Pricing Digital Goods: Discontinuous Costs and Shared Infrastructure

Abstract

In this paper, we analyze a model of usage pricing for digital products with discontinuous supply functions. This model characterizes a number of information technology-based products and services for which variable increases in demand are fulfilled by the addition of blocks of computing or network infrastructure. Such goods are often modeled as information goods with zero variable costs; in fact, the actual cost structure resembles a mixture of zero marginal costs and positive periodic fixed costs. This paper discusses the properties of a general solution for the optimal nonlinear pricing of such digital goods. We show that the discontinuous cost structure can be accrued as a virtual constant variable cost. This paper applies the general solution to solve two related extensions by first investigating the optimal technology capacity planning when the cost function is both discontinuous and declining over time, and then characterizing the optimal costing for the discontinuous supply when it is shared by several business profit centers. Our findings suggest that the widely adopted full cost recovery policies are typically suboptimal.