around forever. Services businesses like to do this a lot. You know, they say, hey, we’ll sell you the, let’s say if you’re a McKinsey type group, you’ll say, you know, we’ll do the initial sort of high level strategy piece. and then we’ll do the operations and the implementation consulting engagement, which is usually a lot more money and we’ll bundle those together. Banks do this, you can have a mutual fund or a mutual fund and a credit card. Well, I don’t know if that’s technically allowed, but you’ll see services companies often will do this stuff. Physical products, they don’t tend to bundle as much because you have to put it on shelves, but digital goods, you can just bundle like. It is so easy to bundle anything. You can put songs together, videos together. You can go on Expedia or and they will immediately try and steer you towards you’re buying a flight, buy the flight and the hotel together. They make more money on their hotels than their flights. So they’re always pushing bundling on Expedia and booking in these places. And you can obviously see why this is a big deal because the marginal cost of a digital good, software, a reservation at a hotel, which is a digital good, the reservation aspect, which is what they do, media, entertainment, the marginal production cost is zero. So when you bundle stuff together, it doesn’t cost you anything. You wanna buy a book? Well, here’s a second book, you can buy them together. that’s very easy to do because it doesn’t cost anything on the production side to add the second book. So that zero marginal production cost is really powerful when you start to bundle. And in the previous podcast, I gave you an example of, why people do cable packages and why you sell two things together because you wanna, if one person really loves sports and another person really loves history, if they’re gonna… subscribe to the history channel, which is pretty great, or they’re going to subscribe to ESPN, which is pretty great. Each of those two groups would be willing to pay more for the thing they love the most, but they’d also probably be willing to pay less for the other thing, even though they don’t like sports as much as they love history. They might pay a little bit for that. So instead of just selling one product to each, you bundle those two together, sports and history, and you sell at a high price and both people end up buying. and you make more money as a provider, as a supplier. And it turns out the consumer is actually happier because they got both. So bundling can be very, very powerful. And a lot of these streaming services and what we see going on now is a lot of bundling. But it obviously tees up the idea of pricing. Right? Okay, what was your goal? Are you trying to do survival pricing? Are you trying to get skimming? I mean, penetration pricing, what is your goal? So that pricing question comes up in bundling all the time. Something I think people don’t talk about nearly enough, which is more in my area, is bundling actually creates a pretty good barrier to entry. That’s a big deal. If you are Microsoft and you offer Microsoft Word and Microsoft Office and Microsoft Excel, okay, those are each separate products in a- I’m competing, let’s say I come up with a really great spreadsheet program when we’ve invested a lot of R&D and we’ve got a great Excel competitor, but then Microsoft bundles Excel with Word and with PowerPoint as one price. How do I compete with that? Do I have to now create a PowerPoint and a Word, which means a lot of R&D, which means a lot more product spend, a lot more expertise required? Bundles can create a really pretty powerful barrier to entry at the product level, at the service level and things like that. And you see this a lot in media that people are starting to bundle, especially people like there’s been kind of a wave of newsletters and podcasts and all of that and news sites, a lot of news sites floating around. They’re starting to bundle up. And Netflix is basically creating sort of a super bundle. where they offer you so many TV shows that a smaller media outlet like CBS or HBO, which are trying to create these streaming services, they’re finding it very hard to replicate that massive library that Netflix has created. Disney’s doing sort of a high quality counter strategy with Disney Plus, but yeah, you can see that bundles create pretty nice barriers to entry. Okay. So when you think about bundling, pricing is gonna be a big, big deal. And the last topic for today, switching costs. I like switching costs. Switching costs have a lot to do with pricing. You really can’t separate these two subjects. Now switching costs, which let me give you some examples. So let’s say you hire an accountant. and they start doing your books and you think, well, I could switch to another accountant and save some money, but this person knows my stuff. I have to change all the information. So when that person comes back and raises the price at the end of the year, probably pay it because there’s a perceived cost, whether it’s in dollars or difficulty or risk to go to someone else. So generally that person has, if they’re gonna raise their price on me every year, they wanna raise their price, but they don’t wanna raise it. beyond my perceived switching cost, which I could put a number around. They stay under that, it’s not worth it, I stay. So that would be one. Putting in ERP systems when you used to choose, like we’re gonna put in Oracle, or we’re gonna put in Sun or Microsoft or whatever. You know, that was a massive switching cost, because once a business did that, it was so expensive to switch. Plus you have to train all your people, it interconnects with all your other systems. So there are tremendous switching costs there. Other ones might be, well, famous one would be like razor blades, where you buy the razor and then you buy the blades. And so you always buy the razor, they charge you more on the blades, buying a printer, but then you have to buy all the ink and the cartridges, buying a big durable good. where, yeah, I mean, I could switch the printer, but the printer’s gonna last for several years. So I’m pretty much stuck with it for those years. So there’s lots of versions about this. And you can think about it as like a couple versions. One would be, it’s a repeat purchase of the same good or service. I buy, let’s say a storage shed. I did this a couple years ago when I left New York. I had some stuff in New York, so I had to put it somewhere. I sold my place and OK, I go to a storage shed. And what are the storage shed people do? They want me to put my stuff in the storage shed. And then I will repeat by the service for months, if not years. So repeat, repeat, repeat, repeat of the same service, which is the storage. A different version of this would be like if you buy something and you buy a big heavy duty printer for your office. you’re not gonna keep buying the heavy-duty printer, what you’re gonna end up is buying the complements. So you, the first purchase is the big printer, but then over time you end up buying ink and services and things like that. So different versions of it. But you really wanna think about it as a two-step process. And the pricing you do on each step is incredibly important. Now, if you wanna buy the storage shed, I go around to Manhattan, I met with some, or I looked up some storage shed, and guess what they all offered me? They offered me a very cheap price for the first six months. Wow, look at this low price to move in, and they’ll actually pay for my shipping, and they’ll pay for that, they’ll give me a discount on the trucking to move my stuff in, right? Low price on the first, because they’re competing for my business at that point with other people. But once I’ve moved in, They effectively have created a monopoly. They’re not competing with anyone really for my business because they know there’s a pretty big hurdle for me to move my stuff somewhere else. I have to hire a truck, it’s a pain, I’d have to go oversee the process. So it’s sort of two-phase pricing. and what did they offer? And so I would go and meet with them, or actually I talked on the phone. My standard question was, okay, we’re gonna sign a rental agreement or a storage agreement. Is the second price specified in the contract? Okay, I know your six month price, but are the price increases for let’s say year one or year two, are they also specified? And they would all say no. They don’t want that specified because if it’s specified in the contract, it turns it from a two phase, price sort of sequence to a one phase and they don’t want to do that. They want to get me in low price and then they want to change the price. And so I basically avoided the big chains and I especially avoided them if they were public because I know what the interests of the public company are which is to maximize cash flow. And what I ended up doing is I ended up looking for small family owned storage places where the primary goal of the owner. was not to maximize pricing, but to maximize stability and occupancy because they were family-owned business and this was like an annuity for them. And I actually did find one and they were great and I sat down and talked to them and I said, hey, do you specify the pricing in the contract for going forward? And they say, no, we don’t do that, but we try to keep it under 3% and that’s been our history for a long time. And I said, great, and that’s what I did. And the truth is they’ve never raised the rate more than 3%. So, you know. Think about that sequence of pricing is important. And we can see this in a lot of digital businesses because it’s so easy to give stuff away for free. You can see this on marketplace platforms where they might go to a small convenience store, mom and pop store and say, hey, why don’t you get on our platform and start selling here? And they will often give away those tools for free at a certain level. That gets them onto the platform. Once they’re in the platform, that creates a… fairly significant switching cost and then they start offering more tools that cost more money or the level of competition on the platform increases and you have to increase your marketing spend. But you can see this sort of two-phase pricing approach in a lot of this stuff when it relates to switching costs and on platform business models it’s a pretty standard strategy. Content creators get sort of locked in. Yeah hey I built this thing on YouTube and I’m getting a Well, then what if they, you know, they, they sell you new tools to make your product more competitive. They don’t usually gouge you like, hey, if you want to stay on, you got to pay more. But they often the degree of competition on whether it’s an audience builder platform or marketplace platform or payment platform or credit tech or whatever, the competition goes up and you’re kind of locked in. And then, you know, you spend more and more on marketing over time and things like that. Doesn’t mean it’s necessarily switching costs aren’t being evil. necessarily, although sometimes they are. But you just have to understand that pricing is critical within switching costs and it usually breaks out in two phases. And that is it for today. I think this stuff is great, but that is a lot of me talking theory at you. Anyways, just to review real quick the key ideas for today. Pricing and switching costs, the last one I talked about, that’s a big deal. That will be one of the key concepts for today. It goes under Learning Goal 29, which is digital economics. Price discrimination and common pricing strategies. I gave you four pricing strategies and then some theory on the price discrimination. Also, so I guess you could consider combinatorial innovation as an idea, but that’s kind of vague and hand wavy. So I’m not really considering that. It’s hugely important, I just think it’s kind of interesting. But it’s the pricing stuff. And we’ll probably do one more of these on digital economics. I’ll get to it in a couple weeks or two, because I like to, I don’t like to go too far from company examples, which is a little easier to get your brain around. But we’ll talk about probably some scale economies and network effects and some other things. But I think that’s enough. Pricing is a pretty deep well of economics thinking. in the digital world in general, and especially when you move into platforms. And then when you move into like taking apart how like Epic and Tencent, these big ecosystem players do their pricing, and it’s crazy. It’s really interesting, but it’s crazy. Anyways, it’s been a pretty great couple days here. I’ve just been doing a ton of reading, ton of work, so I always sort of feel good when I’m productive. Any fun recommendations for this week? I did watch Blackpink. which is this K-pop group that’s gone off like crazy and there’s a Netflix special on them. And it’s whatever, it’s who hears backstage with the girls dancing and how they train and who they are and where they’re from, which I don’t really care about that stuff. And I don’t know their music at all. I just sort of thought it was interesting as a business case. And what jumped out at me is the other show I like is The Mandalorian. And what jumps out at me at both is Whoever’s behind these things, is it me or are they sort of anonymizing the talent? Let’s say commoditizing the talent. Like the Mandalorian, super successful, and I think the key actor who was in Narcos just left the show because they wouldn’t let him take his helmet off. So you don’t know who the Mandalorian is. You could pretty much put anyone under that helmet. I think he does the voiceover or something like that. They’ve kind of commoditized the actor’s role, the persona, you know, you can’t swap out Joey from Friends with somebody else, people aren’t gonna like that. You can kind of swap out whoever’s ever under the mask. And when I look at Blackpink, that kind of jumps out at me as well. It’s like, okay, yeah, I mean, obviously the fans do care about these four specific women, but their skillset is a little bit basic. It ain’t like, I don’t know. Lady Gaga or Billy Joel or whoever you want to think about where the person’s the writer and the singer and the artist and all that. I mean, they’re pretty much just dancing songs, dancing and singing songs somebody else is writing and it’s lower. I think it’s more commoditized. And certain businesses seem to do that. If you ever notice that like animated movies, it’s the same thing like Disney in particular, like they make the Mandalorian, but they also do a lot of animated movies. Okay, there’s no actor for those either. It’s digitally rendered. Thanos in the Avengers, there’s no actor demanding a pay raise if they wanna put that person back in the movies. So as I’m watching this, the sort of business side of my brain is going off like, are they commoditizing the acting role as the CGI gets better? But I think they are. I think this is the whole boy band, girl pop band. I think this is a very well thought out business model. Contestants on the voice, you know. Anyways, there was a speaking of friends, like I used to like friends when I was younger, it was one of my favorite shows. And I always remembered one funny joke in that show where a director was putting actors on the stage and he said, you know, he referred to them as talking props, as a joke, my actors, my talking props. And I’m like, are these dancing props? These animated characters and boy bands and all of that. Anyways, I was sort of thinking, maybe this is a little more devious than I think it is. We’ll see. I respect the business model, but it’s not the nicest thing to do. Anyways, just random thoughts. But the black pink thing was kind of interesting. It’s a cultural phenomenon. It’s got a strong creative aspect. The business has to be fantastic. So as a business case, it’s pretty cool. Anyways, it’s not really my space. I find the creative arts very hard to get my brain around because I don’t I ultimately can’t predict which group will be popular or not. So when I watch the voice or the version in China, the person I always I like always gets voted off and I can never figure out why that is. It’s just not I can’t predict it. So I like whiskey and beer and coke because I can predict what’s going to do well. But I can’t figure out what pop group is going to. do well or not. Anyways, it’s worth checking out. Check out Blackpink. And if that’s not your thing, check out the Mandalorian Season Two is starting, I believe this next week they’re releasing that on Netflix, or Disney for that one. Anyways, that’s it for me. I hope everyone is doing well and thank you so much for subscribing and listening. I hope this is helpful. I am still doing a lot of. phone calling with people, getting feedback. If you’re open to that, send me a note. I’d love to hear your feedback. But other than that, have a great week and I will talk to you next week.

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