Strategy for Information Markets/Introduction

Well into the information revolution, we can see that information markets don't violate the rules of economics, but they can change which rules deserve the most focus. Markets for information goods--and for physical goods with ties to information goods--can seem paradoxical. Products may be offered at wildly divergent prices, apparently having nothing to do with the costs of production. Competition can be extremely fierce, but so can the power of a market leader.

This book will describe features of markets for information goods, and related markets around such goods. It will use a standard economics approach most of the time, but will occasionally rely on insights from behavioral economics. Additionally, the book will examine the business methods and culture of the Internet economy. The book assumes a background in intermediate microeconomics and/or business economics.

There are several features of markets for information goods which make them peculiar, and difficult to study. Other things make these markets surprisingly "pure", matching the kinds of idealized examples an economics instructor would make up for a lecture.

Sunk costs
To create a pure information good is a one-shot affair. Once it has been created, it is available to be used, sold, or ignored without being re-created once a year. This means that for a pure information good, there is a large sunk cost element. That means that a cost has been incurred which can't be recovered even if the information good's seller decides to go out of business. A sunk cost is different than a fixed cost and will have very different strategic implications. (Even this is tricky, however. One thing we'll explore is whether the cost of creating the information good is truly sunk, or if it might be recoverable.)

Low marginal cost
The primary economic aspect of an information good is its cost structure. Information is nearly free to reproduce, which means that the cost structure for information goods is extreme. If there is any cost to produce the first copy, then this will mean a relatively high fixed cost, compared to the very low marginal cost. A low cost of production sounds good, but if the market is competitive, then we might expect the price to become too low to recoup the fixed costs. A low price might sound good for consumers, but this cost structure might mean that there's a natural monopoly. For instance, it is very expensive to produce the first antivirus software but only costs one more dollar to produce the second one. Firms make large profits with low marginal cost due to this cost structure.

"Marginal Cost" (Definition) - the cost a firm incurs to produce and sell exactly one more unit.

Intellectual property
Intellectual property refers to intangible asset as a result of a person's idea or creation. There are four main types of intellectual property: copyright, trademark, patent, trade secret. Because of the ease of reproduction, governments have worried that there won't be adequate incentive for people to produce information goods in the first place. Why put all the work into writing a book or inventing a new drug if someone can come along and copy it for free? The primary attempt to address this problem is in the form of intellectual property laws. These laws give the creators of an information good a legal monopoly (patent or copyright) on that good, usually limited in time and sometimes in scope. This monopoly can potentially change an extremely competitive situation into one where a producer has great market power and profit potential. It could even allow them to extend their power into other markets. Sellers are protected by intellectual property laws to charge price for their goods and support their creation.

Network externalities
Network externalities are the effects that one user of a good or service has on the value of that product to other people. There are positive network externality and negative network externality. Network externalities are not strictly limited to information goods, but their importance becomes more evident with many markets of the information age. A consumer of a product with network externalities benefits when other consumers use the same product. In all, this is a good thing, but it can make markets confusing. Even if there's no competition a market could be unpredictable. Consider the fax machine. If I'm the only person who owns a fax, then it's worthless to me. If many people own faxes, then it becomes valuable. Given this, it's quite reasonable to imagine a world with either zero or many fax machines. When competition between competing networks gets considered, the situation becomes even more complicated.

Tippy Markets
Some markets have a tendency for consumers to prefer to have a single brand or option for purchase. This usually occurs when there are high supply-side economies of scale, high demand-side economies of scale, and low taste for variety. The tippy markets eventually favor the one single product/service, and entry into the market after one has been chosen is extremely difficult. Tippy market is a "winner-take-all" market, there are a number of players but only one player can survive and takes all. Economies of scale and variety are the two factors for judging whether the market is tippy or not.

Other characteristics
There are other aspects of information goods which are less critical, but can also be important.

One-per-person
Frequently, we can imagine that each consumer makes a yes-or-no decision on whether to buy an information good, rather than a how-much decision. Apples, razors, and gasoline are how-much products, where each consumer is deciding whether to buy but also whether to buy a lot or a little. Typically, for an information good like a book or a piece of software, the consumer is only deciding whether to purchase the good at all and doesn't seriously consider buying multiple copies. Within the economics field, this is called "discrete choice".

When a product has this yes-or-no character, we will often use that to think in thinking about the market for the product. It's very important for products with network externalities, for instance, because we'll often assume that the size of a network (in number of consumers) is the same as the number of products sold.

This yes-or-no character certainly isn't strictly true for information goods. A person may decide to watch a movie at a theater repeatedly, might purchase multiple copies of a piece of software for more than one computer, etc.

Durability
Information is almost perfectly durable. We can still read the same Frankenstein that Mary Shelly wrote in 1818. Durable goods can present special strategic concerns, such as how a firm can continue to sell a product when they've already sold it to everyone who's interested. Resale potential also means that yesterday's customers could be today's competitors.

At the same time, many information goods are more transient on a practical level. Many people still want to read Frankenstein, but few are interested in a 5-year-old television review. And changes in formats (VHS to DVD to Blu-Ray video, vinyl to cassette tape to CD to MP3 audio) can refresh the market for the same information.

The media used to store digital goods are durable but not infinitely durable. While the life expectancy of optical media (such as CDs and DVDs)ranges from a few years up to several decades, the durability of magnetic equipment (such as floppy discs, hard-drive and tapes) does not exceed a few years.

Experience goods
Some information goods are experience goods, meaning that the consumer doesn't actually know how much value they put on the good until they've already experienced it. Strategies for such goods involve giving people a taste of what they will experience, and hope they value it enough to come back for more.For instance, a book is an experience good. At a bookstore, there are a number of books on the shelf with the same price. The customer does not know if it is worth buying one of the books. After reading part of the book the customer should know if the book is worth the money and make the decision. There are some social and economic institutions are used to solve the uncertainty problem for consumers such as previewing, reviews and reputation. Amazon usually offers consumers some pages preview of a book to help consumer to decide if he/she really want the book. Some popular websites provide movie reviews to let consumers know whether it is a good movie. Reputation is one of the most helpful ways to overcome the experience goods problem. Consumers prefer a high reputation brand since it is trusted by many other people.

To enhance users' confidence in experience goods, firms have given indications of how much users would enjoy products, and how much other users have enjoyed products in the past. Many firms have begun giving previews to books or websites, allowing only a certain amount of time on a website, or only a few pages of a book. This gives consumers a chance to test their immediate preferences with the product. Another strategy for firms has been to let former users rate their experiences with goods/services. If many consumers have enjoyed the good/service and given great reviews, other consumers are more likely to enjoy it and buy into the product.

Non-rivalry
When goods are competitive in consumption or can only be consumed by one person at a time we call such goods rival. For instance, if A gets more then B gets less. A typical rivalrous good might be a pizza that when one person consuming it there is less for another person to consume. Conversely, a good is non-rivalry if one person uses it doesn't diminish the ability of other people use it. For instance, street light is non-rivalry because one person use it doesn't diminish the ability of other people use it. However, non-rivalry can be part of piracy since someone can pirate an information good without diminishing the ability of other people use it.

Information goods have a high tendency to be non-rival, and, hence, many illicit trading markets have cropped up both online and in hardware form. Because information goods have very low marginal costs, it becomes easy for criminals to reproduce the product using their own manufacturing means. Many Internet users share information goods on Peer-2-Peer file sharing networks, which are free for users to take and receive programs. These areas of the Internet have been referred to as the Dark Net.

Additionally, piracy has become a large issue for information goods. Criminals are able to copy an existing movie or program and add it to a blank disk at very low cost, which they then sell to other users. Consumers enjoy a discounted program and the pirates enjoy the profits, but the movie industry, among others, has lost money to the products unsold by their company.

Excludability
A good or service is excludable when it is possible to exclude people from getting or consuming it if they haven't paid for it. For instance, movie theatre can exclude people without a movie ticket. Information goods may or may not excludable. Information goods like software and e-book are excludable which purchase is require if people want to get it. However, some information goods are non-excludable such as free-to-air television. If an information good is non-excludable then it would be difficult to have a control on copying it or distributing it.

Lock in
Lock-in occurs when consumers decided to stay with current product or network even if there is a better one exist in the market. There are individual lock-in and collective lock-in. It is expensive for an individual consumer switch from on product to another product. On the other hand, it is hard for every one to coordinate on a different standard when there are many people in the system. Many information goods have lock-in such as software. For example, it is costly to switch from Microsoft Office to Apple's iWork. It costs money to replace Microsoft Office with iWork and also costs time to learn how to use.

Software Patents
Information goods are easily replicated by other firms, so it has forced most products to be copyrighted or patented. With the rise of patents, millions of lines of computer code are patented for each program, but it only takes a few lines of identical code in a similar product to be considered patent infringement. Recently, major technological companies have begun buying other smaller firms to collect and own their patents, then look for lines of identical patented computer code other companies are using. Apple has recently taken on this strategy. In 2011, a powerhouse consortium led by Apple (AAPL) and Microsoft (MSFT) had agreed to buy from the bankrupt Nortel Corp. access to more than 6,000 patents covering key telecommunications technologies, from Internet services to wireless data networking. 

Opensource
Some firms, in opposition to the lengthy and cumbersome barriers software patents create, have begun using opensource technology, or technology that is available in source code form. Many Internet browsers have begun letting users download their products at no cost. Supporters of opensource technologies believe it to be a development methodology http://www.gnu.org/philosophy/free-software-for-freedom.html

Bundling
Many manufacturers have also begun bundling multiple products in order to force consumers to pay more for their goods. Sellers love bundling because it helps them better predict the demand for the bundle. If a consumer wants to buy Microsoft Word, they must also buy the entire Microsoft Office package for a much higher fee. Bundling works best when economies of scale are high and marginal costs are low, which perfectly fits the model for most information goods. Additionally, it's easy for some developers to use programs side-by-side and force consumers to own one program if they want to use another. Computer games have begun selling expansion packs that are an entire game in itself, but can't be played without having the original game installed. This also allows companies to sell rights to other firms to make expansion packs. Some consumers see bundling as unfair because it limits their buying power to choose the products they want.