Information Goods

• All products contain some degree of information.• Entertainment products contain a higher degree of

information and smaller component of physical inputs than most other products. That is one reason that digitization is so common for entertainment products. You can’t digitize a car or refrigerator.

• 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).

Some Useful Economic Concepts

• Elasticity

• Price Discrimination

• Public (Information) Goods

• Consumer and producer surplus

• Fixed and Variable Costs

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. If Elasticity is >1 known as elastic (responsive customers)

b. If Elasticity is =1 ; unit elasticc. If Elasticity is <1; inelastic (less responsive

customers)d. Infinite and zero elasticity

D with infinite elasticity

D with zero elasticityP

Q

Illustrations of elasticity

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.

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.

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.

Window's share of total cost

Impact of a 1% increase in the

price of Windows on the price of a

computer

Required % decrease in number of computers

sold to make the increased Windows price unprofitable

Minumum decrease in computer purchases brought about by a 1% price rise in computers that would

cause a Windows price increase to be unprofitable

5% 0.05% 0.990% 19.8%10% 0.10% 0.990% 9.9%15% 0.15% 0.990% 6.6%20% 0.20% 0.990% 5.0%25% 0.25% 0.990% 4.0%30% 0.30% 0.990% 3.3%35% 0.35% 0.990% 2.8%40% 0.40% 0.990% 2.5%45% 0.45% 0.990% 2.2%50% 0.50% 0.990% 2.0%55% 0.55% 0.990% 1.8%60% 0.60% 0.990% 1.7%65% 0.65% 0.990% 1.5%70% 0.70% 0.990% 1.4%75% 0.75% 0.990% 1.3%80% 0.80% 0.990% 1.2%85% 0.85% 0.990% 1.2%90% 0.90% 0.990% 1.1%

Table 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.

P1

Pe

1

2

CS = 1 PS = 2

Qe

Consumer and Producer Surplus

Q1

4

3

DWL = 3+4

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.

S

MR

D

Pc

Qc

Pm

Qm

1

2

3 4

Monopoly charges higher price, produces smaller quantity.Monopoly causes Deadweight Loss 1+2. Area 3+4 is transfer to producer from

consumer

MC

• Fixed And Variable Costs.

– Fixed Costs: Costs that do not change when output changes.

• Creation of a recording master

• Creation of a movie, developing software, writing a book.

– Variable costs: Costs that do change when output changes.

• Marketing, distribution,

The Role of fixed and Variable Costs

The Role of fixed and Variable Costs

• Why are these costs important?

– Entertainment products are high fixed cost/low variable cost items.

– This implies some unusual characteristics of the industry.

– To maximize profits, firms maximize revenues. Elasticity equals one.

– Leads to “natural monopoly” type of result.

Typical Product

AVC

ACFixed and Variable Costs

AFCTotal Fixed

Total Fixed

P

Qq1

Typical Entertainment Product

AVC

AC

Fixed and Variable Costs

AFC

P

Qq1

Price Discrimination

• Perfect

• Two or More Markets

• Bundling and Block Booking

• Versioning

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.

Perfect Price Discrimination.

SP6

P3

P1

D

Qo

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.

price before discrimination

mr1

mr2

MR

D

mr

Market 1Market 2

Q1Q2

P1

P2

D

MR

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.

Examples of Price Discrimination

• Movies (adults, children, seniors)

• Movies: theatrical release, pay per view, dvd, cable, television

• Books: Hardcover and paperback

• Software: full versus ‘lite’ versions

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 ‘mom-and-pop’ stores and grocers from department stores and supermarkets. It was intended to reduce competition.

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.

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.

Bundling (Block Booking)

• Two or more products that are sold as a package.

– CDs versus singles– Cable television bundles versus a la carte.– Subscription services versus pay per use –

cable blanket versus long distance telephone or pay per view; Rhapsody versus iTunes.

– Computers with software– Office suites versus individual components.

When Bundling Works Best

Successful Bundling Makes Demand More Homogeneous

Qx

Px Py

QyPx+y

Qx+y

Advantage of a Bundle

The Matrix Green Tomatoes

X

Y

2000

19001300

1200

Bundle

3200

3200

2 x 1300 2 x 12005000

6400

Issues with Bundling

– Telephone service – consumers presumably preferred certainty of unlimited local calls as opposed to pay per call. Not a ‘bundling’ issue per se, but a psychological one.

– CDs versus singles- pricing versus cannibalism. iTunes versus prior models.

– Cable television bundles versus a la carte.• There are some political moves afoot to force a la

carte service. Why, and what would be the impact?