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IS3240 Economics of E-Business

Course Overview

E-Business Defined
E-business: the conducting of business functions (e.g.,

buying and selling goods and services, servicing customers, collaborating with business partners) electronically, in order to enhance an organization·s operations.
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E-business includes e-commerce (i.e., using web-based systems in the Internet) or using intranet to support corp. operations

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What is This Course About?
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Understand the basic characteristics of e-business Intro to economic issues/topics pertinent to successful conduct of e-business Analyze e-business models and strategies, some may go against conventional wisdom and can be counter-intuitive Foresee the emerging e-business models and the impacts of new information technologies

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Course Learning Objectives
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Understand pertinent economic issues relevant to successful e-businesses Apply relevant economic concepts and methodologies to analyze e-business scenarios Employ rigorous analytical or quantitative methodologies to examine e-business conducts and strategies

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Course Topics Coverage
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Economics of Digital Economy Market and Competitive Analysis Pricing, Bundling and Versioning Lock-in and Switching Costs Network Effects, Compatibility and Standards Economics of Information (e.g., Information Asymmetry and Uncertainty) Online advertisement Emerging technology and new e-business models

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` ` Wasn¶t faster supposed to be better? Why are some companies degrading their product performance or quality even though it is more costly to produce than the original good? 6 . Intel purposely disabled the high-speed floating-point processor on certain chips.Puzzles? Counter-intuitive? ` IBM spent additional money to insert a chip to slow down one of its printers.

` ` ` Why bundle your products when you can sell them separately? What makes bundling attractive? Under what condition is bundling profitable? 7 . Excel.Puzzles? Counter-intuitive? ` ` Microsoft Office is a bundle of applications such as Word. PowerPoint and Access. mobile and broadband services at one fixed monthly subscription fee. Singtel Mio Plan bundle fixed line.

Puzzles? Counter-intuitive? ` IT companies often give away ´free trialµ products such as a stripped-down version of commercial software or a time-locked free trial version. ` ` ` Why give away your products for free? What makes a ´free trialµ strategy attractive? What is the difference between warranty and money-back guarantee? 8 .

Puzzles? ` Amazon MP3 charges a music track for 10 cents less than iTunes. ` ` ` How did Amazon decide this price? Will Amazon beat Apple in digital music market? Should Apple change its pricing strategy to differential pricing? 9 . The tracks downloaded from Amazon are compatible with all MP3 players currently on sale.

by Carl Shapiro and Hal Varian. Harvard Business School Press. 1999 Supplemental readings posted on IVLE ` ` 10 . McGraw-Hill. 2009 Information Rules: A Strategic Guide to the Network Economy. 7th edition. by Michael Baye.Reference Materials ` Managerial Economics and Business Strategy.

Grading Policy ` ` ` ` ` Homework In-class discussion participation Group Project Mid-term Exam* Final Exam* ‡ Exams are Closed-book 5% 5% 30% 20% 40% 11 .

Lecture 1: Economics of Digital Economy: The Primer .

and market equilibrium Consumer surplus Price elasticity 13 .Lecture Agenda ` ` ` What is the Digital Economy? What are the new things in the Digital Economy? Overview of basic economic concepts: ` ` ` ` ` Cost structures Economics of scale and scope Demand. supply curve.

the new economy. including communication networks (the Internet . 14 . software. intranets. and extranets). also sometimes called the Internet economy. and other related technologies.Digital Economy ` An economy based on digital technologies. or the Web economy . computers.

g.g. Basecamp) Third-Party Marketplaces ² leaving web marketing to third party (e. Google Doc. Google App Marketplace) Value-Chain Integrators or service providers (e.Business Models in Digital Economy ` ` ` ` ` ` ` ` E-Shops ² web marketing or a shop (B2C) E-Procurement ² E-tendering & procurement of goods and services (e....g. secondlife) Collaboration Platforms ² tools & infor. Taobao) E-Auctions ² E-implementation of bidding mechanisms (e. Alibaba) E-Shopping Centres/E-Malls² a collection of E-shops (e..g..g. Amazon marketplace.g. environment for members to collaborate (e. eBay) Virtual Communities ² members with common interests (e... Paypal) 15 .g.

catalog or on line Digital Economy Visit web site for publishers and retailers Access campus web site Use digital camera Use speed pass token wave over the sensor and go Metro cards electronic cards Use self ± service kiosks Use hub-like supply chain with digitized picture 16 . metal tokens Visit store.What are new things in Digital Economy? Example Buying and selling text book Registering for classes Photography Paying for Gasoline Paying the Transportation Paying for goods Supplying commercial photos Old Economy Visit the bookstore Walk around campus to Departments. take picture. pay . etc. Registrar¶s office. go inside. take it for processing Fill up your car. take the item. use camera. pay cash or credit card Pay cash. paper. go Use newspapers. Buy film.

chips.What are new things in Digital Economy ` ` High fixed-costs. order customized PC/laptop from vendor·s website) Companies can fine-tune prices much easier and often than conventional retailers Supply-side economies of scale (e. etc) Differentiation of products and prices ` ` Mass customization (e... etc) Demand-side economies of scale (i.g. movies. reduction in fixed costs. low marginal cost structures (e. compete to acquire monopoly. digital music. network externalities) ` Companies compete in both ways: ` ` 17 . software..g.e.g.

we need to understand: ` ` ` ` ` Costs faced by a firm Nature of supply Nature of demand Nature of market competition & equilibrium Elasticities of demand. complementarity and substitution between products 18 .Basic Economic Concepts ` To understand or devise optimal business strategies for ebusiness.

Economic vs. Accounting Costs ` Accounting costs² explicit costs ` ` Costs most often associated with production of output using labor and/or capital Conform to disclosure & accounting standards ITEM Payroll Rent Machines/Internet access COST $$$ $$$ $$$ ` Economic costs ` ` Explicit costs + implicit costs Implicit cost -.Opportunity cost is the highest-valued foregone alternative when any choice is made 19 .

Opportunity Cost ` Firm owns patent for producing a specialized IC ` ` ` Revenue = $800K per year Production cost = $500K per year Accounting Profit =$800K-$500K= $300K /year Royalty earnings: $400K per year ` ` Or it can license its patent and collect royalties ` What is the opportunity cost for using this patent for producing? ` Opportunity cost: $400K per year Economic cost: $900K (=$500K + $400K) per year Economic profit=$800K-$900K=-$100K per year The firm is better off by licensing its patent and collect royalties ` ` What is the economic cost for this patent? ` What is the economic profit for the firm? ` ` 20 .

. and Sunk Costs ` ` ` FC: costs that do not change $ as output changes VC: costs that change with the level of output Sunk cost: ` ` C(Q) = VC + FC VC(Q) ` Cost that is forever lost after being incurred Irrelevant in making profitmaximizing or loss-minimizing choices E.Fixed. Variable. R&D FC Q 21 .g.

Sunk Cost: An Example ` Consider two manufacturing companies: ` ` ` ` Firm A uses an old technology and is considering upgrading to a new technology Firm B is deciding between the old and new technologies and has not invested in either Both old & new technologies yield the same revenue Cost structure of both technologies is as follows: Old Tech Sunk Cost Other Costs S0 c0 New Tech S1 c1 22 .

S1=5. c1=17 ` Firm A: keep old tech. Firm B: invest in new tech Leapfrogging: less established firm can quickly surpass established ones in terms of technical efficiency Barrier to exit: a firm which has incurred in high sunk costs will have difficulty in deciding to exist the market even if it sees good opportunities outside ` ` ` 23 . c0=20.Sunk Cost and Investment ` Choices for Firm A (with sunk cost S0): ` ` New tech: S0+S1+c1 Old tech: S0+c0 New tech: S1+c1 Old tech: S0+c0 ` Choices for Firm B: ` ` ` Evaluate optimal choices for Firm A and Firm B: Where S0=10.

Cost-Related Definitions ` Average Fixed Cost AFC = FC/Q $ MC ATC AVC ` Average Variable Cost AVC = VC(Q)/Q ` Average Total Cost ATC = AVC + AFC ATC = C(Q)/Q ` Marginal Cost MC = [C(Q+(Q)-C(Q)]/(Q = dC/dQ 24 AFC Q0 Q .

Short-Run Costs ` Short-run average costs ` Fixed factors of production are unadjustable within short time horizons Minimum average cost of producing alternative output levels with optimal selection of fixed and variable production factors ` Long-run average costs ` 25 .Long-Run vs.

# of shoes produced) Technical Optimum Economies of Scale Q0 26 Diseconomies of Scale Q .g..Economies of Scale Cost per unit $ LRAC: Long-run Average Cost Everything along this line is a certain level of production (e.

there are economies of scale Example: Computer software. The marginal cost of reproducing a CD is negligible compared with the huge fixed cost associated with software development 27 .Economies of Scale ` ` When the marginal cost is less than average cost.

0) + C(0. if ` C(Q1.Q2) ` Cheaper to produce two outputs jointly Common expressions that describe strategies that exploit the economies of scope ` ´leveraging core competenciesµ ` ´Competing on capabilitiesµ ` Diversification into related products Example: Starhub offers cable TV and cable Internet access at the same time 28 .Economies of Scope ` ` ` ` C(Q1.Q2) > C(Q1.Q2): cost of producing two products simultaneously There are economies of scope.

Walmart) ` Specialization and increased productivity ` ` Inventories ` 29 .Sources of Economies of Scale/Scope ` Spreading of FC ` ` Reduction of AFC due to tradeoffs among technologies. Amazon.g.. capital intensive technology needs to be substituted for labor intensive technology Extensive special expertise and market demand to achieve economies of scale Maintain lower ratio of inventory to sales at same stock-out level (e. capital and labor If output needs to be increased beyond a point.

Source of Economies of Scale/Scope ` Cube-square rule ` ` ` Double the diameter of a hollow sphere and the volume will increase eightfold. whereas the surface area will increase only fourfold The cost of the sphere is likely to increase by less than eight times If the hollow sphere is part of production equipment in a chemical plant. cost savings follow from increased size Oil pipelines Warehousing Brewing tanks ` Example: ` ` ` 30 .

.Sources of Economies of Scale/Scope ` Purchasing ` ` Volume discounts. KRAFT) Minimum feasible size to R&D efforts Spillovers in ideas and findings for new research ` Advertising ` ` ` Research and development ` ` 31 .g. higher advertising reach associated with large firms (e.. purchasing alliances E. ubiquity of STARBUCKS) Umbrella branding: reduced advertising costs per effective message or product image (SONY.g. group insurance Lower advertising costs/customer.

Supply Curve ` ` A supply curve shows the amount of a good that will be produced at different prices. holding other factors constant Law of Supply ` The supply curve is upward-sloping Price S0 Quantity 32 .

Supply Shifters ` Supply of a good is determined by: ` ` ` ` ` ` Input prices Substitutes in production Producer expectations Number of firms in industry Technology or government regulations Taxes 33 .

holding other factors constant ` The demand curve is downward-sloping Price D0 Quantity 34 .Demand Curve ` ` Law of Demand : ` Price & Quantity demanded are inversely related A demand curve shows the amount of a good that will be purchased at each possible price.

Demand Shifters ` ` Definition:Variables other than the price of a good that influence demand Demand of a good is determined by: Income (normal or inferior good) ` Prices of related products (substitutes and complements) ` Product quality Price ` Advertising ` Consumer tastes ` Population ` Consumer expectations ` Increase in demand Decrease in demand Quantity 35 .

` M = income. ` ` Normal good. H.) ` ` ` Qxd = quantity demand of good X. ` ` Substitute good. M. ` H = any other variable affecting demand.PY .The Demand Function ` A general equation representing the demand curve Qxd = f(Px . Complement good. PY = price of a related good Y. Inferior good. 36 . Px = price of good X.

Consumer Surplus ` Reservation price ` ` Maximum price willing to be paid for a product Represents the valuation of product Value consumers get from a good but do not have to pay for =Reservation price ² Market transaction price ` Consumer surplus ` ` 37 .

2 3 4 5 Quantity .Consumer Surplus: The Discrete Case Price 10 8 6 4 2 D 1 38 Consumer Surplus: The value received but not paid for. Consumer surplus = (8-2) + (6-2) + (4-2) = $12.

$8 = $16 Value of 4 units = $24 8 6 4 2 Expenditure on 4 units = $2 x 4 = $8 D 1 39 2 3 4 5 Quantity .Consumer Surplus: The Continuous Case Price $ 10 Consumer Surplus = $24 .

Minimum price accepted by producer 40 .Producer Surplus ` Producer surplus ` ` ` Producer analog to consumer surplus Amount received in excess of minimum necessary to induce production of a good =Market transaction price .

Market Equilibrium Price ($) Consumer Surplus Aggregate Supply Curve P* Producer Surplus Aggregate Demand Curve Q* Quantity Balancing supply and demand (QS=QD) 41 .

Question #1 ` ` Event:The WSJ reports that the prices of PC components are expected to fall by 5-8% over the next six months. Scenarios: ` ` S1:You manage a small firm that manufactures PCs S2:You manage a small software company ` Question: What will be the impact of your product price and sales? 42 .

Question #1: PC Manufacturer Price of PCs P0 P1 S S1 D Quantity of PCs 43 Q0 Q1 .

Question #1: Software Company Price of Software P1 P0 D1 D Quantity of Software S 44 Q0 Q1 .

income.Elasticity Concept ` ` Measures sensitivity of change in one variable with respect to that of another variable E AB « dA » % change in A ¬ A ¼ dA B ! !­ ½! % change in B « dB » dB A ¬B ¼ ­ ½ ` ` Economic variable A: quantity demand Economic variable B: price. advertising 45 .

time.Own-Price Elasticity of Demand ` ` Measures sensitivity of change in quantity demand with respect to change in its own price EQP « dQ » % change in Q ¬ Q ¼ dQ P ½! ! !­ % change in P « dP » dP Q ¬P ¼ ­ ½ ` Determinants: substitutes. switching costs 46 . inputs· price sensitivity. expenditure share.

000 12.Own-Price Elasticity of Demand Price $100 $90 Demand 10.000 Change in price: $90-$100 = -$10   % Change in price = -(10/100)*100 = -10% Change in demand: 12000-10000 = 2000   % Change in demand = (2000/10000)*100 = 20% Own-price elasticity of demand? Ped=%change in qty dd/%change in price = 20/-10 = -2 47 .

Elastic/Inelastic Demand ` ` ` Demand is said to be elastic if |EQP| > 1 Demand is said to be inelastic if |EQP| < 1 Time to think about Puzzle #2 Price Perfectly elastic demand Price Perfectly inelastic demand Quantity 48 Quantity .

Cross-Price Elasticity of Demand ` ` Measures sensitivity of change in quantity demand with respect to change in price of another good ` « dQx » % change in Qx ¬ Qx ¼ dQx Py ­ ½! ! EQxPy ! % change in Py « dPy » dPy Qx ¬ Py ¼ ­ ½ Two products X and Y are: ` ` Substitutes if EQxPy > 0 Complements if EQxPy < 0 49 .

market share for soft drinks. Firm choices & outcomes: ` ` ` Pepsi: sell 12oz bottles at 10c   no sales boost Pepsi: sell 12oz bottles at 5c   sales shot up. Coke had most of U. Pepsi entered bankruptcy. profits increased. out of bankruptcy in 1934 Coke: keep 6oz bottles at 5c   let Pepsi steal share Why didn·t Coke follow Pepsi with the price cut? Why did Pepsi reduce price and yet increased profits? ` Questions: ` ` 50 .S.Question #2 ` ` Event: In 1931.