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Nonlinear Pricing of Information Goods

Authors: Sundararajan, Arun
Keywords: pricing;price discrimination;information goods;digital goods;adverse selection;screening;principal agent;incentives;mechanical design;incentive compatible;monopoly;incomplete information;second-degree price discrimination;two-part tariff;vertical differentiation;software;internet
Issue Date: Dec-2004
Publisher: Management Science
Citation: Vol. 50, No. 12, December 2004, pp. 1660–1673
Series/Report no.: CeDER-PP-2004-03
Abstract: This paper analyzes optimal pricing for information goods under incomplete information, when both unlimited-usage (fixed-fee) pricing and usage-based pricing are feasible and administering usage-based pricing may involve transaction costs. It is shown that offering fixed-fee pricing in addition to a nonlinear usagebased pricing scheme is always profit improving in the presence of nonzero transaction costs, and there may be markets in which a pure fixed-fee is optimal. This implies that the optimal pricing strategy for information goods is almost never fully revealing. Moreover, it is proved that the optimal usage-based pricing schedule is independent of the value of the fixed fee, a result that simplifies the simultaneous design of pricing schedules considerably and provides a simple procedure for determining the optimal combination of fixed-fee and nonlinear usage-based pricing. The introduction of fixed-fee pricing is shown to increase both consumer surplus and total surplus. The differential effects of setup costs, fixed transaction costs, and variable transaction costs on pricing policy are described. These results suggest a number of managerial guidelines for designing pricing schedules. For instance, in nascent information markets, firms may profit from low fixed-fee penetration pricing, but as these markets mature, the optimal pricing mix should expand to include a wider range of usage-based pricing options. Minimum fees, quantity discounts, and adoption levels across the different pricing schemes are characterized, strategic pricing responses to changes in market characteristics are described, and the implications of the paper’s results for bundling and vertical differentiation of information goods are discussed.
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