Transcript Chapter 1 Market

Information Technology

The crucial ideas are:
Complementarity
 Network externality


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.


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).


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.



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?

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.




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.




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.



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.




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).


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.


Choose pC to maximize
pC(a – b(pC + pOS)) – FC
 pC = (a – bpOS)/2b.
Choose pOS to maximize
pOS(a – b(pC + pOS)) – FOS
 pOS = (a – bpC)/2b.
(C)
(OS)



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).



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.


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/3b
and the quantities demanded of computers and
OS are
q*C + q*OS = a - b×2a/3b = a/3.


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.



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.

When the firms merge (or fully cooperate) the
price of a computer and an OS is
p*B = a/2b < 2a/3b
and the quantity demanded of bundled
computers and OS is
q*B = a - b×a/2b = a/2 > a/3.


When the firms merge (or fully cooperate) the
price of a computer and an OS is
p*B = a/2b < 2a/3b
and 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?


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.

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.


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.




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?




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.


All producers set the same nondiscounted price of
p per month.
When is switching producers rational for a
customer?

Consumer’s cost of not switching is
p
p
p
p

  p  .
2
1  r (1  r )
r


Consumer’s cost of not switching is
p
p
p
p

  p  .
2
1  r (1  r )
r
Consumer’s cost from switching is
p
p
p
pd s

  p  d  s  .
2
1  r (1  r )
r

Consumer’s cost of not switching is
p
p
p
p

  p  .
2
1  r (1  r )
r

Consumer’s cost from switching is

p
p
p
pd s

  p  d  s  .
2
1  r switch
(1 ifr )
r
Consumer should
p
p
pd  s  p .
r
r

Consumer’s cost of not switching is
p
p
p
p

  p  .
2
1  r (1  r )
r

Consumer’s cost from switching is

p
p
p
pd s

  p  d  s  .
2
1  r switch
(1 ifr )
r
Consumer should

i.e. if
p
p
pd  s  p .
r
r
d  s.


Consumer should switch if
d  s.
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
d  s. for the customer to switch.
makes it worthwhile

With d = s, the present-value of the producer’s profits is
pc pc
pc
π  pd

  p  d 
2
1  r (1  r )
r
pc
ps
.
r

At equilibrium the present-value of the producer’s profit
is zero.
pc
r
π ps
0  pc
s.
r
1 r
 The producer’s price is its marginal cost plus a markup
that is a fraction of the consumer’s switching cost.

At equilibrium the present-value of the producer’s profit
is zero.
pc
r
π ps
0  pc
s.
r
1 r
 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

At equilibrium the present-value of the producer’s profit
is zero.
pc
r
π ps
0  pc
s.
r
1 r
 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
r
p  c a
s.
1 r



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.




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?



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).
Willingness-to-pay
p = n(1000-n)
Demand Curve
0
n
1000

Suppose all suppliers have the same marginal
production cost, c.
Willingness-to-pay
p = n(1000-n)
Demand Curve
Supply Curve
c
0
n
1000

What are the market equilibria?


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.

Willingness-to-pay
p = n(1000-n)
Demand Curve
Supply Curve
c
(a)
0
n
1000
Willingness-to-pay
p = n(1000-n)
Demand Curve
Supply Curve
c
(a)
0
n’
n
1000


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’.

Willingness-to-pay
p = n(1000-n)
Demand Curve
c
(b)
(a)
0
n’
(c)
n
n” 1000
Supply Curve


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”.

Willingness-to-pay
p = n(1000-n)
Demand Curve
c
(b)
(a)
0
n’
(c)
n
Supply Curve
n” 1000
Which equilibrium is likely to occur?

Suppose the market expands whenever willingnessto-pay exceeds marginal production cost, c.
Willingness-to-pay
p = n(1000-n)
Demand Curve
Supply Curve
c
0
n’
n
n” 1000
Which equilibrium is likely to occur?
Willingness-to-pay
p = n(1000-n)
Demand Curve
Unstable
Supply Curve
c
0
n’
n
n” 1000
Which equilibrium is likely to occur?
Willingness-to-pay
p = n(1000-n)
Demand Curve
Stable
Supply Curve
c
Stable
0
n
n” 1000
Which equilibrium is likely to occur?
Essentially, anything that can be digitized is
information.
 Information Goods:
books, database, magazines, movies, music, web
pages.




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.
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.





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.


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.

Should a good be
sold outright,
 licensed for production by others, or
 rented?


How is the ownership right of the good to be
managed?



Suppose production costs are negligible.
Market demand is p(y).
The firm wishes to
max p( y ) y .
y
p
p( y )
y
p
 ( y )  p( y ) y
p( y )
y
p
 ( y )  p( y ) y
p( y )
p( y*)
y*
y

The rights owner now allows a free trial period. This
causes

a consumption increase;
Y   y,   1

The rights owner now allows a free trial period. This
causes


a consumption increase;
lower sales per consumption unit
y
Y

.
Y   y,   1

The rights owner now allows a free trial period. This
causes



a consumption increase;
lower sales per consumption unit
y
Y
Y   y,   1
.
increase in value to all users increase in willingness-topay;
P (Y )   p(Y ),   1.
p
p( y )
P (Y )   p(Y )
y,Y

The firm’s problem is now to

max P (Y )   p(Y )  p(Y )Y .

 
Y
Y
Y

The firm’s problem is now to

max P (Y )   p(Y )  p(Y )Y .

 
Y
Y

Y
This problem must have the same solution as
max p( y ) y .
y

The firm’s problem is now to

max P (Y )   p(Y )  p(Y )Y .

 
Y
Y


Y
This problem must have the same solution as
So
max p( y ) y .
y*  Y*.
y
p
 ( y )  p( y ) y
p( y )
P (Y )   p(Y )
p( y*)
y*
y

 (Y )  p(Y )Y

 ( y )  p( y ) y
p
p(Y *)
p( y )
P (Y )   p(Y )
p( y*)
y*  Y*
y

1

 higher profit

 (Y )  p(Y )Y

 ( y )  p( y ) y
p
p(Y *)
p( y )
P (Y )   p(Y )
p( y*)
y*  Y*
y

1

 lower profit




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?




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




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
max p( y ) y  cy  F .
y



Is selling for rental more profitable?
Each rental unit is used by k > 1 consumers.
So y units sold  x = ky consumption units.




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).





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.


Rental transaction cost t reduces willingness-to-pay to
p(ky) - t.
Rental store’s willingness-to-pay is
Ps (y)  k[p(ky)  t].

Rental transaction cost t reduces willingness-to-pay to
p(ky) - t.
Rental store’s willingness-to-pay is

P
(
y
)

k
[
p
(
ky
)

t
].
s
Producer’s sale-for-rental problem is

max Ps (y)y  cy  F
y

Rental transaction cost t reduces willingness-to-pay to
p(ky) - t.
Rental store’s willingness-to-pay is

P
(
y
)

k
[
p
(
ky
)

t
].
s
Producer’s sale-for-rental problem is

max Ps (y)y  cy  F  k[p(ky)  t]y  cy  F
y

Rental transaction cost t reduces willingness-to-pay to p(ky)
- t.
Rental store’s willingness-to-pay is

Ps (y) problem
k[p(kyis)  t].
Producer’s sale-for-rental

max Ps ( y) y  cy  F  k[p(ky )  t ]y  cy  F
y
c 
 p(ky )ky    t ky  F.
k 
c 
max p(ky )ky    t ky  F 
y
k 
c 
max p( x ) x    t  x  F
x
k 
This is the same as the direct sale problem
max p( y) y  cy  F
y
except for the marginal cost.
c 
max p(ky )ky    t ky  F 
y
k 
c 
max p( x ) x    t  x  F
x
k 
This is the same as the direct sale problem
max p( y) y  cy  F
y
except for the marginal cost. Direct sale
c
is better for the producer if c   t.
k


Direct sale is better for the producer if
i.e. if
c
c   t.
k
k
c
t.
k 1

Direct sale is better for the producer if
k
c
t.
k 1

Direct sale is better if
replication cost c is low
 rental transaction cost t is high
 rentals per item, k, is small.
