Economics of Information Economics of Information TechnologyTechnology

2nd session2nd session11.02.200311.02.2003

Experiencing MicroeconomicsExperiencing Microeconomics

Introduction 2

AgendaAgenda

‘‘Think like an economist’Think like an economist’

1.1. General Microeconomic conceptsGeneral Microeconomic concepts• Supply demand and cost functionsSupply demand and cost functions

2.2. Microeconomics and the information productMicroeconomics and the information product• First copy costs ,MC, Sunk costs, price First copy costs ,MC, Sunk costs, price

differentiationdifferentiation

3.3. Organization of the courseOrganization of the course• Group presentation and preparation of the Group presentation and preparation of the

academic summariesacademic summaries

Introduction 3

1.1 Supply Demand schedules 1.1 Supply Demand schedules

S

D

P0

S0

Price

Quantity

Equilibrium (EQ)

Introduction 4

1.1 Supply Demand schedules1.1 Supply Demand schedules

S

D

P0

Q0

Price

Quantity

Effect of a tax imposition on the demand curve ( i.e. VAT tax)Effect of a tax imposition on the demand curve ( i.e. VAT tax)

EQT

PT

QT

Introduction 5

1.1 Supply Demand 1.1 Supply Demand Effect of a tax imposition on the supply curve ( i.e corporate Effect of a tax imposition on the supply curve ( i.e corporate

tax)tax)

Price

Quantity

S

D

P0

Q0

PT

QT

ST

EQT

Introduction 6

1.2 Price Elasticity of Demand 1.2 Price Elasticity of Demand

• Price elasticity is greater in the long Price elasticity is greater in the long run (LR) than in the short rum (SR)run (LR) than in the short rum (SR)

Price

Quantity

P0

Q0

P1

QSR

DSR

QL

R

DLR

Introduction 7

1.2 Price Elasticity of Demand 1.2 Price Elasticity of Demand

Price Elasticity Price Elasticity is the % change of a quantity demanded, is the % change of a quantity demanded, brought by 1% change in pricebrought by 1% change in price

Price elasticity = n =Price elasticity = n =Change QChange Q : : Change PChange P QQ00 P P00

If n < 1 If n < 1 demand is inelastic demand is inelastic

If n > 1 If n > 1 demand is elastic demand is elastic

Example: n = 0,75 and change P= + 3% Example: n = 0,75 and change P= + 3% change in demand = change in demand = 2,25%2,25%

Introduction 8

1.2 Price Elasticity of Demand 1.2 Price Elasticity of Demand

• Price elasticity is greater in the long Price elasticity is greater in the long run (LR) than in the short rum (SR)run (LR) than in the short rum (SR)

P

Q

P

Q

Perfectly elastic demand

Perfectly inelastic demand

Introduction 9

1.2 Price elasticity of demand1.2 Price elasticity of demand

Factors that make demand for a product more sensitive:Factors that make demand for a product more sensitive:

1.1. Unique product features, product differentiationUnique product features, product differentiation

2.2. High proportion of buyers expendituresHigh proportion of buyers expenditures

3.3. Intermediate products in price sensitive industries such as PC Intermediate products in price sensitive industries such as PC industryindustry

Factors that make demand for a product less sensitive:Factors that make demand for a product less sensitive:

1.1. Difficult to compare products/servicesDifficult to compare products/services

2.2. Low proportion of buyers expendituresLow proportion of buyers expenditures

3.3. High costs to switch to another productHigh costs to switch to another product

4.4. Products compatibility or product network effectsProducts compatibility or product network effects

Introduction 10

1.3 Cost Functions - 1.3 Cost Functions - Total CostsTotal Costs

Total Costs = FC + VCTotal Costs = FC + VCCost

Quantity

Fixed Costs (FC)

Q0

FC

QT

Total Costs (TC)

Variable Costs (VC)

Introduction 11

1.3 Cost Functions - 1.3 Cost Functions - Total CostsTotal Costs

Total Costs = FC + VCTotal Costs = FC + VC

Cost

Quantity

Fixed Costs (FC)

Total Costs (TC)

Variable Costs (VC)

Introduction 12

1.3 Cost Functions - 1.3 Cost Functions - Average CostsAverage Costs

Average Costs = TC/QAverage Costs = TC/QCost =C

Quantity

Average Costs (AC)

Introduction 13

1.3 Cost Functions – 1.3 Cost Functions – Minimum Minimum

efficient scale of production (MES)efficient scale of production (MES) Average Costs schedules of ‘ old economy firms’Average Costs schedules of ‘ old economy firms’

C

Q

C

Q

Minimum efficient scale

• Until Q’ economies of scale are present• Minimum efficient scale at Q’ when scale economies are exhausted• Q’ – Q’’ constant returns to scale• Beyond Q’’ diseconomies of scale

ACAC

Economies of scale

Constant returns to scale

Diseconomies of scale

Q’ Q’ Q’’

Introduction 14

1.4 Cost Functions - 1.4 Cost Functions - Constant returns to Constant returns to

scalescale Average Costs schedules of ‘ new economy information good Average Costs schedules of ‘ new economy information good

firmsfirms

C

Q

ACEconomies of scale

Constant returns to scale

Diseconomies of scale

• Constant returns to scale theoretically until infinity

Introduction 15

1.5 Cost Functions1.5 Cost Functions – – Marginal CostsMarginal Costs

• The cost of expanding output or cost savings The cost of expanding output or cost savings contracting output contracting output

• The The incremental costincremental cost of producing exactly one more of producing exactly one more unit of outputunit of output

• MC (Q) = MC (Q) = TC (Q + change Q) – TC (Q)TC (Q + change Q) – TC (Q) change Qchange Q

• MC (Q) = VC/QMC (Q) = VC/Q

• Average total costs (ATC) = TC/QAverage total costs (ATC) = TC/Q

• Average variable costs (AVC) = VC/QAverage variable costs (AVC) = VC/Q

Introduction 16

1.5 Cost Functions1.5 Cost Functions – – Marginal CostsMarginal Costs

C

In the event of constant returns to scale MC = ACAC = ATC + AVC

C

Q

FC

TCVC

C/Q

Q

MC=AC

ATC

AVC

Introduction 17

1.5 Cost Functions1.5 Cost Functions – – Marginal CostsMarginal Costs

Quantity

TCTC (Q)

MC (Q)

TC ( Q’ + 1)TC ( Q’)

Q’+1Q’

Q’’+1Q’’

Q’

Q’’

TC ( Q’’ + 1)

TC ( Q’’)

Quantity

MC

MC ( Q’)

MC ( Q’’)

Introduction 18

1.5 Cost Functions1.5 Cost FunctionsRelationship Marginal Costs and Average Cost

1. When AC is a decreasing function of output MC < AC

2. When AC = constant or at MES MC = AC

3. When AC is a increasing function of output MC > AC

C

Q

MC

AC

AV increasesMC > AC

Introduction 19

1.x Price Discrimination1.x Price Discrimination

Introduction 20

1.6 Cost Functions 1.6 Cost Functions Long-run versus short-run cost functions

• The period of time in which the firm cannot adjust the size of its production facilities = short run

• For each level of output there is an optimal plant sizeExample large vs. smaller plant size (see Besanko; figure P.6; pg. 17)

Optimal plant size produces savings from:

1. Lower costs from adequate plant size by either reduction of the fixed costs or the utilization of scale economies

2. More efficient labor allocation, better control over VC3. Optimization of the plants organization

Introduction 21

• Sunk costs are not fixed costs ( e.g. railroad locomotives)

• The opposite of sunk costs are avoidable costs

• Sunk investments are industry specific assets that would neither increase value, nor reduce costs when applied to a different product market. Usually up front investments

• Sunk costs are important for the study of industry strategy, the analysis of rivalry among firms, entry and exit decisions into markets and decisions to adopt new technologies

1.6 Cost Functions1.6 Cost Functions Sunk Costs

Introduction 22

1.7 Economic Costs1.7 Economic CostsEconomic Costs versus Accounting CostsEconomic Costs versus Accounting Costs

• Accounting Profit = Sales revenues – Accounting cost

• Economic profit = very close related to the principle opportunity cost

• Economic profit = Sales Revenue – Economic Cost

• Economic cost = closely aligned with the return on invested capital (ROI), such as plant & equipment

• Economic profit = Sales Revenue – economic cost – accounting cost

Introduction 23

1.7 Economic Costs1.7 Economic CostsEconomic Profit and Net Present ValueEconomic Profit and Net Present Value

• Present Value of an annual accounting profit: PV = Cash Flow (C)

(1+i)t

• Net present value (NPV) = present value of the cash flows generates minus the cost of the investment

• NPV = Acc. profit (C) - Cost of the investment (1+i)t

Introduction 24

2.1 Important Microeconomic 2.1 Important Microeconomic concepts in the ‘Information concepts in the ‘Information

Economy’Economy’

• First copy costsFirst copy costs

• Economies of scale Economies of scale

• Sunk costsSunk costs

• Fixed costsFixed costs

• Variable costs Variable costs

• Marginal costsMarginal costs

Introduction 25

2.2 Costs and competition in the 2.2 Costs and competition in the Information EconomyInformation Economy

• Sunk costsSunk costs => =>industry specific assets that would neither industry specific assets that would neither increase value, nor reduce costs when applied to a different product increase value, nor reduce costs when applied to a different product market. Usually up front investmentsmarket. Usually up front investments

• First copy costsFirst copy costs of an information good are typically high, and of an information good are typically high, and typically cannot be recovered, and are therefore defined as sunk coststypically cannot be recovered, and are therefore defined as sunk costs

• Marginal costs (MC) =>Marginal costs (MC) => the cost of producing an extra the cost of producing an extra unit of a certain productunit of a certain product

• Reproduction costsReproduction costs of an information good are often of an information good are often constant and costs essentially nothing constant and costs essentially nothing MC close to zero MC close to zero

• No capacity limitsNo capacity limits for the reproduction of information goodsfor the reproduction of information goods

Introduction 26

2.3 Costs and competition in the 2.3 Costs and competition in the Information EconomyInformation Economy

• Declining production costs are attracting Declining production costs are attracting competitorscompetitors

• Dominant firms have due to the financial Dominant firms have due to the financial leverageleverage

• Marginal costs (MC) =>Marginal costs (MC) => the cost of producing an extra the cost of producing an extra unit of a certain productunit of a certain product

• Reproduction costsReproduction costs of an information good are often of an information good are often constant and costs essentially nothing constant and costs essentially nothing MC close to zero MC close to zero

• No capacity limitsNo capacity limits for the reproduction of information goodsfor the reproduction of information goods

Introduction 27

3.1 Organization of the course3.1 Organization of the courseGroup PresentationsGroup Presentations

Setting:• The group is performing an consultant firm, while the

class is acting as the top leadership of a respective firm or a governmental body

• Presentation about 25 min plus 15 min for Q&A

• Hand- in by Monday before the next lecture, latest at 15:00 via e-mail to: cls@woco.dk

Introduction 28

3.1 Organization of the course3.1 Organization of the courseGroup PresentationsGroup Presentations

Structure of the presentations:• Introduction

• Industry overview

• The firms business model and strategy

• SWOT analysis of the firm ( competitors, policies and regulations, technology ect.

• Elaborate proposal for problem solution, strategy shift or general improvement of the firms current situation. Show the link to the theoretical framework of the course

• List of recommendations

Introduction 29

3.2 Organization of the course3.2 Organization of the courseSummary of literatureSummary of literature

Summary’s structure • Title and source

• Abstract/Conclusions

• Key terms and concepts in order of appearance

• Main Questions & assertions

• The approach to solve the main questions

• Support of assertions

• Relationship between terms and concepts

• Relation to other articles