e-con.com
Economics of electronic commerce.
e-con.com
• How do the principles of managerial
economics apply in the internet world?
Look at
• Cost structures
• Selling information
• Pricing strategies & auctions
• Industry Standards.
Cost structure
• Typical internet companies have low per
transaction costs and high fixed costs - e.g.
Amazon.com initially (for books & CDs)
had high up-front development costs - $60m
plus - but has almost no per transaction
costs.
• Remains true as long as capacity thresholds
are not crossed.
Amazon
• Initially had no fulfillment costs
• Now has major investments in distribution
centers
• Alliances with Toys-R-Us etc attempts to
leverage Amazon’s reputation and
technology and avoid fulfillment
Cost structure
• What are implications of high fixed and low
variable costs?
• High operating leverage, i.e. swings in
revenues go directly to the bottom line.
• So 30% rise in revenues can double profits.
• Rapidly growing sales can translate into
spectacular growth in earnings - and vice
versa.
Recent Example
• Marconi sales fell 15%
• Profits fell 50%
Cost structure
• Firm should stay in business as long as
variable costs are covered. Low variable
costs means that companies that are losing
money may stay in business even if the
losses are large - depends on whether the
fixed costs are sunk. Could generate intense
price competition.
• Cost structure implies volatile earnings and
a tolerance of losses.
Information Products
• Much of what the Internet excels at is
providing information
• Information is expensive to Produce but
• Cheap to Reproduce
• So average cost is high but marginal cost is
low.
• Competition may lead prices down to MC
Encyclopedia Britanica
• 1991: EB sold @ $1,600
• 1992: Microsoft introduced Encarta (bought
rights to Funk & Wagnalls), sold @ $49.95
• 1995: EB’s sales have halved
• 1995: EB offers on-line subscription for
$120 p.a. or CD for $200
Encyclopedia Britanica
• 1996: EB lowers cost of sub to $85
• 1999: EB offers FREE on-line service
(www.britanica.com)
• Key point: costs of producing EB are fixed
and sunk. Cost of reproducing - MC- is low,
zero on-line.
• Similar story with Yellow Pages.
• Long distance?
Information Products
• Growth can translate into very fast growth
of profits PROVIDED that there is not
strong competition - compare Reuters with
Encyclopedia Britanica.
• Why is Reuters different?
Demand for Information Products
• What am I willing to pay for information?
E.G suppose a stranger says to you “I have a
great piece of information for you. What
will you pay me?” How do you answer? You
try to elicit some of the information by
questions.
• In general I can’t tell what it’s worth until I
know the information.
• At that point I don’t need to buy it!
Information Products
• This is a reason why reputation and brand
image are important for information
providers - unless the information is quite
predictable, as with stock prices. You are
buying blind.
• Value of analysis - which is information depends on skill of analyst - hence brand
images of Dunn & Bradstreet, FT, WSJ, The
Economist, etc.
Selling Information
• Reuters, financial analysts are bundling
information with something else that makes
it possible to charge
• Few examples of successful businesses that
sell information only – usually sell it
bundled with something else
Intellectual Property Rights
• Digital distribution of “information” (which
includes music, videos, software and book)
poses serious challenges to property rights
of the owners – MC is zero
• Hence legal & economic activity on IPR
front. Napster, BMG, peer-to-peer file
sharing etc. (Another issue – unbundling
disk tracks)
Information Products
• Bottom line • Few good business models for making
money from selling information over the
internet. Business models still needed for
Yahoo et al. (eBay is an exception)
• Napster shows clearly the likely impact of
internet distribution on pricing of digital
information.
Demand & Pricing on the Web
• Consumers have better information because
of the web & can compare specs & prices.
• How does this affect pricing policy?
• Certain types of price discrimination not
now possible - e.g. based on zip code.
NetGrocer, Victoria’s Secret cannot price by
zip code on their web sites.
• “Double-click” strategy
Auctions
• Auctions facilitate price discrimination
• Auction Formats
– Traditional English (oral, ascending prices, first or
second price)
– Dutch auction (descending prices)
– Sealed-bid (as in T Bills, oil exploration)
• First price
• Second price
Auctions
Valuation and Information
• Private-value auction: bidders uncertain about
the other bidders’ reservation prices. (Art,
memorabilia)
• Common-value auction: bidders uncertain
what the value of the object is, but this is
similar for all. (Oil drilling rights, spectrum)
Auctions: Best Bidding
Strategies
Private Value Auction
• Most common on internet.
• Second-price sealed bid auction: bid your
reservation price.
• English auction: Bid in small increments
until you reach your reservation price.
Private Value Auction
Bidding in Second Price Auctions
• Key feature:
• What you bid does NOT affect what you
pay. No incentive to understate.
• If I’m the top bidder, and the next is $100,
doesn’t matter whether I bid $101 or $1001:
I pay $100. Not bidding against myself.
Private Value Auction
English Auctions
• Successful bidder has greatest reservation price
• Pays > = reservation price of person with the next
highest reservation price - if I bid against you & you
value item at $1000, I have to pay more
• If I have the highest RP of $100 and the next highest is
$50, I win for about $55: if the next highest is $90, I
win for about $95. Consumer surplus depends on
others’ WTP
Private Value Auction
Dutch Auctions
• If I am willing to pay $100, I should clearly
not bid while the price is > $100.
• As soon as P < $100, it is worth my while to
bid.
• The longer I wait, the more chance I am
outbid - but the better the deal I get.
• Risk-averse buyer should bid at or near
reservation price, leaving little consumer
surplus.
Bottom Line
• Auctions are a mechanism for finding
information about consumers’ willingness to
pay for a good and for extracting consumer
surplus.
Auctions
Common Value Auction
• Examples
– Bidding on a construction job
– Bidding on offshore oil reserves
Auctions
Common Value Auction
• Winner’s Curse
– The winner is worse off than those who did not
win
– Winner is bidder who estimates value of object
to be greatest, and so is likely to be
overestimating.
Distribution of bids in common value auction and the
“winner’s curse”.
# firms with this estimate.
Most likely value
Winning bidder
Estimated $ value of
spectrum (oil reserve)
Winner’s Curse
Common Value Auction
• Example • Recent 3G spectrum auctions for cell
phones in Europe.
• Almost all commentators now recognize
that the winners overpaid.
Demand & Pricing
• Difficulty in discriminating seems to be
leading to more emphasis on related sales,
promotions (a form of discrimination), and
rewards to loyalty.
• Internet also favors two-part pricing with a
joining fee and then usage or purchase fees.
Demand & Pricing
• Sellers of information-based good and
services often differentiate product in order
to discriminate – “versioning”
• Software often has “professional” and
“home” versions - e.g. Quicken, MS Office
vs. Works, Adobe Photoshop, etc.
Demand & Pricing
• In many cases the home version is the same
as the professional version with extra code
to limit its functionality - e.g. Windows NT
in small and large server versions.
“Damaged goods” phenomenon.
• May also differ in terms of support.
Demand & Pricing
Product
VoicePad Pro
Price in $
79
Personal
295
Professional
Office Talk
Law Talk
Voice Med
Voice Ortho
595
795
1,195
6,000
8,000
Description
Vocab of 20,000
words
Vocab of 30,000
words
Vocab of 50,000
General office staff
Legal vocab
Medical vocab
Orthopedic vocab
Standards
• Why is Microsoft so powerful?
• Because demand for its flagship product Windows - is high and highly inelastic, and very
inelastic demand gives great profit potential
– Low PED gives high markup of P over MC
• Also barriers to entry are high.
• Why is demand inelastic and barriers high?
Standards
• People need the product and there is no
competition because • Development costs very high - $1 billion plus.
• Windows is an industry standard:
– The bigger the existing user base, the harder it is
for competitor to enter.
– Large user base means low per user costs, and
many third party support products.
– Switching costs – training, standardization etc.
Standards
• Two main points here:
– High fixed cost imply economies of scale and
difficulty in entering
– Economies of adoption reinforce this.
• Both are characteristic of products that
become industry standards
Network Effects of Standards
• Economies of Adoption:
• Examples - software for Windows vs. Mac,
Palm operating system and third party
support for these.
• Large user base means more third party
products.
• Also third party services such as training.
Network Effects of Standards
• Generates pool of labor with user skills
which reinforces tendency to stick with
standard.
• Users accumulate standard-specific assets
which makes it costly to switch - programs,
skills, hardware (e.g. networks, printers,
VCR players …)
Illustration
• Suppose IBM decides to compete with
Microsoft, buys Apple to promote Mac O/S.
• What hurdles do they face?
• Mac O/S only runs on Apple machines - most
users have PCs, with chip optimized for
Windows.
• Users are trained on Windows applications.
Illustration
• Third party developers have far more
software for PC than Mac.
• More courses training users on PC than Mac
software.
• More IT pros know how to use PC software.
Tech support is easier to get.
• All of these are aspects of being the
industry standard.
Network Effects
• Once a system with network effects begins
to be widely used, demand can explode
• Fax introduced by ATT in 1925 but
exploded from 10% to 95% of market from
1982 to 1987.
• First e-mail sent in 1969, hardly used till
1989, since then more than doubled every
year.
Network Effects
• Main issue in these cases - fax, e-mail etc
are more useful, the more people use
them
• So once they take off there is positive
feedback. Demand creates demand.
Economies of adoption.
Adoption externalities, Standardization.
Price
As the technology is used more
widely people are willing to pay
more for a given amount and
buy more at any price, so demand
curve moves out.
Quantity
Standards
• Can give rise to “lock-in by adoption”.
• Example - typewriter keyboard QWERTY
layout (?).
• Microsoft has generated a very profitable
position by a combination of lock-in of its
operating system, the costs of producing a
competitor, and its ability to sell products
tailored to its operating system.
Standards
• Becoming a standard can be a key aspect of
business strategy.
• Sun has been trying to do this with Java.
• Adobe managed this with Postscript.
• Generally companies go to great lengths to
prevent competitors from becoming a
standard.
Standards
• Challenge to public policy –
• To get the efficiency of a widely-used
standard
• Without the monopoly power that comes
with this.
Microsoft & Standards
• MSFT wants to “own” the standards on
–
–
–
–
Desktop via Windows
Handhelds via pocket version of Windows
Internet via “.net” standard
Transactions via Passport
EBAY
• Most successful pure Internet company
• No bricks & mortar – low fixed costs, no
variable costs
• Central function – providing info about
buyers to sellers & about sellers to buyers
• Providing info is key function of a market –
well suited to Internet
EBAY
• EBAY has economies of scale because costs
are largely fixed – no fulfillment
• Network externalities important – would
you rather sell at an auction with many or
few buyers? Or buy at one with many
sellers? Size breeds success
EBAY
• Note Yahoo & Amazon both ran FREE
auctions to enter this market yet still have
small shares
• EBAY has a good business model as it is
clear how they can charge for the info they
provide – as broker – unlike Yahoo
AOL
• AOL – provides info and Yahoo-like
services but charges as ISP, also a clear
business model
• Also gets advertising revenues
Demand Elasticity with Adoption
Externalities
• For Microsoft and eBay, demand doesn’t
fall off even if competitors offer better
products free.
• Demand is inelastic with respect to price so the markup above MC can be massive.
• In economic terms this is the source of their
profits and their “business model”
EBAY
• Profit margin 14%, operating margin 18%
• In last 6 months revenues up 82% and
profits up 500% - leverage!
Yahoo
• What is Yahoo’s business model?
• Are they selling information?
• If so how do they overcome the problems
listed above?
Amazon
• Initially had no fulfillment costs
• Now has major investments in distribution
centers
• Alliances with Toys-R-Us etc attempts to
leverage Amazon’s reputation and
technology and avoid fulfillment
Where are the real opportunities
for e-commerce to make a
difference?
Microsoft, Intel, Cisco and PC
makers
• Compare Microsoft, Intel, Cisco and a PC
maker - Compaq, Dell, Gateway.
• The first three are more profitable than the
last by any measure of profit margin.
• WHY? After all, they are all in roughly the
same business.
Profit margin
1999/2001
Operating margin
1999/2001
MSFT
40.0%/30.5%
49.5%/46.3%
INTC
25%/17.7%
34.2%/20.7%
CISCO
16.9%/-0.9%
23.4%/-4.4%
CPQ
1.5%/0.8%
2.4%/1.2%
DELL
7%/6.7%
9.9%/8%
Notes to previous slide
• MSFT profits would be down by 75% if
they accounted for stock options to
executives as costs
• Dell profits could also be reduced greatly by
more conventional accounting
Profits depend on demand
elasticity
• This depends how important the product is,
and
• On whether consumers can find substitutes.
• Substitutes are competitors.
• All items - software & O/S, microprocessor,
router and PC - are essential to the user.
Barriers to entry
• What is unique about ITC and MSFT is the
difficulty of a newcomer competing with
them.
• Windows is protected by massive costs of
producing a new O/S and
• by the adoption of Windows as a standard.
Intel
• Is also protected by massive fixed costs
• and by the standardization around its
architecture.
• Has also managed pricing and product cycle
very carefully to keep AMD away from
profitability.
PC makers
• There are no standards that can protect Dell,
Compaq, etc.
• The fixed costs of entering the Wintel PC
market are low.
• Components can be bought from many
sources.
• Technology is standard.
Summary
• Demand for any one PC makers’ product is
elastic whereas
• Demand for Windows, Office and
microprocessors is highly inelastic.
• Barriers to entering and competing translate
into inelastic demand and higher profits.
All Good Things Come To An
End
That’s it for economics!