Monday, October 15, 2012

The Economics of Information Technology

The Economics of Information Technology - Hal Varian, Joseph Farrell and Carl Shapiro, 2004

The book covers two topics:
  • Section 1 (by Varian) is a comparison of the conventional economy with the information economy.
  • Section 2 (by Farell/Shapiro) is a discussion of intellectual property and its effect on the information economy.

This synopsis covers most of Section 1. Section 2 (and the standards subsection of Section 1) will be covered in another post. The book covers several results from research papers by Varian and other researchers in the field. The results are summarized and some of the principles are shown via simple mathematical models and examples that illustrate the principles. The principles are summarized here in an informal manner.

The primary reason that the information economy differs from conventional economies is the cost structure: Both hardware and software have constant fixed costs, low marginal costs. Economic models indicate that this should result in a monopoly. Varian discusses the factors unique to the information economy which ensure that it does not (described in the sections below). In addition he also discusses factors that have contributed to recent rapid advances in the information economy: the effect of combinatorial innovation and open source software.

Price differentiation

The information economy exhibits price differentiation of three types along with price differentiation based on other factors:
  • First degree: Where the product is marketed individually to customers through individual product and price discrimination (a market of one). Ulf shows that there are 2 effects in this kind of market:
    • Enhanced surplus: Firms charge closer to the "reservation price" of a customer.
    • Intensified competition: Each customer must be contested separately by competitors.
Where customer tastes are similar( homogeneous customers), competition dominates surplus and the customers benefit. The opposite happens in a market of heterogeneous customers.
  • Second degree: Where the product is marketed through product lines i.e. some form of versioning. Versioning promotes consumer welfare, by allowing segments to be addressed, albeit at lower quality level.
  • Third degree: Where the same product is marketed at different prices to different groups (price discrimination. Markets with largely homogeneous customers and fixed costs (Armstrong/Vickers) benefit .
  • Purchase history/Search/Bundling: Pricing based on purely on purchase history does not provide benefit when done by a monopoly. However, conditoning prices based on consumer behavior (recommendations) can extract some value. The information economy has a fraction of consumers who make extensive use of search to find products at suitable prices . Several researchers have shown that when customers use search, firms randomize prices on a day to day basis (low to attract searchers, high for when non searchers arrive). The information economies allow for products which can be bundled together.  The effects of this are:
    • Reduced dispersion of willingness to pay (variance of desired price reduces), making the demand curve more elastic.
    • Increased barriers to entry.

Switching costs/lock in

A simple model can be used to determine the first period (lock in) and second period (monopoly) price/profit.  The analysis shows that competition to acquire customers reduces cost in the lock in period. Lockin can be beneficial to customers, because of intense competition to acquire customers. It results in reduced price for new customers,  but a high price for older customers. Interestingly, studies show that welfare may go either way (towards producers or consumers), but in most cases consumers are worse off.

Supply side economies of scale

As mentioned before, the supply side exhibits high fixed costs and low marginal costs - economic analysis indicates that this should result in a natural monopoly. In the case of the information economy, however the competition for a monopoly and scale appear to benefit consumers. In addition, the information economy has several characteristics that prevent long term monopolies:
  • Fixed costs are continuously reduced by advances in technology
  • Rapid market growth can remove the advantages of a monopoly
  • Disruptive technologies continuously change the nature of the market
  • Technology becomes obsolete before functions become obsolete.
The work analyzes supply side economies of scale through models and the welfare theorems.The theorems of welfare indicate that a competitive economy is better for consumer welfare than a monopoly:
  • Every competitive economy is Pareto efficient (no producer/consumer can improve without worsening some other producer/consumer)
  • Pareto efficient economies result in competitive equilibrium at maximum overall welfare
However, where price discrimination exists (as in the information economy):
  • The monopoly has an equilibrium, where it captures all surplus and achieves Pareto efficiency
  • Competition for monopoly transfers this surplus to consumers with same effect as a competitive economy.

Demand side economies of scale

Products of the information economy exhibit network effects: Direct (where the demand depends on how many other people use it (E.g. Use of email(to send) requires other people to use it (to receive)) or indirect (E.g. Availability of DVDs depends on a large market of people using it, so each user depends on others to increase the market). Systems with network effects exhibit multiple equilibrium points: With elastic supplies there are 3 equilibrium points (no adoption, mass adoption and an unstable middle point). A product must cross the middle equilibrium point to start a positive feedback loop.

System effects

System effects refers to the availability of complementary technology needed by a single consumer (a system). Cournot analyzes the pricing of complements and finds the merger of a complementary pair of producers always benefit consumers and producers.

Transactions

The information economy enables the use of new types of contracts based on fine grain revenue sharing. In most cases these are found to increase efficiency.

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