Tuesday, October 02, 2007

Complementary Goods as a Price Discrimination Mechanism

With regard to Radiohead’s decision to offer downloads of its latest album for whatever price people want to pay, my thoughts are fairly similar to Tyler’s and Megan’s. But I might as well put it my way.

Co-blogger Tom argues in a recent paper and blog post that population growth can increase the return on creative effort by making it easier to engage in price discrimination. And as Megan observes, Radiohead’s strategy is essentially one of price discrimination. But the mechanism is not quite what Tom describes. As I understand it, Tom’s mechanism works something like this: When a new rival appears on the scene with a product similar but not identical to yours (e.g., you write poetry, and the new rival writes prose), his presence draws away your less motivated customers (that is, the ones who prefer prose to poetry). Likewise, your presence draws away his less motivated customers (the ones who prefer poetry to prose). As a result, each rival is enabled to focus on a more “pure” customer pool and charge a higher price. And since there is now a larger population, this situation generates higher revenues than would selling your product to a smaller and unsegmented market.

Radiohead’s price discrimination strategy relies on a different mechanism: complementary goods. When complementary goods are sold by a single producer, the producer can effectively charge for both goods by putting a price on only one. For instance, if Nike wanted to, it could charge only for left shoes and give away right shoes for free – and it would make just as much profit that way (except for the losses associated with amputees who only need right shoes). In this example, the left shoes and right shoes are the complements. Now, suppose one of the two complement goods is an idea – the stuff of intellectual property – but for some reason it’s unprotected by copyright or patent. Still, if the other good is a material good (and thus rivalrous and excludable), the producer can still profit from his creative effort. Thus, if fans only want to listen to an album while gazing at an autographed photo of the artist, and if the artist is the only source of autographs, then the full value of the musical work can be captured in the price of autographs. The album can be given away for free.

Now, in reality at least some listeners are willing to listen without an autographed photo. Albums and photos are not perfect complements. The same goes for concert tickets, liner notes, and other items that go well with an album. As a result, the value of the musical work cannot be fully captured in the price of the excludable items. But here’s the key to Radiohead’s strategy: some listeners regard the music and its accoutrements as very close complements, while others do not. That means Radiohead can use the complements to its music as a means of separating consumers by willingness to pay. The less avid consumers self-select into the near-zero price of a download. The more avid consumers self-select into the much higher price of the physical album, which will be a whopping $80.

So Radiohead’s strategy, it seems to me, boils down to the use of complement goods as a means of segregating consumers and price discriminating. Whether this approach will work for any other band will depend on the extent to which their fan base regards the music and its accoutrements as highly complementary. As Tyler observes, Radiohead’s cult-band status may allow a strategy that would not work as well for other artists.


Bertil said...

I like you explanation—and it might explain the recent increase in CD price: with piracy, only the hard-core fans (or people going to a birthday party) are paying for music, so the marginal price is higher.

However, one assumption seems very blunt to me: are you saying that no user at all will buy the digital version for more then 0.01$? How much are you ready to bet for that, and what share of the population over 0.01$ would you would consider? Or maybe how much money shouldn't the band expect?

Bertil said...

Oups: "marginal price"; I meant "optimal price". Celebrating, sorry.