Basic Economics Demand Curve D(p) Price p Quantity Supply Curve S(p) p*

Cost Curves Price p Quantity Price p Quantity “General Motors” “”Microsoft”

Price Competition l If the marginal cost is zero, why doesn’t price competition drive the price down to nothing? – “Information wants to be free” (FSF) – Example: CD Phone books 1986 Nynex $10,000 per disk 1990 Digital Directory Assistance $300/disk Now $19.95 or free on the Web l Monopoly – IPR: Copyright, patent – DRM

Versioning l “Discriminating monopolist” sells to everyone at just the price they will pay l “Pareto efficient” l Many examples – Travel, cars, software etc l Psychology Price p Quantity

Lock-in l Buying a product often commits you to buying more – Services – Complimentary products l Examples: – MS vs Mc vs Linux – Phones, switchgear, cars – Frequent flyer l NPV of customer = total cost of switching – = costs borne by customer + cost borne by supplier l Oligopoly + switching costs behaves like a monopoly

Lock-in 2 l NPV of customer as asset is the net profit attributable to that customer over time, discounted to present values l Example: – Suppose you are an ISP, and it costs £25 to set up a new customer; suppose it costs a customer £50 in hassle to switch – If the NPV of a customer is £100, offer them £60 cash back to switch; they are £10 ahead, you are £40-£25=£15 ahead. l Asymmetric switching costs make things more complex – e.g. To switch from cable to satellite is expensive, includes supply of STB. – Incumbent can bribe cheaply, for example free channels l Hence mobile phone subsidies – Exercise: Why are prepaid phone prices climbing, and being replaced by loyalty plans as the market saturates?

Lock-in 3 l Incumbent tries to maximise switching cost; competitor minimise it – Loyalty programs – Accessory control: Nintendo game cartridges – Crypto and tamper resistance: – Community – its where your friends are BB, chat for registered users – Hassle: e.g. address change.NET

Network Externalities l The more people, the valuable the network – Examples: Telephone late 19 th Century – Fax – – Credit cards 1980s l “Metcalfe’s Law”: The value of a network is proportional to the square of the number of users l Not completely accurate, as the value to each user is non-linear

Network Effects Utility Users Almost nobody uses it Almost everybody uses it who ever will

Virtual Networks l Example: PC and Software – Virtuous circle: – People buy PCs because lots of software available – Developers write software because lots of customers l Many other examples – Credit cards and merchants – VCR/DVD standards and media content l Winner takes all – Dominant firm model Development of effective monopoly/oligopoly Not always: e.g lots of FAX machine makers

Networks l The increase in value of a network is an example of what economists call an “Externality” – an external factor other than price l Once a network passes a critical size it grows rapidly – Success disaster l Network allows opportunity to extract value even when marginal costs are near zero – Price controls l *** “Combination of high fixed/low marginal cots, high switching costs and network externalities lead to a dominant firm model” *** – One sentence summary of information economics

Network Effects l Dominant firm markets -> Huge amount to play for l Control of key de-facto standards l Huge first-mover advantages – Can be displaced by larger entity MS: “Embrace and Extend” – Spreadsheets, word processors l Need to create bandwagon effect with makers of complimentary products – Need to court developers rather than users (e.g. MS) l Price to value – But still need to make a profit

l Business models (= Where’s the money?) – Landgrab – Merchant – PPV or Subscription – Market – Advertising hoarding – Lotteries & scams Extracting Value

Land grab l Maximise market share now; worry about profitability later l Since there are not yet profits, stock market values the company (for a while) on number of customers l Typical of new “Bubble” companies: cable TV, airlines, radio, Railways in 19 th C, colonial exploration in 18 th C l Now discredited: later never comes – At least, not until the next bubble

Merchant l Sells goods or services for more than they cost l Basic to most businesses l Internet technologies add maybe 20% efficiency – Disintermediation – Lower cost market comms – Lower cost order taking – Lower cost distribution, esp for informational goods – “just in time” gives lower cost for stock and inventory – Better modelling and control Mexican cement plant example l BUT still must be a sound business!!! – Established players may be asleep, but are not dead

PPV or Subscription l Pay per View – E.g phone rates l Subscriptions – Actuarial calculations – All you can eat models – Administration issues – charging model never says simple! Matrix of services and products Freebies etc l Copying issues – Provide service – Street Performer Protocol

Market l Commission on other people’s trades – No stock costs – Low barriers to entry l Place for buyers and sellers to meet – eBay, B2B auctions, lastminute.com, bookfinder.com. Instinet l Liquidity Liquidity Liquidity – Network effects l Settlement issue – Paypal, CrestCo, Bolero l Novel pricing models (e.g auctioning demand) – Agent technology l Death of the portal

Better ways to trade l Networks effects – Single marketplace for each class of goods – Markets illiquid for large trades, inefficient for small trades – What is a “fair market”? l Clearance and settlement – Issues for very large and very small trades – Warranties provided by CC & banks Dispute resolution – Bearer certificates? – Tax and jurisdiction? – Privacy vs money laundering

Advertising l Typically rate £10 pcm (thousand impressions) – More for personalisation and targeted adverts – Advertising industry, and advertisers are very conservative – Monitoring l High traffic sites – ISP home pages – Need to drive traffic to the site – Need to refresh site often/build community to keep users returning l Agency sales – E.g. Double-click, Real Media, Tempus l Market saturating – Rates dropping – Different formats – Flash inserts; streaming media – , digital TV etc

Lotteries and Scams l Lotteries: tax on the ignorant – Poor estimate of low probability events l Premium rate telephone scams – TV quiz shows and auctions – Phone this number to win… l Straight frauds – Ponzi schemes (Pyramid sells) – Credit card and other personal details misuse – Telecom scams – Boiler room operations