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

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?


• 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)


• 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

• 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)

Valuation and InformationValuation and Information

Auctions: Best Bidding Strategies

• 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 AuctionPrivate 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.


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


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

• Examples

– Bidding on a construction job

– Bidding on offshore oil reserves

Common Value AuctionCommon Value Auction

Auctions

• 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.


Estimated $ value of spectrum (oil reserve)

# firms with this estimate.

Winning bidder

Distribution of bids in common value auction and the “winner’s curse”.

Most likely value

Winner’s Curse

• 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 Price in $ DescriptionVoicePad Pro 79 Vocab of 20,000

wordsPersonal 295 Vocab of 30,000

wordsProfessional 595 Vocab of 50,000Office Talk 795 General office staffLaw Talk 1,195 Legal vocabVoice Med 6,000 Medical vocabVoice Ortho 8,000 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

• 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 …)

Network Effects of Standards

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.

Quantity

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.

Adoption externalities, Standardization.

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.

• 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.

Summary

All Good Things Come To An End

That’s it for economics!

Documents

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