Mod 1

1. Mod 1 • Useful Concepts • Information goods and Review of some economic concepts.

2. Lecture 1

3. Information (Knowledge) 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.

4. Some Useful Economic Concepts • Elasticity • Price Discrimination • Public (Information) Goods • Reproducing Information Goods • Natural Monopoly

5. 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 • 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

6. Illustrations of elasticity D with zero elasticity P D with infinite elasticity Q

7. 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.

8. 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.

9. Why is Windows so Cheap? • Elasticity indicates that Windows is grossly underpriced relative to short run monopoly price.

11. 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.

12. Consumer and Producer Surplus P1 1 3 Pe 4 2 Qe Q1 CS = 1 PS = 2 DWL = 3+4

13. Monopoly Vs. Competition • Monopoly versus competition (smaller q, higher p) • Imposing a tax on a monopolist similar to competition in that producer still bears part of it. • Price controls and monopoly ...a case where controls may increase efficiency. • Price discrimination. • The tradeoff associated with patents and copyright - deadweight loss in consumption versus possible new products.

14. 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 4 3 1 Pc 2 D Qc Qm MR

15. 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.

16. Natural Monopoly Pm Unregulated Profit Pr Losses with efficient output PE MR AC D MC Qr QE Qm

17. Lecture 2

18. Price Discrimination • Perfect • Two or More Markets • Bundling and Block Booking • Versioning

19. 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.

20. Perfect Price Discrimination. P1 S P3 P6 D Qo

21. Declining Price Schedule • Also true for ‘all-or-nothing’ pricing.

22. 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.

23. Market 2 Market 1 P1 price before discrimination P2 D mr2 D mr Q2 Q1 mr1 MR MR

24. 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.

25. 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.

26. Examples of Price Discrimination • Airline Tickets (Business and Vacationers) • Movies (adults, children, seniors) • Stamps, Coupons • Predictable Sales

27. Versioning • Providing different models of product with differing capabilities. • Can be used to achieve price discrimination, but also might just better meet consumer demands. • Artificial creation of • Problem: avoiding cannibalization of higher end product line.

28. Versioning Examples • ‘lite’ versions of software with reduced functionality. • Putting identical chips in high and low powered calculators. • PC Junior

29. Lecture 3

30. 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.

31. When Bundling Works Best

32. Successful Bundling Makes Demand More Homogeneous Px Py Qx Qy Px+y Qx+y

33. Advantage of a Bundle The Matrix Green Tomatoes Bundle 1200 3200 X 2000 1900 3200 1300 Y 2 x 1300 2 x 1200 6400 5000

34. Mod 2 • Information Goods

35. Public Goods Definition: Goods that do not get used up when consumed. In other words, one person’s consumption of a good doesn’t reduce anyone else’s potential consumption of the same good. Examples: Ideas, television broadcasts, national defense. Obviously, these are not physical items that get used up. Instead they are usually ideas and artistic expressions. They are at the core of the Information Age Economy, since information is a public good. The Demand for Public Goods is the vertical sum of individual demands.

36. Public Goods (cont.) Some definitions of Public Goods claim that consumers can not be excluded from using them. Known as Non-excludability. Some Public Goods, such as broadcasting, or national defense, appear to have this characteristic. This misses the point. Any product for which consumers can not be excluded from using, e.g., apples, will give producers no incentive to produce.

37. Vertical Addition of Demands P4 Σ D P3 P2 D3 P1 D2 Q D1 Q1

38. Public Goods Book titles can be thought of as public goods, but the physical copies of a single book title are private goods that embody a public good. Several questions arise: how many titles are optimal to publish? How many copies of each title would be optimal? How do competitive markets work? Monopolies? Finally, is it possible to produce public goods efficiently?

39. In principle, a perfectly discriminating monopolist can produce efficient amount of public good. S P4 P3 Σ D P2 P1 Q Q2 Q1

40. Lecture 4

41. The Market for a Title Reproductions of a single Title are Private Goods Seller of the Reproductions can not appropriate the entire potential value of the reproductions since he is not a perfect price discriminator. With a single price for the reproductions, too few reproductions are produced (Q*-Qm). One component of lack or appropriation (area 7 in figure). Consumers of the reproductions get surplus, which is another loss of appropriation for the reproduction seller. (1+2 in figure)

42. Production of a Single book title 2 1 Pm 4 3 7 MC of printing 5 8 D 6 Qm Q* MR number of copies of a title

43. Market for Titles Because appropriability for reproductions of any title is imperfect, the sellers of titles can not achieve the vertical sum of demands (perfect discrimination demand in next figure). Instead, the best the sellers can do is some distance below the vertical sum of individual demands (attainable demand curve in the next figure). This leads to too few titles being produced relative to the ‘ideal’.

44. Market Demand for Titles MC of writing another title Pm Perf Discrimination Demand for titles Attainable Demand for titles Qm Q* Q** number of titles written

45. Copyright Tradeoffs • This leads to two tradeoffs: • Under-consumption of individual titles. • Underproduction of titles. • This same tradeoff exists in Copyright. • Copyright exists to give creators of ‘artistic’ works the ability to generate revenues. • The theory is that without copyright, competition in selling reproductions of a title would drive the price down to the marginal cost of producing a reproduction. Competition would also drive the (economic) profits down to zero, leaving no money with which publishers can pay the author.

46. Copyright Tradeoffs • It isn’t clear, however, that competition leaves no payment for the author. • Arnold Plant argued that being first gave enough of a head start that sufficient profits could be earned to allow authors to receive optimal remuneration. (Ex. English authors in the US market). • The lead from being first is, with current technology, unlikely to allow much profit.

47. Optimal Copyright • The figure on the next page illustrates optimal duration of copyright. • It contrasts the gains from lengthier copyright (the value of additional works created) against the harms (unnecessary loss of consumer surplus)

48. Patent (copyright) tradeoff • With no protection, creators do not reap much of the rewards of their creations. • They are given monopoly protection, which increases their revenues, but raises price to consumers. • This increases the number of inventions, but decreases the use of each invention? • We do not know the optimal tradeoff.

49. Lecture 5