Information Technology Chapter Thirty-Four Information Technology

Information Technologies Computers, answering machines, FAXes, pagers, cellular phones, … Many provide strong complementarities. E.g. email is useful only if lots of people use it -- a network externality. And computers are more useful if many people use the same software.

Information Technologies But then switching technologies becomes very costly -- lock-in. E.g. Microsoft Windows. How do markets operate when there are switching costs or network externalities?

Competition & Switching Costs Producer’s cost per month of providing a network service is c per customer. Customer’s switching cost is s. Producer offers a one month discount, d. Rate of interest is r.

Competition & Switching Costs All producers set the same nondiscounted price of p per month. When is switching producers rational for a customer?

Competition & Switching Costs Cost of not switching is

Competition & Switching Costs Cost of not switching is Cost from switching is

Competition & Switching Costs Cost of not switching is Cost from switching is Switch if

Competition & Switching Costs Cost of not switching is Cost from switching is Switch if I.e. if

Competition & Switching Costs Switch if I.e. if Producer competition will ensure at a market equilibrium that customers are indifferent between switching or not 

Competition & Switching Costs At equilibrium, producer economic profits are zero. I.e.

Competition & Switching Costs At equilibrium, producer economic profits are zero. I.e. Since , at equilibrium

Competition & Switching Costs At equilibrium, producer economic profits are zero. I.e. Since , at equilibrium I.e. present-valued producer profit = consumer switching cost.

Competition & Network Externalities Individuals 1,…,1000. Each can buy one unit of a good providing a network externality. Person v values a unit of the good at nv, where n is the number of persons who buy the good.

Competition & Network Externalities Individuals 1,…,1000. Each can buy one unit of a good providing a network externality. Person v values a unit of the good at nv, where n is the number of persons who buy the good. At a price p, what is the quantity demanded of the good?

Competition & Network Externalities If v is the marginal buyer, valuing the good at nv = p, then all buyers v’ > v value the good more, and so buy it. Quantity demanded is n = 1000 - v. So inverse demand is p = n(1000-n).

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve 1000 n

Competition & Network Externalities Suppose all suppliers have the same marginal production cost, c.

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve c Supply Curve 1000 n

Competition & Network Externalities What are the market equilibria?

Competition & Network Externalities What are the market equilibria? (a) No buyer buys, no seller supplies. If n = 0, then value nv = 0 for all buyers v, so no buyer buys. If no buyer buys, then no seller supplies.

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve (a) c Supply Curve 1000 n

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve (a) c Supply Curve n’ 1000 n

Competition & Network Externalities What are the market equilibria? (b) A small number, n’, of buyers buy. small n’  small network externality value n’v good is bought only by buyers with n’v  c; i.e. only large v  v’ = c/n’.

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve (a) c Supply Curve (b) (c) n’ n” 1000 n

Competition & Network Externalities What are the market equilibria? (c) A large number, n”, of buyers buy. Large n”  large network externality value n”v good is bought only by buyers with n’v  c; i.e. up to small v  v” = c/n”.

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve (a) c Supply Curve (b) (c) n’ n” 1000 n Which equilibrium is likely to occur?

Competition & Network Externalities Suppose the market expands whenever willingness-to-pay exceeds marginal production cost, c.

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve c Supply Curve n’ n” 1000 n Which equilibrium is likely to occur?

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve Unstable c Supply Curve n’ n” 1000 n Which equilibrium is likely to occur?

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve c Supply Curve n” 1000 n Which equilibrium is likely to occur?

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve Stable c Supply Curve n” 1000 n Which equilibrium is likely to occur?

Competition & Network Externalities Willingness-to-pay p = n(1000-n) Demand Curve Stable Stable c Supply Curve n” 1000 n Which equilibrium is likely to occur?

Rights Management Should a good be sold outright, licensed for production by others, or rented? How is the ownership right of the good to be managed?

Rights Management Suppose production costs are negligible. Market demand is p(y). The firm wishes to

Rights Management

Rights Management

Rights Management

Rights Management The rights owner now allows a free trial period. This causes an increase in consumption

Rights Management The rights owner now allows a free trial period. This causes an increase in consumption and a decrease in sales per unit of consumption

Rights Management The rights owner now allows a free trial period. This causes increase in value to all users  increase in willingness-to-pay;

Rights Management

Rights Management The firm’s problem is now to

Rights Management The firm’s problem is now to This problem must have the same solution as

Rights Management The firm’s problem is now to This problem must have the same solution as So

Rights Management

Rights Management  higher profit

Rights Management  lower profit

Sharing Intellectual Property Produce a lot for direct sales, or only a little for multiple rentals? Lending books, software. Renting tools, videos etc. Sell movies directly, or only sell to video rental stores, or pay-per-view? When is selling for rental more profitable than selling for personal use only?

Sharing Intellectual Property F is the fixed cost of designing the good. c is the constant marginal cost of copying the good. p(y) is the market demand. Direct sales problem is to

Sharing Intellectual Property F is the fixed cost of designing the good. c is the constant marginal cost of copying the good. p(y) is the market demand. Direct sales problem is to

Sharing Intellectual Property Is selling for rental more profitable? Each rental unit is used by k > 1 consumers. So y units sold  x = ky consumption units.

Sharing Intellectual Property Is selling for rental more profitable? Each rental unit is used by k > 1 consumers. So y units sold  x = ky consumption units. Marginal consumer’s willingness-to-pay is p(x) = p(ky).

Sharing Intellectual Property Is selling for rental more profitable? Each rental unit used by k > 1 consumers. So y units sold  x = ky consumption units. Marginal consumer’s willingness-to-pay is p(x) = p(ky). Rental transaction cost t reduces willingness-to-pay to p(ky) - t.

Sharing Intellectual Property Rental transaction cost t reduces willingness-to-pay to p(ky) - t. Rental store’s willingness-to-pay is

Sharing Intellectual Property Rental transaction cost t reduces willingness-to-pay to p(ky) - t. Rental store’s willingness-to-pay is Producer’s sale-for-rental problem is

Sharing Intellectual Property Rental transaction cost t reduces willingness-to-pay to p(ky) - t. Rental store’s willingness-to-pay is Producer’s sale-for-rental problem is

Sharing Intellectual Property Rental transaction cost t reduces willingness-to-pay to p(ky) - t. Rental store’s willingness-to-pay is Producer’s sale-for-rental problem is

Sharing Intellectual Property is the same problem as the direct sale problem except for the marginal costs.

Sharing Intellectual Property is the same problem as the direct sale problem except for the marginal costs. Direct sale is better for the producer if

Sharing Intellectual Property Direct sale is better for the producer if I.e. if

Sharing Intellectual Property Direct sale is better for the producer if Direct sale is better if replication cost c is low rental transaction cost t is high rentals per item, k, is small.