The Economics of  Knowledge Based Goods

In reality, all goods are knowledge based. But for goods that are at the leading edge of technology, the cost of the knowledge is usually a more important part of the cost of production. For example, the design cost of a microprocessor is likely to be a larger share of total cost of its production than is the design cost of an automobile. The R&D in developing a new drug is likely to be a higher percentage of its total cost than R&D would be for the production of corn, say.

In many respects, this course will really be about the creation of knowledge (as a product of markets). The knowledge itself can be separated from the the physical embodiments of that knowledge in particular products. The writing of the code for a word processor, for example, can be separated from the duplication of the embodiment of that code on a floppy disk or CD-ROM.

The course will begin by examining how markets create knowledge. We will use a theoretical construct called a public good. Then we will examine several other characteristics often found in markets for new, high technology products, such as economies of scale, network economies, standard setting problems and pirating.

Before we get to this, however, we will review some material on price discrimination that will be essential for understanding the pricing that is used by producers of knowledge based goods.

PRICE DISCRIMINATION: Charging different prices for essentially the same good.

Perfect price discrimination : Each unit sells for its maximum price

Demand curve is actually now the MR curve since the price doesn’t have to be lowered in order to sell additional units.

Profit maximizing firm produces the same output as a perfectly competitive market. No deadweight loss. Difference is that entire surplus goes to the producer.

Problem: how to prevent arbitrage, and how to learn the max price for each unit and who is willing to pay it.

Examples: no such thing as pure perfect price discriminator. Cases where producers sell at multiple prices:

a.     automobiles: salesmen try to determine just what a consumer is willing to pay.  Why do we find this for cars and not for food? Was this more prevalent or less prevalent 100 years ago?

b.    

Medical doctors back in the days when they made house-calls and set their own rates

Ordinary Price Discimination

. The key concept is the equalizing of marginal revenues. Logic is simple. If you have two markets where goods are sold at identical prices, but if the marginal revenues are different, profits can be made if sales are increased in the market with high marginal revenue and sales are decreased in the market with low marginal revenue. This will have the effect of tending to equalize the marginal revenues.

rule: increase P in low MR market decrease P in high MR market

Before price discrimination, the price is the same in both markets so that

MR1 =P1(1-1/); MR2 =P2(1-1/2) but P1=P2

MR1 does not equal MR2 (since the marginal revenues are not equal but the prices are).

Requirements:

·       identify customers as belonging to a particular group

·       know the price elasticity of demand in each group (or the reservation price)

·       prevent ARBITRAGE -- buying low and selling high by middlemen.

NOTE: Prior to discrimination the market with the high marginal revenue is also the market with the high elasticity. From the formula that MR=P(1- 1/E)

New Rule: increase price in market with low elasticity (low responsiveness), lower price in the other market. Continue to do this until the marginal revenues are equalized.

 

 Note that when markets are merged, the same price exists in each. But the marginal revenue in the two markets is almost certain to be different in the two markets. Profits can be increased by shifting output from the low marginal revenue market to the high marginal revenue market since we lose only a small increase in revenue from the first market and replace it with a larger increase in revenue in the second market. Before price discrimination occurs, that is when the price is the same in both markets, there exists are clear relationship between the marginal revenues in the two markets and the elasticities. In particular, since MR=P(1-(1/n)), where n= price elasticity of demand, the market with the higher n must have a marginal revenue that is closer to the price, and vice-versa. Thus, markets with higher marginal revenues also have higher elasticities (note: only when the prices are the same!).

 Since we can increase profit by transferring output from low to high marginal revenue markets, we need to lower price in high marginal revenue markets (to increase sales) and raise price in low marginal revenue markets (to decrease sales).

This rule translates into one which goes:

raise price in the market with lower elasticity, lower price in the market with higher elasticity. Continue to do this until the marginal revenues are equated (note: when price is lowered in the high mr market, the mr falls, and vice-versa).

 Methods used to discriminate

 Movies :lower prices to over 65 and children. why?  over 65's are presumably more elastic. They have lots of time and other activities. In particular, they are not likely to come during peak periods, when the least elastic demanders view movies. Cost of servicing is also lower. Children tend to bring their parents. They also eat a lot. Higher cost of cleanup. But they also come during off peak hours. Weekend evenings are prime time. Working people and teenagers are hard-pressed to see movies at other times and have very inelastic demands. This is why we want to charge them the higher price. Others get the low price, but only children and old people can be distinguished at low cost.

 stamps (s&h green stamps, etc.)

  Stores pay the stamp company for the stamps which they give out. Customers get stamps based on the dollar amount of products they purchase. The stamp company redeems these stamps for various products purchased by the stamp company which the consumer can order when they have enough stamps. Stores using stamps have higher costs of doing business since they have to pay for the stamps to cover the costs of the stamp companies. These stores, therefore, have to raise their prices.

  Not all customers redeem the stamps. Some customers lose them, throw them out, or give them away. These customers therefore pay a price which includes the cost of the stamps, but receive nothing extra in return. Those customers who do redeem the stamps are reimbursed for the higher prices by the value of the merchandise they get. In fact, these consumers are subsidized by those who do not redeem the stamps. Thus these two groups (redeemers and non-redeemers) are charged different prices for merchandise sold by the store, and price discrimination is occurring.

 Why do we want to lower the price to those customers who redeem stamps? Presumably these customers are more elastic. After all, they are sensitive enough to price differentials that they are willing to go to the effort of collecting and redeeming the stamps. They presumably would react strongly to any price change.

 Cents-off coupons found in newspapers and product containers.

 Either retailers or manufacturers give back cash to consumers who bring the coupon to the retailer or return the coupon back to the manufacturer.

 Same basic idea as stamps. Those customers who are willing to take the time and effort to cut the coupons out of the paper, carry it with them, and present it to the cashier are fairly dedicated to getting a lower price for their purchases. They would seem to be the more elastic customers and they do receive a lower price than those customers who are not interested in redeeming the coupons.  how else can you explain coupons?

 Regular interval sales: Sales, such as tires as Sears, or food sales, which are quite predictable.

 People who are willing or able to wait can get the lower price. If your battery has died, or your tire has blown you need to get a replacement immediately and generally will have to pay the higher price. If you are not in such a hurry you can get a lower price. Once again, elastic customers get the lower price.

 Dumping: Mercedes had higher prices in the US than in Europe, relative to other makes.

  Geographical discrimination. American customers of this product are less elastic. Mercedes has a better reputation here than there. In Japan, on the other hand, automobile and other produces charge more at home than they do abroad. This is typical since the reputation of a car is usually strongest at home and weakest where it is least known. Japanese consumers much prefer Japanese products, so they are less elastic for Japanese producers.

 Airline fares: requirements for discount = 30 days in advance, stay over weekend.

 Discrimination here is between business and non-business customers. Business customers are less elastic since the value of a business trip is often far greater than the cost of the air fare and little preparation time is available. Business travelers do not as a rule stay over weekends and so they would not be able to take advantage of the lower fare. They also don't often have the luxury of planning 30 days in advance. People on vacation, on the other hand, usually want to stay over a weekend and plan far in advance. hardcover and paperback: markups on hardcover books are much higher than on paperbacks.  Customers are separated according to their urgency to purchase or their value placed on hardcover books. By delaying the paperback introduction the manufacturer is forcing impatient customers to pay a high price. These are probably low elasticity customers. Also, wealthier customers probably have higher reservation prices than others and also prefer hardcover books by a greater extent. The current practice charges a higher price to each group. Etc. for movies (tapes, cable, network). Books turned into screenplays.

  UNFORTUNATELY, THIS ANALYSIS NEGLECTS THE LONG TERM EFFECTS OF ALL FIRMS DOING THIS. However, we can’t get into details in this class.

 

Commodity Bundling (Block Booking)

Bundling consists of selling two or more products together as a package. It differs from tie-in sales in that tie-ins do not fix the quantities of the two goods sold up-front whereas bundling fixes the relative amounts of the two goods at the initial purchase. In other words, tie-in sales allow customers to use different amounts of the tied good whereas bundling forces them to be purchased in fixed proportions. Office Suites are a well-known bundle, as would be computers that come with preinstalled software; a la carte versus complete meals on the menu, etc.

  Computers and Stereo systems are good interesting examples. Complete computer systems are bundles, which normally include monitors, printers, and hard drives. Stereo systems consist of speakers, receivers, tape recorders, turntables, compact disks, etc. Manufacturers may sell complete bundles or they may prefer to sell each component separately, or both.

 It is interesting to note that high end stereos tend to be separate components, whereas high end computers tend to sold as systems. Why might this be?

Two types of bundling: mixed and pure.

Pure bundling: Producer only sells the goods as a bundle

mixed bundling: producer sells products both as a bundle and as separate units.

 Look at the diagram (figure bundle 1). Assume that consumers only buy 1 unit of good X and good Y. The points (large round dots) in this diagram represent people and their values (reservation prices - the maximum price they are willing to pay) for goods X and Y. The point labeled "Mr. A" represents Mr. A's maximum willingness to pay for X (Pax) and Y (Pay). The information on this diagram is the same as the information contained in the market demands for good X and good Y.

Px and Py are the normal profit maximizing prices for the two commodities X and Y. These prices were determined in the normal way. That is to say, the Px's are ranked in descending order to arrive at the demand curve for X (this is how a demand curve is derived, right?). This information is combined with the cost curves and used by the seller to derive the profit maximizing price, Px. The same is done for good Y to determine Py.

 Figure bundle 2 shows the profit maximizing prices Px and Py. This diagram also demonstrate which customers will buy which combinations of products. In the northeast quadrant customers buy both X and Y. In the southeast they buy neither good. In the northwest they by Y only. In the southeast they buy X only.

 Figure bundle 3 demonstrates the case of pure bundling. The downward sloping line represents the price of a bundle. The line must have a slope of 1 since dollars are on both axes. The price of the bundle can be read off either axis. Customers who have a combined value for X and Y greater than the price of the bundle purchase the bundle. Those are the customers to the NE of the bundle price line. Customers with a combined value less than the price of a bundle don't buy the bundle. Those are the customers to the southeast of the bundle line.

How does pure bundling compare with no bundling?

Figure bundle 4 give a particular pair of prices and a bundle price which is equal to the sum of the individual prices. In choosing between pure bundling and no bundling what considerations must be made?

In area B and D, consumers used to buy only one of the two goods. Now they buy both. In areas A and C consumers used to buy one of the two goods, now they buy none. What happens to profits?

Assume that A=20, B=30, C=25 and D=35.

B-C = change in sales of X = 30-25 = +5

D-A = change in sales of Y = 35-20 = +15

Therefore, at the bundle price Px +Py there will be a larger quantity of the two goods demanded than with no bundling. This allows the price of the bundle to be increased and total profits to go up. Of course, if A and C are large relative to B and D, total profits will fall.

 

 Another way of examining these changes is to calculate the marginal profit for X and Y. The changed sales of X multiplied by the marginal profit of X (this is imprecise since the marginal profit of X changes as the quantity of X changes) + the changed sales of Y multiplied by the marginal profit of Y = the change in total profits.

Bottom line: sometimes pure bundling is better than no bundling, sometimes not. It depends on the values of customers.

 

Block-Booking

This is a special case of bundling. In block booking consumers are forced to purchase blocks of products or none at all. Famous antitrust cases involving block booking have to do with being sold in blocks to theaters. Television broadcasters currently buy 'libraries' of movies as opposed to individual titles. Why don't the producers of these products sell the titles one at a time?

Stigler provides an answer.

His answer can be translated into the bundling scheme provided above. He assumes an inverse correlation between the demand for goods X and Y. This translates into tastes represented by a diagram as that shown as figure 1. Because of the inverse correlation, there are no separate prices for X and Y that can take away most of the consumers surplus from customers without also greatly reducing the number of customers actually purchasing the products. In this case, the imposition of bundling in place of pricing will be able to greatly increase profits.

Figure 2 demonstrates this possibility. The bundle is priced so as to remove almost all the consumers surplus yet the number of consumers is at a maximum. In this case pure bundling (block booking) beats pure pricing.

But this doesn't have to be the case. There will be many instances when pure pricing will be superior to pure bundling. It is easy to imagine an example where tastes are aligned in such a way that pure pricing can extract virtually all the surplus from consumers without deterring any consumers from purchasing the products. Yet no bundle could achieve anywhere near that level of results.

The basic intuition underlying these results is that when tastes (reservation prices) are fairly homogeneous for a good, across consumers, pricing will extract most surplus. And when tastes (reservation prices) are homogeneous across consumers for bundles then bundling will work particularly well. This essentially means that if demand curves for products are very flat, pure pricing will do very well at removing consumers surplus. But steeper curves means that pure pricing will leave much potential consumers surplus untapped. Sometimes, the demand for bundles will be flatter than the demand for individual goods, and that is when bundling will work best.

This practice is still common in the film industry. Here is a quote from Silver Screen Partners IV 1991 Annual Report:

A portfolio of films is often likened to a train, with a small number of "locomotives" providing the steam as the films travel through markets around the world. In the Silver Screen Partners IV portfolio, there are some powerful "locomotives" that were major box-office successes and have enormous value. Principal among them are: Beauty and the Beast, Pretty Woman, The Little Mermaid, Dick Tracy, Dead Poets Society, Turner and Hooch and The Rescuers Down Under.

In all forms of television throughout the world, including network and syndicated television and basic and pay cable, films are licensed as packages rather than on a film-by-film basis. As in any portfolio of films, in the Silver Screen IV portfolio there is a wide range of value between the weakest and the strongest films. The art of packaging is to combine the "locomotives" with a variety of other films to maximize the value of the entire portfolio.

 

Public Goods

Two definitions in the literature. Samuelson coined the term when explaining some economic difficulties with the way markets produce products such as television broadcasts.

a) Nonrivalrous consumption

b) Nonrivalrous consumption plus non-excludability of users

 

Are both of the factors totally dependent on the good itself, or do social conventions play a role? Clearly, a) is a function of the good itself, while non-excludability depends on the law and its enforcement.

Non-excludability causes problems in markets for private goods, as well as markets for nonrivalrous goods. If you can not exclude people from using what you create, you won’t create it. If you can’t exclude people from using what you own (your car, say) you wont purchase it. All markets break down.

We will adopt the first definition since it depends only on the good itself.

 

Why do we care about public goods?

Ideas, inventions and designs are public goods. They are also the basis for new technologies. Interestingly, the economic analysis of public goods is very different than the economic analysis of private goods.

How do markets produce public goods?

For Private Goods: demand curve of industry is the Horizontal sum of the demands for all consumers at the given price.

Assume there are four individuals in the market, Mr. A, Ms. B, Mr. C, and Mr. D.

For any given price, we find the quantity that each individual would want. We then add those quantities together to get the quantity the market demands at that price.

If a market had 100,000 consumers who wished to purchase 1 unit and 100,000 who wished to purchase 2 units, the total market demand at that price would be 300,000

For public goods, the analysis is quite different. The demand curve of industry is the Vertical sum of the demands for all consumers at the given quantity.

For any given quantity, we find the price that each individual would be willing to pay. We then add those prices together to get the total price the market is willing to pay for that unit.

If a market had 100,000 consumers who wished to purchase the third unit at a price of ten cents, and 100,000 who wished to purchase the third unit at a price of twenty cents, total market demand would be a willingness to pay $30,000 for the third unit of output.

 

Analyzing Public Goods

Think of book titles as public goods, but physical copies of single book title are private goods that embody a public good.

Several questions arise: how many titles are optimal to publish? How many copies of each title would be optimal? How do competitive markets work? Monopolies? Finally, is it possible to produce public goods efficiently?

 


Production of a Single book title

Take the case of the production of books. First we start with the production of book titles, then we move to the production of individual titles. There are problems with the usual assumption of homogenous units on the quantity axis. In order to come as close as possible to our usual assumptions, let us assume that these books are books by a single author such as John Gresham or Stephen King.

In the above diagram, the producer, having a copyright, and therefore monopoly, produces output Qm units of the book and sells them at a price of Pm.. Note that the profit maximizing quantity is found by equating the MC of printing with the MR curve [for items like software, the appropriate MCs would be the cost of reproduction]. The cost of writing the book doesn’t enter into these calculations at all. In order to determine if this book will be written, the profit (area 3+4) need to be contrasted with the cost of writing the book. As long as the profit is greater, the market will be able to contract to have the book written.

Note that to achieve economic efficiency, any book whose cost of writing is less than 1+2+3+4+7 should be written since it can provide value of 1+2+3+4+5+6+7+8 if sold at the cost of printing. By giving a copyright, some readers of books who get a value greater than the cost of producing the copy will not be able to buy a copy because the price is above MC of printing. Therefore, too few copies of books will be produced compared to the ideal. Note also that if the MC of printing is zero, the publisher (author) would produce up to the point where revenue was maximized (elasticity =1).

 

Production of Book titles

 

The demand for titles is supposed to be the vertical sum of the demands for titles by individual consumers. According to the diagram below, if the price of a title is P, this consumer will demand 7 titles. He will also receive consumer’s surplus of 1+2.


If the producer of books could perfectly discriminate, the amount that any consumer would pay would equal the value they place on each book title, and there would be no consumer surplus.

Determining the demand for titles is where the public good vertical addition of demands comes in. The supplier of titles is the author(s), who gets a payment for each title written. This price of a title is not the price that individual consumers pay, but is instead the total revenue net of printing costs that is available to the author (we assume that book producers only keep the printing costs which include a normal return on investment because the publishing market is competitive).


When determining the market output for this author, or for these close substitute titles, we can imagine two different demand curves. The “true” demand curve, which reflects the total value that society could in theory receive from the writing of the title is given by the perfectly discriminating demand curve. It is truly the sum of the demands of all individual consumers. The theoretically optimal output is Q*, such that every title which has a potential value greater than the cost of writing it gets produced.

The practical (attainable) demand curve represents the revenues that are actually attainable in the market for each individual title. The difference between these two demand curves is related to the areas 1+2 in the figure representing an individuals demand for titles. Q** is the best output we can get given the imperfect attainability of revenue. The producer of these titles, however, if there is monopoly power, will restrict output to Qm. From this we can conclude that the production of public goods will be less than the ideal level. However, it is unclear that there is any reasonable hope of improving this imperfect situation.

 

Joint Products

Joint Products are products that are jointly produced by a production process and which can be used for several noncompeting uses. For example, cows can be used to provide many different types of meat, or leather. The production of Tylenol creates a nitrogen based fertilizer as a by-product.

[Our interest in this model is that public goods can be thought of as a joint product (a single product can serve more than one consumer). The difference is that joint products are normally independent (beef and leather) whereas public goods are the same product sold to different individuals. When we discuss the economics of copying public goods we will treat originals and copies as two separate products that are imperfectly substitutable (imperfectly independent). But we will use this model.]

 The profit maximizing and socially efficient output of these products is somewhat more complicated than simple products.

The accompanying diagram represents some of these difficulties. It represents the market for steers, beef and hides. After steers are slaughtered, producers are left with both beef and hides. The demand for beef and hides are presented in the diagram, along with their marginal revenues.

Competitive solution:  Q=QC ; PH + PB = PS in figure.

The competitive solution is straightforward. The demand for steers, given by the vertical sum of the demand for hides and the demand for beef, intersects the marginal cost of producing steers at Qc. Competitive producers will continue to produce steers as long as the price of a steer is greater than the mc of producing it. Since any producer takes the price as given, PB + PH is compared to the mc of production. This is also the socially efficient solution.  It is possible that either PB or PH could equal zero. If the demand for hides, say, were low enough, the price of hides at Qc might very well be zero. It would be inefficient to prevent anyone from consuming the good since it has already been produced. Competition in the production of cows and hides will lower the price of hides to zero (it becomes a by-product of producing beef and has a zero economic marginal value.

Monopoly solution: Figure 2 Simple minded solution: Equate MC of steers with MR of steers.

This solution may in fact work. If the marginal revenue in both the beef and hide market is positive then this is the profit maximizing solution. If the marginal revenue in one of the markets is negative the profit maximizing solution will require throwing away some of one of the products. If the hide market has negative marginal revenue at output Q* then obviously total revenue in the hide market would increase if output of hides were decreased (leading to an increase in price). After all, this would remove the sale of units which were decreasing revenue. Profits would have to rise. In fact, total revenue in the hides market would be maximized when quantity was set to the point where the marginal revenue equals zero QH2 (with price of PH2). Remember that the marginal cost of hides to the left of Qc is zero since additional steers are being produced in order to sell the hides.  If the quantity of hides is reduced to QH2 then the marginal revenue of steers beyond QH2 becomes identical to the marginal revenue of beef, since only beef is being sold. Total profit maximization then requires that output Q2* of steers be produced. The price of beef is PB2. The quantity of beef sold is QB2 .

The market for new and used goods

This is a variation of the previous set of models. Here you have a good (say a textbook) which can, in its 2 period life, be both a new and a used book. Assume, for a moment that they are only imperfect substitutes for one another, i.e. that they are hardly substitutes at all, as beef and hides are not substitutes. Then there would be separate demands for new and used books. Benjamin and Kormendi is the best reading for this.

Producers of books, if they can rent them out for 1 period, will generate payments equal to the vertical sum of the demand curves. Now what happens if the book producers sell the books? If there is a resale market, we would expect the resale price to equal to rental price of used books, and the net demand for new books become the vertical sum of the pure demand for new books and the demand for used books. And what if there were no market for used books? Then consumers of used books would have to switch to new books if they wanted the books at all. This would lead to the horizontal addition of demand curves (if new books were very good substitutes for used books). The less perfect new books are as substitutes for used books, the lower the demand until it equals the pure demand for new books if they are not substitutes at all.

This is illustrated in the accompanying diagram. For convenience, the demand for new books is assumed identical to the demand for used books. D1 is the demand for new books and D2 is the demand for used books. If new and used books are substitutes, and if the used book market is eliminated, the demanders of used books would switch to the new book market. The addition of new and used demanders in the new book market would lead to a net demand for new books of Dh, the horizontal sum of D1 and D2. If new and used books were only imperfect substitutes, then the net demand curve would lie between D1 and Dh. The less substitutable they are, the closer the curve would lie to D1.

If the used book market is allowed to exist, the net demand is the vertical sum Dv. When would a firm be better off? With or without a used market? This will depend on what the marginal cost cure looks like. It could look like MC1 or MC2.  With a curve like MC1 Dv lies above Dh at the intersection of the demand with the MC curve. If the industry were competitive the equilibrium would lie at the intersection of the demand and mc curves, which would mean the industry would be better off if the used good market existed (implying that Dv was the appropriate demand curve). A monopoly will prefer to produce a smaller output than a competitive firm, so that a monopoly would also produce where Dv lies above Dh, meaning that with a mc of MC1 the monopoly would be better off with the used market.

With a curve like MC2, the competitive market will be better off eliminating the used market (Dv) and having Dh in its place since Dh leads to both a higher price and a higher quantity. A monopolist may or may not be better off eliminating the used market.

If the used market does restrict the profitability of the producer there are several ways in which to enhance profits:

 a. Eliminate used market through legislation.

 b. Rent the items instead of selling them.

 c. Reduce the durability of the product.

 All three methods have costs. Eliminating the used market may not be practical. It may not be legal. It may be expensive.

 Renting the product allows the producer to keep complete control over the quantity of the item available in every period. There is a cost involved with renting, however.

The main cost in renting is the monitoring that is required to make sure that the rentee is not mistreating the product. Renters, since they don't have to suffer any consequences from mistreating durable goods, have less incentive to properly care for them. This tends to increase the number of repairs that must be made, decreases the life expectancy, and lowers the resale value of the good. This is one reason that rented houses cost more than the mortgage carrying costs to the landlord (of course large deposits can alleviate this risk to the landlord). The same should hold true for rented versus sold automobiles except that so often, for the first 3 or 4 years, the purchaser doesn't own the car and thus someone else besides the owner (the bank which made the auto loan) bears some costs if the purchaser decides to mistreat the automobile and walk away from the loan.

What does this imply for the producers of goods which can be copied?

Public goods: goods such that one person's consumption doesn't reduce anyone else's possible consumption. Ideas, computer programs, songs, stories, etc. are examples of these type of goods.

When people can make copies of originals, they are willing to pay more for originals. Making tapes of records, copies of software, etc., are all examples of this.  A key element here is the number of copies made of each original. If, for example, every purchaser of a record made exactly one cassette for use in an automobile, then the net demand for records would be the vertical sum of the demand for just record use and the demand for cassettes, and record producers should be able to price the product and collect revenues from the use of cassettes by raising the price of records. But if some users made 100 copies and other made none, then the vertical sum would consist of two segments, and it would be hard to collect revenues from those making tapes without charging a price which was too high to keep the non copiers in the market.

Site licensing is a form of pricing which explicitly recognizes the extra value in making copies.

Higher journal prices to libraries is another form of this pricing.

A test of this model: Liebowitz 1985

Dependent variable

Constant

Cites

Commercial/NonProfit Dummy

Age of Journal

Rsquare

Plib/PInd

1.29

.0065 [1.99]

.65      [4.14]

 

.17 n=80

Plib/PInd

1.38

.0071 [2.14]

.578     [3.36]

-.16 [1.01]

.17

 

 

Libraries that

1959

1983

Price Discriminate

3

59

Don’t Price Discriminate

35

21

 

Ratio of Book to Journal Expenditures, US Academic Libraries

1941

3.02

1961

3.19

1975

1.70

1944

3.41

1965

3.36

1977

1.54

1946

3.13

1968

3.67

1979

1.26

1950

3.01

1971

2.96

1981

1.13

1959

2.46

1973

1.96

 

 

 

Application to Napster

The entertainment industry has always exaggerated the damage to itself that each new copying technology would bring—from reel-to-reel tapes and videorecorders, to MP3s and Napster. Crying ‘wolf’ too many times, however, shouldn’t by itself negate claims that a new technology will harm copyright owners. Napster is one of those cases where it does.

When record companies estimate the harm they suffer from illicit copying activities, they incorrectly assume that every unauthorized copy substitutes for a sale of an original. No less an authority than Alan Greenspan, when he was still a civilian economist with record companies as his clients, was willing to estimate the harm in this manner.

The are two key factors that actually determine whether copying harms copyright owners, however. First is the question of whether the material being copied substitutes for a sale of an original. Obviously, not everyone willing to use a pirated copy of a work would also be willing to purchase an original. The second, more subtle factor, which I first examined two decades ago, is whether it is possible for copyright owners to indirectly collect revenues from the copying activity.

This last point can be illustrated with the following example. If all purchasers of CDs were to make a single cassette, say for use in their automobiles, record producers need merely raise the price of the CD by an amount that roughly captures the additional value consumers receive from making the cassette. This would allow record companies to indirectly capture the revenue from the copying activity. Illicit copying then increases the price that consumers will pay for CDs and record producers are not harmed.

Alternatively, if certain users made numerous copies, and those users could be identified and charged a higher price than other users, the copyright owner might also benefit from the copying activity. This is what currently happens with photocopying in libraries. Libraries pay a price two, three, or even four times as much as personal subscribers for the same heavily copied journals, and this price differential only arose after the introduction of photocopiers.

Note that if this unauthorized copying were eliminated, copyright holders might actually be worse off. In a world with no copying, record producers might find that consumers are unwilling to pay as much for CDs, lowering revenues and profits (it is not clear how many, if any, of the former copiers would purchase legal copies).

The Betamax case, so called because at the time the case was brought VHS had not yet begun its obliteration of the Beta video format, represented another instance where copying was unlikely to harm copyright owners, althouh for slightly different reasons. Almost all viewing in the early 1980s was of advertising-based over-the-air broadcasters, particularly the big three networks—ABC, CBS, and NBC. Viewers made tapes to timeshift programs for more convenient viewing. Although remote controls made it possible for viewers to fast-forward through commercials, close attention had to be paid to ensure that the viewer wouldn’t also skip by the programming. Combined with the fact that the amount of time-shifting had to be small, it is clear that Betamax was not going to harm copyright owners.

Why would the amount of time shifting be small? Because there was too little free viewing time. The average household viewed six or seven hours of TV a day, including virtually complete participation in prime time programming. There was little free viewing time to watch tapes since a family could not both watch a tape and record a program on their single videorecorder.

Thus it was proper to conclude that videorecorders would not harm the revenues of copyright holders. Fortunately, the courts managed to get it right. Several years later, Hollywood learned that by lowering the price of prerecorded movies from $100 to $20, they could sell a ton of them, so that now Hollywood’s sale of videotaped movies generates more revenue than theatrical showings.

Fast-forward to 2000. Napster’s supporters claim that the online sharing of songs is a latter-day Betamax scenario. They claim that Napster users actually purchase more CDs because Napster allows listeners to sample music with which they might otherwise be unfamiliar. Although some such effect undoubtedly occurs, it seems most unlikely that it would outweigh the negative impacts on copyright holders.

Unlike the cassette example mentioned above, Napster does not allow record companies to indirectly capture the value of the copies being made from legal originals since some originals will have dozens or hundreds of copies made and others none. Nor does it seem likely that the amount of copying will be small—there are no time constraints or confusing instructions preventing widespread copying. Finally, copies are likely to serve as substitutes for the purchase of originals in this case. The people making the copies are the very group that was expected to purchase originals (that is why it is not surprising that surveys indicate that Napster users are among the heaviest purchasers of CDs).

Record companies are right to fear Napster. The Internet, however, should prove a boon to them, once they can get the right pricing. As was true in the video example, record companies need to learn that they are currently charging way too much for music downloads. When they learn that it is more profitable to lower their prices, even if it largely destroys record stores, the old distribution methodology will be seen for what it is—primitive and inefficient.

 

Network Effects

A little background: review the concept of natural monopoly, and the tragedy of the commons.

Natural monopoly: the AC of a firm falls continuously. In an industry where firms have such cost curves, a single firm is likely to become dominant, thus the term natural monopoly. These were the ‘public utilities’.

Define external effect and externality.

Tragedy of the commons: The ‘negative’ externalities that fishermen have on each other cause them to overuse the lake.

Network externality has been defined as a change in the benefit, or surplus, that an agent derives from a good when the number of other agents consuming the same kind of good changes (Katz and Shapiro 1985). As fax machines increase in popularity, for example, your fax machine becomes increasingly valuable since you will have greater use for it.

Sometimes called network externalities, but this is a lazy usage.

Two types of network effects have been identified. Direct network effects have been defined as those generated through a direct physical effect of the number of purchasers on the value of a product (e.g. fax machines). Indirect network effects are “market mediated effects” such as cases where complementary goods (e.g. toner cartridges) are more readily available or lower in price as the number of users of a good (laser printers) increases.

Putting aside definitional concerns, the import of network effects comes largely from the belief that they are endemic to new, high-tech industries, and that accordingly such industries experience problems that are different in character from the problems that have, for more ordinary commodities. The purported problems due to network effects are several, but the most arresting is a claim that markets may adopt an inferior product or network in the place of some superior alternative, which we shall investigate below.

Read the material in Liebowitz and Margolis to understand how our model of network effects shows that getting stuck is possible, but not likely. Chapter 5.

1.  Levels of Network Related Activities

The difference between a network effect and a network externality lies in whether the impact of an additional user on other users is somehow internalized. Since the synchronization effect is almost always assumed to be positive in this literature, the social value from another network user will always be greater than the private value. If network effects are not internalized, the equilibrium network size may be smaller than is efficient. For example, if the network of telephone users were not owned, it would likely be smaller than optimal since no agent would capture the benefits that an additional member of the network would confer on other members. (Alternatively, if the network effects were negative a congestion externality might imply that networks tend to be larger than optimal.) Where networks are owned, this effect is internalized and under certain conditions the profit maximizing network size will also be socially optimal. (see Liebowitz and Margolis 1995b.)

Perhaps surprisingly, the problem of internalizing the network externality is largely unrelated to the problem of choice between competing networks that is taken up in the next section.  In the case of positive network effects, all networks are too small. Therefore, it is not the relative market shares of two competing formats but rather the overall level of network activity that will be affected by this difference between private and social values. This is completely compatible with standard results on conventional externalities. For reasons that we will expand on below, this is a far more likely consequence of uninternalized network effects than the more exotic cases of incorrect choices of networks, standards or technologies.

Network size is a real and significant issue that is raised by network effects.  Nevertheless, this issue has received fairly little attention in contemporary discussions of network externality, perhaps because it is well handled by more conventional economic  models.

 

The 3 Meanings of Lock-In or Path  Dependence

Three distinct forms of path dependence.

First-degree path dependence: Complete knowledge of the future when decision is made, but at some points we have what appears to be regret and inefficient results.  One plans on having a family and buys a large house. Things work out as predicted. When the kids leave the house it too big for just the parents. But this was predictable, and could not be improved upon. Or, you buy a computer. A year later a better computer comes out, as you knew it would, and you wish you had that one. But as a whole you made the best decision.

Second-degree path dependence is durability in the presence of imperfect information. Information is never perfect. Here you buy the big house but wind up getting divorced, which was not planned. This is real regret. And the results are not what you would have wanted if you had know what would happen. But you don’t. or you buy a computer. Next year one comes out that is much better than you anticipated and you would have waited had you known. You make the wrong decisions, but they were correct given your information. The error is not remediable.

Third-degree path dependence involves remediable error. You know you are going to get divorced but by a new house knowing it is a bad idea. You know it would be better to wait, but you buy by a computer now anyway.

The failure to distinguish among these three discrete forms of path dependence has led to some unfortunate mistakes. The error here involves transferring the plausibility of the empirical and logical support for the two weaker forms of path dependence (first- and second-degree) to the strongest implications of third-degree path dependence. Although it is fairly easy to identify allocations, technologies, or institutions that are path-dependent in some form, it is very difficult to establish the theoretical case or empirical grounding for path-dependent inefficiency.

First- and second-degree path dependence are commonplace.

Only third degree is new.

It seems impossible to read David or Arthur and not conclude that this third degree lock-in to inferior technologies is the centerpiece of their theories.

A Popular Version of Lock-In

Here is the way the story usually goes:

ROCKY ROAD

JANUARY 18, 1996

TRANSCRIPT

 


This week Apple Computer, one of the giants of American technology, announced large losses and a painful reorganization. The story provides reason to wonder why some inventions like Apple's Macintosh have trouble in the marketplace. Business Correspondent Paul Solman of WGBH-Boston reports.

 

PAUL SOLMAN: In the event you've been on Mars for the past few months, Microsoft, the Tyrannosaurus Rex of computer software, has successfully launched Windows 95. One goal of the new program is to make the IBM type computers it runs, so-called PC's, easier to operate. Microsoft's other goal: To bury rival systems, most notably the one that runs the Apple Macintosh.


MAN: (Apple Commercial) Hey, you want to see some dinosaurs?

CHILD: Yeah, dinosaurs.

MAN: Loading DOS CD into Windows 95.

CHILD: Where are the dinosaurs, dad?

MAN: I'm not sure.

PAUL SOLMAN: Apple has counter-advertised, touting the legendary user-friendliness of its Macintosh, with its Mac operating system.

ANNOUNCER: If you're looking for a computer that's easy to use--

MAN: Where are you going to kiddo?

CHILD: To the Crandells; they have a Mac.

ANNOUNCER: (Apple Computer) There's still only one way to go.

PAUL SOLMAN: Actually, there's not only one way to go in computer operating systems, at least not yet, and Apple's lucky there isn't, for if there were, the one way would probably be PC's like the IBM running on Microsoft Windows, not the Mac, despite the fact that the Mac technology has widely been considered superior to Microsoft for a decade.

SPOKESMAN: Quick Time VR is a brand new technology that we brought out about a year ago, which allows us to capture environments like this with a standard 35-millimeter camera, bring those images to the computer, and have our computer stitch the images together, and you'd get a 360-degree panoramic scene.

PAUL SOLMAN: Apple's struggle to compete with Microsoft-driven PC's may seem like inside baseball for businessmen but it actually provides a key insight for understanding the world of technology around us. Among the most famous quotes in business history is Ralph Waldo Emerson's: "If a man make a better mousetrap than his neighbor, though he build his house in the woods, the world will make a beaten path to his door." In fact, there are better mousetraps than this one, the ultrasonic pest repeller, for example, yet, this remains the standard. Similarly, the Apple Macintosh may be the better mousetrap in computing, yet, the world has beaten a path to the IBM PC and Microsoft. The question is: Why? Well, one useful answer is an idea known as path dependency, i.e., once enough people follow a particular path in technology, that path becomes the standard one on which future technology and products depend. Consider keyboard technology. Using the same text and equally skilled typists, it was demonstrated back on the silent film in the 1930's that you could type 165 words a minute with the keyboard on the right versus 131 on the left, and which is the one we all use? The apparently slower, older one on the left. The Dvorak System on the right claims to demand less of a left hand, less row to row finger hopping, no irksome pinky stretches. The arrangement of the letters seems to be more efficient but almost no one uses it.

DON NORMAN, Psychology Professor: Dvorak in the 1930's did a whole host of human factor studies and made a keyboard that was far superior--too late. Once you have an installed base, once you have tens of millions of people using the typewriter, it's too expensive to change. And for a small improvement in learning and typing speed, it is not worth it.

PAUL SOLMAN: Don Norman, a long-time psychology professor, is trying to forge new paths for Apple, making its technology ever easier for the consumer. As for Emerson's quote about the better mousetrap, he's blunt.

DON NORMAN: Just not true.

PAUL SOLMAN: And it's not true because?

DON NORMAN: Because Herbert Simon had invented this wonderful concept of satisfy-sync. When something is satisfactory, you don't need to have perfection, and so if something is good enough and serves your needs, then people will buy it, and if people find others buying it, then they will buy it, and soon more and more people buy it. And then soon if somebody comes out with a better thing, like the Dvorak keyboard, well, but this one seems good enough, why should I make an effort to switch?

PAUL SOLMAN: It's arguably the same story with every technology, from the keyboard to the paper clip, when Henry Petroski of Duke has studied.

HENRY PETROSKI, Duke University: What we want the paper clip to do is to sit there, preferably not crease the paper, preferably not leave any permanent marks in the paper, not rust. We'd like it not to come off accidentally. Of course, we wanted it to hold tight while it was on the papers. We don't want it to tear the paper or, or rip the paper when it's coming off.

PAUL SOLMAN: The standard Gem clip falls short on each of these counts. Since its invention in the late 1800's, rust-proof, angular, ribbed, and butterfly clips have all challenged the flawed Gem unsuccessfully.

HENRY PETROSKI: People adapt to technologies that have limitations or have shortcomings, and after a while, we adapt so well that we don't notice the shortcomings.

PAUL SOLMAN: Or for that matter the computer. Apple was the first to come out with an easy to use graphic operating system. Click on an icon and voila, the machine responds. Microsoft did develop its own graphic operating system, Windows, for the IBM PC, but years late, and a few features short. So why does the well-beaten path now lead to PC's with Windows and not Macs with the Apple operating system? Partly, it's Apple's own fault. When Apple launched the Mac with its famous 1984 TV ad, it made what is now seen as a strategic business blunder, refusing to license its graphic user-friendly operating system to other manufacturers. By contrast, Microsoft, which owned the software system to run IBM PC's, licensed its technology to all comers. Today, 10 years later, Microsoft has some 85 percent of the market. As more software programs are written exclusively for Microsoft-driven PC's, it becomes more difficult for lawyer Mac users to resist the IBM Microsoft path. Software designer Richard Anders.

RICHARD ANDERS, Software Designer: Normally, if you're a developer and you look at the numbers and you see that Apple, depending on the market, has anywhere from 10 to maybe on the high end in educational markets or something like that 20 or 30 percent, when you look at those numbers, you start to think, these are very grim; if I'm going to develop software, I want it to be like Willie Sutton said, where the money is, and the money is on the PC side, where everybody else is.

PAUL SOLMAN: If you go into a computer store today, says Anders, there are seven aisles of PC software written for Windows for every aisle of software written for the Mac.

ANNOUNCER: (commercial) Oh, the things people do to decide between two TV shows they want to watch.

PAUL SOLMAN: Now, there's a recent precedent for the Microsoft-Macintosh battle in which the better mousetrap also didn't win: Sony Betamax versus VHS. Again, Apple's Don Norman.

DON NORMAN: Yes, Beta was superior to VHS, but there was a deadly marketing war going on, where the other Japanese companies banded together to teach Sony a lesson, because Sony was being too arrogant and trying to retain all of the property rights for Beta.

PAUL SOLMAN: Beta was better, but Matsushita, JVC, and the rest had the better strategy, teaming up to set a common standard, which induced more movies to be put onto VHS, more consumers to buy the machines to play the movies, you get the picture. Microsoft has, in effect, done the same thing, promoted a sharing of strategy to create an industry standard and to be sure, it's also marketed like mad, throwing its weight around monopoly-like, some would say illegally, to keep the competition at bay. It's in this context that the new improved Windows 95 is luring more consumers down the Microsoft path, while Apple, as it happens, has been stumbling, with manufacturing delays, batteries catching on fire, key executives leaving, and talk of a failed merger with IBM. Now, with newly-reported losses, the company is actually planning significant layoffs. But, says Apple, all is not lost. The company's counting on loyalty to keep its current customers' innovation to attract new ones.

SPOKESMAN: Let's talk about computer voice synthesis.

PAUL SOLMAN: Moreover, since Apple, unlike Microsoft, produces both the software and the hardware for the computers, themselves, it says it can develop and build new ideas into its machines more quickly and cheaply than the competition.

COMPUTER SYNTHESIZER: My name is Bruce. I am generally considered to be one of the best voice synthesizers in the industry today.

PAUL SOLMAN: Also, Apple's finally sharing, having licensed its operating system to other companies to make cheaper Apple clones, but perhaps Apple's best hope for the future is the Internet.

PAUL SOLMAN: Hi, Larry.

PAUL SOLMAN: That high speed network of telephone cables and modems connecting millions of computers worldwide. From company headquarters in Cupertino, California, I'm using Apple Quick Time Conferencing software to play tic tac toe on the Internet with Larry Duffy at the jet propulsion lab in Pasadena over a satellite photo of Mars he just sent me.

SPOKESMAN: You've beaten me. I'm overwhelmed.

PAUL SOLMAN: Information sent on the Internet all adheres to a common standard. It doesn't matter whether it's a Mac or PC at the end of the line, and that gives Apple executives like Don Norman hope.

DON NORMAN: We now suddenly have a way that makes it easy to move around the world and it doesn't matter what computer you're using, and if we move that way, and the new Internet is an example of how it happens, then it's a whole new game again, a completely new game, where the best products can compete and can win.

PAUL SOLMAN: Well, Don Norman may be right and then again he may not be. After all, future paths will depend on all sorts of things that haven't yet happened. But for the present, path dependence can explain a lot about how and why the world of technology around us has taken the shape it has and why the better mousetrap doesn't necessarily prevail.

2.The Simple logic of Third Degree Path Dependence and Lock-In.

If larger competitors have a forever widening advantage over smaller firms, we have entered the realm of natural monopoly, which is exactly where most models of network effects find themselves. Traditionally it has been assumed that the natural monopolist who comes to dominate a market will be at least as efficient as any other producer. This assumption is challenged in the network literature although specifics differ across the many models populating it.

 The mere existence of network effects and increasing returns is not sufficient to lead to the choice of an inferior technology, however. For that, some additional assumptions are needed.

The path dependence literature assumes natural monopoly, and then argues that society often gets stuck with the wrong natural monopoly when it relies on markets. Since network effects are presumed to lead to natural monopoly, these theories dovetail nicely.

The logic of path dependence can be illustrated with the following table, reproduced from Brian Arthur's papers. (We've added the Beta and VHS notations).