Digital Product Pricing

Some argue that information and digital products must be free. One reason is their behavior and the value they represent. In a rather simple fashion, we can summarize: Many types of information and knowledge-based products "propagate" (as John Barlow said) like a living organism. In an extreme sense, the better part of information or an idea is not original since it is built upon previous knowledge. And the fruit of a human creative process should be enjoyed by the society as a whole. The old Internet was well suited for free exchange of ideas and information, and some argue that it will be difficult to ignore that tendency still felt among Internet users.

Strange bed-fellows of these advocates for free information are commercial content providers. They argue that information and digital products sold on the Internet must be priced at zero (i.e., given away free) because the marginal cost of a digital product is (almost) zero. For example, once the first copy of a software program is written and produced, the next copy costs only a few dollars or less. Therefore, argues Microsoft's technology guru, its price will be that duplication cost (marginal cost pricing). (Marginal cost pricing is a phenomenon in a very competitive market.)

No. There are per-copy costs, such as copyright payments, administration, shipping and handling costs. These non-digital portions of the costs behave just like with any other physical product. More importantly, however, marginal costs are important issues in mass production technologies, but will be less important in the electronic marketplace. The reason is that digital products will be highly customized (or the market price is determined one by one--the number of copies becomes irrelevant). Furthermore, the cost we should pay attention to is the cost related to improving quality, which is convex (i.e., costs increase at an increasing rate as we try to improve quality even more, or try to personalize better). The implication is that there will be a limit (in quality or personalization) that can be determined by considering old-fashioned economic cost-benefit analysis. The point? Microeconomics of digital products is not something radically or fundamentally different from physical products.

In a market with highly differentiated and customized products, prices tend to be determined by buyer's willingness to pay rather than by the cost of production. The market force behind this fact is the market power obtained by product differentiation. Thus, pricing is a matter of how valuable a product is to a buyer, not how much it costs to produce. Let's even suppose that a digital product can be produced at zero cost. Even then, prices can be set at the consumer's value. Therefore, its price will not be zero unless the product is truly value-less (junks).

Prices based on user values necessitate better information gathering about consumers' tastes (and income). The lack of privacy on the Internet will decidedly favor sellers who can openly or surreptitiously accumulate information about consumer purchasing and consumption behaviors.