Product Differentiation and Market Segmentation of Information Goods

Large sunk costs of development, negligible costs of reproduction and distribution, and substantial economies of scale make information goods distinct from physical goods. Consequently, how to take advantage of the specific characteristics of information goods to maximize profit is an important managerial problem. Price discrimination and product differentiation are common ways this problem has been addressed. In previous literature, vertical differentiation and relevant pricing strategies are modeled in different contexts such as network externalities (Jing, 2002), competition (Jones and Mendelson, 2005) and anti-piracy (Wu, Chen and Anandalingam, 2003). They all reach the conclusion that vertical differentiation is not optimal without certain constraints, consistent with Bhargava and Choudhary (2001). Bhargava and Choudhary (2005) examine nonlinear utility functions for vertical differentiation of information goods and propose that vertical differentiation is optimal when lower type consumers have greater ratio of valuations than higher type consumers. Bakos and Brynjolfsson (1999) studied the strategy of bundling a large number of information goods and found that bundling large numbers of unrelated information goods can be profitable, but when different market segments of consumers differ systematically in their valuations for goods, simple bundling is no longer optimal. Sundararajan (2004) showed that fixed-fee and usage-based pricing can be used together to maximize producer’s profit for information goods.