Lecture 10

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CH 9 e-ECONOMY: e-Products and e-Marketplaces

e-commerce is already having a noticeable impact upon market structure and the behavior of business

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‘Anyone who fails to become an e-business will become an ex-business’ (Phil Lawler, MD of Hewlett-Packard)

‘In 5 years time, all companies will be Internet companies, or they won’t be companies at all’ (Andy Grove, Chairman of Intel)

The Hype!!

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What kind of things we study in e-economics:

e-products

e-marketplaces

impact of e-economy on market structure, business and consumers

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e-Products

An e-product: can be digitally encoded then

transmitted rapidly, accurately and cheaply e.g. music, films, books, sport …

Fixed costs of producing e-products are huge …

… but marginal costs of distribution are tiny

implying vast economies of scale

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Consuming Information

experience

overload

switching costs

network externalities

Four key features of e-products:

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Experience Products

An experience good or service is one that must be sampled before the user knows its value information is nearly always

new marketing needs careful

attention free samples previews establishing reputation

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Information Overload

… arises when the volume of available information is large

…but the cost of processing it is high

screening devices become crucial search engines and shopping

bots

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Switching Costs

… arise when existing costs are sunk

for example, changing supplier incurs additional costs

smart suppliers use strategies for locking in their customers e.g. air miles, supermarket reward

cards

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Beneficial Network Externalities Many information goods are also

characterized by network externalities: the value of the good to an individual is greater when a large number of people also use the good (e.g. fax machines, Internet, e-mail)

Note that congested trains or roads are unattractive networks. Externalities are not always positive. However, the first fax machine was invented over a hundred years ago, yet they did not become popular till everyone believed everyone else would have one

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Network externalities explain why there is a sudden switch to a new system when public opinion suddenly has confidence in the new network

Network externalities cause positive feedback, in which either initial success or initial failure is self-reinforcing: success breeds success, failure breeds failure

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Critical Mass and Industry Takeoffs When network externalities are

strong, a large proportion of consumers may not be willing to purchase a good unless the number of existing users exceeds a threshold network size

This leads to the critical mass effect, a sudden rapid increase in the network size

Networks with more users are more valuable to belong to networks may therefore subsidize new membership

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Network Externality: Threshold Network Size

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Critical Mass

Critical mass effects change the quantity demanded over time of a good with network externalities. The quantity demanded grows slowly until critical mass is reached; once reached the quantity demanded suddenly explodes.

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Network Externalities

Suppose D1 represents the demand curve for a product exhibiting network externalities

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Quantity

D1

P1

Q1

With price at P1, quantity demand is limited.

If price is reduced to P2, morepeople find the network attractiveso not only is there a move alongthe demand curve, but there is also a shift in demand.

P2

D2

Q2

Long-run demand is moreelastic (D).D

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Case: Apple’s Big Mistake

Even though Apple’s computers were clearly technologically superior to the alternatives well into the 1990s (devotees say they still are), they have always remained a small part of the market .Apple failed to recognize the strength of the network externalities that caused many users to stick with an inferior product that was widely used, especially given the fact that the superior alternative was considerably more expensive.

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Pricing of Information Products

Most workers are employed in the production of conventional goods and services: cars, houses, haircuts, and so on

But considerable resources are now also devoted to producing information goods—products whose value comes not from their physical characteristics but from the information they embody

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Information: the supply side

Given substantial economies of scale, we expect monopoly suppliers of information products1: Dominant firm with competitive

fringe e.g. Microsoft

Niche market monopolies

1industrial economy was made up largely of oligopolies limited by their existing capacity

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Efficiency requires that goods sell at their marginal cost, and information goods have low marginal cost

However, because they have high fixed cost, they won't be created unless the producer can cover its cost of production by charging a price well above marginal cost

But like monopoly, this leads to an inefficiently low quantity of output

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A musical recording has high fixed cost and low marginal cost, a situation similar to natural monopoly

The profit-maximizing price, PM, is $5, the average total cost, ATCM, is $3, resulting in a per-unit profit of $2

Assumptions: FC = $1.5 million, MC = 0

The Profit-Maximizing Quantity of an Information Good

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Pricing Problems for Information Goods

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The Problem of Achieving Efficiency with an Information Good

•The profit-maximizing music company behaves like a monopolist

•Offering the good for free leads to a gain in total surplus of area E

•However, if forced to provide the good for free, the music company is likely to forgo producing the good altogether

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Monopoly is a bad thing, other things equal; it is inefficient to charge a price that is above marginal cost. But the expectation of monopoly profits is necessary to induce the company to produce the good at all. Indeed, economists generally agree that when it comes to information goods, a temporary monopoly may be the necessary price of progress

Why temporary? As we will see, both law and natural forces tend to limit the duration of the monopolies associated with information goods

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Property Rights in Information A patent gives an inventor a

temporary monopoly in the use or sale of an invention; a copyright similarly gives the creator of a literary or artistic work sole rights to profit from that work By creating temporary monopolies,

patents and copyrights facilitate the production of some information goods

When this legal protection is not available, producers of information goods often manage to establish temporary monopolies by exploiting first-mover advantages

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Public Policy towards Information Goods

Antitrust policy Only monopolization -- efforts to

create monopolies -- forbidden What is the dividing line

between legal and illegal actions?

Setting standards Need for common standards

creates a justification for government intervention in the economy

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Some strategies for pricing information products:

Two-part tariff an annual charge to cover fixed

costs, and a small price per unit related to marginal costs

Versioning the deliberate creation of

different qualities to facilitate price discrimination

Bundling the joint supply of more than

one product to reduce the need for price discrimination

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Competition vs. Collaboration A strategic alliance is a blend of

co-operation and competition, in which a group of suppliers provide a range of products that partly complement one another e.g. Microsoft and Intel airline alliances: One World, Star

Alliance etc.

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What's the attraction?

e-Marketplaces

B2C, C2B, C2C, and B2B

eMarketplaces differ widely in both their complexity and objectives

Their principal aim, however, is to bring buyers and sellers together: aggregation and matching

How might such marketplaces achieve these goals? improved computational and

communication capability due to improved ICT

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eMarkets Evolution

EDI1 - N<1999

InternetM - N

1999 – 2001

eMarkets2000–2004

eMarkets SC Integration

2001–2006

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One BuyerOne Seller

Negotiation

Many Buyers

Auction

Many Sellers

Reverse Auction

Exchange orMarkets

Market Framework

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Business introductions Many e-marketplaces, such as

lotsofplastics.com, acts simply as an electronic notice board, bringing together buyers and sellers. Once they have found each other the transaction process is negotiated and settled off-line

On-line catalogues A more sophisticated e-marketplace is

where a seller places on-line their catalogue, detailing products, price availability and delivery. Buyers can then browse, place orders electronically and on certain sites make payments on-line

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On-line or e-auctionsJust as in a normal auction

process, only in this case within an e-market, the seller puts up for sale a given product or service and invites offers eBay and uBid Goindustry.com, a European

e-marketplace for selling used and surplus machinery

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e-exchanges Like a stock exchange, it matches

buyers and sellers via a bid and offer price system

The reverse auction/procurement in e-marketplace Here a buyer puts out a tender

and invites suppliers to put in bids

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Originally it was thought that e-auctions are most suitable for products or services that are relatively basic in which price is the most important

determinant of sale

BUT non-price factors, such as the product’s

quality, terms of delivery, warranty, reliability or after-sales service are often at least as important as the price

More recent auction systems, however, can now handle also multi-issue auctions

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Other services. As well as buying and selling, a number of e-marketplaces are aspiring to greater things

Many currently provide an industry news service. Some are seeking to establish greater collaborative working between industry members, in for example areas such as demand forecasting and logistics

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Who Gains What in an e-Marketplace? Perfect competition

globalizationprices become more transparentcompetition gets harder lower prices

or more segmented markets?firms seeking monopoly power

through product differentiation increased customer information

cookies etc.tailored products

increased price discrimination

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The Gains for Buyers

essentially based on the significant reduction in transaction costs

bidding or auction process likely to drive product or service prices down

buyers will be put into contact, not only with a wider number of suppliers but, with new suppliers as well

easy and direct access to new sources of supply will reduce the need to carry stocks

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The Gains for Sellers

access to new buyers and so potentially increased sales volume

as with the buyer, the seller is likely to experience significant reductions in transaction costs on each sale made

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Gains for consumers from B2B

As procurement costs are cut, the costs of producing goods and services should fall

Some of these cost savings should be passed on to the consumers in lower prices

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Gains for the Economy: New Economy?

Increased productivity in the network economy

IT contributes approximately 50 per cent to GDP growth

It is anticipated that this will rise with the increase of e-business

Goldman Sachs estimates that the effect of B2B on aggregate supply (AS) will increase average growth rates by 0.25 per cent for the next 10 years

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Gains for the Economy: New Economy?

Increased productivity shifts the aggregate supply to right

AS

AD

National output, Y

Inflation, % National output will increase, unemployment decrease AND inflation rate can stay relatively low

AS’

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Long Cycles

Kontratiev, Schumpeter

1 cycle 1790 - 1844 Steam engine

2 cycle 1844 - 1895 Railroads3 cycle 1895 - 1946 Electricity

and motor vehicles

4 cycle 1946 - 1990 Cheap energy

5 cycle 1990 - Information technology

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Understanding the e-Economy

1 The information revolution is changing our lives

but few of its activities or market tactics are unprecedented

2 The revolution in technology has not required a corresponding revolution in economic theory