Chapter ThirtyFive

1
Chapter Thirty-Five

• Information Technology

2
Information Technologies

• The crucial ideas are
• Complementarity
• Network externality

3
Information TechnologiesComplementarity

• 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 TechnologiesNetwork Externality

• 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).

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Complementarity

• 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

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

7
Complementarity

• 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

• The price of a computer is pC.
• The price of the OS is pOS.
• The quantities demanded of computers and the OS
  depends upon pC pOS, not just pC or just pOS.

9
Complementarity

• The price of a computer is pC.
• The price of the OS is pOS.
• The quantities demanded of computers and the OS
  depends upon pC pOS, not just pC or just pOS.
• Suppose the computer and software firms marginal
  production costs are zero. Fixed costs are FC
  and FOS.

10
Complementarity

• Suppose the firms do not collude.
• The computer firms problem is choose pC to
  maximize pCD(pC pOS) FC.
• The OS firms problem ischoose pOS to maximize
  pOSD(pC pOS) FOS.

11
Complementarity

• Suppose the firms do not collude.
• The computer firms problem is choose pC to
  maximize pCD(pC pOS) FC.
• The OS firms problem ischoose pOS to maximize
  pOSD(pC pOS) FOS.
• Assume D(pC pOS) a b(pC pOS).

12
Complementarity

• The computer firms problem is choose pC to
  maximize pC(a b(pC pOS)) FC.
• The OS firms problem ischoose pOS to maximize
  pOS(a b(pC pOS)) FOS.

13
Complementarity

• Choose pC to maximize pC(a b(pC pOS))
  FC? pC (a bpOS)/2b.
  (C)
• Choose pOS to maximize pOS(a b(pC
  pOS)) FOS? pOS (a bpC)/2b.
  (OS)

14
Complementarity

• Choose pC to maximize pC(a b(pC pOS))
  FC? pC (a bpOS)/2b.
  (C)
• Choose pOS to maximize pOS(a b(pC
  pOS)) FOS? pOS (a bpC)/2b.
  (OS)
• A NE is a pair (pC,pOS) solving (C) and (OS).

15
Complementarity

• Choose pC to maximize pC(a b(pC pOS))
  FC? pC (a bpOS)/2b.
  (C)
• Choose pOS to maximize pOS(a b(pC
  pOS)) FOS? pOS (a bpC)/2b.
  (OS)
• A NE is a pair (pC,pOS) solving (C) and (OS).
  pC pOS a/3b.

16
Complementarity

• pC pOS a/3b.
• When the firms do not cooperate the price of a
  computer with an OS is pC pOS
  2a/3band the quantities demanded of computers
  and OS are qC qOS a - b2a/3b a/3.

17
Complementarity

• What if the firms merge? Then the new firm
  bundles a computer and an operating system and
  sells the bundle at a price pB.
• The firms problem is to choose pB to maximize
  pBD(pB) FB pB(a bpB) FB.

18
Complementarity

• What if the firms merge? Then the new firm
  bundles a computer and an operating system and
  sells the bundle at a price pB.
• The firms problem is to choose pB to maximize
  pBD(pB) FB pB(a bpB) FB.
• Solution is pB a/2b

19
Complementarity

• When the firms merge (or fully cooperate) the
  price of a computer and an OS is
  pB a/2b bundled computers and OS is qB a -
  ba/2b a/2 a/3.

20
Complementarity

• When the firms merge (or fully cooperate) the
  price of a computer and an OS is
  pB a/2b bundled computers and OS is qB a -
  ba/2b a/2 a/3.
• The merged firm supplies more computers and OS at
  a lower price than do the competing firms. Why?

21
Complementarity

• The noncooperative firms ignore the external
  benefit (complementarity) each creates for the
  other. So each undersupplies the market, causing
  a higher market price.
• 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

• 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

• 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 TechnologiesLock-In

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

25
Competition Switching Costs

• Producers cost per month of providing a network
  service is c per customer.
• Customers switching cost is s.
• Producer offers a one month discount, d.
• Rate of interest is r.

26
Competition Switching Costs

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

27
Competition Switching Costs

• Consumers cost of not switching is

28
Competition Switching Costs

• Consumers cost of not switching is
• Consumers cost from switching is

29
Competition Switching Costs

• Consumers cost of not switching is
• Consumers cost from switching is
• Consumer should switch if

30
Competition Switching Costs

• Consumers cost of not switching is
• Consumers cost from switching is
• Consumer should switch if
• i.e. if

31
Competition Switching Costs

• Consumer should switch if
• 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

• With d s, the present-value of the producers
  profits is

33
Competition Switching Costs

• At equilibrium the present-value of the
  producers profit is zero.
• The producers price is its marginal cost plus a
  markup that is a fraction of the consumers
  switching cost.

34
Competition Switching Costs

• At equilibrium the present-value of the
  producers profit is zero.
• The producers price is its marginal cost plus a
  markup that is a fraction of the consumers
  switching cost. If advertising reduces the
  marginal cost of servicing a consumer by a then

35
Competition Switching Costs

• At equilibrium the present-value of the
  producers profit is zero.
• The producers price is its marginal cost plus a
  markup that is a fraction of the consumers
  switching cost. If advertising reduces the
  marginal cost of servicing a consumer by a then

36
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.

37
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?

38
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).

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Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
0
1000
n
40
Competition Network Externalities

• Suppose all suppliers have the same marginal
  production cost, c.

41
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
0
1000
n
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Competition Network Externalities

• What are the market equilibria?

43
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.

44
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
(a)
0
1000
n
45
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
(a)
n
0
1000
n
46
Competition Network Externalities

• What are the market equilibria?
• (b) A small number, n, of buyers buy.
• small n ? small network externality value nv
• good is bought only by buyers with nv ? c i.e.,
  only large v ? v c/n.

47
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
(b)
(c)
(a)
n
n
0
1000
n
48
Competition Network Externalities

• What are the market equilibria?
• (c) A large number, n, of buyers buy.
• Large n ? large network externality value nv
• good is bought only by buyers with nv ? c i.e.,
  up to small v ? v c/n.

49
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
(b)
(c)
(a)
n
n
0
1000
n
Which equilibrium is likely to occur?
50
Competition Network Externalities

• Suppose the market expands whenever
  willingness-to-pay exceeds marginal production
  cost, c.

51
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
n
n
0
1000
n
Which equilibrium is likely to occur?
52
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Unstable
Supply Curve
c
n
n
0
1000
n
Which equilibrium is likely to occur?
53
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Stable
Supply Curve
c
Stable
n
0
1000
n
Which equilibrium is likely to occur?
54
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?

55
Rights Management

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

56
Rights Management
57
Rights Management
58
Rights Management
59
Rights Management

• The rights owner now allows a free trial period.
  This causes
• a consumption increase

60
Rights Management

• The rights owner now allows a free trial period.
  This causes
• a consumption increase
• lower sales per consumption unit

61
Rights Management

• 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
Rights Management

• The firms problem is now to

64
Rights Management

• The firms problem is now to
• This problem must have the same solution as

65
Rights Management

• The firms problem is now to
• This problem must have the same solution as
• So

66
Rights Management
67
Rights Management
? higher profit
68
Rights Management
? lower profit
69
Sharing Intellectual Property

• Produce a lot for direct sales, or only a little
  for multiple rentals?
• Sell a tool, or rent it?
• 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?
• When is selling for rental more profitable than
  selling for personal use only?

70
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

71
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

72
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.

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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 consumers willingness-to-pay is p(x)
  p(ky).

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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 consumers willingness-to-pay is p(x)
  p(ky).
• Rental transaction cost t reduces
  willingness-to-pay to p(ky) - t.

75
Sharing Intellectual Property

• Rental transaction cost t reduces
  willingness-to-pay to p(ky) - t.
• Rental stores willingness-to-pay is

76
Sharing Intellectual Property

• Rental transaction cost t reduces
  willingness-to-pay to p(ky) - t.
• Rental stores willingness-to-pay is
• Producers sale-for-rental problem is

77
Sharing Intellectual Property

• Rental transaction cost t reduces
  willingness-to-pay to p(ky) - t.
• Rental stores willingness-to-pay is
• Producers sale-for-rental problem is

78
Sharing Intellectual Property

• Rental transaction cost t reduces
  willingness-to-pay to p(ky) - t.
• Rental stores willingness-to-pay is
• Producers 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

• Direct sale is better for the producer if
• i.e. if

82
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.