Economics of Information Technology

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Economics of Information Technology

• 2nd session
• 11.02.2003
• Experiencing Microeconomics

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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

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1.1 Supply Demand schedules
Price
D
S
Equilibrium (EQ)
P0
S0
Quantity
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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
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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
Quantity
Q0
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1.2 Price Elasticity of Demand
Price
DSR

• Price elasticity is greater in the long run (LR)
  than in the short rum (SR)

DLR
P1
P0
QLR
QSR
Quantity
Q0
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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 lt 1 ? demand is inelastic
• If n gt 1 ? demand is elastic
• Example n 0,75 and change P 3 ? change
  in demand 2,25

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1.2 Price Elasticity of Demand
P
P
Perfectly inelastic demand
Perfectly elastic demand
Q
Q

• Price elasticity is greater in the long run (LR)
  than in the short rum (SR)

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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

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1.3 Cost Functions - Total Costs

• Total Costs FC VC

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

• Total Costs FC VC

Total Costs (TC)
Cost
Variable Costs (VC)
Fixed Costs (FC)
Quantity
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1.3 Cost Functions - Average Costs

• Average Costs TC/Q

Cost C
Average Costs (AC)
Quantity
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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

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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

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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

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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
MCAC
AVC
Q
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1.5 Cost Functions Marginal Costs
TC
TC (Q)
TC ( Q 1)
TC ( Q)
TC ( Q 1)
TC ( Q)
Quantity
Q
Q1
Q
Q1
MC
MC (Q)
MC ( Q)
MC ( Q)
Quantity
Q
Q
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1.5 Cost FunctionsRelationship Marginal Costs
and Average Cost

• When AC is a decreasing function of output ? MC lt
  AC
• When AC constant or at MES ? MC AC
• When AC is a increasing function of output ? MC gt
  AC

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1.x Price Discrimination
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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

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1.6 Cost Functions Sunk 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

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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

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1.7 Economic CostsEconomic Profit and Net
Present Value

• Present Value of an annual accounting profit
  PV Cash Flow (C)
• (1i)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
• (1i)t

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2.1 Important Microeconomic concepts in the
Information Economy

• First copy costs
• Economies of scale
• Sunk costs
• Fixed costs
• Variable costs
• Marginal costs

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2.2 Costs and competition in the Information
Economy

• Sunk costs gtindustry 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) gt the cost of producing an
  extra unit of a certain product
• Reproduction costs of an information good are
  often constant and costs essentially nothing ? MC
  close to zero
• No capacity limits for the reproduction of
  information goods

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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) gt the cost of producing an
  extra unit of a certain product
• Reproduction costs of an information good are
  often constant and costs essentially nothing ? MC
  close to zero
• No capacity limits for the reproduction of
  information goods

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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 QA
• Hand- in by Monday before the next lecture,
  latest at 1500 via e-mail to cls_at_woco.dk

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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

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3.2 Organization of the courseSummary of
literature

• Summarys 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