Mod 1 • Useful Concepts • Information goods and Review of some economic concepts. Lecture 1 Information (Knowledge)Goods • • • All products contain some degree of information. It is generally believed, and probably true, that modern products contain a higher degree of information and smaller component of physical inputs than older products. The Internet Economy is particularly suited to the transmission of information goods. Some Useful Economic Concepts • Elasticity • Price Discrimination • Public (Information) Goods • Reproducing Information Goods • Natural Monopoly 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 • • • 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 • • • • • 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 underpriced relative to short run monopoly price. T a b le 1 W in d o w 's s h a re o f to ta l c o s t 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% Im p a c t o f a 1 % R e q u ir e d % d e c r e a s e M in u m u m d e c r e a s e in c o m p u te r in c r e a s e in th e in n u m b e r o f c o m p u te r s p u r c h a s e s b r o u g h t a b o u t b y a 1 % p r ic e o f W in d o w s s o ld to m a k e th e p r ic e r is e in c o m p u te r s th a t w o u ld o n th e p r ic e o f a in c r e a s e d W in d o w s c a u s e a W in d o w s p r ic e in c r e a s e to c o m p u te r p r ic e u n p r o f ita b le b e u n p r o f ita b le 0 .0 5 % 0 .9 9 0 % 1 9 .8 % 0 .1 0 % 0 .9 9 0 % 9 .9 % 0 .1 5 % 0 .9 9 0 % 6 .6 % 0 .2 0 % 0 .9 9 0 % 5 .0 % 0 .2 5 % 0 .9 9 0 % 4 .0 % 0 .3 0 % 0 .9 9 0 % 3 .3 % 0 .3 5 % 0 .9 9 0 % 2 .8 % 0 .4 0 % 0 .9 9 0 % 2 .5 % 0 .4 5 % 0 .9 9 0 % 2 .2 % 0 .5 0 % 0 .9 9 0 % 2 .0 % 0 .5 5 % 0 .9 9 0 % 1 .8 % 0 .6 0 % 0 .9 9 0 % 1 .7 % 0 .6 5 % 0 .9 9 0 % 1 .5 % 0 .7 0 % 0 .9 9 0 % 1 .4 % 0 .7 5 % 0 .9 9 0 % 1 .3 % 0 .8 0 % 0 .9 9 0 % 1 .2 % 0 .8 5 % 0 .9 9 0 % 1 .2 % 0 .9 0 % 0 .9 9 0 % 1 .1 % 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 • Monopoly versus competition (smaller q, higher p) • Imposing a tax on a monopolist similar to competition in that producer still bears part of it. • Price controls and monopoly ...a case where controls may increase efficiency. • Price discrimination. • 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 Natural Monopoly • Downward sloping AC curve. • More efficient to have 1 large firm than many small firms. • Rate of return regulation is how we regulate these firms. • Removes incentive to keep costs down. Natural Monopoly Pm Unregulated Profit Pr Losses with efficient output PE AC MC Qm Qr QE Lecture 2 Price Discrimination • Perfect • Two or More Markets • Bundling and Block Booking • Versioning Perfect Price Discrimination • • • • • • 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. 19 Perfect Price Discrimination. P1 S P3 P6 D Qo Declining Price Schedule • Also true for ‘all-or-nothing’ pricing. Price Discrimination - 2 or more Markets • • • • • 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 • • • • 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. Price Discrimination Law • • • • 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. Examples of Price Discrimination • • • • Airline Tickets (Business and Vacationers) Movies (adults, children, seniors) Stamps, Coupons Predictable Sales Versioning • Providing different models of product with differing capabilities. • Can be used to achieve price discrimination, but also might just better meet consumer demands. • Artificial creation of • Problem: avoiding cannibalization of higher end product line. Versioning Examples • ‘lite’ versions of software with reduced functionality. • Putting identical chips in high and low powered calculators. • PC Junior Lecture 3 Bundling (Block Booking) • Two or more products that are sold as a package. – – Related to ‘Tie-Ins’ but differs in that bundling is not ‘contractual’. That is, when you buy the bundle your purchase is finished. A tie-in is a contract where you agree to buy any of product X that you use, from a particular vendor. But you need not buy X at all. Example: if you buy a photocopy machine from me, you also need to purchase any toner that you need from me as well. 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 Mod 2 • Information Goods Public Goods 1. 2. 3. 4. 5. Definition: Goods that do not get used up when consumed. In other words, one person’s consumption of a good doesn’t reduce anyone else’s potential consumption of the same good. Examples: Ideas, television broadcasts, national defense. Obviously, these are not physical items that get used up. Instead they are usually ideas and artistic expressions. They are at the core of the Information Age Economy, since information is a public good. The Demand for Public Goods is the vertical sum of individual demands. Public Goods (cont.) 1. 2. 3. Some definitions of Public Goods claim that consumers can not be excluded from using them. Known as Non-excludability. Some Public Goods, such as broadcasting, or national defense, appear to have this characteristic. This misses the point. Any product for which consumers can not be excluded from using, e.g., apples, will give producers no incentive to produce. Vertical Addition of Demands P4 ΣD P3 P2 D3 D2 D1 P1 Q1 Q Public Goods 1. 2. Book titles can be thought of as public goods, but the physical copies of a single book title are private goods that embody a public good. Several questions arise: how many titles are optimal to publish? How many copies of each title would be optimal? How do competitive markets work? Monopolies? Finally, is it possible to produce public goods efficiently? In principle, a perfectly discriminating monopolist can produce efficient amount of public good. S P4 P3 ΣD P2 P1 Q Q1 Q2 Lecture 4 The Market for a Title 1. Reproductions of a single Title are Private Goods 2. Seller of the Reproductions can not appropriate the entire potential value of the reproductions since he is not a perfect price discriminator. 3. With a single price for the reproductions, too few reproductions are produced (Q*-Qm). One component of lack or appropriation (area 7 in figure). 4. Consumers of the reproductions get surplus, which is another loss of appropriation for the reproduction seller. (1+2 in figure) Production of a Single book title Pm 1 2 4 3 7 MC of printing 5 6 Qm 8 D Q* MR number of copies of a title Market for Titles 1. 2. 3. Because appropriability for reproductions of any title is imperfect, the sellers of titles can not achieve the vertical sum of demands (perfect discrimination demand in next figure). Instead, the best the sellers can do is some distance below the vertical sum of individual demands (attainable demand curve in the next figure). This leads to too few titles being produced relative to the ‘ideal’. • Market Demand for Titles Pm Qm Q** Q* number of titles written Copyright Tradeoffs • This leads to two tradeoffs: – Under-consumption of individual titles. – Underproduction of titles. • This same tradeoff exists in Copyright. • Copyright exists to give creators of ‘artistic’ works the ability to generate revenues. • The theory is that without copyright, competition in selling reproductions of a title would drive the price down to the marginal cost of producing a reproduction. Competition would also drive the (economic) profits down to zero, leaving no money with which publishers can pay the author. Copyright Tradeoffs • It isn’t clear, however, that competition leaves no payment for the author. • Arnold Plant argued that being first gave enough of a head start that sufficient profits could be earned to allow authors to receive optimal remuneration. (Ex. English authors in the US market). • The lead from being first is, with current technology, unlikely to allow much profit. Optimal Copyright • The figure on the next page illustrates optimal duration of copyright. • It contrasts the gains from lengthier copyright (the value of additional works created) against the harms (unnecessary loss of consumer surplus) Patent (copyright) tradeoff • • • • With no protection, creators do not reap much of the rewards of their creations. They are given monopoly protection, which increases their revenues, but raises price to consumers. This increases the number of inventions, but decreases the use of each invention? We do not know the optimal tradeoff. Lecture 5 Fair Use • There is in the law an attempt to balance the interests of copyright holders and those of users. • Fair use is a defense to copyright infringement. It allows copying in instances when the copying appears not to be hurting the copyright owners revenues. • Betamax Case said home videotaping was fair use, and thus home videotaping was allowed. Fair Use • 4 factors – Amount of the copyright product that is copied. – Nature of the Copyright product (commercial versus academic or scholarly. – Nature of the use of the copied product – Impact on the revenues of the copyright holder. • Last factor is the most important. Indirect Appropriability • Basic Idea: Producer Can Generate Revenues from those making unauthorized copies. • Consumers who make duplicates are willing to pay more for originals since the get value from making duplicates. • Producer can charge more for originals, thus indirectly appropriating some of the value in the copies. Diagram of Copying Impact P D V DH Q Copying Outlawed P DH Q Diagram of Copying Impact Impact of Piracy • Although we don’t know whether copyright currently has a duration that is too large or too small, we still have to deal with piracy. • Example of having all purchasers of CDs make a cassette for their automobile is an example where copying causes no harm, and may even be beneficial, depending on whether these individuals would have purchased a second CD or prerecorded cassette. Evidence on Price Discrimination and Indirect Appropriability Dependent variable Constant Cites Non-Profit Age of R-square Dummy Journal Plib/PInd 1.29 .0065 .65 [1.99] [4.14] Plib/PInd 1.38 .0071 .578 [2.14] [3.36] .17 n=80 -.16 [1.01] .17 Continued Libraries that: 1959 1983 Price Discriminate 3 59 Don’t Price Discriminate 35 21 Ratio of Book to Journal Expenditures, US Academic Libraries 1941 3.02 1961 3.19 1975 1.70 1944 3.41 1965 3.36 1977 1.54 1946 3.13 1968 3.67 1979 1.26 1950 3.01 1971 2.96 1981 1.13 1959 2.46 1973 1.96 Application to Napster • Can indirect appropriability work in Napster-like environment? • Problem: large variability in the number of copies made from each original • Problem: identifying at time of sale which originals are going to be duplicated. • Large scale copying will harm copyright owners significantly. Newer Issues • Automatic Rights Mechanisms – Copyright owner can imbed code into software that will monitor use and charge accordingly. It can also prevent copying. • Question: Is this protection ‘too strong’? Fair use seems like it would disappear. Copyright owner can now costlessly collect revenues from users. Lecture 6 Mod 3 • Network Goods Network Effects • • • • Increased market size makes product more valuable to consumers. This is just like an economy of scale in that it benefits large firms relative to small ones. Leads to natural monopoly. It implies that demand increases for large networks, and that prices should rise. In Microsoft case, judge decided that they are a barrier to entry. Network Effects • Definition: a product becomes more valuable to a consumer the more other consumers there are of the product. • Virtually identical theoretically to economies of scale • Markets will tend toward monopoly, winner-take-all result (in simple world). • Example: Fax machines, some software, languages, online networks, computer standards,. • Literal networks (physical connections, e.g., fax machines) and Virtual Networks (e.g., software) Characteristics of Information Markets • Bigger is better, large firms (standards) have advantages over smaller firms (standards). – – Economies of Scale: large fixed costs Network Effects • – – Definition: a product becomes more valuable to a consumer the more other consumers there are of the product. Instant scalability: the ability to increase output extremely quickly. Not the same as zero marginal cost. If these effects are not exhaustible, we have ‘natural monopoly’, which used to be thought to require government regulation. Potential Problems Due to Network Effects • Traditional Problem: Network is the wrong size. Old fashioned negative externality. • New Problem: Getting stuck with the wrong network—i.e., lock-in. Effects versus Externalities • Where we have positive externalities, activity is too small (golf courses, research?). • Where we have negative externalities, activity is too big (e.g., air pollution, traffic). • One key element is whether external effects are internalized, or whether they are truly externalities. Tragedy of the Commons • • • • Example of Negative Externality. Common Property Resource – lake, forest, any productive resource that allows free use. The tragedy is that the resource is overused. Greater tragedy is that it is overused to the point where its entire value might be dissipated. Fishermen on Lake Fishermen Fish per Fisherman Total Catch Marginal Catch 1 10 10 2 9 18 8 3 8 24 6 4 7 28 4 5 6 30 2 6 5 30 0 7 4 28 -2 Illustrating Overuse Fish per Fishermen Fisherman 1 10 2 9 3 8 4 7 5 6 6 5 7 4 Total Catch 10 18 24 28 30 30 28 Marginal Opportunity Catch Cost 6 8 12 6 18 4 24 2 30 0 36 -2 42 Net Value 4 6 6 4 0 -6 -14 Lock-in • Claim: Markets do not adopt best products even when it is efficient to do so. – QWERTY, VHS-Beta are most common purported examples. • Story is one of coordination failure. – We all prefer Beta. But VHS dominates, and most movies are on VHS. Since we think that everyone else will get VHS, we get VHS too. • My work with Margolis has shown the key examples of lock-in to be false. Lock-in Table T able 1: A D O P T IO N P A Y O F F S N um ber of P revious A do ptions 0 10 20 30 40 50 60 70 80 90 100 T echnolo g y B (B eta) T echnolo g y V (V H S ) 10 4 11 12 13 14 15 16 17 18 19 7 10 13 16 19 22 25 28 31 20 34 • Technology B Wins although Technology A is better. 40 Figure 1 V 30 B 20 10 Benefits 0 10 20 30 40 50 60 Number of Adopters 70 80 90 • Assumption about different slopes? What does it really entail, and is it reasonable? Qwerty Story • Most famous case; – simple to identify ‘quality’ (speed of typing) – Consistent with chaos theories of unpredictable small events leading to big outcomes. • Usual Story: – Qwerty Keyboard was designed to slow down typing to keep keys from getting stuck. – In a famous typing contest in Cincinnati, pitting touch typist against ‘hunt-and-peck’ the touch typist used a Qwerty and won. This is the small accident leading to big outcomes, since people then associated Qwerty with speed. – Prof Dvorak designed a keyboard to speed things up in 1930s. – During WWII Navy tested new keyboard and found that speed increased 40% and cost of retraining was recouped within 10 days of completed switch. – Keyboard never adopted. End of war reduced Navy’s need for fast typists. Qwerty Story • Actual Story – No evidence that Qwerty Keyboard was designed to slow down typing speed, and it wasn’t necessary to keep keys from getting stuck. – There were many other typing contest pitting touch typist against other touch typists on different keyboards and Qwerty won many of these. The point is that the Cincinnati contest was not crucial. – A highly publicized 1954 test of the Dvorak keyboard by the General Services Administration found no advantage in switching to Dvorak. – The WWII Navy study was biased in the way it calculated it results. All the biases were in favor of Dvorak. It also appears that the author of the study was probably Dr. Dvorak, the designer and patent holder of the keyboard. – Ergonomics studies on keyboard design confirm that Qwerty is a good design and not much different than Dvorak in terms of speed Beta-VHS Story • Claim Story –. – Ergonomics studies on keyboard design confirm that Qwerty is a good design and not much different than Dvorak in terms of speed Other Stories • • • • • • • Quadraphonic sound Railroad gauges Macintosh versus dos Internal combustion engine Metric versus English measurement Stereo AM AC versus DC Network Effects • • • • Increased market size makes product more valuable to consumers. This is just like an economy of scale in that it benefits large firms relative to small ones. Leads to natural monopoly. It implies that demand increases for large networks, and that prices should rise. In Microsoft case, judge decided that they are a barrier to entry. Lecture 7 Business Applications • Should a firm have internal charges when one division helps another (e.g. technical support)? • Network Effects (again). • Midterm, meeting 7 • Lecture 8 Measuring Network Effects • Several attempts: – Gandal examined spreadsheet prices. • Examined whether Lotus file compatibility and ability to link to external databases were characteristics that led to higher prices. – Brynjolfsson and Kemerer examined spreadsheet prices • Examined whether Lotus menu structure and installed based lead to higher prices. – Literal networks: fax machines (Saloner and Shepard). Network Effects and Software • Standard Claims: – Winner-takes-all. • Market should gravitate toward a single winner. • Note that ‘instant scalability’ can also lead to winner-take-all type of result since market can follow preferences of consumers more strongly than would be typical. – Lock-In: Network effects presumably strengthen monopoly of leader. • Superior challengers can replace leader with built in network effects until difference in quality becomes – Tipping: At some point network effects support one firm or product so strongly that it becomes the standard and takes the market. Quick answers : – Product quality is key to success. • Inferior products lose market share amazingly rapidly. • Success seems to come only to the #1 product. • Price plays only a small role. – Evidence to support winner-take-all claims – No evidence to support lock-in. In fact, quite the opposite. • Products deemed better seem to quickly replace inferior products. – No evidence of a ‘tipping’ point. What has led to Software Success? The same factor that causes success in software markets in general…. Product Quality •Measured by Magazine Reviews. • We count ‘wins’ and measure ratings. Figure 8.7: Spreadsheet Wins 8 7 Excel Quattro Lotus 6 5 4 3 2 1 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 R atin g s 50 40 30 7 20 106 0 5 Lotus E xc el P C M a ga zin e 2/ 18/ 97 P C M a g a zin e B yt e 12/1/ 96 2/ 1/ 98 PC W o rld 4/ 1/ 96 H om e O ff C om p 2/28/ 94 11/ 10/ 92 P C M a ga zine 12/ 31/ 91 P C M a ga zine 9/ 1/ 91 P C W o rld 6/1/ 91 Quattro INF OW OR LD By t e 7/ 1/ 89 Excel 2/ 8/94 8 10/ 12/ 92 60 IN FO W O RLD 70 P ers on a l C o mp u tin g 9/ 1/88 P e rs o na l Co m pu t ing Figure S Set R atings Figure 8 .8 :8.12: C o mRevenue parison S hare preadofshe 100 10 90 809 L otus Q ua ttro 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 F igure 8.12: Revenue S hare of S S 100 90 80 70 60 E xc el 50 40 Q uattro Lotus 30 20 10 0 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 9 8 7 Ami Pro MS Word Windows WordPerfect for Windows PC Magazine 2/18/97 PC Magazine 11/21/95 PC Magazine 2/8/94 PC Magazine 11/9/93 PC Computing 8/1/93 PC Magazine 2/25/92 Infoworld 2/10/92 Infoworld 1/7/91 ComputerWorld 5/24/93 PC Magazine 12/11/90 Personal Computing 8/1/90 Figure 9.5: Windows WP Ratings 10 Word Processor Market Shares 100% WordPerfect Word Star 90% Microsoft Word Ami 80% 70% 60% 50% 40% 30% 20% 10% 0% 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Fig 9.21: M idrange DT P W ins 7 6 5 4 3 2 1 0 pre 1990 1990-1991 MS Publisher 1992-1993 Publish It! 94-95 96-98 Other F ig 9.22: M id ran g e P C D T P S h ares 90% 80% 70% 60% 50% Mic ros oft P ublis her E xpres s P ublis her S erif P ageP lus O ther 40% 30% F irs t P ublis her C orel P rinthous e P ublis h It 20% 10% 0% 1990 1991 1992 1993 1994 1995 1996 F ig 9 .1 0 : P e rs o n a l F in a n c e W in s 9 Managing Your Money Q uic ken Mic ros oft Money 8 7 6 5 4 3 2 1 0 86-90 91-92 93-94 95-96 97-98 Fig 9.12: M arke t S hare P C P e rsonal Finance 80% 70% 60% 50% 40% 30% Q uic k en M ic ros oft M oney M anaging Y our M oney 20% 10% 0% 1989 1990 1991 1992 1993 1994 1995 1996 8.5 8 11 /1 /9 3 M a c U se r 6/ 1/ 89 10 /2 5/ 93 InfoW orl d 8/ 3/ 92 InfoW orl d 11 /5 /9 0 InfoW orl d 1/ 1/ 90 9 P e rsona l C om p ut in g 9.5 M a c U se r 6/ 20 /8 8 InfoW orl d 10.5 F ig . 9 .1 4 : HIg h E n d M a c in to s h D T P 10 P ageM akerM Q uarkXP ressM F ig u re 9.15: M arket S h are M ac H ig h -E n d D T P 80% PageMaker 70% Quark Frame 60% 50% 40% 30% 20% 10% 0% 1990 1991 1992 1993 1994 1995 1996 5 4 3 6 1 0/10 /95 P C M aga zine 5 /6 /97 P C M aga zine 1 1/19 /96 7 /1 /95 C om puse rve P C M aga zine 6 /1 1/9 6 8 M acu se r AOL P C M aga zine 6 /1 /95 M SN P C W orld 2 /2 1/9 5 P C M aga zine 3 /1 5/9 4 P C M aga zine 2 /2 3/9 3 P C M aga zine 1 1/12 /91 P C M aga zine F ig u re 4 1 : O n lin e S e rv ic e R a tin g s 11 P rodigy 10 9 7 Figure 9.27: Online Market Shares AOL CompuServe MSN Prodigy 70% 60% 50% 40% 30% 20% 10% 0% 1991 1992 1993 1994 1995 1996 1997 In 1994 Prodigy dropped its $14.95 unlimited use pricing and went to the same pricing as its competitors ($10 for 5 hours, $3/hr after). Mod 4 • Lecture 8 Mod 4 Lecture 8 • Products that lend themselves to the Internet. • First, two types of Internet models – Full Internet: no brick and mortar, only virtual. No costs for warehouses, trucks, stores, salespeople, and so forth. This was the original Amazon model. – Partial Internet: Perhaps just for order taking (usual warehouses, customers pick up from brick-andmortar retail outlet. – Or some combination. Characteristics of Products that are Likely to Determine the Extent of the Internet Transformation. • • • • • Look to the mail order industry Size and Bulk relative to Value Immediate Gratification Factor (Impulse buying) Perishability Experience Products • The Role of Taxes • The Ability to Lower Costs Types of Products Most Compatible with E-tailing? • Digitized Products: no bulk, zero shipping costs, immediate gratification. – Computer software. – Songs (when format issues, piracy, and copyright issues are resolved). – Videos (with same caveat) – Information (databases, telephone numbers, and so forth) – Books: when E-books become practical for most or many readers. Markets likely to resist the Internet assault. • Grocery Items : high bulk relative to value, distribution systems likely to be inefficient, many products are experience goods, perishability problems. • Automobiles: experience goods • Furniture: experience goods, costly shipping. • Prescription Drugs: immediate need (instant gratification. Majority of Markets • Can use Internet for advertising, information, maybe sales. • Shoppers could then pick up orders at local store – this only makes sense if the Internet experience is faster or cheaper for consumers as opposed to going through the store. • Distribution systems not impacted. Lecture 9 • Likely financial performance of Internet firms. Meaning of Profit Margins • In competitive industries, economic profits are driven to zero for the industry (or at least for potential entrants). • This mean that the return on investment is equal to the normal return in competitive industries (in equilibrium). Less competitive industries can earn above normal returns. • Normal returns on investment do not imply normal returns on sales!! The return on sales depends on the value added. The Concept of Value Added • Usually: The larger the investment as a percentage of the sales revenue the larger the percentage of total value of the product sold that is created by the seller. • This is the reason that supermarkets have such low returns on SALES (but not necessarily low returns on investment!) Implications for E-firms • Internet firms, particularly full Internet firms, are expected to have lower costs than brick-and-mortar firms. • Who do Internet firms compete with? Brick-and-mortar firms or other Internet firms? This is an important question. • If other Internet firms, then returns on sales will be lower for Internet firms than the brick-and-mortar counterparts. • If the competition is really between brick-and-mortar and Internet firms, then profitability depends on who is more efficient, and this will determine returns on sales. Advertising on the Net • Original model was subscription based – AOL ISP model with specialized content. • ESPN, Wall Street Journal, Slate, and a host of others tried this. • Then advertising was added in, as in TV. • Only WSJ and a few others stayed with subscriptions. Others found that when they charged user, number of users dropped dramatically, hurting ad revenue and dashing their hopes for large market share (they believed that network effects made first movers the winners. Advertising on the Net • Net firms thought they could be solely advertising based. • The TV model that they were thinking of was a flawed model. It was due to unusual historical factors, not economic forces. • Pure advertising models almost never are used: magazines, cable networks, newspapers, all use both advertising and subscriptions. • Based on these analogies, the model that will win in the end almost certainly will be a mixture of advertising and subscriptions. Advertising on the Net • Net advertising revenues seem unlikely to be large enough to support many sites. • Banner advertisements are not going to be very effective. Too small, too easy to avoid. • Compare to TV ads: TV ads interrupt, have sound and music, can provide an aura about the product. Until Net Ads can do the same, they will never be as effective. • Net ads do have an advantage of being very easy to monitor (click-throughs) and sites can be very specialized. • Dot-com fever made the advertising model seem feasible for a while, although even dot-coms went to TV to get market share. Lecture 10 • What happened to cause the melt-down in Internet stocks? – Trying to sell products on the Internet that didn’t make sense. – Belief that first to market and market share leaders get to take away all the winnings (misapplying network effects stories). • See “The great Net giveaway gimmick” as an example of the mentality. – Installed base was used to determine stock valuations. As if profit per user were assured. – Too much investment lead to lower returns. – Throwing out usual business rules: profits, business plans, managers with experience. – Cash rich net firms overspent on advertising and each other, causing a bubble that was amazing while it happened. Too Much Investment • Impact of ‘too much’ investment. – As an analogy, even in the greatest oil find imaginable, if firms have to bid on the fields, and if there are many excited bidders, prices can be bid so high that there are no profits after the oil is developed. Look to the sale of spectrum frequencies for an example. – Additional investment depresses the prices that can be charged the results of the investments Lecture 11 • Interactive Pricing (Auctions) versus Listed Prices – Who benefits? Is it better for sellers? Buyers? Could it be better for both? – Is this a form of Price Discrimination? – Are we going to move to a world of auctions? History of Haggling • Was common until recent times in Modern Countries • Why did it end? High cost of time • Shopping with fixed prices is more convenient than haggling. • Will the Internet allow haggling without the inconvenience? Mod 5 • Public Policy and high technology. Information Goods and Antitrust • Winner-takes-all nature of these goods implies very large market shares. It is efficient to have a standard. • Competition may take a different form: competition to be the next generation standard. • Is there a role for these theories in antitrust? Are consumers in danger? • Owners of Standards need to coordinate consumers and partners to achieve the best result. Could this coordination appear ‘anti-competitive’? Microsoft Case Background • Microsoft ‘sells’ DOS to IBM for use on PCs. IBM allows Microsoft to sell MSDOS to third party computer manufacturers. • PCs quickly eclipse Apple as leading computer platform. • Microsoft and IBM ‘jointly’ begin work on graphical interface (OS/2) which has very ambitious specifications and is not based on DOS. IBM’s attempt to recapture PC market by having special version that only runs on its PCs. • Microsoft develops Windows as a temporary graphical interface that runs on top of DOS. Tells IBM that it doesn’t compete with OS/2. Microsoft Case Background (cont) • Windows 1.0 and 2.0 are flops, but Windows 3.0 takes off in 1990. • PC manufacturers quickly adopt Windows on the machines they sell. Windows is much cheaper than OS/2. • Microsoft and IBM have a falling out and IBM takes over OS/2 development. • Microsoft develops Windows NT as a more advanced OS to compete with high end workstations such as Sun. Since Microsoft now dominates PCs, workstations are a new market opportunity. Microsoft Case Background (cont) • 4 anonymous firms hire law firm (Gary Reback) to lobby for government examination of Microsoft’s tactics. • Government investigates large market share of DOS. FTC tie vote, and then Justice Department investigation. • Government and Microsoft reach consent agreement over Microsoft’s pricing tactics. • Justice begins new investigation about Microsoft’s inclusion of MSN with each version of Windows. AOL claims it can not compete and that Microsoft was trying to leverage its ownership of Windows to dominate online services. AOL’s continued growth, however, destroy the credibility of the claim. Microsoft Case Background (cont) • Justice then investigates Microsoft’s inclusion of Internet browser (Explorer) with each copy of Windows. Claims it is a violation of consent decree. • Judge Jackson hears this case and orders an injunction forcing Microsoft to sell to computer manufacturers a version of Windows without the browser. • Microsoft slaps judge in face by selling a version of Windows without the browser, but which also doesn’t operate. • On appeal, Judge Jackson’s injunction is overturned. Then Justice bring forward, along with 19 states, a new antitrust case based on the browser. Microsoft Case • Government’s theory: – Microsoft has a monopoly in its Windows OS. To strengthen claim they argue that the proper market definition is Intel based PCs. – This monopoly is protected by network effects, referred to as the “application barrier to entry”. – Netscape browser, along with Java language, are a threat to Windows since they allow programmers to write programs that will run on any OS, removing the great appeal of Windows, its large installed base. – Microsoft engaged in illegal acts to protect its monopoly. It foreclosed the market for Netscape's browser by tying Internet Explorer to the OS. Microsoft Case • Problems with Government’s theory: – Government’s view of network effects suffers from the fact that there is no empirical support for the lock-in claim. Software market examination earlier showed this (Microsoft presented similar evidence after seeing galleys of the book). – It isn’t clear that Netscape/java is a substitute for Windows, and if it were it isn’t clear that its market share wasn’t big enough. – Showing consumer harm has become more important in antitrust in recent decades, and government has had a hard time demonstrating how consumers were hurt. – The following charts illustrate Microsoft’s impacts on consumers, at least with regard to price. Impact on Consumers F ig . 1 : W o rd P ro c e s s o r & S p re a d s h e e t P ric e s $250 $200 $150 $100 Ave rage W o rd P ro c e s s o r P ric e Ave rage Spre ads he e t pric e $50 S ourc e: S . Liebow itz and S . Margolis , : W inners , Los ers and M ic ros oft: C om petition and A ntitrus t in H igh T ec hnology , 1999, Independent Ins titute $0 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Impact on Consumers Figure 3: N orm alize d P rice C hange s $140 $120 $100 $80 $60 $40 Non-Mic ros oft Markets Markets W here Mic ros oft C om petes $20 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 Impact on Consumers F ig u re 2 : Y e a rly P ric e C h a n g e s 30.00% Non-Mic ros oft Markets 20.00% Mic ros oft in Market 10.00% 0.00% -10.00% -20.00% -30.00% -40.00% 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 90% $180 80% $160 70% $140 60% $120 50% $100 40% $80 30% $60 20% $40 10% $20 0% 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 P C P ric e M ac P ric e P C S hare Microsoft Word M ac S hare M ar k et S h a re s W ho les ale P ric es F ig u re 9.9: M icro so ft W o rd in M a c a n d W in d o w s $200 $250 100% $230 90% $210 80% $190 70% $170 60% $150 50% $130 40% $110 30% $90 20% $70 10% $50 0% 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 PC Price Mac Price PC Share Microsoft Excel Mac Share Market Share Wholesale Prices Fig 8.15: Excel in PC and Mac Markets Impact on Consumers • What did government say about consumer harm? – Three claimed instances: • Wasted space on hard drive for Internet explorer for those people wishing to use Netscape. • Wasted time putting Netscape on computer instead of having OEM do it. • Lost innovation from Microsoft smothering everyone else. – This last claim is obviously the most important, but it is impossible to either prove or disprove. In general there is no evidence that monopolists are less inventive than others. And the fact that Microsoft has 120,000 developers indicates that they do not destroy all the good ideas. Lecture 12 • Microsoft Case Lecture 13 Foreclosing Netscape • Government claimed that Microsoft prevented Netscape from being able to get its product into consumer’s hands. – Contracts with OEMs (computer manufacturers). • Microsoft enforced a provision in Windows requiring that OEMs not remove any Windows icons. They could add other Icons, such as Netscape, but they couldn’t be larger than the Windows icons. – Contracts with ISPs (Internet service providers such as AOL). • Microsoft entered into agreements whereby the ISPs provided Internet Explorer bundled with their service. Of course, users were free to use any browser they wished. Microsoft tended to give their product away. Foreclosing Netscape (Cont) – Contracts with ISVs (independent software vendors such as Quicken). • These companies used Internet Explorer within their programs, say, if users wished to access the web while using Quicken. • Microsoft replied that: – Netscape also had contracts with ISPs and OEMs. The one with Compaq started much of the ruckus regarding the placement of icons. Microsoft’s browser was ‘componentized’, meaning that others could put their names on it, or use just parts of it, Netscape’s wasn’t. – Netscape's browser was available online and through carpet bombing, with 100 million copies in the hands of users. Foreclosing Netscape (Cont) • Why did Internet Explorer gain market share? – Government says for the reasons given above. – Microsoft says that it gained market share because it was a better product. • Here is some evidence. Fig 9.23: Browser W ins 8 Int Explorer Netsc ape Other 7 6 5 4 3 2 1 0 95-1 95-2 96-1 96-2 97-1 97-2 Fig 9.24: Browser Shares 100% 90% 80% 70% 60% Netsc ape Internet Explorer 50% 40% 30% 20% 10% 0% Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Giving Away Internet Explorer • Judge believes there is no rational economic reason to give Internet Explorer away, or to work so hard to get ISPs and ISVs to use it, except to destroy Netscape. • Of course, RealNetworks gives away its player os it can make money on the server software. And CBS, NBC, and so forth give away their programming, so they can make money on the advertising. Etrade pays new users to open an account. Juno gives away Internet service to users who will watch the advertisements. So giving away a product can have rational economic purposes. Judge’s Findings • Microsoft is a monopoly • Accepted government’s case almost in its entirety. • Didn’t hold hearings on remedy. Asked both sides to put forward a remedy and accepted that from the government. • Decision was in two parts: findings of facts and findings of law. • Judge gave interviews during the case that indicated that he felt Microsoft witnesses were lying to him and were unrepentant. These interviews didn’t come out until after his decision. Government ‘Remedy’ • Structural and Conduct • Structural (10 years) – Two companies, one selling applications, the other selling operating systems. – They can not trade with one another. – The application company gets all software except operating systems [Windows, Windows NT (2000), Windows CE]. Everything else goes to the application company. Conduct Remedies (3 years) • • • • • Uniform Windows pricing Disclosure of APIs No sabotage of competitors products No exclusive dealing/tying OEM Choice of Features – Price of Windows lowered by size of features that are removed. • No agreements to restrict competition • Continued sale of old versions without raising the price. Problems Created by Remedies • The restriction on interaction, in combination with the application company getting almost all products, will make innovations in the operating system much more difficult. • Server software, voice recognition, developer tools all belong with the operating system company. Operating system is much weaker without them. NT was not part of case, yet it is much less able to compete without server software. • For example, we get inefficient result if best voice recognition was made by Microsoft. • X-box problems: Hardware goes with application company, operating system with OS company. 3DO tried this and it failed. Problems Created by Remedies • X-box problems: – Hardware goes with application company, operating system with OS company. – 3DO tried this model and it failed. It fails because game hardware is sold often at a loss with the profits made up on the games. That cannot be done if the OS and hardware companies are different. Since Microsoft was the underdog in this market, it can not be good for consumers to reduce competition here. • Reduced competition in workstation/server market. – Windows NT and 2000, with various server software packages were supposed to compete with the likes of Sun and Oracle. It will be much harder under the remedy to compete successfully. Since Microsoft was the underdog in this market, it can not be good for consumers to reduce competition here. More Problems • OEM choice of features. – Seems innocuous, pay for only what you use, as on an a la carte restaurant menu. – Prices on this menu are a function of the number of letters in the name of the dish??? – But an operating system is not a restaurant. – The operating system is a type of standard, and this choice fragments the standard. Software developers can’t count on what features will be included. – Example of Game Developer with sound compression. More problems (cont) • Even non-sabotage clause is unreasonable – Microsoft shall not take any action that it knows will interfere with or degrade the performance of any non-Microsoft Middleware when interoperating with any Windows Operating System Product without notifying the supplier of such non-Microsoft Middleware in writing that Microsoft intends to take such action, Microsoft's reasons for taking the action, and any ways known to Microsoft for the supplier to avoid or reduce interference with, or the degrading of, the performance of the supplier’s Middleware.” • How do you define ‘performance’? – Speed? Reliability? Quality? – If Windows 98 moves to NT Kernal, performance improves for machines with lots of memory, but decreases for machines with little memory. – How much testing does it need to do, on how many machines? How many developers does Microsoft need to contact? More problems (cont) • Even disclosure of APIs, which I believe is a worthwhile goal, is poorly done in the government proposal. – “To facilitate compliance, and monitoring of compliance, with the foregoing, Microsoft shall create a secure facility where qualified representatives of OEMs, ISVs, and IHVs shall be permitted to study, interrogate and interact with relevant and necessary portions of the source code and any related documentation of Microsoft Platform Software for the sole purpose of enabling their products to interoperate effectively with Microsoft Platform Software.” – Doesn’t protect intellectual property. – Inefficient way of disclosing APIs Potential Costs T a b le 3 : A d d itio na l C o s ts to C o ns um e rs f ro m hig he r A p p C o A p p lic a tio n P ric e s (B illio ns ) In US in 2 0 0 0 In US 2 0 0 0 -2 0 0 2 W o rld w id e in W o rld w id e 2 0 0 0 - assuming 2 5 % yearly 2000 2 0 0 2 assuming 2 5 % gro w th. 1. A p p licatio n gro w th. R ev enues p lus $ 7 .5 5 $ 2 8 .7 7 $ 1 7 .8 6 $ 6 8 .0 9 2 . E xtra C o st A ssuming P rices $ 1 .8 9 $ 7 .1 9 $ 4 .4 6 $ 1 7 .0 2 $ 3 .7 7 $ 1 4 .3 8 $ 8 .9 3 $ 3 4 .0 4 $ 5 .6 6 $ 2 1 .5 7 $ 1 3 .3 9 $ 5 1 .0 7 $ 1 1 .3 2 $ 4 3 .1 5 $ 2 6 .7 9 $ 1 0 2 .1 3 5 0 % M arkup rise b y 2 5 % 3 . E x tra C o st A ssuming P rice s rise by 5 0 % 4 . E xtra C o st A ssuming P rices rise b y 7 5 % 5 . E xtra C o st A ssuming P rices rise b y 1 5 0 % D ata c om e from ID C S oftw are R eview and F orec as t, 1999. Mic ros oft applic ation s oftw are values c om es from page 147 table 1. Mic ros oft developm ent tools c om es from page 114, table 8. 1998 values are inc reas ed by 25% per year, the expec ted grow th rate ac c ording to tables 17 and 18, row for 32 bit W indow s m arket, w here app developm ent tools is expec ted to grow 25.6% annually and applic ation s oftw are to grow 28.8% . Potential Costs T a ble 2 : A dditio na l C o s ts to C o ns ume rs fro m H ighe r W indo ws P ric e (B illio ns ) In US in 1999 In US 2000-2002 W orldw ide in W orldw ide 2000- assuming 15% 1999 2002 assuming 15% grow th rate. grow th rate. N umber of PC s sold (in 45.10 180.09 113.32 452.53 millions) E xtra C ost $2.18 $8.71 $5.48 $21.88 A ssuming $9.54 $38.10 $23.97 $95.73 W indow s R ise s by $250 E xtra C ost A ssuming $16.11 $64.32 $40.47 $161.62 W indow s R ises by $500 E xtra C ost A ssuming $22.55 $90.04 $56.66 $226.27 A ssuming W indow s R ises by $50 E xtra C ost W indow s R ises by $1000 D ata o n P C sale s c o m e fro m the ID C P C Trac ke r database . ID C e stim ate s ye arly gro wth in 3 2 -bit W indo ws o pe rating syste m s and subsyste m s re ve nue s o f 1 8 .9 % fro m 1 9 9 8 -2 0 0 3 . Se e Table 6 , page 1 5 , Syste m So ftware and U tilitie s: 1 9 9 9 W o rldwide M arke ts and Tre nds, Analysts: R . P aul M aso n, D an K usne tzky, and P hilip M e ndo za, ID C 1 9 9 9 . ID C also e stim ate s num be r o f P C s shippe d to inc re ase by 1 7 % a ye ar fro m 1 9 9 9 to 2 0 0 1 . An Aside: How Important are OEMs anyway? Figure 8.3: OEM Sales as Share of Sales of Office Suites 1996 units 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1996 Revenue 1997 units 1997 Revenue Microsoft IBM/Lotus Corel Market Source: IDC Tie-In sales. • • • • Generally considered to be an ‘extension of monopoly’ by courts. In other words, courts believed it was an attempt to use one monopoly to create a second. Tie-In sales are poorly understood by courts, imperfectly understood by most economists. Frequently, tying good is sold very cheaply, while tied good is very expensive. Famous cases: IBM and computer cards, Xerox and toner, Canning machines and tin plate. Two monopolies are not better than one if products are used together (in fixed proportions). Tie In Sale when products used together PP MC=AC pairs of shoes 2PL PP-PL MC=AC left or right shoes PL MR Q1 D pairs of shoes Q PD version of Tie-In Story 1. Seller is thought to have two types of customers – heavy versus light users. 2. Tied good is thought to ‘meter’ the use of the tying good, to separate heavy from light users. 3. By lowering price of tying good, and raising price of tied-good, producer increases payments made by heavy user relative to light user. 4. Problems: heavy users likely to use up machines faster – tie-in may have no impact on relative payments. Risk Reduction version of Tie-In 1. Consumers are unsure how much use they will get from the tying good (machine). 2. This riskiness causes them not to be willing to pay the full expected (predicted) value of the product. 3. Seller has many such customers and can provide ‘insurance’ since the large numbers makes overall results predictable. 4. By lowering price of tying good, and raising price of tied-good, producer provides insurance for consumers afraid they might not have much use for machine. Compatibility Costs of Fragmented Windows.