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The cost structure of information goods
Many of the unique pricing and market structure questions in IT industries stems from a specific unusual cost structure: high fixed costs of production, but near-zero or zero variable costs of production. This cost structure characterizes a class of technology products which are collectively termed information goods. Put differently, the cost of producing the first unit of an information good is very high, and yet the cost of producing each additional unit is virtually nothing. For instance, Microsoft spends hundreds of millions of dollars on developing each version of its Windows operating system. Once this first copy of the OS has been developed, however, it can be replicated costlessly.
Early examples of information goods were computer-based information services and software; currently, a wide variety of diverse products -- video, music, textbooks, research, digital art, long-distance telephone service, network bandwidth, to name a few -- share this unique cost structure. Since this cost structure is a fundamental property of digital information, as more and more previously physical or analog products become digital, this class of products is expanding; in addition, a number of other technology products comprise a bundle of a physical device and an information good.
Pricing strategies for information goods
A sound (and creative) pricing/price-discrimination strategy is critical for sellers of information goods, since they have to recover their high fixed costs while ensuring that competition does not force their prices close to variable costs. Moreover, the pricing strategies available to each seller can be a critical determinant of equilibrium market structure. A unique advantage that sellers in technology markets often have is that these variable costs are in fact almost zero, and this feature underlies many of the popular and successful pricing strategies:
Rapid technological progress
The technology that semiconductor devices (like computers and networking equipment) are based on evolves very rapidly. For microprocessors, one aspect of this progress is summarized by the well-known Moore's Law. Moreover, the fixed manufacturing costs of creating the 'fab' for each successive generation of microprocessors increases exponentially; however, the long-run variable costs per microprocessor do not change significantly. This leads to cycles of high initial prices for 'new generation' microprocessors, followed by steep price declines (especially just before a new generation is announced), and overall, relatively stable prices over time. According to this McKinsey Global report (see exhibit 5), average Intel microprocessor prices fluctuated between $210 and $230 between 1995 and 1999, even as their processing power increased several-fold. Similarly, the average price of a PC has fallen over the last 10 years, despite a tremendous increase in performance.
It is likely that an essential first step towards explaining these pricing trends is to understand the underlying economics of general purpose technologies like the semiconductor. Helpman's book and Breshanan and Trajtenberg 1995 are good places to start; on a somewhat related note, Bresnahan and Greenstein 1999 provide a great analysis of the evolution of the computer industry. On the demand side, Mantena and Sundararajan 2002 suggest that continuously expanding product scope in conjunction with underlying technological progress can also lead to similar cycles.
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Copyright © 2003 Arun Sundararajan.