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Information Technology Presented by (in order of presentation): José Coutinho João Silva Ana Paiva Inês Costa Marco Bravo.

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Presentation on theme: "Information Technology Presented by (in order of presentation): José Coutinho João Silva Ana Paiva Inês Costa Marco Bravo."— Presentation transcript:

1 Information Technology Presented by (in order of presentation): José Coutinho João Silva Ana Paiva Inês Costa Marco Bravo

2 Presentation Structure 1.Background 1.The 1990’s 2.Technology and Market Structure 3.Intellectual Property (Combinatorial Innovation) 4.The Internet Boom 5.Where are we now? 2.Economic Thinking 1.Price discrimination 2.Switching costs and lock-in 3.Supply-side economies of scale 4.Demand-side economies of scale 5.Standards 6.System Effects 7.Computer mediated transactions 3.Summary and Conclusions José Coutinho João Silva Ana Paiva Inês Costa Marco Bravo

3 1. Background Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 1990s Technology and Market Structure Combinatorial innovation The Internet Boom Where are we now?

4 The 1990’s Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Events that stimulated investments in IT Telecommunications deregulation (1996) “Y2K” problem (1998-99) “dot com” boom (1999-2000) Euro (1 Jan 2002) Investment Boom US \ Year960207 Services \% total revenues ordinary, local and long- distance wired voice calls 904020 wireless3040 data3040 1. Telecommunications deregulation 1996 Telecommunications Act (US) local phone service 1998 – EU Liberalization of all public voice telephony services 2000 – Portugal => Dramatic run-up of stock prices for IT companies

5 The 1990’s Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Real Y2K Spending and the Change in Real Fixed Investment in Information Processing Equipment and Software “Y2K” problem (1998-99) Billions of dollarsPercentPercentage points YearY2KIPESY2K / IPESIPES / GDP IPES contributi on to real GDP growth Potential Y2K contribution to real GDP growth 19954.336.211.83.50.560.07 199615.544.534.83.70.620.22 199729.462.547.03.90.770.36 199837.779.547.44.10.850.40 199936.578.846.34.30.730.34 20006.875.29.04.50.630.06 20010.8–34.8–2.34.0–0.260.01 1995-2001130.9341.9N/A 3.901.45 NOTE: Estimates for 1999-2001 are projections. Real Y2K spending is the current-dollar value of spending deflated by the chain-type price index for IPES. Sums subject to rounding. SOURCE: Economics and Statistics Administration, Bureau of Economic Analysis, Haver Analytics, and the author’s calculations (final column).

6 The 1990’s Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Social Value “competition worked very well during this period, so that much of the social gain from Internet technology ended up being passed along to consumers, leaving little surplus in the hands of investors” “dot com” boom (1999-2000) Productivity Growth Many macroeconomists attribute Increase in productivity growth in the late 1990s to the investment in IT during the first half of that decade we have yet to reap the benefits of the IT investment of the late 1990s World Changed Email, WWW, IM (children => business communication)

7 Technology and Market Structure Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 THE SAME MARKET FORCES High-technology industries Other industries Some are particularly important Network industries in 1990s Telephone and wireless in the 1890s Minor => industrial economy Critical => Information economy Other Qt / Intellectual property Copyright law Patent law Policy issues Security, and Privacy Ex: Cost Structures Constant fixed costs Zero marginal costs Rarely observed for physical products Capacity constraints in nearly every production process Very common for information goods (indeed it is the baseline) Information goods Physical goods - Chips

8 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 “Every now and then a technology, or set of technologies, comes along that offers a rich set of components that can be combined and recombined to create new products. The arrival of these components then sets off a technology boom as innovators work through the possibilities.” Interchangeable parts (Early 19th century) Gears, pullies, chains, cams, and other mechanical devices Standardization of Design American system of manufacture Weapons Domestic appliances Eli Whitney US government contract 10 000 muskets to be produced within two years, even though he had no factory or machines It actually took eight years to deliver the order, as Whitney perfected and developed new techniques and machines 15,000 muskets within the following two years

9 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Gasoline Engine Motorcycles, Automobiles, Airplanes 1864 - Siegfried Marcus (Austria) 1876 - “Otto cycle” Nicolaus August Otto 1885 - Karl Benz / first practical automobile 1908 - Ford T Integrated circuit Electronics Industry Moore´s law Microprocessor (1971) Routers, Servers, PCs

10 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Personal Computer 1975 - First Personal Computer Apple I (1976) II (1977) Stephen Wozniak / Steve Jobs IBM PC (1981)

11 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

12 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Software Industrial Evolution Software ICs Superdistribution Brad J. Cox (1986, 1991) Object-Oriented Programming (encapsulation, dynamic binding Objective-C => Java => C# (c + Smaltalk-80) NeXT Apple Mac OS X

13 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 “I wrote the program using a NeXT computer. This had the advantage that there were some great tools available - it was a great computing environment in general. In fact, I could do in a couple of months what would take more like a year on other platforms, because on the NeXT, a lot of it was done for me already. There was an application builder to make all the menus as quickly as you could dream them up. there were all the software parts to make a wysiwyg (what you see is what you get - in other words direct manipulation of text on screen as on the printed - or browsed page) word processor. I just had to add hypertext, (by subclassing the Text object)”

14 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 WorldWideWeb (1991) The first web browser (browser-editor) Originally developed to provide a distributed hypermedia system. Easy access to any form of information anywhere in the world. Revolutionised modern communications and even our, way of life (?) Parts: HTML, HTTP, URL => Nexus (program) => World Wide Web (information space) Initially non-graphic => MOSAIC (1993) Tim Berners-Lee / CERN

15 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 “Waves (“clusters”) of innovation 1. “Demand-side” Overcome Social Resistance / Adoption 2. “Supply-side” Same components Same invention at almost the same time Electric light, Airplane, Automobile, Telephone. 3. Development of complements Paved roads (Bicycle boom) Gasoline => fuel stationary engines used on farms Others (Pneumatic Tires,...) => Automobile => Roads => Gasoline, Oil “Indirect network effect”

16 Combinatorial innovation Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Development / Adoption Time Interchangeable parts took over a century to become truly reliable Gasoline engines took decades to develop Microelectronics industry took 30 years to reach its current position Internet revolution took only a few years Time to reach 30% penetration (US population) Telephone – 38 years Television – 17 years PC – 13 years Internet – 7 years Mobile Phone - …

17 The Internet Boom Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Internet revolution Minor revolution ?? “Immaterial components” Physical devices => “just bits” Ideas, standards specifications, protocols, programming languages, and software. No delay in manufacture, or shipping costs, or inventory problems Never run out of HTML! DateNumber% PopSource May 2002580.78 million9.57Nua Ltd January 2002562.47 million9.26Nua Ltd January 2001455.55 million7.5Nua Ltd January 2000254.29 million4.19Nua Ltd December 1998160 million3.91IDC December 199770 million1.71IDC December 199636 million.88IDC December 199516 million.39IDC How many online? Worlwide DateNumber% PopSource June 20024.4 million43.6ICP December 20013.6 million34.37ICP December 20002 million19.9ICP October 1999565,0005.7CyScan December 1998200,0002.02IDC January 1998188,0001.9IDC September 1997200,0002Nua est. How many online? Portugal

18 The Internet Boom Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 New Applications Combine and recombine the software components to create a host of new applications: Web pages, chat rooms, clickable images, web mail, MP3 files, online auctions and exchanges... Few basic tools and OPEN protocols HTML, HTTP, URLs Perl, Phyton, other interpreted languages

19 The Internet Boom Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Open Source Software Combinatorial innovation Education (look inside the black box) Sourceforge.net => 65,000 collaborative software projects (clearinghouse for the open source community) Closed Sorce Software Microsoft / XML Web Services /.NET ?? Open Standards and Specifications ?? Message-ID: 1991Aug25.205708.9541@klaava.helsinki.fi From: torvalds@klaava.helsinki.fi (Linus Benedict Torvalds) To: Newsgroups: comp.os.inix Subject: What would you like to see most in minix? Summary: small poll for my new operating system Hello everybody out there using minix-I'm doing a (free) operating system (just a hobby, won't be big and professional like gnu) for 386 (486) AT clones. This has been brewing since april, and is starting to get ready. I'd like any feedback on things people like/dislike in minix, as my OS resembles it somewhat Any suggestions are welcome, but I won't promise I'll implement them :-) Linus In the Beginning

20 The Internet Boom Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Finantial speculation “Euphoria of 1923,” / Broadcast radio Business Model / tax on vacuum tubes “dumb money” / Crash 1929 recession Internet Bubble Human Capital (biggest investment) “Being Digital”  “Being Mechanical” Productivity

21 Where are we now? Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Period of rapid Innovation Confluence of Moore’s Law, Internet, Digital awareness, and Financial markets The result: Excess Capacity Period of Consolidation Quiet phase of combinatorial innovation Not fully incorporated into organizational work practices Challenge Re-enginner the flow of information over the entire value chain Michael Dell / Mass Customization

22 Where are we now? Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 KeyPtUS Population10 000 000275 000 000 Rural population (% of total population) 199937.20 %23.02 % Main telephone lines per 100 inhabitants43.0469.97 Internet hosts per 10,000 inhabitants62.022928.32 Personal computers per 100 inhabitants10.4858.52 Percent of PCs connected to Internet5.92 %50.04 % Internet users per host35.902.04 Internet users per 100 inhabitants22.2759.75 Cell phone subscribers per 100 inhabitants66.5139.79 Readiness for the Networked World Global Information Technology Report 2001- 2002

23 Where are we now? Progress 1 1.1 1.2 1.3 1.4 1.5 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Human Capital Productivity 1.4% a year 1972 – 1995 2.5% a year 1995 – 2000 (tot 79%) Higher quality for lower prices Individual Investor Empowerment eCommerce / eBanking Amazon E-bay Alternative to Microsoft Linux / Red Hat, IBM Cheap Bandwich (Cable, xDSL)

24 2. Economic Thinking Differentiation of products and prices Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Price deviates from marginal cost; Deviation from marginal cost may indicate market power; Market must not be competitive; Market forces go on to say that price discrimination can be output-increasing and is therefore not necessarily inefficient or bad; Usually measures almost always produce outcomes less efficient than the ones that they were designed to change; IT through privacy intrusions serve to provide the information that allows sellers to determine buyers' willingness to pay; IT also allows for monitoring usage, to ensure that arbitrage is not used to bypass discriminatory pricing; The issue is not privacy, per se, but rather trust: consumers want to control how information about themselves is used;

25 First-degree price discrimination  Firms charge the highest price they can to each consumer, thereby capturing the entire consumer surplus; Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Price Discrimination

26 Second-degree price discrimination  Everyone faces the same menu of prices for a set of related products; Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Price Discrimination

27 Third-degree price discrimination  Selling at different prices to different groups; Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Price Discrimination

28 Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Price Discrimination Conditioning on purchase history  Discrimination based on purchase history; Bundling  Selling two or more distinct goods together for a single price;

29 Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Price Discrimination The public's dislike for price discrimination will be combined with new tools for detecting price discrimination; New tools are products of the same technologies that enable sellers to practice differential pricing; The result is likely to be that price discrimination will grow, but in a concealed form;

30 Switching costs and lock-in Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Consumer  Switching costs make consumers reluctant to move to completely new solutions; Supplier  Switching costs or cannibalisation of existing products make suppliers reluctant to pursue new product opportunities;  High difficulty of market penetration unless products on offer are compatible with existing complementary solutions;

31 Switching costs and lock-in Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

32 Information and Technology Large fixed costs Small marginal costs Natural Monopolies Have costs structures Solution Government Regulation Inefficiencies !? Supply-Side Economies of Scale Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

33 Supply-Side Economies of Scale Average cost decreases with scale 1. Scale economies important in online retailing  Customers benefit from low prices while companies build economies of scale (e.g. Amazon) 2. Can overcome cost advantages when the market is growing rapidly  Difficult to sustain market-leadership (e.g Betamax) 3. IT reduces the minimum efficient scale of operation in many markets  Off-the-shelf reduces need for experts & lowers barriers to entry (e.g. desktop publishing) Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

34 Supply-Side Economies of Scale Competition to acquire monopoly  Forces lower prices for consumers Competition with your prior production  Existing output can compete with new products Pressure from complementary products  Providers of complimentary products want to see lower prices & will exert pressure to accomplish this Inventing around  Patents create barriers to entry, but competitive firms will find new ways to produce the same / better products Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

35 Competition and welfare In mature industry with large fixed costs equilibrium price will typically exceed marginal cost In a static model, correct formulation for the efficiency condition is that marginal price should equal marginal cost Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

36 Competing for monopoly theorems of welfare economics assert that: a perfectly discriminating monopolist can capture all surplus for itself and therefore produce Pareto efficient output competition among perfectly discriminating monopolists will transfer this surplus to consumers, yielding the same outcome as pure competition THE TWO IMPORTANT QUALIFICATIONS TO KEPT IN MIND ithe choice of the dimensions in which to compete the rules of competition Competition for perfectly price discriminating monopolist Deadweight lossProducer Surplus

37 The currency of competition Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 competition is good, but regulation may be required to make sure that competition takes socially beneficial forms strategic variables: for the firms: are prices tend to benefit consumers: Innovation and quality choice environmental: attractive policy goals but firms also compete in other dimensions: political lobbying accumulation of excess capacity premature entry …

38 Demand-side economies of scale Average revenue increases with scale Known as “network externalities” or “network effects” since they occur in network industries:  When demand for a good depends on how many other people purchase it  Usual example is of a fax machine ( more picture phones and email)  Recent e.g.: availability of Playstation v. Xbox games If market gets above critical mass, positive feedback kicks in & product becomes successful Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

39 In each case, the demand for the infrastructure depends on the availability of applications, and vice versa Indirect network effects are endemic in high-tech products The cure for the current slump, according to industry pundits, is a new killer app.Movies on demand, interactive TV, mobile commerce-there are plenty of candidates, but investors are wary, and for good reason: there are very substantial risks involved Current challenges include residential broadband and applications, and 3G wireless and applications Demand-side economies of scale Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

40 demand side economies of scale supply side economies of scale average cost decreases with scale average revenue (demand) increases with scale competition to acquire a monopoly Demand-side economies of scale

41 Network effects clearly prominent in some hi-tech industries  Customers choose software that everyone else is using so that file- sharing, working on common documents (…more valuable), etc is easier Network effects & price discrimination  Early adopters normally pay more than later users Network effects & lock-in  If everyone is using a particular product, the cost of switching to an alternative one can be high Demand-side economies of scale Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

42 Demand and supply for a network goodCaused by usual effects of selling to consumers with progressively lower willingness to pay quantity sold increasing when demand is greater than supply and decreasing when demand is less than supply perfectly elastic supply curve Demand-side economies of scale number of people who connect is low and hight, the willingness to pay the marginal individual is low (because there aren't many other people out there that he can communicate with)

43 Price and shipments of fax machines Avarage Price Fax Machines Shipped network effects are present, early adopters may value the network good less than subsequent adopters sellers offer them a lower price, this practice is known as ”penetration pricing” Lock-in (ex:drive on the right hand... Demand-side economies of scale Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3

44 Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Definition: specifications, regulations, and guidelines that help clarify, guide and control processes and activities crucial to our everyday functioning and lives. They specify definitions, performance, and design criteria, creating a common language with which engineers, researchers, businesses, and even students can communicate, create, and learn. "Daddy, what's a standard?"“It's the basic building block of all the neat things we can put on top of it." "But where do standards come from?" “Well, they come from companies competing with each other. Each company offers its own standard and the marketplace decides which innovation to accept." "That's not what my dolly told me." "Where did you get that thing?" "A friend gave it to me at school. He gave one to all the children. He said standards are like that, that they're like presents. I like presents." "Now, dear, there are presents, and there are presents. You know we've taught you not to take presents from strangers. There might be viruses on them. They might be impossible to fix. Good standards come from stores. Remember those wooden nesting dolls I got you? You buy the doll on the outside, and on the inside are presents and presents and more presents." "Give me back my Linus! My friend said you wouldn't like it, and he was right. I showed him my nesting dolls. He said they were bad. He called them a bundle. He said standards should be free!My friend said a real standard is something everyone can have, and everyone can improve. I can dress Linus any way I want, even draw on him, and my friends can play with him, too. They can't really play with my nesting dolls." "But your nesting dolls are safe. They all work together. They're a complete play system."

45 Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Definition: specifications, regulations, and guidelines that help clarify, guide and control processes and activities crucial to our everyday functioning and lives. They specify definitions, performance, and design criteria, creating a common language with which engineers, researchers, businesses, and even students can communicate, create, and learn. "I'm sorry, but I won't have that kind of talk in this house. That's not innovation. That's...that's communism! Now, now, stop crying. Daddy will get you a pony. Would you like a pony?" "My friend called them dependent. They only work if you have them all, and they only work in one way. He said Linus can play all games, and everyone can play together. And he said no one has to pay for Linus. He's free. He's open source." "Proprietary?" "Uh, uh. My friend said you'd do that. He called you popiety!" "Well maybe I am, but that's the only way we can protect innovation, and the freedom to innovate we all depend upon. I'm afraid you won't be seeing that friend any more. What was his name?" "Yes, popiety." "Well, friends can be bought. Or we can get you new friends. And when everyone is using my new nesting dolls, he'll have to throw out that penguin or be left on his own." "I don't remember, but I remember he had a bunch of friends." "Well, children must be protected." "Like little Stevie and that Apple he tried to give the teacher? Or Jimmy and Marc and that looking glass they brought to school one day? You sure showed them, Daddy. You copied all their best features, put them inside your nesting dolls, and made them cry. I love you, daddy."

46 Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Definition: specifications, regulations, and guidelines that help clarify, guide and control processes and activities crucial to our everyday functioning and lives. They specify definitions, performance, and design criteria, creating a common language with which engineers, researchers, businesses, and even students can communicate, create, and learn. Your value = Your share X Total Industry Value Besen and Farrell (1994) gave us three forms of competition in standards setting: Standards War : Firms compete to determine the standard; (Nintendo vs Sony) Standards Negotiation : Both firms want a standard, but disagree about what standard should be; Standards Leader : One firm leads with a proprietary standard, the other firm wants to interoperate with the existing standard;

47 Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Common Tactics Penetration pricing : pricing below cost, to build an early lead; Building Alliances with suppliers of complementary products; Expectations management : bragging about market share /product pre-announcements; Commitments to low prices in the future; WARS Examples: AM Stereo: auto industry invested…but radio didn’t Digital Wireless Phones: Europe (GSM) vs USA (GSM, TDMA,CDMA) Rival Revolution Revolution vs Evolution Incompatible Evolution vs Revolution Rival Evolution Compatible IncompatibleCompatible My Technology His Technology CLASSIFICATION

48 Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Negotiation Classic Battle of the Sexes game: Each player prefers a standard to no standard, but each prefers its own standard to the other’s So… Common Tactics o Power of Threat : What happens if negotiations fail? o Form Official standards body to oversee negotiations o Dealing with mistrust o Require firms to disclose all relevant information o Cede control to an independent third party Examples: Microsoft and C#, competitor to Java

49 FOLLOWERS LEADERS Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Leader Typical case of standards leader: Large, established firm wants to maintain a proprietary standard, but a small upstart wants to interconnect with that standard Common Tactics Protection by intellectual property laws Leader changes technology frequently Use an adapter / converter for the technology Can be done with / without leader’s permission Examples: AM /FM Open Source community, Samba+Unix interoperation with Microsoft, Word, Excel

50 Standards Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 Cost Advantage of Standardization There is considerable cost savings due to economics of scale in manufacture and risk reduction Thompson (1954) Chain of Events 1.Smaller firms were interested in standardization in order to reap sufficient economies of scale to compete with Ford and G.M; 2.Small suppliers were also interested in standardization: diversify the risk associated with supplying idiosyncratic parts to one customer; 3.The Society of Automotive Engineers (SAE) carried out the standardization process, which yielded many cost advantages to the automotive industry; 4.Late 1920s: Ford and GM began to see the advantages of standardization, at first focusing on the products of complementors (tires, petroleum products, and the like) but eventually playing a significant role in automobile parts standardization;

51 System Effects Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 + Useless products unless combined into a system, with other products COMPLEMENTARITIES DIRECT NETWORK EFFECTS: symmetric form of complementarities INDIRECT NETWORK EFFECTS: chicken and egg problems TYPES OF SYSTEM EFFECTS ECONOMIC ISSUES Who will do the system integration? How will the value be divided up among the suppliers of complementarities?

52 System Effects Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 ECONOMIC ISSUES COURNOT (1838) Analyzed the strategic interactions between producers of complementary products, considering a market with two companies... Company Z Monopolist ZINC producer Company C Monopolist COPPER producer COMPANIES B Brass producers What would happen to the price of brass if the copper and zinc producers merged? Assume Z + C = B 1. p b = p c + p z Competition push p b down to it’s cost 2. D b = D(p c + p z ) Demand for brass 3. Max p c D(p c + p z ) Copper producer wants to maximize his profits 4. Max p z D(p c + p z ) Analogous problem for Zinc producer 5. Max (p z +p c )D(p c + p z ) MERGER:solve the joint max problem PRODUCERS HAPPY CONSUMERS HAPPY

53 System Effects Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 ECONOMIC ISSUES There are a variety of ways a firm might induce a complementor to cut its price: o Integrate: One complementor acquires the other, forming a merged entity which internalizes the externality; o Collaborate : The firms set up a formula for revenue sharing, then one firm sets the price of the joint system.(Ex: aircraft manufacturers); o Negotiate: A firm may commit to cutting its price if the other firm also cuts its price.(Ex: DVD); o Nurture: One firm works with others to reduce their costs.(Ex: Adobe and printers); o Commoditize: One firm attempts to stimulate competition in the other's market, thereby pushing down prices. (Ex: Microsoft) Other ways to cut prices...

54 Computer mediated transactions Progress 1 1.1 1.2 1.3 1.4 1.5 2. 2.1 2.2 2.3 2.4 2.5 2.6 2.7 3 o Data gathered mined for consumer information and behavior can allow for various forms of price discrimination; o Allow firms to contract on aspects of transactions that were previously unobservable; Video Tape Rental Industry Before 1988 Distributors sold videotapes to rental stores at 60$ each (in excess of marginal costs) After 1988 Studios provided tapes between 0 and 8$.The revenues were split between the studios and the video store, which received between 40 and 60%. Blockbuster computer recorded each title rental and send a report to the central office: all parties in transaction were able to verify the revenues were being shared in the agreed-upon way. Trucking Industry Last twenty years Trip recorders and electronic vehicle management systems (EVMS) have become widespread in the industry. Now… EVMS collects info about location and transmits it in real time, helping with dispatch coordination, operation efficiency, insure liability and fraud detection, making the industry more cost effective.

55 Summary and Conclusions 1. Competition and "complementers“ (ex: Apple Mac: worries with competitors and software developers); 2. Lock-in: IT components  systems  switching any component often involves switching others as well  switching costs are high! (ex: switching Mac to Windows-based PC) - cost of changing to a  system is so high that switching is virtually inconceivable ; BAD for consumers, GOOD for sellers:  user has a very inelastic demand;  seller can  prices - extract consumer surplus (although consumers and competition impose some barriers) – Monopoly power (charge more than marginal cost of the product/service);  Ex: choosing an ISP (Internet service provider);

56 Model of competition with switching costs (ISP example) Perfectly competitive market (many identical firms); c=cost of providing a customer with internet access; No switching costs  price of internet service = p = c; s = switching costs; d=1 st month discount; r=monthly interest rate; New ISP: pay (p-d) + s; Keep old ISP: pay p; The consumer will only switch if: The consumer will be indifferent if: Discount covers for the switching cost  d=s d>s

57 s = switching costs; d = 1 st month discount; Adding switching costs raises monthly price of service above cost …but competition for this profit forces the initial price down the producer is investing in the discount d=s in order to acquire the flow of markups in the future. In reality, many ISPs have other sources of revenue than just the monthly income from their customers (ex: AOL = derives substantial revenue from advertising  offer discounts, to capture customers, even if they have to provide Internet connections at rates at or below cost)

58 Summary – Network Externalities Situations in which one person's consumption directly influences another person's utility; Are a special kind of externalities in which one person's utility for a good depends on the number of other people who consume this good  a person's utility could depend on the identity of other users  People are partially influenced by what other people buy/use  however, there is an upper bound to these externalities (when too many people are using something, it usually falls out of “fashion”); Example: consumer's demand for a fax machine or a modem (people want fax machines so they can communicate with each other. If no one else has a fax machine, it certainly isn't worthwhile for you to buy one. Same with telephones and modems  are worthless if there is no one else to communicate with);

59 Complementary goods = Indirect effect for network externalities: Ex:  Video store  demand for video tapes depends on the number of VCRs and the demand for VCRs depends on the number of video tapes available;  Demand for computers depends on the operating system and other types of software they support and vice-versa; Question of compatibility: Competition in the market for some goods (ex: word processing programs or video tapes) may be seriously difficulted by complementary products (operating systems or vcr’s) which are only technologically compatible with one of the competitors Ex: It is generally recognised that Betamax was a better video system than VHS, but the faster diffusion of VHS -compatible vcr’s resulted in the failure of Betamax Summary – Network Externalities

60 …became a basic determinant of firms’ strategies (VHS and the DOS system became winners because their creators promoted a rapid diffusion of users by forfeiting exclusive rights to their use) …become a determinant for market failure by awarding monopoly power to firms that offer products that are complementary to a good with a large installed base (Microsoft is able to offer many types of specialised software - office software and internet-related programs - together with the Windows system, thereby gaining an advantage over competitors offering substitute goods, even if these goods can also work with Windows)

61 Demand curve Supply curve SIZE OF NETWORK WILLINGLESS TO PAY Relationship between price of the good/number of users: If there are n people who purchase the good  the willingness to pay of the marginal individual is given by the height of the curve; If number of people who connect is low  the willingness to pay of the marginal individual is low (because there aren't many other people out there that he can communicate with); If number of people connected is large  the willingness to pay of the marginal individual is low (everyone else who valued it more highly has already connected); Plausible to assume: when people are willing to pay more than the cost of the good - market . When people are willing to pay less than the cost of the good - market . Figure: Network Externalities - 3 intersections where demand = supply DEMAND Analysis of the DEMAND SIDE OF THE MARKET: Summary – Network Externalities

62 Demand curve Supply curve SIZE OF NETWORK WILLINGLESS TO PAY Suppose that the good can be provided by a constant returns to scale technology  supply curve is a flat line at price = average cost; 3 possible intersections of the demand/supply curves: 1.Low-level equilibrium where n*=0 (no one consumes the good, so no one is willing to pay anything to consume the good  "pessimistic expectations" equilibrium); 2.Middle equilibrium with a positive but small number of consumers (people don't think the network will be very big, so they aren't willing to pay that much to connect to it - and therefore the network isn't very big); 3.Large number of people equilibrium – nH (price is small because the marginal person who purchases the good doesn't value it very highly, even though the market is very large). SUPPLY Analysis of the SUPPLY SIDE OF THE MARKET: Summary – Network Externalities

63 Demand curve Low cost SIZE OF NETWORK WILLINGLESS TO PAY High cost Low-level equilibrium  no one connects; High-level equilibrium  many people connects; Middle-level equilibrium  unstable  unlikely to be the final resting point of the system; 2 possible stable equilibrium  low-level & high level; Which is likely to occur? – think about how costs might change over time... For the kinds of examples we have discussed (faxes, VCRs, Computer networks), the cost of the good starts out high and then decreases over time due to technological progress: Stable Figure: Cost adjustment and network externalities When the cost is high, the only equilibrium implies a market of size zero. As the cost goes , 2 other equilibrium becomes possible;

64 Adding some noise to the system... Perturbing the number of people connected to the network around the equilibrium point  perturbations could be random, or part of business strategies (such as initial discounts or other promotions); As the cost gets smaller and smaller, it becomes increasingly likely that one of these perturbations (critical mass) will kick the system up past the unstable equilibrium  the dynamic adjustment will push the system up to the high-level equilibrium: It starts out at essentially zero, with a few small perturbations over time. The cost , and at some point we reach a critical mass that kicks us  past the low-level equilibrium and the system then zooms  to the high-level equilibrium Critical Mass TIME SIZE OF NETWORK Figure: Possible adjustment to equilibrium The number of users connected to the network is initially small, and increases only gradually as costs fall. When a critical mass is reached, the network growth takes of dramatically

65 Summary – Implications of Network Externalities Critical mass issue is very important: if one user's demand depends on how many other users exist, it is very important to try to stimulate growth early in the life cycle of a product;  Nowadays it is quite common to see producers offering very cheap access to a piece of software or a communications service in order to "create a market" where none existed before;  For the increasing returns to be fully exploited, the network has to reach a particular critical mass;

66 Summary – Implications of Network Externalities One way to achieve critical mass is through cost reductions over time: 1. As new processes are implemented and improved  costs of production and prices  (microchips, vcr’s, faxes, computers,…); 2. Costs would  from the high marginal cost curve to the low marginal cost curve; 3. As the cost gets smaller and smaller, it becomes increasingly likely that any small disturbance will kick the system up past the unstable (middle) equilibrium, making it reach the critical mass necessary to push it to the high-level equilibrium; 4. If costs do not fall enough, or if the firm fails to diffuse the product up to the critical mass for other reasons (a competitor might do it faster), then adjustment will rut to the low-level of equilibrium; Demand curve Low cost SIZE OF NETWORK WILLINGLESS TO PAY High cost

67 Real-life example: market for fax machines: Figure: Fax market The demand for fax machines was small for a long time since so few people used them. During the mid-eighties, the price fell significantly and the demand suddenly exploded, due to the “critical mass”

68 EXAMPLE#1: Network Externalities in Computer Software - Adobe Adobe's strategy paid off: several competitors emerged (including one that gave its product away) and PostScript became a widely used standard for desktop publishing; Ironically, Adobe's market success was due to its ability to encourage entry by its competitors! Exchanging data files & tips with other users of the same software advantage to the largest seller in a given market leads software producers to invest heavily in acquiring market share Adobe Systems invested in developing a "page description language" called PostScript for desktop publishing Realized that no one would invest the time and resources necessary to learn PostScript unless it was the clear "industry standard” Deliberately allowed competitors to "clone" its language in order to create a competitive market in PostScript interpreters

69 EXAMPLE#2: Network Externalities in Computer Software – JVC & SONY JVC made the VHS system available to all potential producers of vcr’s, while Sony kept Betamax proprietary It did not take long for Sony to realise its mistake, but it was time enough for VHS to achieve enough critical mass to eventually exclude Betamax from the market Unfortunately for JVC, it did not have the necessary ability to keep ahead in the development of the product, so it eventually lost most of its market power

70 EXAMPLE#3: Network Externalities in Computer Software – MICROSOFT & NETSCAPE Market failure is intensified by the existence of complementary products. Although other companies produce software that is compatible with Windows (such as Netscape ), Microsoft is still able to gain an advantage in the markets for these kinds of products by offering its own versions (such as Excel, Word and Explorer ) within the Windows package, or at considerable price reductions Microsoft has chosen to offer Explorer together inside the Windows package in order to prevent Netscape (who entered the market earlier) from creating enough critical mass to become a standard Microsoft used one kind of network externality to preclude another kind from taking complete effect

71 The role played by governmental Network Externalities The Internet was originally used only by a few small research labs to exchange data files mid-80s: National Science Foundation used the Internet technology to connect several large universities to 12 supercomputers deployed at various locations (researchers at the universities would send data back and forth to the supercomputers) Fundamental property of communications networks: if you are all connected to the same thing, you are all connected to each other Researchers started sending emails to each other (had nothing to do with the supercomputers) Critical mass of users connected to the Internet  value to new users  dramatically (most of them had no interest in the supercomputer centers, even though this was the original motivation for providing the network) Although still very much in its early stages Industrial regulation try to cope with new types of market failure (regulation, anti-trust,…)  Until now, only market failure associated with complementary products has been focused (by trying to force Microsoft to offer Netscape within its Windows package, as it does with Explorer)

72 Summary: Rights Management Intelectual Property transactions take a variety of forms: 1.Books are sold outright and also borrowed from libraries; 2.Textbooks (are shared among students from one term to the next via the resale market; 3.Videos can either be sold or rented; 4.Some software is licensed for particular uses. Other software is sold outright; 5.Shareware is a form of software in which payment is voluntary. Librarians established the "rule of five" for interlibrary loan: an item may be loaned out up to five times before additional royalty payments should be made to the publisher  Publishers and authors are unenthusiastic about the resale market for books;  Digital information can be perfectly reproduced, and "sharing" can be taken to new extremes; CDs do not deteriorate with replay and it is possible to buy a CD, record it, and then sell it to the used-CD store; Critical Business Decision = Choosing the terms and conditions under which a piece of intellectual property is offered: 1.Should you use copy protection? 2.Should you encourage users to share a new item with a friend? 3.Should you sell to individuals or use site license?

73 Example: Video Rental Video stores can choose the terms and conditions under which they rent videos; This tended to lead to a form of product differentiation (new releases are rented for short periods  profits from other renters are very substantial. Older videos are rented for longer periods  less cost to the store from the video being unavailable). The longer you can keep the video  more valuable it is to you (longer period of time during which you can watch it) The longer you keep the video  less profit the store makes from it (it is unable to rent it to someone else) Optimal choice: involves trading off these two effects

74 Most profitable actions for producers (video store). If:  Large production cost and small renting cost  produce a few copies, sell them at a high price, and let the consumers rent;  Renting cost > production cost  forbid renting (since renting is so inconvenient for the consumers, video stores aren't willing to pay much more for the "shared" videos, and so the producer is better off selling); Example: Video Rental

75 Because information technology works together in systems, it is costly to consumers to switch any one component; In equilibrium, the discount offered first period is paid for by increased prices in future periods; Network externalities arise when one person’s willingness to pay for a good depends on the number of other users of that good; Models with network externalities typically exhibit, multiple equilibria. The ultimate outcome often depends on the history of the industry; Copyright helps to stimulate the production of intellectual property. The degree to which copyright is enforced therefore influences the price of the material produced; Rights management involves a trade-off between increased value and prices versus reduced sales ; Information goods like books and videos are often rented or shared as well as purchased. Rental or purchase can be more profitable depending on how transactions costs compare with production costs. Summary – General Conclusions

76 Review Questions If the cost to a customer from switching long-distance carriers is on the order of $50, how much should a long-distance carrier be willing to pay to acquire a new customer? Describe how the demand for a word processing package might exhibit network externalities. Suppose that the marginal cost of producing an extra video is zero and the transactions cost of renting a video is zero. Does a producer make more money by selling the video or by renting it? Does it make sense to have larger fines for copying products with larger development costs?

77 References and Links III. The Economics of the Internet, Information Goods, Intellectual Property and Related Issues Compiled by Hal R. Varian IV. www.sims.berkeley.edu/resources/infoecon/www.sims.berkeley.edu/resources/infoecon/ V. World Wide Web Consortium VI. www.w3c.orgwww.w3c.org VII. CID - Center for International Development at Harvard University VIII. www.cid.harvard.edu/cr/profiles.htmlwww.cid.harvard.edu/cr/profiles.html IX. Magazines X. www.fastcompany.comwww.fastcompany.com XI. www.redherring.comwww.redherring.com XII. www.wired.comwww.wired.com I. Economics of the Information Technology, Hal R. Varian II. Intermediate Microeconomics, Hal R. Varian, 5th edition


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