Chapter Thirty-Five Information Technology. Information Technologies The crucial ideas are: ...
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Transcript of Chapter Thirty-Five Information Technology. Information Technologies The crucial ideas are: ...
Chapter Thirty-Five
Information Technology
Information Technologies
The crucial ideas are: Complementarity Network externality
Information Technologies;Complementarity
Definition: Commodity A complements commodity B if more of commodity A increases the value of an extra unit of commodity B. More software increases the value of a
computer. More roads increase the value of a car.
Information Technologies;Network Externality
Definition: A commodity has a positive (negative) network externality if the utility to a consumer of that commodity increases (decreases) as more people also consume the commodity. Email gives more utility to any one user if
more other people use email. A highway gives less utility to any one user
as more people use it (congestion).
Complementarity
Information technologies have increased greatly the complementarities between commodities. Computers and operating systems (OS). DVD players and DVD disks. WiFi sites and laptop computers. Cell phones and cell phone towers.
Complementarity
How should a firm behave when it produces a commodity that complements another commodity?
The problem is: When you make more of your product (commodity A) you increase the value of firm B’s product (commodity B). Can you get for yourself some of gain you create for firm B?
Complementarity
An obvious strategy is for firms A and B to cooperate somewhat with each other. Microsoft releases part of its OS to firms
making software that runs under its OS. DVD manufacturers agree upon a
standard format for their disks.
Complementarity
The price of a computer is pC. The price of the OS is pOS. The quantities demanded of computers
and the OS depends upon pC + pOS, not just pC or just pOS.
Complementarity
The price of a computer is pC. The price of the OS is pOS. The quantities demanded of computers
and the OS depends upon pC + pOS, not just pC or just pOS.
Suppose the computer and software firms’ marginal production costs are zero. Fixed costs are FC and FOS.
Complementarity
Suppose the firms do not collude. The computer firm’s problem is:
choose pC to maximize pCD(pC + pOS) – FC.
The OS firm’s problem is:choose pOS to maximize pOSD(pC + pOS) – FOS.
Complementarity
Suppose the firms do not collude. The computer firm’s problem is:
choose pC to maximize pCD(pC + pOS) – FC.
The OS firm’s problem is:choose pOS to maximize pOSD(pC + pOS) – FOS.
Assume D(pC + pOS) = a – b(pC + pOS).
Complementarity
The computer firm’s problem is: choose pC to maximize pC(a – b(pC + pOS)) – FC.
The OS firm’s problem is:choose pOS to maximize pOS(a – b(pC + pOS)) – FOS.
Complementarity
Choose pC to maximize pC(a – b(pC + pOS)) – FC
pC = (a – bpOS)/2b. (C) Choose pOS to maximize
pOS(a – b(pC + pOS)) – FOS
pOS = (a – bpC)/2b. (OS)
Complementarity
Choose pC to maximize pC(a – b(pC + pOS)) – FC
pC = (a – bpOS)/2b. (C) Choose pOS to maximize
pOS(a – b(pC + pOS)) – FOS
pOS = (a – bpC)/2b. (OS) A NE is a pair (p*C,p*OS) solving (C)
and (OS).
Complementarity
Choose pC to maximize pC(a – b(pC + pOS)) – FC
pC = (a – bpOS)/2b. (C) Choose pOS to maximize
pOS(a – b(pC + pOS)) – FOS
pOS = (a – bpC)/2b. (OS) A NE is a pair (p*C,p*OS) solving (C) and
(OS). p*C = p*OS = a/3b.
Complementarity
p*C = p*OS = a/3b. When the firms do not cooperate the
price of a computer with an OS is p*C + p*OS = 2a/3band the quantities demanded of computers and OS are q*C + q*OS = a - b×2a/3b = a/3.
Complementarity
What if the firms merge? Then the new firm bundles a computer and an operating system and sells the bundle at a price pB.
The firm’s problem is to choose pB to maximize pBD(pB) – FB = pB(a – bpB) – FB.
Complementarity
What if the firms merge? Then the new firm bundles a computer and an operating system and sells the bundle at a price pB.
The firm’s problem is to choose pB to maximize pBD(pB) – FB = pB(a – bpB) – FB.
Solution is p*B = a/2b < 2a/3b.
Complementarity
When the firms merge (or fully cooperate) the price of a computer and an OS is p*B = a/2b < 2a/3band the quantity demanded of bundled computers and OS is q*B = a - b×a/2b = a/2 > a/3.
Complementarity
When the firms merge (or fully cooperate) the price of a computer and an OS is p*B = a/2b < 2a/3band the quantity demanded of bundled computers and OS is q*B = a - b×a/2b = a/2 > a/3.
The merged firm supplies more computers and OS at a lower price than do the competing firms. Why?
Complementarity
The noncooperative firms ignore the external benefit (complementarity) each creates for the other. So each undersupplies the market, causing a higher market price.
These externalities are fully internalized in the merged firm, inducing it to supply more computers and OS and thereby cause a lower market price.
Complementarity
More typical cooperation consists of contracts between component manufacturers and an assembler of a final product. Examples are: Car components and a car assembler. A computer assembler and
manufacturers of CPUs, hard drives, memory chips, etc.
Complementarity Alternatives include:
Revenue-sharing. Two firms share the revenue from the final product made up from the two firms’ components.
Licensing. Let firms making complements to your product use your technology for a low fee so they make large quantities of complements, thereby increasing the value of your product to consumers.
Information Technologies;Lock-In
Strong complementarities or network externalities make switching from one technology to another very costly. This is called lock-in.
E.g., In the USA, it is costly to switch from speaking English to speaking French.
How do markets operate when there are switching costs or network externalities?
Competition & Switching Costs
Producer’s cost per month of providing a network service is c per customer.
Customer’s switching cost is s. Producer offers a one month discount,
d. Rate of interest is r.
Competition & Switching Costs
All producers set the same nondiscounted price of p per month.
When is switching producers rational for a customer?
Competition & Switching Costs
Consumer’s cost of not switching is
.)1(1 2 r
pp
r
p
r
pp
Competition & Switching Costs
Consumer’s cost of not switching is
Consumer’s cost from switching is
.)1(1 2 r
psdp
r
p
r
psdp
.)1(1 2 r
pp
r
p
r
pp
Competition & Switching Costs
Consumer’s cost of not switching is
Consumer’s cost from switching is
Consumer should switch if
.r
pps
r
pdp
.)1(1 2 r
psdp
r
p
r
psdp
.)1(1 2 r
pp
r
p
r
pp
Competition & Switching Costs
Consumer’s cost of not switching is
Consumer’s cost from switching is
Consumer should switch if
i.e. if .r
pps
r
pdp
.sd
.)1(1 2 r
psdp
r
p
r
psdp
.)1(1 2 r
pp
r
p
r
pp
Competition & Switching Costs
Consumer should switch if Producer competition will ensure at a
market equilibrium that customers are indifferent between switching or not
I.e., the equilibrium value of the discount only just makes it worthwhile for the customer to switch.
.sd
.sd
Competition & Switching Costs
With d = s, the present-value of the
producer’s profits is
.
)1(1 2
r
cpsp
r
cpdp
r
cp
r
cpdpπ
Competition & Switching Costs
At equilibrium the present-value of the producer’s profit is zero.
The producer’s price is its marginal cost plus a markup that is a fraction of the consumer’s switching cost.
.1
0 sr
rcp
r
cpspπ
Competition & Switching Costs
At equilibrium the present-value of the producer’s profit is zero.
The producer’s price is its marginal cost plus a markup that is a fraction of the consumer’s switching cost. If advertising reduces the marginal cost of servicing a consumer by a then
.1
0 sr
rcp
r
cpspπ
Competition & Switching Costs
At equilibrium the present-value of the producer’s profit is zero.
The producer’s price is its marginal cost plus a markup that is a fraction of the consumer’s switching cost. If advertising reduces the marginal cost of servicing a consumer by a then
.1
0 sr
rcp
r
cpspπ
.1
sr
racp
Competition & Network Externalities
Individuals 1,…,1000. Each can buy one unit of a good,
providing a network externality. Person v values a unit of the good at
nv, where n is the number of persons who buy the good.
Competition & Network Externalities
Individuals 1,…,1000. Each can buy one unit of a good
providing a network externality. Person v values a unit of the good at
nv, where n is the number of persons who buy the good.
At a price p, what is the quantity demanded of the good?
Competition & Network Externalities
If v is the marginal buyer, valuing the good at nv = p, then all buyers v’ > v value the good more, and so buy it.
Quantity demanded is n = 1000 - v. So inverse demand is p = n(1000-
n).
Competition & Network Externalities
0 1000n
Willingness-to-pay p = n(1000-n)
Demand Curve
Competition & Network Externalities
Suppose all suppliers have the same marginal production cost, c.
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curvec
Willingness-to-pay p = n(1000-n)
Competition & Network Externalities
What are the market equilibria?
Competition & Network Externalities
What are the market equilibria? (a) No buyer buys, no seller supplies.
If n = 0, then value nv = 0 for all buyers v, so no buyer buys.
If no buyer buys, then no seller supplies.
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curvec
Willingness-to-pay p = n(1000-n)
(a)
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curve
n’
c
Willingness-to-pay p = n(1000-n)
(a)
Competition & Network Externalities
What are the market equilibria? (b) A small number, n’, of buyers buy.
small n’ small network externality value n’v
good is bought only by buyers with n’v c; i.e., only large v v’ = c/n’.
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curve
n’
(b)
n”
(c)
(a)
c
Willingness-to-pay p = n(1000-n)
Competition & Network Externalities
What are the market equilibria? (c) A large number, n”, of buyers buy.
Large n” large network externality value n”v
good is bought only by buyers with n’v c; i.e., up to small v v” = c/n”.
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curve
n’
(b)
n”
(c)c
Which equilibrium is likely to occur?
Willingness-to-pay p = n(1000-n)
(a)
Competition & Network Externalities
Suppose the market expands whenever willingness-to-pay exceeds marginal production cost, c.
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curve
n’ n”
c
Which equilibrium is likely to occur?
Willingness-to-pay p = n(1000-n)
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curve
n’ n”
c
Which equilibrium is likely to occur?
Willingness-to-pay p = n(1000-n)
Unstable
Competition & Network Externalities
0 1000n
Demand Curve
Supply Curve
n”
c
Which equilibrium is likely to occur?
Willingness-to-pay p = n(1000-n)
Stable
Stable
Information
Essentially, anything that can be digitized is information.
Information Goods: books, database, magazines, movies,
music, web pages.
Cost of producing information
Information is costly to produce but cheap to reproduce.
In economics terms, production of an information good involves high fixed cost but low marginal cost.
Therefore, we price information according to its value, not its cost.
Managing Intellectual Property
Since an information good can be reproduced cheaply, others can copy it cheaply.
Intellectual property is very important, but enforcement is an issue.
e.g., patent, copyright, trademark When managing IP, the goal should be to
choose the terms and conditions that maximize the value of the IP, not the ones that maximize the protection.
Information as an “Experience Good”
A good is an experience good if consumers must experience it to value it.
Information is an experience good every time it’s consumed.
How do you know today’s Wall Street Journal is worth $1?
Most media producers overcome the experience the experience good problem through branding and reputation.
Information as an “Experience Good” (Cont’d)
The brand name of the wall Street Journal is one of its chief asset, and the Journal heavily in building a reputation for accuracy, timeliness, and relevance.
The Journal’s online edition carries over the look and feel of the print version extending the same authority, brand identity, and customer loyalty from the print product to the on-line product.
Rights Management
Should a good be sold outright, licensed for production by others, or rented?
How is the ownership right of the good to be managed?
Rights Management
Suppose production costs are negligible.
Market demand is p(y). The firm wishes to max
yp y y( ) .
Rights Management
y
p
p y( )
Rights Management
y
p
p y( )
( ) ( )y p y y
Rights Management
y* y
p
p y( )
( ) ( )y p y y
p y( *)
Rights Management
The rights owner now allows a free trial period. This causes a consumption increase; Y y , 1
Rights Management
The rights owner now allows a free trial period. This causes a consumption increase; lower sales per consumption unit
yY
.
Y y , 1
Rights Management
The rights owner now allows a free trial period. This causes a consumption increase; lower sales per consumption unit
increase in value to all users increase in willingness-to-pay;
yY
.
Y y , 1
P Y p Y( ) ( ), . 1
Rights Management
y Y,
p
p y( )P Y p Y( ) ( )
Rights Management
The firm’s problem is now to
maxY
P YY
p YY
p Y Y( ) ( ) ( ) .
Rights Management
The firm’s problem is now to
This problem must have the same solution as
maxy
p y y( ) .
maxY
P YY
p YY
p Y Y( ) ( ) ( ) .
Rights Management
The firm’s problem is now to
This problem must have the same solution as
So maxy
p y y( ) .
y Y* *.
maxY
P YY
p YY
p Y Y( ) ( ) ( ) .
Rights Management
y
p
p y( )
( ) ( )y p y y
y*
p y( *) P Y p Y( ) ( )
Rights Management
y Y* *
p y( *)p Y( *)
y
p
p y( )
( ) ( )y p y y
( ) ( )Y p Y Y
1 higher profit
P Y p Y( ) ( )
Rights Management
y Y* *
p y( *)p Y( *)
y
p
p y( )
( ) ( )y p y y
( ) ( )Y p Y Y
1 lower profit
P Y p Y( ) ( )
Sharing Intellectual Property
Produce a lot for direct sales, or only a little for multiple rentals?
Sell a tool, or rent it? Allow a movie to be shown only at a
theatre, or sell only to video rental stores, or sell only by pay-per-view, or sell DVDs in retail stores?
When is selling for rental more profitable than selling for personal use only?
Sharing Intellectual Property
F is the fixed cost of designing the good.
c is the constant marginal cost of copying the good.
p(y) is the market demand. Direct sales problem is to
Sharing Intellectual Property
F is the fixed cost of designing the good.
c is the constant marginal cost of copying the good.
p(y) is the market demand. Direct sales problem is to
maxy
p y y cy F( ) .
Sharing Intellectual Property
Is selling for rental more profitable? Each rental unit is used by k > 1
consumers. So y units sold x = ky consumption
units.
Sharing Intellectual Property
Is selling for rental more profitable? Each rental unit is used by k > 1
consumers. So y units sold x = ky consumption
units. Marginal consumer’s willingness-to-pay
is p(x) = p(ky).
Sharing Intellectual Property
Is selling for rental more profitable? Each rental unit used by k > 1
consumers. So y units sold x = ky consumption
units. Marginal consumer’s willingness-to-pay
is p(x) = p(ky). Rental transaction cost t reduces
willingness-to-pay to p(ky) - t.
Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
].)([)( tkypkyPs
Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
Producer’s sale-for-rental problem is].)([)( tkypkyPs
FcyyyPsy
)(max
Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
Producer’s sale-for-rental problem is].)([)( tkypkyPs
FcyytkypkFcyyyPsy
])([)(max
Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
Producer’s sale-for-rental problem is].)([)( tkypkyPs
.)(
])([)(max
Fkytk
ckykyp
FcyytkypkFcyyyPsy
Sharing Intellectual Property
Fxtk
cxxp
Fkytk
ckykyp
x
y
)(max
)(max
This is the same as the direct sale problem
Fcyyypy
)(max
except for the marginal cost.
Sharing Intellectual Property
Fxtk
cxxp
Fkytk
ckykyp
x
y
)(max
)(max
This is the same as the direct sale problem
Fcyyypy
)(max
except for the marginal cost. Direct sale
is better for the producer if .tk
cc
Sharing Intellectual Property
Direct sale is better for the producer if
i.e. if
.tk
cc
.1t
k
kc
Sharing Intellectual Property
Direct sale is better for the producer if
Direct sale is better if replication cost c is low rental transaction cost t is high rentals per item, k, is small.
.1t
k
kc