Managerial Economics Jack Wu Externality Managerial Economics Jack Wu

Externalities one party directly conveys benefit or cost to others positive negative benchmark: collective marginal benefit = collective marginal cost

Saks: Fifth Avenue vs Mall Externalities New York, NY: 611 Fifth Avenue Stamford, CT: Town Center Mall Chevy Chase, MD: 5555 Wisconsin Ave McClean, VA: Tysons Galleria (c) 1999-2001, Ivan Png Hong Kong example: Park ‘N Shop – inside shopping mall at Winsor House Wellcome – along Great George Street (across street from Winsor House) Saks has long history, good reputation, and advertises heavily; will attract business for neighbours; on street, generates “externalities” for other businesses; mall is owned and operated by single entity; if “anchor” store attracts business for specialty stores, management can charge higher rent to specialty stores and subsidize anchor tenant. Worldwide trend: shops gravitating away from open streets and towards malls Pashigian and Gould (1998): in the United States, average department store rent = $2.24 per square foot; after controlling for differences in sales per square foot, average speciality store rent = $11.88 per square foot.

Sak’s Positive Externalities 15 13.4 group marginal benefit 10 Sak’s marginal benefit (Hundred thousand dollars) Marginal benefit/cost 9 florist’s marginal benefit 4 profit gain from additional investment 3.6 marginal cost 1 0.8 1 5 9 10 shoe store’s marginal benefit Hundred thousand dollars of investment

Sak’s Negative Externalities 10 marginal benefit profit gain from reducing investment (Hundred thousand dollars) Marginal benefit/cost group marginal cost b a 2 Sol’s marginal cost 1 Sak’s marginal cost c 5 7.5 9 10 Hundred thousand dollars of investment

Silicon Valley Stanford University Xerox Palo Alto Research Center Externalities Stanford University Xerox Palo Alto Research Center Hewlett-Packard Cisco Systems 3Com Yahoo! (c) 1999-2001, Ivan Png Hewlett and Packard were inspired by Stanford Engineering Dean Fred Terman; after HP formed, Stanford established Industrial Park -- capturing some externalities; HP became one of first tenants Xerox PARC was origin of many important inventions: Windows interface and mouse – commercialized by Apple and then Microsoft local area network – commercialized by 3Com Venture capitalists congregate on Sand Hill Road behind Stanford campus -- no benefit to Stanford.

Singapore: Raffles Place Financial Centers Externalities London: The City New York: Wall Street Hong Kong: Central Singapore: Raffles Place (c) 1999-2001, Ivan Png Very concept of financial center implies externalities; externalities among service providers --> concentrate in one location Opposing concept: get closer to customers  disperse all over the country. Question: can telecommunications and IT provide same “closeness” without physical proximity? closeness to other service providers closeness to customer

Resolving Externalities Economic inefficiency ® opportunity for profit merger collective action When the sum of the marginal benefits is not equal to the sum of the marginal costs a profit can be made by resolving an externality profit opportunity disappears when externality is resolved (sum of the marginal benefits equals the sum of the marginal costs) Merger: doesn’t matter whether source buys recipient of externality, or vice versa Example: Disneyland Anaheim: bought hotels around theme park; Hong Kong: theme park will have authority to exclude aircraft and ships from peeking at fireworks. Collective action: standards for telecoms and Internet GSM --> 3rd generation IEEE standards committees

Intel Inside Externalities Cooperative advertising resolves positive externality from one retailer to other retailers (c) 1999-2001, Ivan Png Compaq frequently advertises its products with the “Intel Inside” label; potential generates externality for other PC manufacturers using Intel microprocessors Intel resolves the positive externality through cooperative advertising. Another example: advertisements by travel agents featuring airlines -- Cathay Pacific, Singapore Airlines, British Airways; these advertisements benefit other travel agents and also the airlines airlines should provide cooperative advertising payment to resolve the externality

Network Externality Externality where benefit/cost depends on total number in network English language Internet email international telephone service Network externality need not necessarily be related to service provided through network; English language: Why is it so useful to learn English? Because so many other people speak and use it -- size of benefit/cost depends on total number in network; Similarly with Internet email and international telephone service

Network Effect benefit/cost depends on total number in network through market, not directly conveyed resolved by producer or service provider Network effect If you are the only person in the world with a telephone, who do you call? Similarly with MSN Messenger Difference from network externality: in case of network effect, someone resolves the externality -- the market achieves economic efficiency or approximates Telephone service: service is concentrated, as of Feb 2001, only 3% of US users had choice of telephone service provider; provider will price relatively low, to stimulate subscribers and hence network effects, because it will capture the additional subscribers Microsoft resolves network effect surrounding MS-Excel: prices relatively low so that more will use and generate benefit to other users Similarly, AOL, Yahoo and others provide free Instant Messenger service Contrast network externality – unresolved by market, so possible role for government Example -- Internet access. Provision of service is fragmented. If one provider prices low to stimulate demand, the the additional subscribers may join other providers – original price cutter is just generating an externality for other providers.

Critical Mass definition: number of users at which demand becomes positive Critical mass: examples Telephone service – Telephone companies understand the importance of critical mass. Long ago, AT&T advocated the concept of “universal service” MSN Messenger – Little demand because so few people have this service; most people subscribe to AOL Instant Messenger, which is incompatible.

Network Effects: Demand Elasticity highly elastic around tipping point highly inelastic at low demand levels Consider history of Microsoft Word vs WordPerfect: Microsoft invested heavily to achieve critical mass of users – demand very inelastic when MS user base was low after long and expensive investment, MS got close to tipping point WordPerfect missed transition from DOS to Windows, then quickly collapsed – demand very elastic around tipping point Tipping: tendency for the market demand to shift toward a product that has gained a small initial lead Contrast demand for office productivity software like MS-Word and conventional products, eg, car stereo systems: demand for car stereos is conventional – no tipping point between brands, competing brands can co-exist for long period of time

Public Good Non-rival consumption -- one person’s increase does not reduce quantity to others extreme economy of scale Public good = provides non-rival consumption/usage. eg, radio broadcast other examples: all forms of knowledge – scientific knowledge, artistic creation national defense Good that provides non-rival consumption yields extreme economy of scale – cost of serving 1 million users is same as cost of serving one. Government provides both public goods, eg immunization, national defense, private goods, eg, nursing care, legal aid, education Not all goods and services provided by government are public goods

Television Distinguish content delivery Externalities Distinguish content delivery (c) 1999-2001, Ivan Png Information technology, telecommunications, and media industries consist of three layers: content, eg, business-to-consumer commerce, information, entertainment service (Internet access and service) infrastructure Within content layer, information (eg, weather, news, images) is public good – just like knowledge; but compare delivery mechanisms newspaper radio television Internet Are they public goods?

non-rival consumption Rivalness congestible public good private good rival consumption non-rival consumption Consumption is congestible: one person’s increase in consumption by some quantity reduces the total quantity available to others but by less than that quantity bridge or tunnel at peak hour Internet during busy period Services of infrastructure may be public good or congestible depending on demand

Efficiency in Public Good 10 8.9 vertical sum of marginal benefits 5.6 Marginal benefit/cost ($ per minute) marginal cost 5 Alan 4.5 4 3.6 Mary At the economically efficient provision (benchmark) of public good, sum of marginal benefits = marginal cost Similarly, as with externality, when the sum of the marginal benefits is not equal to the marginal cost a profit can be made by resolving an externality profit opportunity disappears when externality is resolved (sum of the marginal benefits equals the marginal cost) 1 Peter 0.8 1 4 5 10 Minutes of fireworks

Excludability Provider can exclude particular consumer law technology Many public goods also have another aspect – difficult to exclude particular consumers broadcast television national defense However, conceptually, two concepts are different nonrival consumption excludability – depends on law and technology

Excludability: Law patent – product or process copyright – artistic expression Law of intellectual property creates property rights  right to exclude particular person from consuming/using the item; Astra has patent on ulcer drug, Losec  monopoly power  incentive for research and development Oracle has copyright over database systems

Intellectual Property Externalities trade-off benefit from usage incentive for future creation (c) 1999-2001, Ivan Png Scientific concepts and new ideas are public good more usage  greater benefit at no additional cost, so ideally, let everyone use freely need to give incentive to scientists and writers, so give them intellectual property and they will set price to exclude some users

Discussion Let b represent marginal benefit and q the amount of Sogo’s investment in the new ZhongXiao Fushing store. Suppose that the investment generates marginal benefis, b=10-q for Sogo, b=4-0.4q for the florist, and b=1-0.2q for the shoe store. Given the marginal cost of 1, calculate the profit-maximizing quantity of Sogo’s investment and the economically efficient quantity of Sogo’s investment.