1. Economics of Information Technology 2nd session 11.02.2003 Experiencing Microeconomics

2. Introduction2 Agenda ‘Think like an economist’ 1.General Microeconomic concepts Supply demand and cost functionsSupply demand and cost functions 2.Microeconomics and the information product First copy costs,MC, Sunk costs, price differentiationFirst copy costs,MC, Sunk costs, price differentiation 3.Organization of the course Group presentation and preparation of the academic summariesGroup presentation and preparation of the academic summaries

3. Introduction3 1.1 Supply Demand schedules S D P0P0 S0S0 Price Quantity Equilibrium (EQ)

4. Introduction4 1.1 Supply Demand schedules S D P0P0 Q0Q0 Price Quantity Effect of a tax imposition on the demand curve ( i.e. VAT tax) EQ T PTPT QTQT

5. Introduction5 1.1 Supply Demand Effect of a tax imposition on the supply curve ( i.e corporate tax) Price Quantity S D P0P0 Q0Q0 PTPT QTQT STST EQ T

6. Introduction6 1.2 Price Elasticity of Demand Price elasticity is greater in the long run (LR) than in the short rum (SR)Price elasticity is greater in the long run (LR) than in the short rum (SR) Price Quantity P0P0 Q0Q0 P1P1 Q SR D SR Q LR D LR

7. Introduction7 1.2 Price Elasticity of Demand Price Elasticity  is the % change of a quantity demanded, brought by 1% change in price Price elasticity = n =Change Q : Change P Q 0 P 0 Q 0 P 0 If n < 1  demand is inelastic If n > 1  demand is elastic Example: n = 0,75 and change P= + 3%  change in demand = 2,25%

8. Introduction8 1.2 Price Elasticity of Demand Price elasticity is greater in the long run (LR) than in the short rum (SR)Price elasticity is greater in the long run (LR) than in the short rum (SR) P Q P Q Perfectly elastic demand Perfectly inelastic demand

9. Introduction9 1.2 Price elasticity of demand Factors that make demand for a product more sensitive: 1.Unique product features, product differentiation 2.High proportion of buyers expenditures 3.Intermediate products in price sensitive industries such as PC industry Factors that make demand for a product less sensitive: 1. Difficult to compare products/services 2.Low proportion of buyers expenditures 3.High costs to switch to another product 4.Products compatibility or product network effects

10. Introduction10 1.3 Cost Functions - Total Costs Total Costs = FC + VC Cost Quantity Fixed Costs (FC) Q0Q0 FC QTQT Total Costs (TC) Variable Costs (VC)

11. Introduction11 1.3 Cost Functions - Total Costs Total Costs = FC + VC Cost Quantity Fixed Costs (FC) Total Costs (TC) Variable Costs (VC)

12. Introduction12 1.3 Cost Functions - Average Costs Average Costs = TC/Q Cost =C Quantity Average Costs (AC)

13. Introduction13 1.3 Cost Functions – Minimum efficient scale of production (MES) Average Costs schedules of ‘ old economy firms’ C Q C Q Minimum efficient scale Until Q’ economies of scale are present Minimum efficient scale at Q’ when scale economies are exhausted Q’ – Q’’ constant returns to scale Beyond Q’’ diseconomies of scale AC Economies of scale Constant returns to scale Diseconomies of scale Q’ Q’’

14. Introduction14 1.4 Cost Functions - Constant returns to scale Average Costs schedules of ‘ new economy information good firms C Q AC Economies of scale Constant returns to scale Diseconomies of scale Constant returns to scale theoretically until infinity

15. Introduction15 1.5 Cost Functions – Marginal Costs The cost of expanding output or cost savings contracting outputThe cost of expanding output or cost savings contracting output The incremental cost of producing exactly one more unit of outputThe incremental cost of producing exactly one more unit of output MC (Q) = TC (Q + change Q) – TC (Q)MC (Q) = TC (Q + change Q) – TC (Q) change Q change Q MC (Q) = VC/QMC (Q) = VC/Q Average total costs (ATC) = TC/QAverage total costs (ATC) = TC/Q Average variable costs (AVC) = VC/QAverage variable costs (AVC) = VC/Q

16. Introduction16 1.5 Cost Functions – Marginal Costs C In the event of constant returns to scale MC = AC AC = ATC + AVC C Q FC TC VC C/Q Q MC=AC ATC AVC

17. Introduction17 1.5 Cost Functions – Marginal Costs Quantity TC TC (Q) MC (Q) TC ( Q’ + 1) TC ( Q’) Q’+1 Q’ Q’’+1 Q’’ Q’ Q’’ TC ( Q’’ + 1) TC ( Q’’) Quantity MC MC ( Q’) MC ( Q’’)

18. Introduction18 1.5 Cost Functions 1.5 Cost Functions Relationship Marginal Costs and Average Cost 1.When AC is a decreasing function of output  MC < AC 2.When AC = constant or at MES  MC = AC 3.When AC is a increasing function of output  MC > AC C Q MC AC AV increases MC > AC

19. Introduction19 1.x Price Discrimination

20. Introduction20 1.6 Cost Functions 1.6 Cost Functions Long-run versus short-run cost functions The period of time in which the firm cannot adjust the size of its production facilities = short run For each level of output there is an optimal plant size Example large vs. smaller plant size (see Besanko; figure P.6; pg. 17) Optimal plant size produces savings from: 1.Lower costs from adequate plant size by either reduction of the fixed costs or the utilization of scale economies 2.More efficient labor allocation, better control over VC 3.Optimization of the plants organization

21. Introduction21 Sunk costs are not fixed costs ( e.g. railroad locomotives) The opposite of sunk costs are avoidable costs Sunk investments are industry specific assets that would neither increase value, nor reduce costs when applied to a different product market. Usually up front investments Sunk costs are important for the study of industry strategy, the analysis of rivalry among firms, entry and exit decisions into markets and decisions to adopt new technologies 1.6 Cost Functions 1.6 Cost Functions Sunk Costs

22. Introduction22 1.7 Economic Costs Economic Costs versus Accounting Costs Accounting Profit = Sales revenues – Accounting cost Economic profit = very close related to the principle opportunity cost Economic profit = Sales Revenue – Economic Cost Economic cost = closely aligned with the return on invested capital (ROI), such as plant & equipment Economic profit = Sales Revenue – economic cost – accounting cost

23. Introduction23 1.7 Economic Costs Economic Profit and Net Present Value Present Value of an annual accounting profit: PV = Cash Flow (C) (1+i) t Net present value (NPV) = present value of the cash flows generates minus the cost of the investment NPV = Acc. profit (C) - Cost of the investment (1+i) t

24. Introduction24 2.1 Important Microeconomic concepts in the ‘Information Economy’ First copy costsFirst copy costs Economies of scaleEconomies of scale Sunk costsSunk costs Fixed costsFixed costs Variable costsVariable costs Marginal costsMarginal costs

25. Introduction25 2.2 Costs and competition in the Information Economy Sunk costs => industry specific assets that would neither increase value, nor reduce costs when applied to a different product market. Usually up front investmentsSunk costs => industry specific assets that would neither increase value, nor reduce costs when applied to a different product market. Usually up front investments First copy costs of an information good are typically high, and typically cannot be recovered, and are therefore defined as sunk costsFirst copy costs of an information good are typically high, and typically cannot be recovered, and are therefore defined as sunk costs Marginal costs (MC) => the cost of producing an extra unit of a certain productMarginal costs (MC) => the cost of producing an extra unit of a certain product Reproduction costs of an information good are often constant and costs essentially nothing  MC close to zeroReproduction costs of an information good are often constant and costs essentially nothing  MC close to zero No capacity limits for the reproduction of information goodsNo capacity limits for the reproduction of information goods

26. Introduction26 2.3 Costs and competition in the Information Economy Declining production costs are attracting competitorsDeclining production costs are attracting competitors Dominant firms have due to the financial leverageDominant firms have due to the financial leverage Marginal costs (MC) => the cost of producing an extra unit of a certain productMarginal costs (MC) => the cost of producing an extra unit of a certain product Reproduction costs of an information good are often constant and costs essentially nothing  MC close to zeroReproduction costs of an information good are often constant and costs essentially nothing  MC close to zero No capacity limits for the reproduction of information goodsNo capacity limits for the reproduction of information goods

27. Introduction27 3.1 Organization of the course Group Presentations Setting: The group is performing an consultant firm, while the class is acting as the top leadership of a respective firm or a governmental body Presentation about 25 min plus 15 min for Q&A Hand- in by Monday before the next lecture, latest at 15:00 via e-mail to: cls@woco.dk

28. Introduction28 3.1 Organization of the course Group Presentations Structure of the presentations: Introduction Industry overview The firms business model and strategy SWOT analysis of the firm ( competitors, policies and regulations, technology ect. Elaborate proposal for problem solution, strategy shift or general improvement of the firms current situation. Show the link to the theoretical framework of the course List of recommendations

29. Introduction29 3.2 Organization of the course Summary of literature Summary’s structure Title and source Abstract/Conclusions Key terms and concepts in order of appearance Main Questions & assertions The approach to solve the main questions Support of assertions Relationship between terms and concepts Relation to other articles