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Lock in and switch: Asymmetric information and new product diffusion

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Abstract

Many new web-based services are introduced as free services. Depending on the seller’s business model, some remain free in the long run, while others switch to pay mode at some point in time. I characterize the relation between buyers and a new service seller when the former are uncertain about the latter’s business model and need to incur a one-time sunk cost before enjoying the new service. I derive a natural signaling equilibrium where the seller plays a “lock-in-and-switch” strategy, while buyers play a “wait-and-see” strategy. Specifically, a high-cost seller starts by pricing at zero and waits for a sufficient number of consumers to adopt the new service, at which point the seller switches to pay mode. In this gradual separation equilibrium, the signal is given not by the price level (which always starts at zero) but rather by the duration of the introductory offer. Finally, I show the equilibrium entails diffusion even though consumers are identical and equally aware of the new service’s existence.

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Notes

  1. AvantGo offers a premium service for a fee. In Section 5, I consider the case when a seller’s set of options extends beyond the choice of free and pay modes.

  2. By contrast, Hitsch (2006), among others, considers the case when the seller is uncertain about demand.

  3. Even if the optimal monopoly price is positive, there may be reasons why zero is a better pricing strategy. See Bawa and Shoemaker (2004), Shampanier et al. (2007).

  4. In some cases, negative prices are feasible and observed in equilibrium. For example, for a while PayPal paid consumers $10 for opening an account; and opentable.com (an online reservation and review site) sometimes provides dollar-off coupons for restaurants as a reward for using their service. The results in this paper follow through if there exists a finite lower bound to price, which may be negative. The important assumptions are that (1) the seller has no commitment to price beyond the current moment; and (2) the seller is unable to make a fixed transfer to the buyer.

  5. Note that, as expected, for p = 0 we get π H (p) = 0 and Eq. 6 reduces to Eq. 2.

  6. http://www.eudora.com/download/, visited on April 16, 2008.

  7. See Bass (1969) and Jensen (1982) for examples of the former approach; and Griliches (1957), David (1969), Davies (1979) for examples of the latter approach. See also Geroski (2000) for a good survey of this literature.

  8. Danaher (2002) considers optimal pricing strategies for a new subscription service. See Essegaier et al. (2002) for a related approach. One important difference with respect to my model is that these papers look at the case of recurrent fixed feeds (e.g., the monthly rental in a cell phone plan), whereas I consider the one-time sunk cost a consumer must incur before beginning to enjoy a new product or service.

  9. (See for example Fudenberg and Tirole 1983; Ghemawat and Nalebuff 1985; Cabral 2004).

  10. See Rosenthal (1982, 1986), Chen and Rosenthal (1996).

  11. See Gerstner and Hess (1990), Lazear (1995), Wilkie et al. (1998). These papers are inconclusive as to the welfare effects of bait-and-switch, a (currently) illegal activity.

  12. See for example Ellison (2005).

  13. See also Bagwell and Riordan (1991), Judd and Riordan (1994). See Dawar and Sarvary (1997) for a (successful) test of some implications of price signaling theory. In addition to price, other variables, such as specialization, may be used as signals. See Kalra and Li (2008)

  14. See also Cabral and Riordan (1994).

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Acknowledgements

The author thanks Jim Anton, Kyle Bagwell, Yuxin Chen, Judy Chevalier, Tülin Erdem, Mike Katz, Alessandro Lizzeri, Barry Nalebuff, Roy Radner, and seminar participants at NYU and ECARES for useful comments and suggestions with reference to a previous (and substantially different) version of this paper. The usual disclaimer applies, especially considering the differences between this and previous drafts of the paper. The author is also grateful to the Editor and to two referees for helpful comments and suggestions. A previous draft under the same title was circulated as NYU Stern WP EC-07-11.

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  1. Stern School of Business, New York University, 44 West 4th Street, New York, NY, 10012, USA

    Luís Cabral

  2. CEPR, London, UK

    Luís Cabral

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Cabral, L. Lock in and switch: Asymmetric information and new product diffusion. Quant Mark Econ 10, 375–392 (2012). https://doi.org/10.1007/s11129-012-9120-0

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