Information Complements, Substitutes, and Strategic Product Design

Abstract:     
Competitive maneuvering in the information economy has raised a pressing question: how can firms raise profits by giving away products for free? This paper provides a possible answer and articulates a strategy space for information product design. Free strategic complements can raise a firm's own profits while free strategic substitutes can lower profits for competitors.

We introduce a formal model of two-sided market externalities based in textbook economics -- a mix of Katz & Shapiro network effects, price discrimination, and product differentiation -- that leads to novel strategies such as an eagerness to enter into Bertrand price competition. This combination helps to explain many recent firm strategies such as those of Microsoft, Netscape (AOL), Sun, Adobe, and ID.

The model presented here argues for three simple and intuitive results. First, a firm can rationally invest in a product it intends to give away into perpetuity even in the absence of competition. Second, we identify distinct markets for content-providers and end-consumers and show that either can be a candidate for the free good. Third, a firm can use strategic product design to penetrate a market that becomes competitive post-entry. The model therefore helps to explain several interesting market behaviors such as free goods, upgrade paths, split versioning, and strategic information substitutes.

Keywords: free information, complements, substitutes, network effects, network externality, pricing, bundling, two-sided markets, two sided networks

JEL Classifications: D4, L0, L1, L2

Working Paper Series