1. Information Technology
Chapter Thirty-Four
Information Technology

2. Information Technologies
Computers, answering machines, FAXes, pagers, cellular phones, …
Many provide strong complementarities.
E.g. 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 = v.
So inverse demand is p = n(1000-n).

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

23. Competition & Network Externalities
Willingness-to-pay p = n(1000-n)
Demand Curve
(a) c
Supply Curve n’
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) c
Supply Curve
(b)
(c) n’ n”
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) c
Supply Curve
(b)
(c) n’ n”
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 c
Supply Curve n’ n”
1000 n
Which equilibrium is likely to occur?

30. Competition & Network Externalities
Willingness-to-pay p = n(1000-n)
Demand Curve
Unstable c
Supply Curve n’ n”
1000 n
Which equilibrium is likely to occur?

31. Competition & Network Externalities
Willingness-to-pay p = n(1000-n)
Demand Curve c
Supply Curve n”
1000 n
Which equilibrium is likely to occur?

32. Competition & Network Externalities
Willingness-to-pay p = n(1000-n)
Demand Curve
Stable c
Supply Curve n”
1000 n
Which equilibrium is likely to occur?

33. Competition & Network Externalities
Willingness-to-pay p = n(1000-n)
Demand Curve
Stable
Stable c
Supply Curve n”
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 consumption and 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

51. 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

52. Sharing Intellectual Property
Is selling for rental more profitable?
Each rental unit is used by k > 1 consumers.
So y units sold  x = ky consumption units.

53. Sharing Intellectual Property
Is selling for rental more profitable?
Each rental unit is used by k > 1 consumers.
So y units sold  x = ky consumption units.
Marginal consumer’s willingness-to-pay is p(x) = p(ky).

54. Sharing Intellectual Property
Is selling for rental more profitable?
Each rental unit used by k > 1 consumers.
So y units sold  x = ky consumption units.
Marginal consumer’s willingness-to-pay is p(x) = p(ky).
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.

55. Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is

56. Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
Producer’s sale-for-rental problem is

57. Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
Producer’s sale-for-rental problem is

58. Sharing Intellectual Property
Rental transaction cost t reduces willingness-to-pay to p(ky) - t.
Rental store’s willingness-to-pay is
Producer’s sale-for-rental problem is

59. Sharing Intellectual Property
is the same problem as the direct sale
problem
except for the marginal costs.

60. Sharing Intellectual Property
is the same problem as the direct sale
problem
except for the marginal costs. Direct sale
is better for the producer if

61. Sharing Intellectual Property
Direct sale is better for the producer if
I.e. if

62. Sharing Intellectual Property
Direct sale is better for the producer if
Direct sale is better if
replication cost c is low
rental transaction cost t is high
rentals per item, k, is small.