For a few dollars more (III)

At a high level, the answer to these questions is the default Economics 101 answer: Firms want to maximize their profit. But this goal is complicated by three economic characteristics of books and many other information-based products. First, the cost of developing and promoting the first copy of a book (what economists refer to as a product’s fixed costs) is vastly greater than the cost of printing each additional copy (what economists refer to as a product’s marginal costs).

Second, the value of a book can differ radically for different customers. Big fans are willing to pay a high price, casual fans are willing to pay much less, and many customers might not be willing to pay much at all. Third, consumers may not have a good idea of what they are willing to pay for a book in the first place. Books and other information goods are what economists refer to as “experience goods,” which means that consumers must experience the product to know with certainty how valuable it is to them.

This, of course, creates a problem for the seller. Once customers have read a book, they will probably be less willing to pay for it. Thus, the seller must strike a balance. On the one hand, the seller must provide enough information that consumers will know their value for the product; on the other, the seller must limit how much information is given to consumers, so that they will still want to purchase the product.

These characteristics cause sellers of books and other information goods to face several challenges in the marketplace. In this series, we’ll focus on three specific challenges: extracting value for their products, helping consumers discover their products, and avoiding direct competition from closely related products.

Extracting Value

In a world in which customers have radically different values for a book and the marginal cost of printing an additional copy is very low, a publisher will extract the most profit from the market by convincing “high-value” customers to pay a high price for the book while still allowing “low-value” customers to pay a low price.

But in a world in which customers are free to choose what product they buy, a company can’t maximize profit if it can sell only a single product at a single price. If a publisher sells only at a high price, it will make money from high-value customers but will forgo income from low-value customers, who will buy only at a lower price. Alternatively, a publisher could generate income from both high-value and low-value customers by setting a lower price, but that would leave money on the table from high-value customers who would have been willing to pay more.

Of course, these statements aren’t true only of books and other information goods; they apply in any market in which consumers have different values for a product. There are, however, two main ways in which these issues are more salient for information goods than for most other products. First, it is easier to vary the quality and usability of information goods than it is to vary the quality and usability of physical products.

If you want to make a bigger engine, or a fancier stereo for a car, it costs money. But making a hardcover book costs only slightly more than making a paperback book. And for digital goods, the cost differences can be nearly zero. The cost of making a high definition copy of a movie, for example, is nearly the same as the cost of making a standard-definition copy. Likewise, the cost of making a copy of a television show that can be streamed once is nearly the same as the cost of making a copy that can be downloaded and watched multiple times.

Second, the fact that the marginal cost of producing additional copies of information goods is essentially zero opens up far more of the market than is possible for physical products. If it costs $15,000 to manufacture a car, anyone who isn’t willing to pay even that marginal cost is excluded from the market. But if the marginal cost of producing an additional copy of a book is zero, everyone is a potential customer.

Thus, it is particularly important for sellers of information goods to find a way to maximize revenue from both high-value and low-value consumers. One way to do this is to convince consumers to reveal, either explicitly or implicitly, how much they are willing to pay – something that requires a set to strategies that economists call “price discrimination.” To perfectly “discriminate” between consumers with different values for a product, publishers and other sellers of information goods would need to know exactly what each customer is willing to pay.

With that information (and if they could prevent arbitrage between low-value and high-value customers), sellers could simply charge each customer their maximum price, in the process extracting the maximum possible value from the market. The economist Arthur Pigou referred to this ideal scenario as “first-degree price discrimination. Unfortunately for sellers, customers are rarely so forthcoming about their willingness to pay. Lacking perfect information about consumers’ values, sellers are left with two imperfect options.

First, a seller could set prices for different groups of consumers on the basis of an observable signal of each group’s willingness to pay (a strategy economists refer to as “third-degree price discrimination”). For example, many operators of movie theaters discount ticket prices for students and senior citizens on the notion that these two groups of consumers generally have a lower ability to pay than other segments of the population and on the basis of the theater operators’ ability to reliably identify these groups through age-based or membership-based ID cards.