1. MANAGERIAL ECONOMICS An Analysis of Business Issues
Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall

2. the Information Sector
Chapter 19:
Network Economics and
the Information Sector
Objectives:
To examine the special features of ‘network’ industries
To evaluate the debate over the impact of these industries on the working of a market economy

3. Is it a New World? Macro-economic laws suspended
growth, high output, high employment without inflation
Dot.com firms with no profits had very high valuations
BUT Shapiro and Varian (1999)
Technology changes, Economic laws do not

4. The Information Sector has some unusual features
On the revenue side - network effects
On the cost side - sunk costs, high fixed cost very low marginal cost
Overall - “increasing returns” which might threaten the effective working of the market economy - MAYBE

5. The Information Sector has some unusual features
Not usually covered in elementary texts
Require some new analytical tools
Analysis not really ‘settled down’ yet
Shapiro and Varian
Liebowitz and Margolis
Economides

6. Networks “Nodes” and “links” Network effects
in computing, in marketing, in sociology, in economics (firms or people and cables or radio signals)
Network effects
the value of a network product increases as more are connected to it, or use it

7. Network Effects may lead to Externalities
Externality - a cost or a benefit which is not taken into account by the decision-maker
pollution - a negative externality
vaccination - a positive externality
the benefit others get when I join a network or use a standard product - a positive externality
Externalities lead to ‘market failure’ but the problem may be resolved by ‘internalising’ the externality - perhaps through ownership

8. See Liebowitz and Margolis
MB=MR
Marginal Cost
Figure 19.1
MC*
AB =AR P*
No of participants
Q Q*

9. A Demand Curve for a Network Can Be Derived
See p.402
Under perfect competition the network is ‘too small’
Under monopoly , smaller and more expensive
Under Cournot competition, with one standard, varies between the two above

10. Choice of Standards autarky value synchronisation value total value
supply price
net value
the ‘tipping point’ - X

11. Choice of Standards Figure 19.3a Synchronization Value Total Value
Autarky Value
0% in Format A
100% in Format A

12. Choice of Standards Figure 19.3b Total Value Supply Price Net Value
0% in Format A
100% in Format A

13. Choice of Standards Figure 19.4 X Net Value for B Net Value for A
Total Value
Supply Price
Net Value X
0% in Format A
100% in Format A

14. Choice of Standards
Note that if different consumers have different X’s multiple standards may be an equilibrium
Multiple standards will also arise if the supply price slope is greater than the synchronisation value i.e downward sloping net value curve for A

15. Choice of Standards Can an inferior standard dominate?
If one standard is STRICTLY SUPERIOR preferred to another at all divisions of the market, the superior will prevail
If one standard is WEAKLY superior i.e. A is preferred to B when both have z% market share, A will dominate

16. Choice of Standards
An inferior standard might dominate in the following situation;
A is weakly preferred to B by all customers, whose switch points are between 10% and 30% (some will prefer A if it has only 10% share, some don’t prefer A until it has 30% share)
if A has less than 10% everyone prefers B
see Figure 19.5
if the better standard enters first, it dominates. The owner of the inferior standard can only take over if 87.5% of customers can be shifted
if the inferior standard arrives first, it dominates, but the owner of the superior standard only has to persuade 12.5% of customers to shift

17. Choice of Standards Figure 19.5 Share of A in new sales
0% % 12.5% %
Share of A in purchases to date

18. Other Results on Standards
What decides whether a firm adopts a standard when a number are available?
Size of extra benefit to customers from the firm joining - affects ‘new member’ and existing members in same direction
The size of the ‘coalition’ being joined - numbers already using the standard
The increase in competition within the coalition
THE LAST TWO WORK IN OPPOSITE DIRECTIONS AND DEFINE AN EQUILIBRIUM
Also the cost of compatibility relative to extra profits earned
If cost of compatibility is less than extra profit 100% compatibility will be achieved, but not otherwise

19. A Monopolist Invites and Helps Entrants?
Intel licensed its technology to AMD, creating a competitor - WHY?
Because Intel’s sales depend on customers expectations of ‘how many people will buy this?’
People know that monopolists restrict output so licensing someone else increases the volume of sales

20. The Cost Side High fixed costs, which are also sunk costs
‘first copy’ costs
promotion costs
Very low marginal costs
Easy ‘scalability’ - no natural limits to output

21. Consequences of This Cost Structure?
With identical products, price is forced down to MC - Bertrand competition
No viable ‘business model’ without price discrimination or product differentiation
Price discrimination:
personalised pricing - first degree p.d e.g.Lexi Nexis
third degree - different prices by group

22. ‘Versioning’ Delay Complexity and Power of the Interface Convenience
Image Resolution
Speed
Flexibility
Features
Annoyance
Technical Support

23. How Many Versions? How many identifiable markets?
The ‘Goldilocks’ approach
consumer psychology -‘framing’ choices affects the choices made -prospect theory
with a cheap/medium choice buyers chose cheap
with a cheap/medium/expensive choice most chose medium
Bundling - Microsoft Office

24. Lock-In Switching costs create lock-in
CDs to minidisk
printers which work with only one type of PC
training to use a new approach
changing mobile phone numbers (if no portability of numbers)
Lock-In creates profits because price can be raised above MC

25. How Can I Create Lock-In?
contracts
durability
specific training
formatting information
be the sole supplier with the capability
search costs
loyalty programmes - air miles

26. Increasing Returns: The Biggest Issue of All
Market economies fail, just as we reach the ‘End of History’
Scale Economies are the Simplest Example
Network effects and Lock-In mean that History Matters and there is Path Dependence
Markets may ‘Lock-In’ inferior products
Firms Acquire Monopoly Positions and the market fails
IS THIS TRUE?

27. Arthur and David’s Argument

28. But Is It True?
If there is a superior standard it will pay the owner to induce the first sales
lease it with cancellation option
get a ‘high profile’ early adopter to influence others
bribe early adopters
advertise
give distributors incentives

29. Example 1: The QWERTY Keyboard
QWERTY was designed to be inefficient in the 1890s
Because of the network effects and lock-in we still use it
There are better keyboards, e.g. Dvorak
BUT THIS IS A MYTH!

30. Example 2: Word/Excel/Money
Wordprocessing was dominated by Wordperfect
Spreadsheets dominated by Lotus and then QuattroPro
Both failed to adjust to GUI/Windows and to integrate: Office is a better product!
Microsoft Money does not dominate so ownership of Windows does not give guaranteed leverage

31. Some Sceptical Questions About the Basics
The value of a network or a standard increases as more participants join
but does it always? Standard economic logic predicts decreasing returns - the most valuable links come first successive links are less valuable
Marginal cost is almost zero and ‘scalability’ is huge
but what if complementary products needed?

32. Is It Really So Different?
When we eventually get the analysis right will we find that the network economy and information products are really just like everything else?