Chapter Thirty-Four

1
Chapter Thirty-Four

• Information Technology

2
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.

3
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?

4
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.

5
Competition Switching Costs

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

6
Competition Switching Costs

• Cost of not switching is

7
Competition Switching Costs

• Cost of not switching is
• Cost from switching is

8
Competition Switching Costs

• Cost of not switching is
• Cost from switching is
• Switch if

9
Competition Switching Costs

• Cost of not switching is
• Cost from switching is
• Switch if
• I.e. if

10
Competition Switching Costs

• Switch if
• I.e. if
• Producer competition will ensure at a market
  equilibrium that customers are indifferent
  between switching or not ?

11
Competition Switching Costs

• At equilibrium, producer economic profits are
  zero.
• I.e.

12
Competition Switching Costs

• At equilibrium, producer economic profits are
  zero.
• I.e.
• Since , at equilibrium

13
Competition Switching Costs

• At equilibrium, producer economic profits are
  zero.
• I.e.
• Since , at equilibrium
• I.e. present-valued producer profit consumer
  switching cost.

14
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.

15
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?

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Competition Network Externalities

• If v is the marginal buyer, valuing the good at
  nv p, then all buyers v gt v value the good
  more, and so buy it.
• Quantity demanded is n 1000 - v.
• So inverse demand is p n(1000-n).

17
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
0
1000
n
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Competition Network Externalities

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

19
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?

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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.

22
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
(a)
Supply Curve
c
0
1000
n
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Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
(a)
Supply Curve
c
n
0
1000
n
24
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.

25
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
(a)
Supply Curve
c
(b)
(c)
n
n
0
1000
n
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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.

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Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
(a)
Supply Curve
c
(b)
(c)
n
n
0
1000
n
Which equilibrium is likely to occur?
28
Competition Network Externalities

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

29
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?
30
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?
31
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Supply Curve
c
n
0
1000
n
Which equilibrium is likely to occur?
32
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Stable
Supply Curve
c
n
0
1000
n
Which equilibrium is likely to occur?
33
Competition Network Externalities
Willingness-to-pay p n(1000-n)
Demand Curve
Stable
Stable
Supply Curve
c
n
0
1000
n
Which equilibrium is likely to occur?
34
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?

35
Rights Management

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

36
Rights Management
37
Rights Management
38
Rights Management
39
Rights Management

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

40
Rights Management

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

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Rights Management

• The rights owner now allows a free trial period.
  This causes
• increase in value to all users ? increase in
  willingness-to-pay

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Rights Management
43
Rights Management

• The firms problem is now to

44
Rights Management

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

45
Rights Management

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

46
Rights Management
47
Rights Management
? higher profit
48
Rights Management
? lower profit
49
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?

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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

51
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

52
Sharing Intellectual Property

• Is selling for rental more profitable?
• Each rental unit is used by k gt 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 gt 1 consumers.
• So y units sold ? x ky consumption units.
• Marginal consumers willingness-to-pay is p(x)
  p(ky).

54
Sharing Intellectual Property

• Is selling for rental more profitable?
• Each rental unit used by k gt 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.

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Sharing Intellectual Property

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

56
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

57
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

58
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

59
Sharing Intellectual Property
is the same problem as the direct sale problem
except for the marginal costs.
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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
61
Sharing Intellectual Property

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

62
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.