Sunday, September 2, 2007

Increasing Network Value I: Transaction Value and Pricing

Connectivity value in a network is at least one metric for valuing networks. Others, such as Reed, have proposed other metrics such as group-forming value, but let's stick with connectivity value for a moment. Even in Web 2.0 and Enterprise 2.0, groups exist due to relationships which are based on transactions across connections.

If, as I've proposed, there are conditions where connectivity value is linear in the size of the network -- be it a communications network, a producer-consumer network, or anything else -- does that mean that networks have limited value?

Of course not.

If we define the connectivity value of a link as the expected value (i.e., likelihood-adjusted) of the net present value (i.e., adjusted for time value of money) of the transaction stream of that link, then one easy way to increase the value of the connection is to increase the size (i.e., value) of the transactions.

For example, if the connectivity value between me and my car dealer is defined by buying a car every four years, that connectivity value will increase if I buy a Lamborghini every four years instead of a used Yugo. (For those that don't know, the Yugo was of note when it went on sale in the '80s as the cheapest car sold in the U. S. Presumably used ones are still for sale).

Nothing has changed in the order of the value of the network: it is still order (n), in other words, proportional to the number of nodes, which in this case, are many car buyers and a relative few car dealers). However, if everyone started buying Lamborghinis instead of Yugos, the connectivity value of the "global automotive sales network" would increase by several orders of magnitude.

Of course, merely raising prices or selling more expensive products doesn't do the trick. Wal-Mart's revenues are higher than Henri Bendel's. As first steps, understanding price elasticity of demand (what would happen if we charged 10% more for this product) and using dynamic pricing for yield management (this is why airline seat prices appear to fluctuate randomly) can maximize total value of the system.

Also, price targeting, discussed in extremely readable fashion in "The Undercover Economist," by Tim Harford, subtly extracts more money from price insensitive or otherwise ignorant customers. He addresses three main mechanisms: individual targeting, group targeting, and "self-incrimination." It is this last technique that enables gourmet coffee shops to sell a cheap regular coffee right next to a $5.00 super half-caf iced mocha caramel choco-frappuccino. Lest you think that this is because of special hand-picked beans which cost isn't. Tim assures us that the production and operations cost differential between cheap and expensive cups may be disregarded.

In summary, one way to increase the value of a network? Raise prices. Or lower them. Or change them dynamically. Whatever it takes to maximize the expected net present value of the connection. And, as Tim points out, in a free market economy such pricing represents the "truth" about what maximizes value to all parties in the transaction: consumers as well as producers.

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