Transcript Information Technology

Information Technology
Presented by (in order of presentation):
José Coutinho
João Silva
Ana Paiva
Inês Costa
Marco Bravo
Presentation Structure
1.
Background
1.
2.
3.
4.
5.
2.
3.
The 1990’s
Technology and Market Structure
Intellectual Property (Combinatorial Innovation)
The Internet Boom
Where are we now?
José Coutinho
Economic Thinking
1.
2.
Price discrimination
Switching costs and lock-in
3.
4.
Supply-side economies of scale
Demand-side economies of scale
Ana Paiva
5.
6.
7.
Standards
System Effects
Computer mediated transactions
Inês Costa
Summary and Conclusions
João Silva
Marco Bravo
1. Background
Progress
1
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
1990s
 Technology and Market Structure
 Combinatorial innovation
 The Internet Boom
 Where are we now?

The 1990’s
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
Events that stimulated investments in IT
Investment Boom
• Telecommunications deregulation (1996)
• “Y2K” problem (1998-99)
• “dot com” boom (1999-2000)
=> Dramatic run-up of stock prices
for IT companies
• Euro (1 Jan 2002)
2.3
2.4
2.5
2.6
2.7
3
1. Telecommunications deregulation
• 1996 Telecommunications Act (US)
•local phone service
• 1998 – EU
US
Services
\ Year
\
96
02
07
% total revenues
• Liberalization of all public voice telephony
ordinary, local and longdistance wired voice calls
services
wireless
30
40
data
30
40
• 2000 – Portugal
90
40
20
Progress
1
1.1
1.2
The 1990’s
Real Y2K Spending and the Change in
Real Fixed Investment in Information
Processing Equipment and Software
“Y2K” problem (1998-99)
1.3
Billions of dollars
1.4
Percent
Percentage points
1.5
2
IPES
Potential Y2K
contribution to
real GDP growth
Year
Y2K
IPES
Y2K / IPES
IPES / GDP
1995
4.3
36.2
11.8
3.5
0.56
0.07
2.5
1996
15.5
44.5
34.8
3.7
0.62
0.22
2.6
1997
29.4
62.5
47.0
3.9
0.77
0.36
2.7
1998
37.7
79.5
47.4
4.1
0.85
0.40
1999
36.5
78.8
46.3
4.3
0.73
0.34
2000
6.8
75.2
9.0
4.5
0.63
0.06
2001
0.8
–34.8
–2.3
4.0
–0.26
0.01
1995-2001
130.9
341.9
N/A
N/A
3.90
1.45
2.1
2.2
2.3
2.4
3
contributi
on to real
GDP
growth
NOTE: Estimates for 1999-2001 are projections. Real Y2K spending is the current-dollar value of spending
deflated by the chain-type price index for IPES. Sums subject to rounding.
SOURCE: Economics and Statistics Administration, Bureau of Economic Analysis, Haver Analytics, and the
author’s calculations (final column).
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
Social Value
The 1990’s
“dot com” boom (1999-2000)
• “competition worked very well during this
period, so that much of the social gain from
Internet technology ended up being passed
along to consumers, leaving little surplus in the
hands of investors”
2.2
2.3
2.4
2.5
2.6
2.7
3
Productivity Growth
Many macroeconomists attribute
• Increase in productivity growth in the late
1990s to the investment in IT during the first
half of that decade
• we have yet to reap the benefits of the IT
investment of the late 1990s
World Changed
• Email, WWW, IM
(children => business communication)
Progress
1
1.1
1.2
1.3
1.4
THE SAME MARKET FORCES
• High-technology industries
• Other industries
2
Some are particularly important
• Network industries in 1990s
2.1
• Telephone and wireless in the 1890s
1.5
2.2
2.3
2.4
2.5
Minor => industrial economy
Critical => Information economy
2.6
2.7
3
Technology
and Market Structure
Ex: Cost Structures
• Constant fixed costs
• Zero marginal costs
Rarely observed for physical products
• Capacity constraints in nearly every
production process
Other Qt / Intellectual property
Very common for information goods
Copyright law
(indeed it is the baseline)
Patent law
• Information goods
Policy issues
• Physical goods - Chips
Security, and Privacy
Combinatorial innovation
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Interchangeable parts
(Early 19th century)
Eli Whitney
• Gears, pullies, chains, cams,
and other mechanical devices
• US government contract
•Standardization of Design
•American system of
manufacture
• 10 000 muskets to be produced within two
years, even though he had no factory or
machines
•Weapons
• It actually took eight years to deliver the order,
as Whitney perfected and developed new
techniques and machines
•Domestic appliances
• 15,000 muskets within the following two years
“Every now and then a technology, or set of technologies,
comes along that offers a rich set of components that can be
combined and recombined to create new products. The
arrival of these components then sets off a technology boom
as innovators work through the possibilities.”
Combinatorial innovation
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Gasoline Engine
Motorcycles, Automobiles, Airplanes
• 1864 - Siegfried Marcus (Austria)
• 1876 - “Otto cycle” Nicolaus August Otto
• 1885 - Karl Benz / first practical automobile
• 1908 - Ford T
Integrated circuit
• Electronics Industry
• Moore´s law
Microprocessor (1971)
• Routers, Servers, PCs
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Personal Computer
• 1975 - First Personal Computer
• Apple I (1976) II (1977)
• Stephen Wozniak / Steve Jobs
• IBM PC (1981)
Combinatorial innovation
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Combinatorial innovation
Progress
1
Combinatorial innovation
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Software Industrial Evolution
Software ICs
Superdistribution
• Brad J. Cox (1986, 1991)
• Object-Oriented Programming
• (encapsulation, dynamic binding
• Objective-C => Java => C#
• (c + Smaltalk-80)
• NeXT
• Apple Mac OS X
Progress
1
Combinatorial innovation
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
“I wrote the program using a NeXT computer. This had the
advantage that there were some great tools available - it was a
great computing environment in general. In fact, I could do in a
couple of months what would take more like a year on other
platforms, because on the NeXT, a lot of it was done for me
already. There was an application builder to make all the menus
as quickly as you could dream them up. there were all the
software parts to make a wysiwyg (what you see is what you get
- in other words direct manipulation of text on screen as on the
printed - or browsed page) word processor. I just had to add
hypertext, (by subclassing the Text object)”
Combinatorial innovation
Progress
1
1.1
Tim Berners-Lee / CERN
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
WorldWideWeb (1991)
The first web browser (browser-editor)
• Originally developed to provide a
distributed hypermedia system.
• Easy access to any form of
information anywhere in the world.
• Revolutionised modern
communications and even our, way of
life (?)
• Parts: HTML, HTTP, URL
•=> Nexus (program)
•=> World Wide Web (information space)
Initially non-graphic
=> MOSAIC (1993)
Combinatorial innovation
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
“Waves (“clusters”) of innovation
1. “Demand-side”
• Overcome Social Resistance / Adoption
2. “Supply-side”
• Same components
• Same invention at almost the same time
• Electric light, Airplane, Automobile,
Telephone.
3. Development of complements
• Paved roads (Bicycle boom)
• Gasoline => fuel stationary engines used on farms
• Others (Pneumatic Tires, ...)
=> Automobile
=> Roads
=> Gasoline, Oil
“Indirect network effect”
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Combinatorial innovation
Development /
Adoption Time
Interchangeable parts
Time to reach
• took over a century to become truly reliable
30% penetration
Gasoline engines
(US population)
• took decades to develop
Telephone – 38 years
Microelectronics industry
Television – 17 years
• took 30 years to reach its current position
PC – 13 years
Internet revolution
Internet – 7 years
• took only a few years
Mobile Phone - …
Progress
1
1.1
Date
1.2
The Internet Boom
How many online? Worlwide
Number
% Pop
Source
May 2002
580.78 million
9.57
Nua Ltd
1.3
January 2002
562.47 million
9.26
Nua Ltd
1.4
January 2001
455.55 million
7.5
Nua Ltd
1.5
January 2000
254.29 million
4.19
Nua Ltd
2
December 1998
160 million
3.91
IDC
2.1
December 1997
70 million
1.71
IDC
2.2
December 1996
36 million
.88
IDC
2.3
December 1995
16 million
.39
IDC
2.4
How many online? Portugal
2.5
2.6
Date
2.7
3
Number
% Pop
Source
June 2002
4.4 million
43.6
ICP
December 2001
3.6 million
34.37
ICP
December 2000
2 million
19.9
ICP
October 1999
565,000
5.7
CyScan
December 1998
200,000
2.02
IDC
January 1998
188,000
1.9
IDC
September 1997
200,000
2
Nua est.
Internet revolution
Minor revolution ??
“Immaterial components”
• Physical devices => “just bits”
• Ideas, standards specifications,
protocols, programming languages, and
software.
• No delay in manufacture, or shipping
costs, or inventory problems
• Never run out of HTML!
The Internet Boom
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
New Applications
Combine and recombine the software
components to create a host of new
applications:
• Web pages, chat rooms, clickable
images, web mail, MP3 files, online
auctions and exchanges . . .
Few basic tools and OPEN protocols
• HTML, HTTP, URLs
• Perl, Phyton, other interpreted languages
2.3
Growth of Domains in US and the World
2.4
2.5
40
2.6
3
35
Millions of Domains
2.7
30
25
ccTLD
20
non-US gTLD
15
US gTLD
10
5
0
Jul-98 Jan-99 Jul-99 Jan-00 Jul-00*
Jan01*
Jul-01*
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
Open Source Software
• Combinatorial innovation
• Education (look inside the black box)
• Sourceforge.net => 65,000 collaborative
software projects (clearinghouse for the
open source community)
The Internet Boom
Closed Sorce Software
• Microsoft / XML Web Services / .NET
• ?? Open Standards and Specifications ??
2.3
2.4
2.5
2.6
2.7
Message-ID: [email protected]
From: [email protected] (Linus Benedict Torvalds)
To: Newsgroups: comp.os.inix
In the
Subject: What would you like to see most in minix?
Summary: small poll for my new operating system
Beginning
3
Hello everybody out there using minix-I'm doing a (free) operating system (just a
hobby, won't be big and professional like gnu) for 386 (486) AT clones. This has
been brewing since april, and is starting to get ready. I'd like any feedback on
things people like/dislike in minix, as my OS resembles it somewhat
Any suggestions are welcome, but I won't promise I'll implement them :-)
Linus
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Finantial speculation
“Euphoria of 1923,” / Broadcast radio
• Business Model / tax on vacuum tubes
• “dumb money” / Crash 1929
• recession
Internet Bubble
Human Capital
(biggest investment)
• “Being Digital”  “Being Mechanical”
• Productivity
The Internet Boom
Where are we now?
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Period of rapid Innovation
• Confluence of Moore’s Law, Internet,
Digital awareness, and Financial markets
• The result: Excess Capacity
Period of Consolidation
• Quiet phase of combinatorial innovation
• Not fully incorporated into organizational
work practices
Challenge
• Re-enginner the flow of information over
the entire value chain
• Michael Dell / Mass Customization
Where are we now?
Progress
1
1.1
1.2
Readiness for the Networked World
1.3
1.4
Global Information Technology Report 20012002
1.5
2
2.1
Key
2.2
Population
2.3
2.4
Rural population (% of total population) 1999
Pt
US
10 000 000
275 000 000
37.20 %
23.02 %
2.5
Main telephone lines per 100 inhabitants
43.04
69.97
2.6
Internet hosts per 10,000 inhabitants
62.02
2928.32
Personal computers per 100 inhabitants
10.48
58.52
Percent of PCs connected to Internet
5.92 %
50.04 %
Internet users per host
35.90
2.04
Internet users per 100 inhabitants
22.27
59.75
Cell phone subscribers per 100 inhabitants
66.51
39.79
2.7
3
Where are we now?
Progress
1
1.1
1.2
1.3
1.4
1.5
2
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Human Capital
Productivity
• 1.4% a year 1972 – 1995
• 2.5% a year 1995 – 2000 (tot 79%)
Higher quality for lower prices
Individual Investor Empowerment
eCommerce / eBanking
• Amazon
• E-bay
Alternative to Microsoft
• Linux / Red Hat, IBM
Cheap Bandwich (Cable, xDSL)
Progress
1
1.1
1.2
Price deviates from marginal cost;

Deviation from marginal cost may indicate market power;

Market must not be competitive;

Market forces go on to say that price discrimination can be output-increasing
and is therefore not necessarily inefficient or bad;

Usually measures almost always produce outcomes less efficient than the ones
that they were designed to change;

IT through privacy intrusions serve to provide the information that allows
sellers to determine buyers' willingness to pay;

IT also allows for monitoring usage, to ensure that arbitrage is not used to
bypass discriminatory pricing;

The issue is not privacy, per se, but rather trust: consumers want to control
how information about themselves is used;
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Differentiation of products and prices

1.3
1.4
2. Economic Thinking
Progress
1
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3

Price Discrimination
First-degree price discrimination
 Firms charge the highest price they can to each consumer, thereby capturing the
entire consumer surplus;
Progress
1
Price Discrimination
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3

Second-degree price discrimination
 Everyone faces the same menu of prices for a set of related
products;
Progress
1
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3

Price Discrimination
Third-degree price discrimination
 Selling at different prices to different groups;
Progress
1
1.1

Conditioning on purchase history
 Discrimination based on purchase history;

Bundling
 Selling two or more distinct goods together for a single price;
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Price Discrimination
Progress
1
Price Discrimination
1.1
1.2
1.3
1.4
1.5

The public's dislike for price discrimination will be combined
with new tools for detecting price discrimination;

New tools are products of the same technologies that enable
sellers to practice differential pricing;

The result is likely to be that price discrimination will grow, but
in a concealed form;
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Switching costs and lock-in
Progress
1
1.1
1.2
1.3

Consumer
 Switching costs make consumers reluctant to move to completely
new solutions;

Supplier
 Switching costs or cannibalisation of existing products make
suppliers reluctant to pursue new product opportunities;
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
 High
difficulty of market penetration unless products on offer are
compatible with existing complementary solutions;
Progress
1
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Switching costs and lock-in
Supply-Side Economies of Scale
Progress
1
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
Large fixed costs
Information and
Technology
Have costs structures
Small marginal costs
2.3
2.4
2.5
2.6
2.7
Natural Monopolies
3
?
Solution
!
Government Regulation
Inefficiencies
Progress
1
Supply-Side Economies of Scale
1.1
1.2
1.3
1.4
1.5

Average cost decreases with scale
2.
2.1
2.2
2.3
2.4
1. Scale economies important in online retailing
 Customers benefit from low prices while companies build
economies of scale (e.g. Amazon)
2.5
2.6
2.7
3
2. Can overcome cost advantages when the market is growing rapidly
 Difficult to sustain market-leadership (e.g Betamax)
3. IT reduces the minimum efficient scale of operation in many markets
 Off-the-shelf reduces need for experts & lowers barriers to entry
(e.g. desktop publishing)
Progress
1
Supply-Side Economies of Scale
1.1
1.2
1.3
1.4
1.5

2.
2.1

2.2
2.3
2.4

2.5
2.6
2.7
3

Competition to acquire monopoly
 Forces lower prices for consumers
Competition with your prior production
 Existing output can compete with new products
Pressure from complementary products
 Providers of complimentary products want to see lower prices &
will exert pressure to accomplish this
Inventing around
 Patents create barriers to entry, but competitive firms will find
new ways to produce the same / better products
Progress
1
Competition and welfare
1.1
1.2
1.3
1.4
1.5
In mature industry with large fixed costs
2.
2.1
2.2
2.3
2.4
2.5
equilibrium price will typically exceed marginal cost
2.6
2.7
3
In a static model, correct formulation for the efficiency
condition is that marginal price should equal marginal cost
Competing for monopoly
Competition for perfectly price discriminating monopolist
Producer Surplus
Deadweight loss
THE TWO
IMPORTANT
QUALIFICATIONS
TO KEPT IN MIND
• ithe choice of the
dimensions in
which to compete
• the rules of
competition
theorems of welfare economics assert that:
• a perfectly discriminating monopolist can capture all surplus for itself and therefore
produce Pareto efficient output
• competition among perfectly discriminating monopolists will transfer this surplus to
consumers, yielding the same outcome as pure competition
Progress
1
1.1
The currency of competition
1.2
1.3
1.4
1.5
2.
2.1
2.2
strategic variables:
for the firms: are prices
tend to benefit consumers:
Innovation and quality choice
environmental:
attractive policy goals
2.3
2.4
2.5
2.6
2.7
3
but firms also compete
in other dimensions:
political lobbying
accumulation of excess capacity
premature entry
…
competition is good, but
regulation may be
required to make sure that
competition takes socially
beneficial forms
Demand-side economies of scale
Progress
1
1.1
1.2
1.3
1.4

Average revenue increases with scale

Known as “network externalities” or “network effects” since they
occur in network industries:
1.5
2.
2.1
2.2
2.3

2.4
2.5

2.6
2.7

3

When demand for a good depends on how many other people
purchase it
Usual example is of a fax machine ( more picture phones and
email)
Recent e.g.: availability of Playstation v. Xbox games
If market gets above critical mass, positive feedback kicks in &
product becomes successful
Progress
1
Demand-side economies of scale
1.1
1.2
1.3
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
Indirect network effects are
endemic in high-tech products
Current challenges include residential broadband
and applications, and 3G wireless and applications
In each case, the demand for the infrastructure depends
on the availability of applications, and vice versa
The cure for the current slump, according to industry
pundits, is a new killer app.Movies on demand,
interactive TV, mobile commerce-there are plenty of
candidates, but investors are wary, and for good
reason: there are very substantial risks involved
Demand-side economies of scale
competition to acquire a monopoly
demand side economies of scale
supply side economies of scale
average revenue (demand)
increases with scale
average cost decreases
with scale
Progress
1
Demand-side economies of scale
1.1
1.2
1.3
1.4

Network effects clearly prominent in some hi-tech industries
 Customers choose software that everyone else is using so that filesharing, working on common documents (…more valuable), etc is
easier

Network effects & price discrimination
 Early adopters normally pay more than later users
Network effects & lock-in
 If everyone is using a particular product, the cost of switching to an
alternative one can be high
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3

Demand-side economies of scale
Demand and supply for a network good
Caused by usual
effects of selling to
consumers with
progressively lower
willingness to pay
quantity sold increasing
when demand is greater
than supply and
decreasing when demand
is less than supply
perfectly elastic supply curve
number of people who connect is low and hight,
the willingness to pay the marginal individual is low
(because there aren't many other people out there
that he can communicate with)
Progress
1
Demand-side economies of scale
1.1
1.2
1.3
Price and shipments of fax machines
1.4
1.5
2.
Avarage Price
Fax Machines Shipped
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
network effects are present,
early adopters may value the
network good less than
subsequent adopters
sellers offer them a lower price, this
practice is known as ”penetration pricing”
Lock-in (ex:drive on the right hand...
Progress
1
1.1
1.2
1.3
Standards
Definition: specifications, regulations, and guidelines that help clarify, guide and control processes and
activities crucial to our everyday functioning and lives. They specify definitions, performance, and design
criteria, creating a common language with which engineers, researchers, businesses, and even students can
communicate, create, and learn.
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
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you? You buy the doll on the outside, and on
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Progress
1
1.1
1.2
1.3
Standards
Definition: specifications, regulations, and guidelines that help clarify, guide and control processes and
activities crucial to our everyday functioning and lives. They specify definitions, performance, and design
criteria, creating a common language with which engineers, researchers, businesses, and even students can
communicate, create, and learn.
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
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play all games, and
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everyone can play together. And he said he
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their best features, put
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be left on his own."
Standards
Progress
1
1.1
1.2
1.3
1.4
1.5
Definition: specifications, regulations, and guidelines that help clarify, guide and control
processes and activities crucial to our everyday functioning and lives. They specify definitions,
performance, and design criteria, creating a common language with which engineers,
researchers, businesses, and even students can communicate, create, and learn.
2.
2.1
2.2
Your value = Your share X Total Industry Value
2.3
2.4
2.5
Standards War: Firms compete to determine the
standard; (Nintendo vs Sony)
2.6
2.7
3
Besen and Farrell
(1994) gave us three
forms of
competition in
standards setting:
Standards Negotiation: Both firms want a standard,
but disagree about what standard should be;
Standards Leader: One firm leads with a proprietary
standard, the other firm wants to interoperate with
the existing standard;
Progress
1
His Technology
1.1
1.2
Compatible
Incompatible
Compatible
Rival
Evolution
Evolution vs
Revolution
Incompatible
Revolution vs
Evolution
Rival
Revolution
1.3
Standards
WARS
My
Technology
1.4
1.5
2.
2.1
2.2
2.3
2.4
2.5
Common Tactics
2.6
Penetration pricing: pricing below cost, to build an early lead;
2.7
3
Building Alliances with suppliers of complementary products;
Expectations management: bragging about market share /product pre-announcements;
Commitments to low prices in the future;
Examples:
AM Stereo: auto industry invested…but radio didn’t
Digital Wireless Phones: Europe (GSM) vs USA (GSM, TDMA,CDMA)
Progress
1
1.1
1.2
1.3
1.4
Classic Battle of the Sexes game:
Each player prefers a standard to no standard, but each
prefers its own standard to the other’s
Standards
Negotiation
1.5
2.
2.1
2.2
Common Tactics
oPower of Threat : What happens if negotiations fail?
2.3
2.4
o Form Official standards body to oversee negotiations
2.5
2.6
o Dealing with mistrust
2.7
3
o Require firms to disclose all relevant information
o Cede control to an independent third party
Examples:
Microsoft and C#, competitor to Java
So…
Progress
1
1.1
1.2
1.3
1.4
Typical case of standards leader:
Large, established firm wants to maintain a proprietary standard,
but a small upstart wants to interconnect with that standard
Standards
Leader
1.5
2.
2.1
2.2
2.3
2.4
Common Tactics
Protection by intellectual property laws
Leader changes technology frequently
LEADERS
2.5
2.6
2.7
3
Use an adapter / converter for the technology
Can be done with / without leader’s permission
FOLLOWERS
Examples:
AM /FM
Open Source community, Samba+Unix interoperation with Microsoft , Word, Excel
Standards
Progress
1
Cost Advantage of Standardization
1.1
1.2
1.3
1.4
There is considerable cost savings due to economics of scale in manufacture and risk
reduction
1.5
2.
2.1
Thompson (1954)
2.2
Chain of Events
2.3
2.4
2.5
1.
Smaller firms were interested in standardization in order to reap sufficient economies of scale to
compete with Ford and G.M;
2.
Small suppliers were also interested in standardization: diversify the risk associated with supplying
idiosyncratic parts to one customer;
3.
The Society of Automotive Engineers (SAE) carried out the standardization process, which yielded many
cost advantages to the automotive industry;
4.
Late 1920s: Ford and GM began to see the advantages of standardization, at first focusing on the
products of complementors (tires, petroleum products, and the like) but eventually playing a significant
role in automobile parts standardization;
2.6
2.7
3
System Effects
Progress
1
1.1
TYPES OF SYSTEM EFFECTS
1.2
1.3
1.4
Useless products unless combined into a
system, with other products
1.5
2.
2.1
+
COMPLEMENTARITIES
2.2
2.3
2.4
2.5
DIRECT NETWORK EFFECTS: symmetric form of complementarities
INDIRECT NETWORK EFFECTS: chicken and egg problems
2.6
2.7
3
ECONOMIC ISSUES
Who will do the system integration?
How will the value be divided up among the
suppliers of complementarities?
System Effects
Progress
1
1.1
1.2
1.3
1.4
COURNOT (1838)
ECONOMIC ISSUES
Analyzed the strategic interactions between producers of complementary products, considering a market
with two companies...
1.5
Company Z
Company C
2.
Monopolist ZINC producer
Monopolist COPPER producer
2.1
What would happen to
the price of brass if the
copper and zinc
producers merged?
2.2
2.3
2.4
2.5
COMPANIES B
Assume
Brass producers
Z+C=B
2.6
2.7
1. pb= pc+ pz
Competition push pb down to it’s cost
3
2. Db= D(pc+ pz)
Demand for brass
5. Max (pz+pc)D(pc+ pz)
MERGER:solve the joint max problem
3. Max pcD(pc+ pz)
Copper producer wants to maximize his profits
PRODUCERS HAPPY
4. Max pzD(pc+ pz)
CONSUMERS HAPPY
Analogous problem for Zinc producer
System Effects
Progress
1
ECONOMIC ISSUES
1.1
1.2
Other ways to cut prices...
1.3
1.4
There are a variety of ways a firm might induce a complementor to cut its price:
1.5
2.
2.1
2.2
2.3
2.4
2.5
2.6
2.7
3
o Integrate: One complementor acquires the other, forming a merged entity which
internalizes the externality;
o Collaborate: The firms set up a formula for revenue sharing, then one firm sets the price
of the joint system.(Ex: aircraft manufacturers);
o Negotiate: A firm may commit to cutting its price if the other firm also cuts its price.(Ex:
DVD);
o Nurture: One firm works with others to reduce their costs.(Ex: Adobe and printers);
o Commoditize: One firm attempts to stimulate competition in the other's market, thereby
pushing down prices. (Ex: Microsoft)
Computer mediated transactions
Progress
1
1.1
1.2
1.3
1.4
1.5
2.
2.1
o Data gathered mined for consumer information and behavior can allow for various forms of price
discrimination;
o Allow firms to contract on aspects of transactions that were previously unobservable;
Video Tape Rental Industry
Trucking Industry
2.2
Before 1988
Last twenty years
2.3
Distributors sold videotapes to rental stores at 60$
each (in excess of marginal costs)
Trip recorders and electronic vehicle
management systems (EVMS) have become
widespread in the industry.
2.4
2.5
2.6
2.7
3
After 1988
Studios provided tapes between 0 and 8$.The
revenues were split between the studios and the
video store, which received between 40 and 60%.
Blockbuster computer recorded each title rental and
send a report to the central office: all parties in
transaction were able to verify the revenues were
being shared in the agreed-upon way.
Now…
EVMS collects info about location and
transmits it in real time, helping with dispatch
coordination, operation efficiency, insure
liability and fraud detection, making the
industry more cost effective.
Summary and Conclusions
1.
Competition and "complementers“ (ex: Apple Mac: worries with competitors and
software developers);
2.
Lock-in:

IT components  systems  switching any component often involves switching
others as well switching costs are high! (ex: switching Mac to Windows-based
PC) - cost of changing to a  system is so high that switching is virtually
inconceivable;

BAD for consumers, GOOD for sellers:

user has a very inelastic demand;

seller can  prices - extract consumer surplus (although consumers and
competition impose some barriers) – Monopoly power (charge more than
marginal cost of the product/service);

Ex: choosing an ISP (Internet service provider);
Model of competition with switching costs (ISP example)
• New ISP:
• Keep old ISP:
 pay (p-d) + s;
 pay p;
The consumer will only switch if:
p  d  p  s  p  p
r
r
The consumer will be indifferent if:
( p  d)  s  p
d>s
Perfectly competitive market
(many identical firms);
c=cost of providing a customer
with internet access;
Discount covers for the switching cost  d=s
No switching costs  price of
internet service = p = c;
s=switching costs;
d=1st month discount;
r=monthly interest rate;
Adding switching costs
s = switching costs;
d = 1st month discount;
raises monthly price of service above cost
…but competition for this profit forces the initial
price down
the producer is investing in the discount d=s in
order to acquire the flow of markups in the future.
In reality, many ISPs have other sources of revenue than just the monthly
income from their customers (ex: AOL = derives substantial revenue from
advertising  offer discounts, to capture customers, even if they have to
provide Internet connections at rates at or below cost)
Summary – Network Externalities

Situations in which one person's consumption directly influences
another person's utility;

Are a special kind of externalities in which one person's utility for a
good depends on the number of other people who consume this
good  a person's utility could depend on the identity of other users

People are partially influenced by what other people buy/use 
however, there is an upper bound to these externalities (when too many
people are using something, it usually falls out of “fashion”);

Example: consumer's demand for a fax machine or a modem (people
want fax machines so they can communicate with each other. If no one
else has a fax machine, it certainly isn't worthwhile for you to buy one.
Same with telephones and modems  are worthless if there is no one
else to communicate with);
Summary – Network Externalities

Complementary goods = Indirect effect for network externalities:

Ex:
 Video store demand for video tapes depends on the number of VCRs and
the demand for VCRs depends on the number of video tapes available;
 Demand for computers depends on the operating system and other types
of software they support and vice-versa;
Question of compatibility:
Competition in the market for some goods (ex: word processing programs or video tapes)
may be seriously difficulted by complementary products (operating systems or vcr’s)
which are only technologically compatible with one of the competitors
Ex: It is generally recognised that Betamax was a better video system than VHS, but the
faster diffusion of VHS-compatible vcr’s resulted in the failure of Betamax
Summary – Network Externalities
…became a basic determinant of firms’ strategies (VHS and the DOS
system became winners because their creators promoted a rapid diffusion
of users by forfeiting exclusive rights to their use)
…become a determinant for market failure by awarding monopoly power
to firms that offer products that are complementary to a good with a large
installed base (Microsoft is able to offer many types of specialised
software - office software and internet-related programs - together with the
Windows system, thereby gaining an advantage over competitors offering
substitute goods, even if these goods can also work with Windows)
Summary – Network Externalities
• Relationship between price of the good/number of users:
WILLINGLESS
TO PAY
Demand curve
Supply curve
SIZE OF NETWORK
Figure: Network Externalities - 3 intersections where demand = supply
Analysis of the DEMAND SIDE OF THE MARKET:
• If there are n people who purchase the good  the willingness to pay of the marginal
individual is given by the height of the curve;
• If number of people who connect is low  the willingness to pay of the marginal individual
is low (because there aren't many other people out there that he can communicate with);
• If number of people connected is large  the willingness to pay of the marginal individual
is low (everyone else who valued it more highly has already connected);
• Plausible to assume: when people are willing to pay more than the cost of the good - market
. When people are willing to pay less than the cost of the good - market .
WILLINGLESS
TO PAY
Demand curve
Supply curve
Summary –
Network
Externalities
SIZE OF NETWORK
Analysis of the SUPPLY SIDE OF THE MARKET:
•
•
Suppose that the good can be provided by a constant returns to scale technology 
supply curve is a flat line at price = average cost;
3 possible intersections of the demand/supply curves:
1. Low-level equilibrium where n*=0 (no one consumes the good, so no one is willing to
pay anything to consume the good "pessimistic expectations" equilibrium);
2. Middle equilibrium with a positive but small number of consumers (people don't think
the network will be very big, so they aren't willing to pay that much to connect to it and therefore the network isn't very big);
3. Large number of people equilibrium – nH (price is small because the marginal person
who purchases the good doesn't value it very highly, even though the market is very
large).
 Low-level
equilibrium  no one connects;
Stable
 High-level equilibrium  many people connects;
 Middle-level equilibrium  unstable  unlikely to be the final resting point of the
system;
2 possible stable equilibrium  low-level & high level;
 Which is likely to occur? – think about how costs might change over time...
 For the kinds of examples we have discussed (faxes, VCRs, Computer networks), the
cost of the good starts out high and then decreases over time due to technological
progress:

WILLINGLESS
TO PAY
High cost
Demand curve
Low cost
SIZE OF NETWORK
Figure: Cost adjustment and network
externalities
• When the cost is high, the only
equilibrium implies a market of size
zero. As the cost goes , 2 other
equilibrium becomes possible;
Adding some noise to the system...

Perturbing the number of people connected to the network around the equilibrium
point  perturbations could be random, or part of business strategies (such as initial
discounts or other promotions);

As the cost gets smaller and smaller, it becomes increasingly likely that one of these
perturbations (critical mass) will kick the system up past the unstable equilibrium 
the dynamic adjustment will push the system up to the high-level equilibrium:
SIZE OF
NETWORK
Critical
Mass
TIME
• It starts out at essentially zero, with
a few small perturbations over time.
The cost , and at some point we
reach a critical mass that kicks us 
past the low-level equilibrium and
the system then zooms  to the
high-level equilibrium
Figure: Possible adjustment to equilibrium
The number of users connected to the network is initially small, and increases only gradually as costs fall. When a
critical mass is reached, the network growth takes of dramatically
Summary – Implications of Network Externalities
Critical mass issue is very important: if one user's demand depends on
how many other users exist, it is very important to try to stimulate
growth early in the life cycle of a product;

Nowadays it is quite common to see producers offering very cheap
access to a piece of software or a communications service in order to
"create a market" where none existed before;

For the increasing returns to be fully exploited, the network has to reach
a particular critical mass;
Summary – Implications of Network Externalities
One way to achieve critical mass is through cost reductions over time:
1.
As new processes are implemented and improved  costs of production and prices 
(microchips, vcr’s, faxes, computers,…);
2.
Costs would  from the high marginal cost curve to the low marginal cost curve;
3.
As the cost gets smaller and smaller, it becomes increasingly likely that any small
disturbance will kick the system up past the unstable (middle) equilibrium, making it
reach the critical mass necessary to push it to the high-level equilibrium;
4.
If costs do not fall enough, or if the firm fails to diffuse the product up to the critical mass for
other reasons (a competitor might do it faster), then adjustment will rut to the low-level of
equilibrium;
WILLINGLESS
TO PAY
High cost
Demand curve
Low cost
SIZE OF NETWORK
Real-life example: market for fax machines:
2500
2000
1500
1000
500
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
0
AVERAGE PRICE FOR FAX MACHINES SOLD
FAX MACHINES SHIPPED (thousands)
Figure: Fax market
The demand for fax machines was small for a long time since so few people used
them. During the mid-eighties, the price fell significantly and the demand suddenly
exploded, due to the “critical mass”
EXAMPLE#1: Network Externalities in Computer Software - Adobe
Exchanging data files & tips with other users of the same software
advantage to the largest
seller in a given market
leads software producers to invest
heavily in acquiring market share
Adobe Systems invested in developing a "page description language"
called PostScript for desktop publishing
Realized that no one would invest the time and resources necessary to learn PostScript unless
it was the clear "industry standard”
Deliberately allowed competitors to "clone" its language in order to create a competitive market
in PostScript interpreters

Adobe's strategy paid off: several competitors emerged (including one that gave its product away) and
PostScript became a widely used standard for desktop publishing;

Ironically, Adobe's market success was due to its ability to encourage entry by its competitors!
EXAMPLE#2: Network Externalities in Computer Software – JVC & SONY
JVC made the VHS system available to all potential producers of
vcr’s, while Sony kept Betamax proprietary
It did not take long for Sony to realise its mistake, but it was time enough
for VHS to achieve enough critical mass to eventually exclude Betamax
from the market
Unfortunately for JVC, it did not have the necessary ability to keep ahead
in the development of the product, so it eventually lost most of its market
power
EXAMPLE#3: Network Externalities in Computer Software –
MICROSOFT & NETSCAPE
Although other companies produce software that is compatible with Windows (such as
Netscape), Microsoft is still able to gain an advantage in the markets for these kinds of products
by offering its own versions (such as Excel, Word and Explorer) within the Windows package, or
at considerable price reductions
Microsoft has chosen to offer Explorer together inside the Windows package in order
to prevent Netscape (who entered the market earlier) from creating enough critical
mass to become a standard
Microsoft used one kind of network externality to preclude another
kind from taking complete effect

Market failure is intensified by the existence of complementary
products.
The role played by governmental Network Externalities
The Internet was originally used only by a few small research labs to exchange data files
mid-80s: National Science Foundation used the Internet technology to connect several large
universities to 12 supercomputers deployed at various locations (researchers at the universities
would send data back and forth to the supercomputers)
Fundamental property of communications networks:
if you are all connected to the same thing, you are all connected to each other
Researchers started sending emails to each other (had nothing to do with the supercomputers)
Critical mass of users connected to the Internet  value to new users dramatically
(most of them had no interest in the supercomputer centers, even though this was the original
motivation for providing the network)
Although still very much in its early stages Industrial regulation try to cope with new types of
market failure (regulation, anti-trust,…)  Until now, only market failure associated with
complementary products has been focused (by trying to force Microsoft to offer Netscape within
its Windows package, as it does with Explorer)
Summary: Rights Management
•
Intelectual Property transactions take a variety of forms:
1. Books are sold outright and also borrowed from libraries;
2. Textbooks (are shared among students from one term to the next via
the resale market;
3. Videos can either be sold or rented;
4. Some software is licensed for particular uses. Other software is sold
outright;
5. Shareware is a form of software in which payment is voluntary.
Librarians established the "rule of five" for interlibrary loan: an item may be loaned out up to
five times before additional royalty payments should be made to the publisher 
Publishers and authors are unenthusiastic about the resale market for books;

Digital information can be perfectly reproduced, and "sharing" can be taken to new extremes;
CDs do not deteriorate with replay and it is possible to buy a CD, record it, and then sell it to
the used-CD store;
•
Critical Business Decision = Choosing the terms and conditions under which a
piece of intellectual property is offered:
1. Should you use copy protection?
2. Should you encourage users to share a new item with a friend?
3. Should you sell to individuals or use site license?
Example: Video Rental

Video stores can choose the terms and conditions under which they rent
videos;
The longer you can keep the video 
more valuable it is to you (longer period
of time during which you can watch it)
The longer you keep the video  less
profit the store makes from it (it is unable
to rent it to someone else)
Optimal choice: involves trading off these two effects

This tended to lead to a form of product differentiation (new releases are
rented for short periods  profits from other renters are very
substantial. Older videos are rented for longer periods  less cost to
the store from the video being unavailable).
Example: Video Rental

Most profitable actions for producers (video store). If:
 Large production cost and small renting cost
 produce a
few copies, sell them at a high price, and let the consumers
rent;
 Renting cost > production cost  forbid renting (since
renting is so inconvenient for the consumers, video stores
aren't willing to pay much more for the "shared" videos, and
so the producer is better off selling);
Summary – General Conclusions

Because information technology works together in systems, it is costly to consumers to
switch any one component;

In equilibrium, the discount offered first period is paid for by increased prices in future
periods;

Network externalities arise when one person’s willingness to pay for a good depends on the
number of other users of that good;

Models with network externalities typically exhibit, multiple equilibria. The ultimate outcome
often depends on the history of the industry;

Copyright helps to stimulate the production of intellectual property. The degree to which
copyright is enforced therefore influences the price of the material produced;

Rights management involves a trade-off between increased value and prices versus
reduced sales;

Information goods like books and videos are often rented or shared as well as purchased.
Rental or purchase can be more profitable depending on how transactions costs compare with
production costs.
Review Questions
• If the cost to a customer from switching long-distance carriers is
on the order of $50, how much should a long-distance carrier be
willing to pay to acquire a new customer?
• Describe how the demand for a word processing package might
exhibit network externalities.
• Suppose that the marginal cost of producing an extra video is
zero and the transactions cost of renting a video is zero. Does a
producer make more money by selling the video or by renting it?
• Does it make sense to have larger fines for copying products
with larger development costs?
References and Links
I.
Economics of the Information Technology, Hal R. Varian
II.
Intermediate Microeconomics, Hal R. Varian, 5th edition
III.
The Economics of the Internet, Information Goods, Intellectual Property
and Related Issues Compiled by Hal R. Varian
IV.
www.sims.berkeley.edu/resources/infoecon/
V.
World Wide Web Consortium
VI.
www.w3c.org
VII. CID - Center for International Development at Harvard University
VIII. www.cid.harvard.edu/cr/profiles.html
IX.
Magazines
X.
www.fastcompany.com
XI.
www.redherring.com
XII. www.wired.com