Pricing Digital Goods: Discontinuous Costs and Shared Infrastructure
We develop and analyze a model of pricing for digital products with discontinuous supply functions. This characterizes a number of information technology-based products and services for which variable increases in demand are fulfilled by the addition of "blocks" of computing or network infrastructure. Examples include internet service, telephony, online trading, on-demand software, digital music, streamed video-on-demand and grid computing. These goods are often modeled as information goods with variable costs of zero, although their actual cost structure features a mixture of positive periodic fixed costs, and zero marginal costs. The pricing of such goods is further complicated by the fact that rapid advances in semiconductor and networking technology lead to sustained rapid declines in the cost of new infrastructure over time. Furthermore, this infrastructure is often shared across multiple goods and services in distinct markets. The main contribution of this paper is a general solution for the optimal nonlinear pricing of such digital goods and services. We show that this can be formulated as a finite series of more conventional constrained pricing problems. We then establish that the optimal nonlinear pricing schedule with discontinuous supply functions coincides with the solution to one specific constrained problem, reduce the former to a problem of identifying the optimal number of "blocks" of demand that the seller will fulfil under their optimal pricing schedule, and show how to identify this optimal number using a simple and intuitive rule (which is analogous to "balancing" the marginal revenue with average "marginal cost"). We discuss the extent to which using "information-goods" pricing schedules rather than those that are optimal reduce profits for sellers of digital goods. A first extension includes the rapidly declining infrastructure costs associated with Moore’s Law to provide insight into the relationship between the magnitude of cost declines, infrastructure planning and pricing strategy. A second extension examines multi-market pricing of a set of digital goods and services whose supply is fulfilled by a shared infrastructure. Our paper provides a new pricing model which is widely applicable to IT, network and electronic commerce products. It also makes an independent contribution to the theory of second-degree price discrimination, by providing the first solution of monopoly screening when costs are discontinuous, and when costs incurred can only be associated with the total demand fulfilled, rather than demand from individual customers.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Shaler Stidham, 1992. "Pricing and Capacity Decisions for a Service Facility: Stability and Multiple Local Optima," Management Science, INFORMS, vol. 38(8), pages 1121-1139, August.
- Gupta, Alok & Stahl, Dale O. & Whinston, Andrew B., 1997.
"A stochastic equilibrium model of internet pricing,"
Journal of Economic Dynamics and Control,
Elsevier, vol. 21(4-5), pages 697-722, May.
- Alok Gupta & Dale O. Stahl, 1996. "A Stochastic Equilibrium Model of Internet Pricing," CARE Working Papers 9604, The University of Texas at Austin, Center for Applied Research in Economics.
- So, Kut C. & Song, Jing-Sheng, 1998. "Price, delivery time guarantees and capacity selection," European Journal of Operational Research, Elsevier, vol. 111(1), pages 28-49, November.
- Philipp Afèche & Haim Mendelson, 2004. "Pricing and Priority Auctions in Queueing Systems with a Generalized Delay Cost Structure," Management Science, INFORMS, vol. 50(7), pages 869-882, July.
- Eric Maskin & John Riley, 1984. "Monopoly with Incomplete Information," RAND Journal of Economics, The RAND Corporation, vol. 15(2), pages 171-196, Summer.
- J. Christopher Westland, 1992. "Congestion and Network Externalities in the Short Run Pricing of Information System Services," Management Science, INFORMS, vol. 38(7), pages 992-1009, July.
- Arun Sundararajan, 2003. "Nonlinear pricing of information goods," Industrial Organization 0307003, EconWPA.
- Sanjeev Dewan & Haim Mendelson, 1990. "User Delay Costs and Internal Pricing for a Service Facility," Management Science, INFORMS, vol. 36(12), pages 1502-1517, December.
- Albert Y. Ha, 1998. "Incentive-Compatible Pricing for a Service Facility with Joint Production and Congestion Externalities," Management Science, INFORMS, vol. 44(12-Part-1), pages 1623-1636, December.
- Arun Sundararajan, 2004. "Nonlinear Pricing of Information Goods," Management Science, INFORMS, vol. 50(12), pages 1660-1673, December.
- Xianjun Geng & Maxwell B. Stinchcombe & Andrew B. Whinston, 2005. "Bundling Information Goods of Decreasing Value," Management Science, INFORMS, vol. 51(4), pages 662-667, April.
- Yannis Bakos & Erik Brynjolfsson, 1999. "Bundling Information Goods: Pricing, Profits, and Efficiency," Management Science, INFORMS, vol. 45(12), pages 1613-1630, December.
- Yannis Bakos & Erik Brynjolfsson, 1997. "Bundling Information Goods: Pricing, Profits and Efficiency," Working Paper Series 199, MIT Center for Coordination Science.
When requesting a correction, please mention this item's handle: RePEc:net:wpaper:0611. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Nicholas Economides)
If references are entirely missing, you can add them using this form.