Transcript Economics of Information Goods

Information Goods
• All products contain some degree of information.
• Entertainment products contain a higher degree of
information and smaller component of physical
inputs than most other products. That is one reason
that digitization is so common for entertainment
products. You can’t digitize a car or refrigerator.
• The Internet Economy is particularly suited to the
transmission of information goods.
• First module is a review of Useful Economic
Concepts that you may or may not have had in the
past (in MECO 6201, which you should have had).
Some Useful Economic Concepts
• Elasticity
• Price Discrimination
• Public (Information) Goods
• Consumer and producer surplus
• Fixed and Variable Costs
Price Elasticity Of Demand
• def: percentage change in quantity divided
by percentage change in price
• (ΔQ/Q)/(ΔP/P) or (ΔQ/ΔP) (P/Q)
• measure of responsiveness
a.
b.
c.
d.
If Elasticity is >1 known as elastic (responsive
customers)
If Elasticity is =1 ; unit elastic
If Elasticity is <1; inelastic (less responsive
customers)
Infinite and zero elasticity
Illustrations of elasticity
D with zero elasticity
P
D with infinite elasticity
Q
Elasticity and TR
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When elasticity is greater than 1 (elastic)
increases in price lead to decreases in
revenue and vice-versa
When elasticity is equal to 1, changes in
price lead to no change in revenues
When elasticity is less than 1 (inelastic)
increases in price lead to increases in
revenue.
Implications of Elasticity
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If Elasticity is <1, firm can always increase
Profit by increasing price (revenues increase and
costs decrease because output decreases)
If Elasticity =1, firm can always increase profit
by increasing price
If Elasticity>1 firm can not necessarily increase
its profits by a change in price.
Thus firms that maximize profits must have
elasticities >1.
Example of VideoTape Sales Demonstrates
Importance of knowing elasticity.
Why is Windows so Cheap?
• Elasticity indicates that Windows is grossly
under-priced relative to short run monopoly
price.
• Find it hard to believe? Check out the
analysis for yourself.
Consumer and Producer Surplus
• Consumer surplus is the difference between
the price paid and the higher price that
consumers would have been willing to pay
for the product.
• Producer surplus is the difference between
the payment received and the minimum
payment that producers would have
accepted.
Consumer and Producer Surplus
P1
1
3
Pe
4
2
Q1
CS = 1
PS = 2
Qe
DWL = 3+4
Monopoly Vs. Competition
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Monopoly versus competition
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Smaller Quantity
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Higher Price
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Price discrimination.
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The tradeoff associated with patents and
copyright - deadweight loss in consumption
versus possible new products.
Monopoly charges higher price, produces smaller quantity.
Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to producer from
consumer
MC
S
Pm
3
Pc
4
1
2
D
Qm
Qc
MR
The Role of fixed and Variable Costs
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Fixed And Variable Costs.
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Fixed Costs: Costs that do not change when output
changes.
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Creation of a recording master
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Creation of a movie, developing software, writing a book.
Variable costs: Costs that do change when output
changes.
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Marketing, distribution,
The Role of fixed and Variable Costs
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Why are these costs important?
–
Entertainment products are high fixed cost/low
variable cost items.
–
This implies some unusual characteristics of the
industry.
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To maximize profits, firms maximize revenues.
Elasticity equals one.
–
Leads to “natural monopoly” type of result.
Typical Product
Fixed and Variable Costs
AC
P
AVC
Total Fixed
AFC
Total Fixed
q1
Q
Typical Entertainment Product
Fixed and Variable Costs
P
AC
AFC
q1
AVC
Q
Price Discrimination
• Perfect
• Two or More Markets
• Bundling and Block Booking
• Versioning
Perfect Price Discrimination
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Theoretical ideal. Cannot be fully achieved.
Find maximum price that every consumer is
willing to pay and charge them that price.
Requires more information than any firm has,
and the prevention of arbitrage.
Demand Curve becomes MR curve.
No Deadweight Loss.
Approximate examples: automobile dealers,
doctors in the old days.
Perfect Price Discrimination.
P1
P3
S
P6
D
Qo
Price Discrimination - 2 or more Markets
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If markets for a single product have
different MRs, profits can be increased by
shifting output from low MR markets to
high MR markets.
Raise price in low MR market and lower
price in high MR market.
High MR market is high elasticity market.
Need to Prevent Arbitrage.
Examples: Airlines with business travelers
and vacationers. Coupons.
Market 2
Market 1
P1
price before discrimination
P2
D
mr2
D
mr
Q2
Q1
mr1
MR
MR
Price Discrimination Rules
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Raise price in market with lower elasticity
(lower responsiveness)
Lower price in market with higher elasticity.
Do this until MRs are equalized. But prices will
not be equalized.
Examples: Airlines with business travelers and
vacationers.
Examples of Price Discrimination
• Movies (adults, children, seniors)
• Movies: theatrical release, pay per view,
dvd, cable, television
• Books: Hardcover and paperback
• Software: full versus ‘lite’ versions
Price Discrimination Law
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Illegal if it gives some firm an advantage
over other firms.
If individuals are consumers, is not illegal.
Price Discrimination is not likely to harm
efficiency. Perfect Price discrimination is
perfectly efficient.
Intention of this rule was to protect ‘momand-pop’ stores and grocers from
department stores and supermarkets. It
was intended to reduce competition.
Versioning
• Sometimes (frequently) creating different
grades of products might just better meet
consumer demands.
• Versioning is artificially creating different
products (where the high end product would
meet all needs) to achieve price
discrimination.
• Problem: avoiding cannibalization of higher
end product line.
Versioning Examples
• Luxury versus regular automobile brands.
• PC Junior.
• ‘lite’ versions of software with reduced
functionality.
• Putting identical chips in high and low
powered calculators.
Bundling (Block Booking)
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Two or more products that are sold as a
package.
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CDs versus singles
Cable television bundles versus a la carte.
Subscription services versus pay per use –
cable blanket versus long distance telephone
or pay per view; Rhapsody versus iTunes.
Computers with software
Office suites versus individual components.
When Bundling Works Best
Successful Bundling Makes Demand More
Homogeneous
Px
Py
Qx
Qy
Px+y
Qx+y
Advantage of a Bundle
The Matrix Green Tomatoes Bundle
X
2000
1200
3200
Y
1300
1900
3200
2 x 1300
2 x 1200
5000
6400
Issues with Bundling
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Telephone service – consumers presumably
preferred certainty of unlimited local calls as
opposed to pay per call. Not a ‘bundling’
issue per se, but a psychological one.
CDs versus singles- pricing versus
cannibalism. iTunes versus prior models.
Cable television bundles versus a la carte.
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There are some political moves afoot to force a la
carte service. Why, and what would be the impact?