Applying micro-economics to the information economy

A brief summary of:

Carl Shapiro & Hal R. Varian: Information Rules. A strategic guide to the network economy, Boston: Harvard Business School, 1999

Principles of the information economy (1)

→Production of information goods involves high fixed costs (often: sunk costs) and low marginal costs

Remember:

Fixed costs Initial start-up costs that are independent of the quantity produced

Sunk costs Fixed costs that are specific to a certain activity and can only be earned back if the activity succeeds (irreversibility)

Marginal costs Costs of producing one unit extra

Implications of this principle:

• Information is costly to produce (first copy) but cheap to reproduce (strong economies of scale!)

• Cost-based pricing does not work• In the case of failure (e.g. a CD or film that does not

sell): no recovery of sunk costs• Other than for physical goods: There is hardly any

capacity constraint for copying of information goods • Imperfect markets:

→Either dominant firm model: A cost leader enjoys strong economies of scale coming close to a "natural monopoly" (e.g. Microsoft)→Or: Monopolistic competition with product differentiation: Several firms producing similar products in different varieties (e.g. films, publishing, TV)

Recommended strategies:

• Price according to consumer value (and try to differentiate prices)

• Sell your product in different versions in order to obtain different prices from consumers with different preferences; use time delays (e.g. first a hardcover, later a paperback).

• 'Limit pricing': sacrifice some profits in order to reduce the chance that other firms are attracted to your market

• 'Play tough': convince potential entrants that you will respond with dramatic price cuts if they enter your market

Ways of versioning: In general, offer a menu of choices to your customers in order to sell to different market segments at different prices.

Examples for versioning:• Time delay: e.g. normal mail versus 'priority mail'• User interface: convenient 'stripped' version of a program ('no

training required') for inexperienced users versus a more sophisticated version for professional users

• Peak-off pricing: e.g. access only after 5 o'clock p.m.• Speed of operation: e.g. number of copies per minute of a

printer (home use versus professional use)• Features and functions: basic version versus luxury version• Annoyance: e.g. no interruption of films by ads if you pay a

higher fee

Problem: Avoid 'cannibalization' of 'high end' by 'low end' version

How to solve my dilemma?

→How to maximize my revenues (or how to minimize consumer surplus, and not loose clients)?

Total revenue:

p x q Demand

Price

Pri

ce

Quantity

These clients enjoy a consumer surplus as my

price is too low! I could have earned more on them!

Revenues lost: these clients do not buy as my price is too high!

The solution: price discrimination!

→I charge different prices to people who have a different willingness to pay (and different preferences for time and comfort), exploiting product differentiation ("versioning")

The example of airplane tickets:• Starting point: business people have lots of money

but little time; for tourists and backpackers it's the opposite

• How to make use of that?

Price discrimination with airplane tickets

1. Tickets including a Saturday night between arrival and return are cheaper than during-the-week tickets (business people want to return home as soon as possible)

2. A ticket with departure and arrival times fixed is cheaper than a ticket with flexible times (business people pay for flexibility)

3. A ticket booked weeks or months in advance is cheaper than a ticket booked short before travel (tourists can plan their flights long before; business people often can not)

4. Comfort (size of chairs, meals, drinks)

→ All these criteria (indirectly) select passengers according to their "willingness to pay"!

Good price discrimination (one and the same flight for many different prices) reduces consumer surplus and increases my revenues!

D

Quantity

Tic

ket

pri

ces Ambassadors

Top managers

Middle management

Tourists

Students

Principles of the information economy (2):

Intellectual property rights are harder to protect

• Costs of reproduction (of perfect copies) are dramatically reduced• Distribution becomes much quicker, easier and cheaper

Solutions:• Give away free samples; perhaps even give away the full text, but do

that in a way that it cannot be (fully) copied or (fully) printed out (e.g. MIT Press)

• Or give access to tables of contents (Elsevier)• Note that easy reproduction and/or distribution is not only a danger,

but also a chance (e.g. libraries, videos etc.)

Principles of the information economy (3)

Information is an 'Experience Good'

→How do you know whether today's Wall Street Journal is worth its price until you have read it?

Solution: Brand names and reputation

Principles of the information economy (4)

A wealth of information creates a poverty of attention

Solution:• Selective marketing and advertising for specific

groups• Ideally: One-to-one marketing

Principles of the information economy (5)

The Internet is a systems-rich and standards-rich environment

Solution:• In competing for standards you need strategic

alliances (e.g. 'Wintel' versus Apple)

• Create multiple sources for your partner's piece of the system but prevent the emergence of a strong rival for your own piece

Principles of the information economy (6)

Standards create switching costs and lock-ine.g. phonograph recorder (LPs) versus CD player

General problem: • Sunk costs from investment in capital goods and in

education and learning (think of data files and text files written with old soft ware, or: QWERTY).

Types of lock-in and associated switching costsType of lock-in: Switching costs:

Contractual commitments Compensatory or liquidated damages

Durable purchases Replacement of equipment; tends to decline as the durable ages

Brand-specific training Learning a new system, both direct costs and lost productivity; tends to rise over time

Information and databases

Converting data to new format; tends to rise over time as collection grows

Specialized suppliers Funding of new supplier; may rise over time if capabilities are hard to find/maintain

Search costs Combined buyer and seller search costs; includes learning about quality of alternatives

Loyalty programs Any lost benefits from incumbent supplier, plus possible need to re build cumulative use

Principles of the information economy (7)

Network externalities can create explosive growth

(e.g. railways, telegraph, telephone, fax, email etc.). A system becomes more valuable as more people use it.

Implication:• Compete for achieving a critical mass! E.g. use extensive

advertising and aggressive penetration pricing (economies of scale!)

• Exploit first mover advantages (brand name, learning-by-doing)• Create expectations (pre-announcement of a new system can

become a self-fulfilling prophecy)

Optimal timing: • Don't move too early (infancy bugs, insufficient allies)• Don't move too late (consumers may already be locked-in by

competing technologies)

Another way of deterring entry:

• Learning-by-doing: A downward movement of unit costs as output rises, due to increasing experience in handling the production process.

Example: • In the semiconductor industry, unit costs are estimated to fall

by about 28% with each doubling of output.

Implication: • The presence of learning curves may encourage aggressive

pricing policies, especially by firms trying to eliminate other firms that are at an earlier point on their learning curve.

• Scale economies and learning curves may function as barriers to entry for new firms that have higher costs.