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The Impact of Switching Costs and Network Externalities on Information Technology Markets

This chapter discusses the interplay between switching costs and network externalities within information technology markets. It examines how technologies, such as computers and software, create strong complementarities, leading to network effects where the utility increases with the number of users. It highlights the implications of these factors for consumer behavior and market dynamics, illustrating how competition shapes equilibrium when switching costs and externalities are present. The analysis of consumer indifference to switching underlines the critical role of competitive pricing in influencing market outcomes.

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The Impact of Switching Costs and Network Externalities on Information Technology Markets

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  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 • Producer’s cost per month of providing a network service is c per customer. • Customer’s 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?

  16. 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).

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

  18. 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

  20. Competition & Network Externalities • What are the market equilibria?

  21. 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

  23. 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 n’v • good is bought only by buyers with n’v  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

  26. Competition & Network Externalities • What are the market equilibria? • (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”.

  27. 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

  41. Rights Management • The rights owner now allows a free trial period. This causes • increase in value to all users  increase in willingness-to-pay;

  42. Rights Management

  43. Rights Management • The firm’s problem is now to

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

  45. Rights Management • The firm’s 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?

  50. 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

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