From: aci10@eng.cam.ac.uk (A.C. Innes)
Newsgroups: comp.os.os2.advocacy
Subject: Re: Bundling Networks, OS/2 v. NT
Date: 14 Oct 92 05:45:55 GMT
Organization: Cambridge University Engineering Department, England

WARNING: this post contains long and excrutiatingly tedious (not to
say boring) expositions of simple facts of microeconomics as they
might apply to the pricing of NT with or without networking, etc.
(I also make no claims as to the veracity of my arguments -- I could
be totally confused myself about these issues.)

Please type "n" now to spare yourself!

In article <1992Oct13.062712.10777@microsoft.com> petesk@microsoft.com (Pete Skelly) writes:
>In article <1992Oct12.211315.28385@mksol.dseg.ti.com> mccall@mksol.dseg.ti.com wrote:
>> In <1992Oct11.093615.7205@microsoft.com> petesk@microsoft.com (Pete Skelly) writes:
>> 
>> >In article <1992Oct10.231756.49561@ns1.cc.lehigh.edu> sjb5@ns1.cc.lehigh.edu wrote:
>> 
>> >> >
>> >> >Well, I hate to say it, but software doesn't work that way.
>> >> >Software is almost all startup up cost and and very little
>> >> >production cost.  Software has no intrinsic value besides what
>> >> >people are willing to pay for it...

If by "value" the writer meant "monetary value", then the second
statment is not true -- this is only half of the matter.

It is appropriate to think of two things here: the price-demand curve
which expresses how much people are willing to pay for a product, and
the price-production curve which captures the price at which producers
are willing to make and sell the product.  In both cases there is a
curve (rather than a single point) because lower prices attract more
buyers thus increasing demand, while higher prices attract more
producers thus increasing production capacity.  (This is true, at
least in the case of general commodities which can be produced by many
producers and which are considered to be "substitutable" by
consumers).  If there is perfect competition in the market, then an
equilibrium price will be reached (the "market price") at which the
consumer demand equals the production capacity (the intersection of
the two curves).

(For those who don't know, equilibrium is maintained because of the
market reaction when the price is either too high or too low.  If the
price is too high, then fewer consumers will be willing to buy, so
there will be excess (unused) capacity forcing producers to lower
their prices to attract buyers.  Those producers who cannot maintain a
satisfactory profit margin at the lower price will stop producing,
thus reducing the production capacity until it balances demand.
Conversely, if the price drops below the market price, too many
producers will be forced out of production because of inadequate
profits, so the demand will exceed the production capacity, allowing
producers to increase the price.)

I apologize for being long-winded, but the main point to notice is
that production costs (including fixed costs like development
amortized over the number of units sold) DO affect the market price
-- that is, the market "knows" implicitly about the production costs,
because of the willingness or unwillingness of producers to sell at
different prices.  This means that the value of software is NOT simply
the amount that "people are willing to pay for it", but it depends
also on the cost of making it, at least indirectly.

>> >> >...and if what you say is true, that most people won't be using
>> >> >the networking products, then the networking products will be
>> >> >worth little to them.  They will be willing to pay what they
>> >> >were willing to pay for the orrigional WNT product, minus the
>> >> >value of the networking products, which was little or nothing.

The logic here is flawed, but the explanation is a bit long...

To use my terminology, we are assuming that the price-demand curve
drops very steeply, with very few people willing to pay a substantial
amount for networking software (if it were a separate product; we will
deal with the complication of bundling later).  However, the market
price would still have to be no lower than the minimum price at which
the total cost of production can be recovered (the break-even price),
otherwise no-one would produce it at all.  Of course, the equilibrium
demand/production will be very small in this case, and the price quite
high because the development cost must be borne by a small number of
buyers.

Thus, if networking software was unimportant to most consumers, its
market price (paid only by those who really want it) would be high.
So how would this affect the pricing of the combined product?  Read
on...

>> >> >The net price will not have changed.  All that will change is
>> >> >the possible price for the WNT with the networking, which may
>> >> >go up, because the people willing to buy it will pay more for
>> >> >it.

No, if most people don't want networking (and hence won't pay much
more for NT with networking), then *removing* the networking from NT
(selling it separately as a self-financing product if necessary) would
indeed drop the cost of producing NT and thus its market price (at
least in a perfectly competitive market).

To see this, suppose for a moment that the base NT and the networking
stuff were separate commodities.  There would be a market price for
each, with a high price for the networking software as discussed
above.  Because we assume the majority of consumers have no interest
in networking, the price-demand curve for NT+networking is only
slightly higher than that for just NT (ie. for the same price, there
will be only slightly more demand for NT+networking than just NT).

However, the price-production curve for the combination is
significantly lower than for just NT (ie. fewer producers would be
willing to sell the combination for the same price as NT alone) since
the production (development) cost is higher but the demand (potential
sales volume) is hardly changed.  As a result, the market price for
NT+networking will be substantially higher than the market price for
NT alone.

To put it another way, removing an unpopular component (especially one
that adds significantly to the total cost) will allow the remainder of
the product to be made at lower cost and yet enjoy almost the same
level of demand (for any given price) as the original product.  This
results either in increased profit (by keeping the market price of the
original product, at least until competition forces it down) or
maintaining profit at the real market price, with increased sales
volumes (in the market as a whole).  In terms of competing with other
producers of equivalent products, removing or unbundling an unpopular
component can provide a price edge over the competition, with all the
desirable consequences that entails.

If instead networking was quite popular, then the demand for NT plus
networking would be significantly greater, for the same price, than
for NT alone (because networking is now worth something to many
people).  In this case, the market price for the combination might not
even go up (and could even drop if networking was more popular than
the basic NT features) because the increased sales volumes could cover
the increased development costs.  At least any increase in the market
price will be less than the case where networking is unimportant to
most consumers.

Notice that, in this case, the producers might make more money by
selling the popular component separately, since the market price for
the remainder of the product wouldn't need to drop very much, and
possibly less than the market price of the unbundled component.  There
is a resemblance between networking being unpopular, making it
desirable to unbundle it, and the base OS being "unpopular" (relative
to the networking) in which case it might be desirable to "unbundle"
it.  The difference is that the base OS is presumably much more
valuable than the networking component, so it may also be advantageous
to use the popularity of the component to boost the sales volumes of
the base package by bundling them together.


In all cases, this behaviour is that which would happen in a perfectly
competitive market selling a product whose production cost is
dominated by fixed development costs.  In this environment,
artificially high prices (eg. from adding the market price of
networking to the market price of NT alone, when the market price of
the combination would be less) would be quickly undercut by
competitors offering equivalent products at the true market price.

The extent to which the pricing of NT does not follow this behaviour
may indicate the extent to which the market for NT-class operating
systems is not perfectly competitive, or the extent to which the
offerings of different producers are not considered substitutable, or
the extent of any of a host of other "imperfections" in this market.


>> >> So no money went into developing that networking software?  If
>> >> people want and/or need the networking, they *will* buy it.  If
>> >> they don't need it, don't force them into it.  Are you claiming
>> >> that NT would cost just as much if we removed networking,
>> >> multiprocessing, and security features?  Of course it wouldn't.
>> >> In fact people would really bitch and moan about this.

If you accept my reasoning, it is to the advantage of the vendor to
unbundle unpopular components, otherwise they may price themselves out
of the market (or at least THAT market, but possibly provide better
positioning in ANOTHER market which places different values on the
components).  In a highly competitive market, that would be the
vendor's problem, since the consumer would have no lack of choice of
alternatives.  Perhaps we should discuss whether the market NT will
enter will be competitive enough for that to happen.  (And which
market is that? -- we can guess at the market Microsoft is aiming at
according to the way they price their product, assuming we are willing
to attribute them with a reasonable degree of marketing skill. :-)


>> >Let X be the cost of development per unit sold.
>> >Let Y be the price per unit per unit sold.
>> 
>> >To make a profit, X < Y.
>> 
>> >Now, who ever said that Y = f(X).  
>> 
>> If it isn't, you are not in a competitive environment and hence should
>> be a regulated monopoly.

I would agree with this last statement: in a competitive market, Y and
X are definitely interrelated.  It would be better to talk about the
development cost C and the number of units sold N rather than their
ratio X.  Thus we would have C < NxY, where N is properly a function
of Y (ie. the price-demand curve).  In a competitive environment,
there would be an upper bound on NxY as well, dictated by the general
profit margin (or return on investment) that is accepted in that
market.  Since C is fixed, we have that X = C/N(Y) ~= Y/(1+profit
margin), so that X is indeed essentially a function of Y (an implicit
function, since it depends on the value of Y that satisfies a
constraint; see below).

>I think not exactly.
>
>Let's say that Z is the price people are willing to pay for the product.
>
>Y = f(Z), in most cases, Y = Z.
>
>Z, I would say, is based on the prices of what competitors products are,
>among other things, and not so much on how much it takes to develop the
>software.  There are psychological factors involved.  If you lower the
>price too much below what people expect, they think that it's not as good
>of a product.

Well, really there is an entire function N(Y) that expresses what
people are willing to pay for the product.  Of course, you are right
that the price-demand curve can depend on psychological factors.
However, we should be more precise about the prices of competing
products as a factor affecting N(Y): if they are considered equivalent
to (ie. substitutes for) your product, then there is really only *ONE*
market with one price-demand and price-production curve and thus a
single market price for that commodity made by you and your
competitors.  And this market price (call it Y*) which roughly
satisfies the equation C x (1 + profit margin) = N(Y*) x Y* certainly
depends very much on the cost of developing the software (C in the
equation).

If your competitors' products are not considered (perfect) substitutes
for yours, then the situtation is similar except that some products
may be allowed a price premium over the basic market price, which is
otherwise still in rough equilibrium (assuming reasonably strong
competition).  Thus, the basic market price does still depend on the
development costs of the products.

>> 
>> >More to the point, Y is not necessarily based on the value of X, more than
>> >it should be more than X to make a profit.  Y is based on what the market
>> >will pay for the product.  Simple economics.
>> 
>> Yeah.  simple economics, indeed.  It seems you should have taken
>> Einstein's advice with regard to simplicity on this one; make things
>> as simple as possible, but no simpler.
>
>Y is based on what the market expects to pay for the product.  Sorry I left
>that part out.  Also, remember that the market knows or cares little about
>X.  

See my discussion at the beginning of this post.  The market price Y*
implicitly embodies the value of X, or more accurately C.  If the
market "expected" to pay $100 for product Foo when no-one can make it
for less than $200 a unit, then no-one (at least, no profit-making
concern without ulterior motives) is going to MAKE product Foo!  Of
course, because normally there would be a segment of the market
prepared to pay $200 or more, enough producers would eventually make
and sell product Foo at a price (above $200) that allows them a profit
in the quantity that the market is willing to buy at that price.

>> >> >>So in asking to remove networking, you are asking to raise the price of
>> >> >the networking version, and not lower the price of the non-networked
>> >> >version.
>> >> 
>> >> No you are lowering the price of the non-networking version.
>> >> The costs didn't go into that version and so the company can't
>> >> honestly claim that the pdevelopment price is just as much.
>> >
>> >The price for the Non-networked version will be what people will
>> >pay for it.  People, like yourself, will not pay more for the
>> >networked version.  So, if networks are shipped with all versions,
>> >then to sell it to you, the price should be the same as the price
>> >you would have paid for a non-networked version.  What's wront if
>> >the price is the same for the networked and non-networked
>> >versions.

It is fine to have the same price for the networked and non-networked
versions (and the consumer who had no use for networking shouldn't
care if they are the same) -- provided that no other competitor is
able to offer the non-networked version (or a substitute) for less
than yours.  If networking is "popular", it may be that the proper
market prices for the bundled and unbundled versions should be roughly
the same (because the cost of developing the networking stuff is
recovered from the increased sales at the same price).

>> Because you have increased your value of X above (that floor price
>> below which there is no profit in selling the thing) because now some
>> proportion of the network stuff costs must be included in X.  In a
>> competetive environment, Y (selling price) most generally is a
>> function of X (development plus production costs, maintenance, etc.).
>> If your Y is *NOT* some sort of function of X, expected sales, market
>> competition, etc., then you are operating from a monopoly position and
>> should probably be regulated.
>
>I would argue that this is not really that true in many goods that are 
>information based.  (Products with little cost of manufacture and goods).
>Any Econ folks out there to shed more light on this?

This is the kind of product I have analysed above; I hope you will
accept my reasoning that an "unpopular" component that adds to the
production (development) cost, but does little to increase the value
of the product (ie. the quantity that could be sold at any given
price), will simply have the effect of putting you at a disadvantage
with other competitors who don't have to bear the extra development
cost, and so can afford to undercut your price.  In this case, it is
better to unbundle the unpopular component and sell it at its proper
market price (that price which will sell a sufficient quantity to
make back its development cost plus profit).

In contrast, a popular component could be bundled in order to increase
sales (which usually means increasing your market share) while still
maintaining the same profit margin, even though unbundling the
components might earn you more over all.

>> >Then MS is eating the cost
>> >of network development, so to speak.  Would you still complain.
>> 
>> Right.  I can see them doing that.  NOT!
>
>how many people regularly use edlin right now.  Why do they ship it still.

One answer to this is to point out that the contribution to the total
production (development) cost of NT (or DOS or whatever) of including
edlin is essentially zero.  It may never have been much when it was
first developed (version 1.0 of PC-DOS?), but its cost has long since
been completely amortized anyway.  Unless it will require rigorous and
time-consuming testing to work on NT! :-)

As to the possibility of Microsoft "eating the cost of network
development"... that is certainly possible, and even sensible under
certain circumstances (from MS's point of view).  This would normally
only be conceivable in an "imperfect" market, where there is the
possibility to exploit "inadequacies" in the competition to gain an
advantage that will later have a payoff (eg. from establishing brand
loyalty or whatever).  Under perfect competition, such delayed payoffs
would not be possible, so all costs would need to be borne "up front"
and passed to the consumer (and if your costs were -- or would be --
excessive, then you would withdraw from the market).

>> >If not, then why not ship everyone the networked version, at the 
>> >cost you would have paid for the non-networked version.
>> >Would it not then be possible that the development costs of the network
>> >be made up by the extra sales of people who would buy NT because it
>> >is a good networking deal.
>> 
>> It is possible, but it all rather depends on the mix of people.  After
>> all, people who want to use NT for networking would still have to buy
>> NT, even if the networking were separate.  It all depends on what
>> percentage of prospective NT customers Microsoft expects to want the
>> networking stuff (as opposed to folks who don't want it, folks who
>> prefer to buy some 3rd party product that comes bundled with something
>> else that they need, etc.).  

(Cf. the discussion of "popular" vs. "unpopular" components above.)

>> What the current strategy does is reinforce the idea that NT is for
>> NETWORK SERVERS ONLY.  A few people might install it on
>> workstation-class machines that aren't networked, but that's not real
>> likely in most cases.  MS seems to be saying that that market isn't
>> large enough to be important.
>
>Go read the marketing info on NT again.  I don't get this impression.

The only marketing info I have seen is that posted in this group.
From the fact that NT will be (or is expected to be) bundled with a
substantial degree of networking capability (and giving the MS
marketing dept. some credit for ability), it would seem likely that NT
will be aimed primarily at a market that would place high value on
networking (and on other features of a similar nature, eg. SMP,
extensive accounting hooks, security features, etc.).  In other words
(as translated by many people here, at least), a primary market is
file servers (and other types of servers).  Of course, the high-end
graphics support and similar stuff (MM support, and even DOS/Win16
etc.) points to another market, at least it would seem so, since
these features are of less significance in the server market.

Presumably, this other market has not entirely dissimilar values for
many of NT's expected features as the server market, otherwise MS
might do poorly in both markets from trying to make one product be too
many things to too many people :-).

>petesk@microsoft.com
>My Opinions...

--
Andrew Innes (aci10@eng.cam.ac.uk)
Engineering Dept.
Cambridge University
Cambridge, England.
Newsgroups: comp.os.os2.advocacy