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Economics of Information Goods • All products contain some degree of information. • It is generally believed, and probably true, that modern products contain a higher degree of information and smaller component of physical inputs than older products. • The Internet Economy is particularly suited to the transmission of information goods. • First module is a review of Useful Economic Concepts that you may or may not have had in the past (in MECO 6201, which you should have had). • Understanding the later modules will depend on these concepts. 1 Some Useful Economic Concepts • Elasticity • Price Discrimination • Public (Information) Goods • Consumer and producer surplus • Natural Monopoly 2 Price Elasticity Of Demand • def: percentage change in quantity divided by percentage change in price • (ΔQ/Q)/(ΔP/P) or (ΔQ/ΔP) (P/Q) • measure of responsiveness a. b. c. d. If Elasticity is >1 known as elastic (responsive customers) If Elasticity is =1 ; unit elastic If Elasticity is <1; inelastic (less responsive customers) Infinite and zero elasticity 3 Illustrations of elasticity D with zero elasticity P D with infinite elasticity Q 4 Elasticity and TR • • • When elasticity is greater than 1 (elastic) increases in price lead to decreases in revenue and vice-versa When elasticity is equal to 1, changes in price lead to no change in revenues When elasticity is less than 1 (inelastic) increases in price lead to increases in revenue. 5 Implications of Elasticity • • • • • If Elasticity is <1, firm can always increase Profit by increasing price (revenues increase and costs decrease because output decreases) If Elasticity =1, firm can always increase profit by increasing price If Elasticity>1 firm can not necessarily increase its profits by a change in price. Thus firms that maximize profits must have elasticities >1. Example of VideoTape Sales Demonstrates Importance of knowing elasticity. 6 Why is Windows so Cheap? • Elasticity indicates that Windows is grossly under-priced relative to short run monopoly price. • Find it hard to believe? Check out the analysis for yourself. 7 Table 1 W indow's share of total cost 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% Im pact of a 1% Required % decrease Minum um decrease in com puter increase in the in num ber of com puters purchases brought about by a 1% price of W indows sold to m ake the price rise in com puters that would on the price of a increased W indows cause a W indows price increase to com puter price unprofitable be unprofitable 0.05% 0.990% 19.8% 0.10% 0.990% 9.9% 0.15% 0.990% 6.6% 0.20% 0.990% 5.0% 0.25% 0.990% 4.0% 0.30% 0.990% 3.3% 0.35% 0.990% 2.8% 0.40% 0.990% 2.5% 0.45% 0.990% 2.2% 0.50% 0.990% 2.0% 0.55% 0.990% 1.8% 0.60% 0.990% 1.7% 0.65% 0.990% 1.5% 0.70% 0.990% 1.4% 0.75% 0.990% 1.3% 0.80% 0.990% 1.2% 0.85% 0.990% 1.2% 0.90% 0.990% 1.1% Consumer and Producer Surplus • Consumer surplus is the difference between the price paid and the higher price that consumers would have been willing to pay for the product. • Producer surplus is the difference between the payment received and the minimum payment that producers would have accepted. 9 Consumer and Producer Surplus P1 1 3 Pe 4 2 Q1 CS = 1 PS = 2 Qe DWL = 3+4 10 Monopoly Vs. Competition • Monopoly versus competition • Smaller Quantity • Higher Price • Price discrimination. • The tradeoff associated with patents and copyright - deadweight loss in consumption versus possible new products. 11 Monopoly charges higher price, produces smaller quantity. Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to producer from consumer MC S Pm 3 Pc 4 1 2 D Qm Qc MR 12 Natural Monopoly • Downward sloping AC curve. • More efficient to have 1 large firm than many small firms. • Rate of return regulation is how we regulate these firms. • Removes incentive to keep costs down. 13 Natural Monopoly Pm Unregulated Profit Pr Losses with efficient output PE AC MC Qm Qr QE 14 Price Discrimination • Perfect • Two or More Markets • Bundling and Block Booking • Versioning 15 Perfect Price Discrimination • • • • • • Theoretical ideal. Cannot be fully achieved. Find maximum price that every consumer is willing to pay and charge them that price. Requires more information than any firm has, and the prevention of arbitrage. Demand Curve becomes MR curve. No Deadweight Loss. Approximate examples: automobile dealers, doctors in the old days. 16 Perfect Price Discrimination. P1 P3 S P6 D Qo 17 Price Discrimination - 2 or more Markets • • • • • If markets for a single product have different MRs, profits can be increased by shifting output from low MR markets to high MR markets. Raise price in low MR market and lower price in high MR market. High MR market is high elasticity market. Need to Prevent Arbitrage. Examples: Airlines with business travelers and vacationers. Coupons. 18 Market 2 Market 1 P1 price before discrimination P2 D mr2 D mr Q2 Q1 mr1 MR MR 19 Price Discrimination Rules • • • • Raise price in market with lower elasticity (lower responsiveness) Lower price in market with higher elasticity. Do this until MRs are equalized. But prices will not be equalized. Examples: Airlines with business travelers and vacationers. 20 Examples of Price Discrimination • • • • Airline Tickets (Business and Vacationers) Movies (adults, children, seniors) Stamps, Coupons Predictable Sales 21 Price Discrimination Law • • • • Illegal if it gives some firm an advantage over other firms. If individuals are consumers, is not illegal. Price Discrimination is not likely to harm efficiency. Perfect Price discrimination is perfectly efficient. Intention of this rule was to protect ‘momand-pop’ stores and grocers from department stores and supermarkets. It was intended to reduce competition. 22 Versioning • Sometimes (frequently) creating different grades of products might just better meet consumer demands. • Versioning is artificially creating different products (where the high end product would meet all needs) to achieve price discrimination. • Problem: avoiding cannibalization of higher end product line. 23 Versioning Examples • Luxury versus regular automobile brands. • PC Junior. • ‘lite’ versions of software with reduced functionality. • Putting identical chips in high and low powered calculators. 24 Bundling (Block Booking) • Two or more products that are sold as a package. – – Related to ‘Tie-Ins’ but differs in that bundling is not ‘contractual’. That is, when you buy the bundle your purchase is finished. A tie-in is a contract where you agree to buy any of product X that you use, from a particular vendor. But you need not buy X at all. Example: if you buy a photocopy machine from me, you also need to purchase any toner that you need from me as well. 25 When Bundling Works Best 26 Successful Bundling Makes Demand More Homogeneous Px Py Qx Qy Px+y Qx+y 27 Advantage of a Bundle The Matrix Green Tomatoes Bundle X 2000 1200 3200 Y 1300 1900 3200 2 x 1300 2 x 1200 5000 6400 28