Economics of Information Technology

1. Economics of Information Technology 2nd session 11.02.2003 Experiencing Microeconomics

2. Agenda ‘Think like an economist’ • General Microeconomic concepts • Supply demand and cost functions • Microeconomics and the information product • First copy costs ,MC, Sunk costs, price differentiation • Organization of the course • Group presentation and preparation of the academic summaries

3. 1.1 Supply Demand schedules Price D S Equilibrium (EQ) P0 S0 Quantity

4. 1.1 Supply Demand schedules Effect of a tax imposition on the demand curve ( i.e. VAT tax) Price D S P0 PT EQT QT Q0 Quantity

5. 1.1 Supply Demand Effect of a tax imposition on the supply curve ( i.e corporate tax) Price D ST S EQT PT P0 QT Q0 Quantity

6. 1.2 Price Elasticity of Demand • Price elasticity is greater in the long run (LR) than in the short rum (SR) Price DSR DLR P1 P0 QLR QSR Q0 Quantity

7. 1.2 Price Elasticity of Demand Price Elasticity  is the % change of a quantity demanded, brought by 1% change in price Price elasticity = n =Change Q: Change P Q0 P0 If n < 1  demand is inelastic If n > 1  demand is elastic Example: n = 0,75 and change P= + 3%  change in demand = 2,25%

8. 1.2 Price Elasticity of Demand • Price elasticity is greater in the long run (LR) than in the short rum (SR) P P Perfectly inelastic demand Perfectly elastic demand Q Q

9. 1.2 Price elasticity of demand Factors that make demand for a product more sensitive: • Unique product features, product differentiation • High proportion of buyers expenditures • Intermediate products in price sensitive industries such as PC industry Factors that make demand for a product less sensitive: • Difficult to compare products/services • Low proportion of buyers expenditures • High costs to switch to another product • Products compatibility or product network effects

10. 1.3 Cost Functions - Total Costs Total Costs = FC + VC Cost Total Costs (TC) Variable Costs (VC) FC Fixed Costs (FC) QT Q0 Quantity

11. 1.3 Cost Functions - Total Costs Total Costs = FC + VC Total Costs (TC) Cost Variable Costs (VC) Fixed Costs (FC) Quantity

12. 1.3 Cost Functions - Average Costs Average Costs = TC/Q Cost =C Average Costs (AC) Quantity

13. 1.3 Cost Functions – Minimum efficient scale of production (MES) Average Costs schedules of ‘ old economy firms’ C C AC AC Diseconomies of scale Economies of scale Minimum efficient scale Constant returns to scale Q Q Q’ Q’’ Q’ • Until Q’ economies of scale are present • Minimum efficient scale at Q’ when scale economies are exhausted • Q’ – Q’’ constant returns to scale • Beyond Q’’ diseconomies of scale

14. 1.4 Cost Functions - Constant returns to scale Average Costs schedules of ‘ new economy information good firms C Diseconomies of scale AC Economies of scale Constant returns to scale Q • Constant returns to scale theoretically until infinity

15. 1.5 Cost Functions – Marginal Costs • The cost of expanding output or cost savings contracting output • The incremental cost of producing exactly one more unit of output • MC (Q) = TC (Q + change Q) – TC (Q) change Q • MC (Q) = VC/Q • Average total costs (ATC) = TC/Q • Average variable costs (AVC) = VC/Q

16. 1.5 Cost Functions – Marginal Costs C TC VC C FC Q In the event of constant returns to scale MC = AC AC = ATC + AVC C/Q ATC MC=AC AVC Q

17. 1.5 Cost Functions – Marginal Costs TC TC (Q) TC ( Q’’ + 1) TC ( Q’’) TC ( Q’ + 1) TC ( Q’) Quantity Q’ Q’+1 Q’’ Q’’+1 MC MC (Q) MC ( Q’’) MC ( Q’) Quantity Q’ Q’’

18. AV increases MC > AC C MC AC Q 1.5 Cost FunctionsRelationship Marginal Costs and Average Cost • When AC is a decreasing function of output  MC < AC • When AC = constant or at MES  MC = AC • When AC is a increasing function of output  MC > AC

19. 1.x Price Discrimination

20. 1.6 Cost Functions Long-run versus short-run cost functions • The period of time in which the firm cannot adjust the size of its production facilities = short run • For each level of output there is an optimal plant size • Example large vs. smaller plant size (see Besanko; figure P.6; pg. 17) • Optimal plant size produces savings from: • Lower costs from adequate plant size by either reduction of the fixed costs or the utilization of scale economies • More efficient labor allocation, better control over VC • Optimization of the plants organization

21. 1.6 Cost FunctionsSunk Costs • Sunk costs are not fixed costs ( e.g. railroad locomotives) • The opposite of sunk costs are avoidable costs • Sunk investments are industry specific assets that would neither increase value, nor reduce costs when applied to a different product market. Usually up front investments • Sunk costs are important for the study of industry strategy, the analysis of rivalry among firms, entry and exit decisions into markets and decisions to adopt new technologies

22. 1.7 Economic CostsEconomic Costs versus Accounting Costs • Accounting Profit = Sales revenues – Accounting cost • Economic profit = very close related to the principle opportunity cost • Economic profit = Sales Revenue – Economic Cost • Economic cost = closely aligned with the return on invested capital (ROI), such as plant & equipment • Economic profit = Sales Revenue – economic cost – accounting cost

23. 1.7 Economic CostsEconomic Profit and Net Present Value • Present Value of an annual accounting profit: PV = Cash Flow (C) (1+i)t • Net present value (NPV) = present value of the cash flows generates minus the cost of the investment • NPV = Acc. profit (C) - Cost of the investment (1+i)t

24. 2.1 Important Microeconomic concepts in the ‘Information Economy’ • First copy costs • Economies of scale • Sunk costs • Fixed costs • Variable costs • Marginal costs

25. 2.2 Costs and competition in the Information Economy • Sunk costs =>industry specific assets that would neither increase value, nor reduce costs when applied to a different product market. Usually up front investments • First copy costs of an information good are typically high, and typically cannot be recovered, and are therefore defined as sunk costs • Marginal costs (MC) =>the cost of producing an extra unit of a certain product • Reproduction costsof an information good are often constant and costs essentially nothing  MC close to zero • No capacity limitsfor the reproduction of information goods

26. 2.3 Costs and competition in the Information Economy • Declining production costs are attracting competitors • Dominant firms have due to the financial leverage • Marginal costs (MC) =>the cost of producing an extra unit of a certain product • Reproduction costsof an information good are often constant and costs essentially nothing  MC close to zero • No capacity limitsfor the reproduction of information goods

27. 3.1 Organization of the courseGroup Presentations Setting: • The group is performing an consultant firm, while the class is acting as the top leadership of a respective firm or a governmental body • Presentation about 25 min plus 15 min for Q&A • Hand- in by Monday before the next lecture, latest at 15:00 via e-mail to: cls@woco.dk

28. 3.1 Organization of the courseGroup Presentations Structure of the presentations: • Introduction • Industry overview • The firms business model and strategy • SWOT analysis of the firm ( competitors, policies and regulations, technology ect. • Elaborate proposal for problem solution, strategy shift or general improvement of the firms current situation. Show the link to the theoretical framework of the course • List of recommendations

29. 3.2 Organization of the courseSummary of literature Summary’s structure • Title and source • Abstract/Conclusions • Key terms and concepts in order of appearance • Main Questions & assertions • The approach to solve the main questions • Support of assertions • Relationship between terms and concepts • Relation to other articles