35 Information Technology

35 Information Technology - CHAPTER 3 5 INFORMATION...

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Unformatted text preview: CHAPTER 3 5 INFORMATION TECHNOLOGY One of the most radical changes in the economy in the last 15 years has been the emergence of the information economy. The popular press is filled with stories about advances in computer technology, the Internet, and new software. Not surprisingly, many of these stories are on the business pages of the newspaper, for this technological revolution is also an economic revolution. Some observers have gone so far as to put the Information Revolution on a par with the Industrial Revolution. Just as the Industrial Revolution transformed the way goods were produced, distributed, and consumed, the Information Revolution is transforming the way information is produced, distributed, and consumed. It has been claimed that these dramatically new technologies will require a fundamentally different form of economics. Bits, it is argued, are fun— damentally different than atoms. Bits can be reproduced costlessly and distributed around the world at the speed of light, and they never deteri0« rate. Material goods, made of atoms, have none of these properties: they are costly to produce and transport, and they inevitably deteriorate. It is true that the unusual properties of bits require new economic anal— ysis, but I would argue that they do not require a new kind of economic 650 INFORMATION TECHNOLOGY (Ch. 35) analysis. After all, economics is primarily about people not goods. The models we have analyzed in this book have had to do with how people make choices and interact with each other. We have rarely had occasion to refer to the specific goods that were involved in the transactions. The fundamental concerns were the tastes of the individuals, the technology of production, and the structure of the market, and these same factors will determine how markets for information will work . . . or not work. In this chapter we will investigate a few economic models relevant to the information revolution. The first has to do with the economics of networks, the second with switching costs, and the third with rights management for information goods. These examples will illustrate how the fundamental tools of economic analysis can help us to understand the world of hits as well as the world of atoms. 35.1 Systems Competition Information technology is generally used in systems. Such systems involve several components, often provided by different firms, that only have value if they work together. Hardware is useless without software, a DVD player is useless without DVD disks, an operating system is worthless without applications, and a web browser is useless without web servers. All of these are examples of complements: goods where the value of one component is significantly enhanced by the presence of another component. In our discussion of consumer theory, we described left shoes and right shoes as complements. The cases above are equally extreme: the best computer hardware in the world can’t function unless there is software written for it. But unlike shoes, the more software that is available for it, the more valuable it becomes. Competition among the providers of these components often have to worry just as much about their “complementors” as their competitors. A key part of Apple’s competitive strategy has to involve their relations with software developers. This gives competitive strategy in information technology (IT) industries a different flavor than strategy in traditional industries. 1 35.2 The Problem. of Complements To illustrate these points, let us consider the case of a Central Process- ing Unit (CPU) and an Operating System (OS). A CPU is an integrated 1 See Shapiro, Carl and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy, Harvard Business School Press, 1998, for a guide to competitive strategy in IT industries. THE PROBLEM OF COMPLEMENTS 651 circuit that is the “brain” of a computer. Two familiar manufacturers of CPUs are Intel and Motorola. An OS is the software that allows users and applications to access the functions of the CPU. Apple and Microsoft both make operating systems. Normally, a special version of an operating system has to be created for each CPU. From the viewpoint of the end user, the CPU can only be used if there is a compatible operating system. The CPU and the OS are complements, just as left shoes and right shoes are complements. ' The most popular CPUs and 038 in the world today are made by Intel and Microsoft, respectively. These are, of course, two separate companies that set the prices of their products independently. The PowerPC, another popular CPU, was designed by a consortium consisting of IBM, Motorola, and Apple. Two commercial operating systems for the PowerPC are the Apple OS and IBM’s AIX. In addition to these commercial operating sys— tems, there are free systems like BSD and GNUdLinux that are provided by groups of programmers working on a volunteer basis. Let us consider the pricing problem facing sellers of complementary prod- ucts. The critical feature is that the demand for either product depends on the price of both products. If p1 is the price of the CPU and 102 is the price of the OS, the cost to the end user depends on p1 -+- 102. Of course, you need more than just a CPU and an OS to make a useful system, but that just adds more prices to the sum; we’ll keep things simple by sticking with two components. The demand for CPUs depends on the price of the total system, so we write D(p1 +102). If we let C; be the marginal cost of a CPU and F the fixed cost, the profit-maximization problem of the CPU maker can be written mfx (p1 — 01)D(P1 +P2) — F1- 1 Similarly, the profit—maximization problem of the OS maker can be written 128$ (P2 " Ci)D(P1 +292) — F2. 2 In order to analyze this problem, let us assume that the demand function has the linear form DUO) = a — bp- Let us also assume, for simplicity, that the marginal costs are so small that they can be ignored. Then the CPU profit-maximization problem becomes “33X 101 [a — b(101 +p2)l - F1: or rrzijax cpl — bpf - bplpg — F1. 1 652 INFORMATION TECHNOLOGY (Ch. 35) It turns out that the marginal revenue from a price increase Ap; is (a ‘ 2bpl — 5P2) A191. If profit is maximized, then the change in revenue from an increase in p1 must be zero: a—2bp1 — bpg = 0. Solving this equation we have qa*bp2 101— 2b - In exactly the same way, we can solve for the profit—maximizing choice of the OS price: __ a ‘— bpl P2 ~ 2b - Note that the optimal choice of each firm’s price depends on what it expects the other firm to charge for its component. As usual, we are interested in a Nash equilibrium, where each firm’s expectations about the other’s behavior are satisfied. Solving the system of two equations in two unknowns, we have _._ _9 CL P1 - Z72 — 3b. This gives us the profit-maximizing prices if each firm unilaterally and independently sets the price of its component of the system. The price of the total system is 2a 101 + 272 = 3;];- Now let us consider the following experiment. Suppose that the two firms merge to form an integrated firm. Instead of setting the prices of the components, the integrated firm sets the price of the final system, which we denote by p. Its profit-maximization problem is therefore max p(a — bp). :0 The marginal revenue from increasing the system price by Ap is (a — 2bp) Ap. Setting this equal to zero and solving, we find that the price that the integrated firm will set for the final system is THE PROBLEM OF COMPLEMENTS 653 Note the following interesting fact: the profit—maximizing price set by the integrated firm is less than the profitrmaximizing price set by the two independent firms. Since the price of the system is lower, consumers will buy more of them and be better off. Furthermore, the profits of the inte— grated firm are larger than the sum of the equilibrium profits of the two independent firms. Everyone has been made better off by coordinating the pricing decision! This turns out to be true in general: a merger of two monopolies that produce complementary products results in lower prices and higher profits than if the two firms set their prices independently.2 The intuition is not hard to see. When firm 1 contemplates a price decrease for the CPU, it will increase demand for CPUs and 085. But it only takes into account the impact on its own profit from cutting price, ignoring the profits that will accrue to the other firm. This leads it to cut prices less than it would if it were interested in maximizing joint profit. The same analysis applies to firm 2, leading to prices that are “too high” from the viewpoint of both profit~maximization and consumer surplus. Relationships among Complementors The “merger of complementors” analysis is provocative, but we shouldn’t immediately leap to the conclusion that mergers of OS and CPU manu— facturers are a good idea. What the result says is that independent price setting will lead to prices that are too high from the viewpoint of joint profitability, but there are lots of intermediate cases between totally inde— pendent and fully integrated. For example, one of the firms can negotiate prices for components and then sell an integrated bundle. This is, more or less, what Apple does. They buy PowerPC CPUs in bulk from Motorola, build them into computers, and then bundle the operating system and computers together for sale to the end customers. Another model for dealing with the systems pricing problem is to use revenue sharing. Boeing builds airplane bodies and GE builds airplane engines. The end user generally wants both a body and an engine. If GE and Boeing each set their prices independently, they could decide to set their prices too high. So what they do instead is to negotiate a deal in which GE will receive a fraction of the revenue from the sale of the assembled aircraft. Then GE is happy to have Boeing negotiate to get as high a price as possible for the package, confident that it will receive its specified share. 2 This rather remarkable fact was discovered by Augustin Cournot, whom we previously met in Chapter 27. 654 INFORMATION TECHNOLOGY (Ch. 35) There are other mechanisms that work in different industries. Consider, for example, the DVD industry mentioned in the introduction. This has been a very successful new product, but making it work was tricky. Con— sumer electronics firms didn’t want to produce players unless they were as- sured that there would be plenty of content available, and content providers didn’t want to produce content unless they were sure that would be lots of DVD players out there. On top of this, both the consumer electronics firms and the content producers would have to worry about the pricing of complements problem: if there were only a few providers of players and only a few providers of content, then they would each want to price their products “too high,” reducing the total profit available in the industry and making consumers worse off. Sony and Philips, who held the basic patents on the DVD technology, helped solve this problem by licensing the technology widely at attractive prices. They also realized that there had to be a lot of competition to keep the prices down and kick start the industry. They recognized that it was much better to have a small share of a large, successful industry than to have a large share of a nonexistent industry. Yet another model for relationships among complementors might be called “commoditize the complemen .” Look back at firm 1’s profit maxi— mization problem: IgaXPiDWi +102) — F1- 1 At any given configuration of prices, reducing p1 may or may not increase firm 1’s revenues, depending on the demand elasticity. But lowering p2 will always increase firm 1’s revenue. The challenge facing firm 1 is then: how can I get firm 2 to cut its price? One way is to try to make competition for firm 2 more intense. Vari- ous strategies are possible here, depending on the nature of the industry. In technology—intensive industries, standardization becomes an important tool. An OS producer, for example, would want to encourage standardized hardware. This not only makes its job easier, but it also ensures that the hardware industry will be highly competitive. This will ensure that com- petitive forces push down the price of hardware and reduce the total system price to end users, thereby increasing the demand for operating systems.3 35.3 Lock-In Since IT components often work together as systems, switching any one component often involves switching others as well. This means that the 3 See Brandenburger, Adam and Barry Nalebuff, Competition, Doubleday, 1997 for further analysis of strategy for complementors. LOCK-IN 655 switching costs associated with one component in IT industries may be quite substantial. For example, switching from a Macintosh to a Windows- based PC involves not only the hardware costs of the computer itself, but also involves purchasing of a whole new library of software, and, even more importantly, learning how to use a brand new system. When switching costs are very high, users may find themselves experi— encing lock—in, a situation where the cost of changing toa different system is so high that switching is virtually inconceivable. This is bad for the con— sumers, but is, of course, quite attractive for the seller of the components that make up the system in question. Since the locked-in user has a very inelastic demand, the seller(s) can jack up the prices of their components to extract consumer surplus from the user. Of course, wary consumers will try to avoid such lock—in, or, at the very least, bargain hard to be compensated for being locked in. Even if the consumers themselves are poor at bargaining, competition among sellers of systems will force prices down for the initial purchase, since the locked—in consumers can provide them with a steady revenue stream afterwords. Consider, for example, choosing an Internet service pr0vider (ISP). Once you have committed to such a choice, it may be inconvenient to switch due to the cost of notifying all of your correspondents about your new 6- mail address, reconfiguring your Internet access programs, and so on. The monopoly power due to these switching costs means that the ISP can charge more than the marginal cost of providing Service, once it has acquired you as a customer. But the flip side of this effect is that the stream of profits of the locked-in customers is a valuable asset, and ISPs will compete up front to acquire such customers by offering discounts and other inducements to sign up with them. A Model of Competition with Switching Costs Let’s examine a model of this phenomenon. We assume that the cost of providing a customer with Internet access is 0 per month. We also assume a perfectly competitive market, with many identical firms, so that in the absence of any switching costs, the price of Internet service would simply be p : c. But now suppose that there is a cost .3 of switching ISPs and that ISPs can oifer a discount of size d for the first month to attract new customers. At the start of a given month, a consumer contemplates switching to a new ISP. If he does so, he only has to pay the discounted price, p — d, but he also has to endure the switching costs 3. If he stays with his old provider, he has to pay the price p forever. After the first month, we assume that both providers continue to charge the same price p forever. The consumer will switch if the present value of the payments to the new provider plus the switching cost is less than the present value of the 656 INFORMATION TECHNOLOGY (Ch, 35) payments to the original ISP. Letting r be the (monthly) interest rate, the consumer will switch if (p—d)+1—j+s<p+-IZ. r 7" Competition between providers ensures that the consumer is indifferent between switching or not switching, which implies (P—d)+5=p- It follows that d = s, which means the discount offered just covers the switching cost of the consumer. On the producer side, we suppose that competition forces the present value of profits to be zero. The present value of profit associated with a single customer is initial discount, plus the present value of the profits in future months. Letting r be the (monthly) interest rate, and using the fact that d = s, the zero—profit condition can be written as (p—s)—c+p—C=0. (35.1) 7‘ Rearranging this equation gives us two equivalent ways to describe the equilibrium price: p — c r p — c + 2 s, (35.2) 01‘ 7. 1+r Equation (35.2) says that the present value of the future profits from the consumer must just equal the consumer’s switching cost. Equation (35.3) says that the price of service is a markup on marginal cost, with the amount of the markup is proportional to the switching costs. Adding switching costs to the model raises the monthly price of service above cost, but competition for this profit flow forces the initial price down. Effectively, 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. America Online, for example, derives a sub- stantial part of its Operating revenue from advertising. It makes sense for them to offer large up-front discounts, in order to capture advertising rev- enue, even if they have to provide Internet connections at rates at or below cost. We can easily add this effect to the model. If a is the advertising revenue generated by the consumer each month, the zero-profit condition requires p = c + s. (35.3) (p—s)+a—c+‘?—+—:——C=0. (35.4) LOCK-lN 657 Solving for p we have 7" 1+1‘ This equation shows that what is relevant is the net cost of servicing the customer, c — a, which involves both the service cost and the advertising revenues. p:C+a+ 3. EXAMPLE: Online Bill Payment Many banks offer low—cost or even free bill payment services. Some banks will even pay customers who start using their online bill payment services. Why the big rush to pay bills online? The answer is that banks have found that once a customer goes to the trouble of setting up the bill—paying service, he or she is much less likely to switch banks. According to a Bank of America study, the frequency of switching goes down by 80 percent for such customers.4 It’s true that once you get online bill payment up and running, it’s hard to give it up. Switching to another bank to get an extra tenth of a percent of interest on your checking account doesn’t seem very attractive. As in the analysis of lock—in presented above, investing in services that create switching costs can be very profitable for businesses. EXAMPLE: Number Portability on Cell Phones At one time, cell phone providers prevented individuals from transferring their phone numbers when they switched carriers. This prohibition in— creases individual switching costs significantly, since anyone who switched would have to notify all of his or her friends about the new number. As the model presented in this chapter describes, the fact that customers could be charged more when they faced high switching costs meant that the phone providers would compete even more aggressively to sign up such highly profitable customers. This competition took the form of providing low-cost or even free phones, along with offers of “free minutes,” “rollover plans,” “cell-to-cell discounts,” and other marketing gimmicks. The cell phone industry was united in its efforts to block number porta— bility and lobbied regulatory agencies and Congress to maintain the status quo. Slowly but surely, the tide started to turn against the cell phone industry as consumers demanded number portability. The Federal Communications Commission, which regulates the telephone business, started dropping hints 4 Michelle Higgins, “Banks Use Online Bill Payment In Effort to Lock In Customers,” Wall Street Journal, September 4, 2002. 658 INFORMATION TECHNOLOGY (Ch. 35) that cell phone providers should consider ways in which they could imple— me...
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