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MANAGERIAL ECONOMICSAn Analysis of Business Issues

Howard Daviesand Pun-Lee Lam

Published by FT Prentice Hall

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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

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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

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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

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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

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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

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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

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See Liebowitz and Margolis

Figure 19.1

AB =AR

MB=MRMarginal Cost

MC*

P*

Q Q*

No of participants

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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

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Choice of Standards

autarky value synchronisation value total value supply price net value the ‘tipping point’ - X

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Choice of Standards

Figure 19.3a

0% in Format A100% in Format A

Total Value

Autarky Value

Synchronization Value

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Choice of Standards

Figure 19.3b

0% in Format A100% in Format A

Total Value

Supply Price

Net Value

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Choice of Standards Figure 19.4

0% in Format A100% in Format A

Total Value

Supply Price

Net Value

Net Value for B Net Value for A

X

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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

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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

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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

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Choice of Standards Figure 19.5

Share of A in purchases to date

Share of A in new sales

0% 10% 12.5% 30%

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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

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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

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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

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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

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‘Versioning’ Delay Complexity and Power of the Interface Convenience Image Resolution Speed Flexibility Features Annoyance Technical Support

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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

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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

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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

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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?

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Arthur and David’s Argument

Table 19.1Payoffs to Alternative Technologies

Number of Adoptions 0 10 20 30 40 50 60 70 80 90 100

Technology A 10 11 12 13 14 15 16 17 18 19 20

Technology B 4 7 10 13 16 19 22 25 28 31 34

Source: Liebowitz and Margolis (1999) p.57

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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

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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!

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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

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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 come first successive links are less valuable

Marginal cost is almost zero and ‘scalability’ is huge– but what if complementary products needed?

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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?