MANAGERIAL ECONOMICS An Analysis of Business Issues

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

2. Chapter 10: 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” • 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 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% 10% 12.5% 30% 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 1-2-3 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 comefirst successive links are lessvaluable • 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?