1. Chapter Thirty-Five Information Technology

2. Information Technologies u The crucial ideas are: –Complementarity –Network externality

3. Information Technologies; Complementarity u Definition: Commodity A complements commodity B if more of commodity A increases the value of an extra unit of commodity B. –More software increases the value of a computer. –More roads increase the value of a car.

4. Information Technologies; Network Externality u Definition: A commodity has a positive (negative) network externality if the utility to a consumer of that commodity increases (decreases) as more people also consume the commodity. –Email gives more utility to any one user if more other people use email. –A highway gives less utility to any one user as more people use it (congestion).

5. Complementarity u Information technologies have increased greatly the complementarities between commodities. –Computers and operating systems (OS). –DVD players and DVD disks. –WiFi sites and laptop computers. –Cell phones and cell phone towers.

6. Complementarity u How should a firm behave when it produces a commodity that complements another commodity? u The problem is: When you make more of your product (commodity A) you increase the value of firm B’s product (commodity B). Can you get for yourself some of gain you create for firm B?

7. Complementarity u An obvious strategy is for firms A and B to cooperate somewhat with each other. –Microsoft releases part of its OS to firms making software that runs under its OS. –DVD manufacturers agree upon a standard format for their disks.

8. Complementarity u The price of a computer is p C. u The price of the OS is p OS. u The quantities demanded of computers and the OS depends upon p C + p OS, not just p C or just p OS.

9. Complementarity u The price of a computer is p C. u The price of the OS is p OS. u The quantities demanded of computers and the OS depends upon p C + p OS, not just p C or just p OS. u Suppose the computer and software firms’ marginal production costs are zero. Fixed costs are F C and F OS.

10. Complementarity u Suppose the firms do not collude. u The computer firm’s problem is: choose p C to maximize p C D(p C + p OS ) – F C. u The OS firm’s problem is: choose p OS to maximize p OS D(p C + p OS ) – F OS.

11. Complementarity u Suppose the firms do not collude. u The computer firm’s problem is: choose p C to maximize p C D(p C + p OS ) – F C. u The OS firm’s problem is: choose p OS to maximize p OS D(p C + p OS ) – F OS. u Assume D(p C + p OS ) = a – b(p C + p OS ).

12. Complementarity u The computer firm’s problem is: choose p C to maximize p C (a – b(p C + p OS )) – F C. u The OS firm’s problem is: choose p OS to maximize p OS (a – b(p C + p OS )) – F OS.

13. Complementarity u Choose p C to maximize p C (a – b(p C + p OS )) – F C  p C = (a – bp OS )/2b. (C) u Choose p OS to maximize p OS (a – b(p C + p OS )) – F OS  p OS = (a – bp C )/2b. (OS)

14. Complementarity u Choose p C to maximize p C (a – b(p C + p OS )) – F C  p C = (a – bp OS )/2b. (C) u Choose p OS to maximize p OS (a – b(p C + p OS )) – F OS  p OS = (a – bp C )/2b. (OS) u A NE is a pair (p* C,p* OS ) solving (C) and (OS).

15. Complementarity u Choose p C to maximize p C (a – b(p C + p OS )) – F C  p C = (a – bp OS )/2b. (C) u Choose p OS to maximize p OS (a – b(p C + p OS )) – F OS  p OS = (a – bp C )/2b. (OS) u A NE is a pair (p* C,p* OS ) solving (C) and (OS). p* C = p* OS = a/3b.

16. Complementarity u p* C = p* OS = a/3b. u When the firms do not cooperate the price of a computer with an OS is p* C + p* OS = 2a/3b and the quantities demanded of computers and OS are q* C + q* OS = a - b×2a/3b = a/3.

17. Complementarity u What if the firms merge? Then the new firm bundles a computer and an operating system and sells the bundle at a price p B. u The firm’s problem is to choose p B to maximize p B D(p B ) – F B = p B (a – bp B ) – F B.

18. Complementarity u What if the firms merge? Then the new firm bundles a computer and an operating system and sells the bundle at a price p B. u The firm’s problem is to choose p B to maximize p B D(p B ) – F B = p B (a – bp B ) – F B. u Solution is p* B = a/2b < 2a/3b.

19. Complementarity u When the firms merge (or fully cooperate) the price of a computer and an OS is p* B = a/2b a/3.

20. Complementarity u When the firms merge (or fully cooperate) the price of a computer and an OS is p* B = a/2b a/3. u The merged firm supplies more computers and OS at a lower price than do the competing firms. Why?

21. Complementarity u The noncooperative firms ignore the external benefit (complementarity) each creates for the other. So each undersupplies the market, causing a higher market price. u These externalities are fully internalized in the merged firm, inducing it to supply more computers and OS and thereby cause a lower market price.

22. Complementarity u More typical cooperation consists of contracts between component manufacturers and an assembler of a final product. Examples are: –Car components and a car assembler. –A computer assembler and manufacturers of CPUs, hard drives, memory chips, etc.

23. Complementarity u Alternatives include: – Revenue-sharing. Two firms share the revenue from the final product made up from the two firms’ components. –Licensing. Let firms making complements to your product use your technology for a low fee so they make large quantities of complements, thereby increasing the value of your product to consumers.

24. Information Technologies; Lock-In u Strong complementarities or network externalities make switching from one technology to another very costly. This is called lock-in. u E.g., In the USA, it is costly to switch from speaking English to speaking French. u How do markets operate when there are switching costs or network externalities?

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

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

27. Competition & Switching Costs u Consumer’s cost of not switching is

28. Competition & Switching Costs u Consumer’s cost of not switching is u Consumer’s cost from switching is

29. Competition & Switching Costs u Consumer’s cost of not switching is u Consumer’s cost from switching is u Consumer should switch if

30. Competition & Switching Costs u Consumer’s cost of not switching is u Consumer’s cost from switching is u Consumer should switch if u i.e. if

31. Competition & Switching Costs u Consumer should switch if u Producer competition will ensure at a market equilibrium that customers are indifferent between switching or not  I.e., the equilibrium value of the discount only just makes it worthwhile for the customer to switch.

32. Competition & Switching Costs u With d = s, the present-value of the producer’s profits is

33. Competition & Switching Costs u At equilibrium the present-value of the producer’s profit is zero. u The producer’s price is its marginal cost plus a markup that is a fraction of the consumer’s switching cost.

34. Competition & Switching Costs u At equilibrium the present-value of the producer’s profit is zero. u The producer’s price is its marginal cost plus a markup that is a fraction of the consumer’s switching cost. If advertising reduces the marginal cost of servicing a consumer by a then

35. Competition & Switching Costs u At equilibrium the present-value of the producer’s profit is zero. u The producer’s price is its marginal cost plus a markup that is a fraction of the consumer’s switching cost. If advertising reduces the marginal cost of servicing a consumer by a then

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

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

38. Competition & Network Externalities u 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. u Quantity demanded is n = 1000 - v. u So inverse demand is p = n(1000-n).

39. Competition & Network Externalities 01000 n Willingness-to-pay p = n(1000-n) Demand Curve

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

41. Competition & Network Externalities 01000 n Demand Curve Supply Curve c Willingness-to-pay p = n(1000-n)

42. Competition & Network Externalities u What are the market equilibria?

43. Competition & Network Externalities u What are the market equilibria? u (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.

44. Competition & Network Externalities 01000 n Demand Curve Supply Curve c Willingness-to-pay p = n(1000-n) (a)

45. Competition & Network Externalities 01000 n Demand Curve Supply Curve n’ c Willingness-to-pay p = n(1000-n) (a)

46. Competition & Network Externalities u What are the market equilibria? u (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’.

47. Competition & Network Externalities 01000 n Demand Curve Supply Curve n’ (b) n” (c) (a) c Willingness-to-pay p = n(1000-n)

48. Competition & Network Externalities u What are the market equilibria? u (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”.

49. Competition & Network Externalities 01000 n Demand Curve Supply Curve n’ (b) n” (c) c Which equilibrium is likely to occur? Willingness-to-pay p = n(1000-n) (a)

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

51. Competition & Network Externalities 01000 n Demand Curve Supply Curve n’n” c Which equilibrium is likely to occur? Willingness-to-pay p = n(1000-n)

52. Competition & Network Externalities 01000 n Demand Curve Supply Curve n’n” c Which equilibrium is likely to occur? Willingness-to-pay p = n(1000-n) Unstable

53. Competition & Network Externalities 01000 n Demand Curve Supply Curve n” c Which equilibrium is likely to occur? Willingness-to-pay p = n(1000-n) Stable

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

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

56. Rights Management

59. u The rights owner now allows a free trial period. This causes –a consumption increase;

60. Rights Management u The rights owner now allows a free trial period. This causes –a consumption increase; –lower sales per consumption unit

61. Rights Management u The rights owner now allows a free trial period. This causes –a consumption increase; –lower sales per consumption unit –increase in value to all users  increase in willingness-to-pay;

62. Rights Management

63. u The firm’s problem is now to

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

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

66. Rights Management

67.  higher profit

68. Rights Management  lower profit

69. Sharing Intellectual Property u Produce a lot for direct sales, or only a little for multiple rentals? u Sell a tool, or rent it? u Allow a movie to be shown only at a theatre, or sell only to video rental stores, or sell only by pay-per-view, or sell DVDs in retail stores? u When is selling for rental more profitable than selling for personal use only?

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

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

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

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

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

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

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

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

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

79. Sharing Intellectual Property This is the same as the direct sale problem except for the marginal cost.

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

81. Sharing Intellectual Property u Direct sale is better for the producer if u i.e. if

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