Strategy for Information Markets/Cost Structure

Once the first copy of an information good has been created, it is nearly free to reproduce. This is a simplification, of course. There are some information goods where the instantiation of the good is very costly. For example, many works of art, such as sculptures and paintings, are inherently physical in spite of being information goods, and the process for recreating them is not standardized enough to achieve low-cost copying. As another example, consider a piece of music for a full symphony. Copying the sheet music, or an audio recording of the piece is very low-cost. However, recreating the full experience of a live symphony performance is very costly. When we talk about information goods being cheap to reproduce, we are assuming that the good is (or can be made) digital, and that the technology is readily available to turn that digital form into a useful form (e.g. a video, piece of software, book, etc).

However, more and more information goods do fall into this category. It used to be fairly costly to print a high-quality book with color pictures. Now it is fairly cheap to create a decent paper book, even if it is a one-time printing via a print on demand service, and there are platforms such as tablet computers which support a good reading experience of nearly-free digital versions of books. With experimentation in 3D printing and desktop manufacturing, it could be that a doll or a mug could soon be downloaded and recreated at home, and so be considered an "information good".

In general, the characteristics of information goods include the following:

Total costEdit

Total cost is the aggregate of all monetary inputs to produce a given outcome relative to output.Total cost is usually determined by two major costs: the fixed cost and the variable cost. Let FC be the fixed cost and VC(Q) be the function of variable cost depending on the quantity Q. Then the total cost TC(Q) is:

TC(Q) = FC + VC(Q)

Sunk costsEdit

A sunk cost is:

  • A cost that has already been incurred at the beginning of a project or before a business has even started.
  • A cost that cannot be recovered
  • Sunk cost is a retrospective cost

Information goods typically have very high sunk costs. Sunk costs are a type of fixed costs. The sunk cost can have an impact on whether or not a firm will enter a market. Often times a sunk cost is incurred at the beginning of a project but sunk costs are not limited to this phase of a project. For example, office equipment is needed before business can be conducted, therefore, depending on the size and type of business, an example of a startup cost could be a studio and equipment for music producers. The cost to purchase the equipment has been incurred and thus are sunk costs.

Sunk costs are unavoidable. In order to start a project or new venture these costs cannot be overlooked. Sunk costs are specific to a firm or project and therefore cannot be fully recovered. For example, a movie production team needs to use a main street in Los Angeles for a day and arranges an agreement with the city to pay to block off this street for a day; this is a sunk cost. In this case whoever is producing the movie will not be able to recover the fee even if it is raining that day and they are unable to film. A sunk cost is a retrospective cost because it is a cost that has occurred in the past. Prior to incurring sunk costs, a firm should determine if it will be able to recover sunk costs after entry into the market. Once sunk costs are already incurred, a firm should no longer consider the sunk costs in its decision-making, and should instead focus on maximizing net income or minimizing losses.

Fixed costsEdit

A fixed cost is a type of cost that a firm must pay regardless of its level of output, typically held over a certain period of time. Fixed costs must be paid whether or not the firm actually produces the good or not. Things like monthly or annual salaries, rent, and utilities are all examples of a firm's fixed costs. For firms producing information goods, the fixed costs tend to normally be very high. There are no fixed costs in the long run, but there are quasi-fixed costs in the long run.

Quasi-fixed costs Quasi-fixed costs are costs that only need to be paid if the firm is successful in producing output. Quasi-fixed costs are usually in the long run and are present when a firm must pay before any output is produced at all. This means that before the company starts production of any sort they must pay start up costs specific to that product.[1]

Average costEdit

Average cost is defined as the cost per unit of output. This is determined mathematically by dividing total cost (fixed + variable costs) by the quantity. Average cost curves are important part of a firm being able to maximize economies of scale. A firm is maximizing economies of scale when average costs are at the lowest point possible. Companies often invest capital into becoming more efficient and minimizing average costs while keeping the integrity of the of the product or service. Although, the process of minimizing average costs can actually hurt the value of the product if not observed carefully. The function of average cost is: AC(Q) = \frac {TC(Q)}{Q}

Marginal costEdit

Marginal cost is described as the cost associated with increasing quantity by one unit. When referring to information goods, marginal costs are usually low. An example would be the cost of producing one more of the Beatles' hit albums Abbey Road . This is an example of when marginal costs would be very low because the inputs needed to make one more vinyl record are not very expensive.

The marginal cost function is the derivative of the total cost function, and can be expressed as:

              MC=\frac{dTC}{dQ}   or  MC=\frac{\Delta TC}{\Delta Q}

As mentioned above, for most information goods the marginal cost is typically very low (near zero), and many times constant. This is inherent when considering an example of a firm that designs and develops software. The costs in creating and developing the software may have been high, but once created, the costs associated with distributing and selling additional copies of the software tend to be very low.

Marginal costs and non-rivalrous goodsEdit

Information goods are usually non-rivalrous, meaning that Amelia can consume more without Barry needing to consume less. While we introduced the idea of rivalrous and non-rivalrous goods as matters regarding consumption, it is actually a matter of the costs of production.

If a good is rivalrous, that means there is some limit on the quantity. That limit may be extremely rigid (there is a finite amount of gold on planet Earth), or less rigid (there is only so much gold available to people and it is costly to locate and mine more). For most goods, the less-rigid limitations are more important to us than the nearly-absolute rigid limits. The limitations are in how much it will cost to make more of the good available[2]. "How much will it cost?" really means "what other things do we need to give up to make it happen?" Costs are always a matter of trade-offs.

With a truly non-rivalrous good, there are no trade-offs. One person can consume more without depriving anyone else of the good, so no trade-offs means zero marginal cost. These two properties go hand-in-hand.

In practice, there frequently are small but non-zero marginal costs associated with information goods. Most of these costs, however, are not essential to providing the good, they are essential to earning revenue for the good. For instance, if a piece of software is made available on a store shelf, it will be on some medium such as a CD and it will have a box, all of which will need to be shipped and stored, and the materiel, transportation and inventory all have costs. However, if the company providing the software was not concerned with earning revenue from its sale, the software could be available free of charge from the beginning and allowed to pass from one consumer to another, for the minimal price of a little data storage and transmission. A company which provides software via download will have costs associated with maintaining their servers and billing, but if they didn't care about revenue, they would not have to host the software on their own servers and would not need to track billing at all.

Economies of scale and minimum efficient scale (MES)Edit

Supply-side economies of scale is defined simply as the process where producing more units allows a producer to do so at a lower per-unit average cost. More technically, a production process for a good or service displays economies of scale over a range of output when the average cost is declining over that range. This can create a cost advantage for a particular firm over their competitors. Essentially the bigger the better; firms receive cost benefits when expanding. Economies of scale are also referred to as scale economies.

When average cost declines as output increases, this means that marginal cost must be below average cost over that same period and the firm is exhibiting economies of scale. Conversely, when marginal cost reaches a greater than average cost the firm is displaying diseconomies of scale. Generally, average costs decline at low output levels and costs are increase at high levels of output. This creates a U-shaped average cost curve with price per unit on the y-axis and quantity on the x-axis. A U-shape average cost curve typically depicts a firm’s costs in the short run, because capacity constraints can increase costs.

U-shaped average cost graph

As showed in the graph above,

when MC < AC, AC is going down;

when MC > AC, AC is going up;

when MC = AC, AC is at its minimum and called Minimum Efficient Scale (MES), which represents the smallest quantity for a firm to produce to maintain the lowest average cost.

Economies of scale is a long-run concept that hinges on expansion. Some costs can be averted or spread through expansion. For example, when a firm begins to produce more they are able to spread their fixed costs over a larger output, achieving a lower average cost. Variable costs will continue throughout expansion, however, these fixed costs stay fairly consistent.

L-shaped average cost graph

Sometimes average cost curves are L-shaped, where costs decline with an increase in output to a certain point which is the Minimum Efficient Scale (MES) point, and the curve flattens out. Up until the MES point, costs are declining and after, costs remain constant. It can also be noted that economies of scale are exhausted at the MES because costs are no longer declining. An L-shaped cost curve is usually seen when a firm is extremely efficient in production.

A graph to show the situation of no Minimum Efficient Scale (MES) point in a market that the marginal cost is low and constant.

In the graph above, there is actually no MES point when the marginal cost is low and constant. The curve of average cost is approaching the marginal cost line but they do not cross with each other. In this case, there is no MES point.

Economies of scopeEdit

Defined as the relative total cost of producing a variety of goods and services in one firm rather than two separate firms, economies of scope, enhance productivity and allow firms a competitive advantage. Much like economies of scale, economies of scope create a competitive advantage through cost reductions. When economies of scope are established, it is less costly for one firm to produce both goods instead of separate firms producing the same goods. A firm exhibits economies of scope when:

TC(Q_A,Q_B) < TC(Q_A,0) + TC(0,Q_B)

If the total cost of one firm producing goods A and B is less than the total cost of one firm producing good A and one producing good B, then economies of scope are being utilized. This shows how a firm can reduce costs of goods and services while increasing variety. When relating information goods to economies of scope high school can be used as an example. Consider two firms that produce inputs to textbook manufacturing, Firm A produces paper and Firm B produces the hardcover backing for the textbooks. Firm A performs a cost analysis and realizes that it can use the same paper product to produce the hard cover for the textbooks. Firm A then begins producing both paper and hardcovers for less than the cost of firms A and B producing them separately.

Learning economiesEdit

Learning economies are defined as the cost reductions gained from experience in the field. Learning economies are also referred to as a learning curve; the steeper the learning curve, the more opportunity there are for cost advantages. As companies remain in a certain industry, over time they begin to perfect their trade and production process which leads to a decline in costs. The longer a firm is in working with a certain good or service there is more opportunity for learning. Learning economies are simply learning-by-doing activities. Much like the saying practice makes perfect; more time with a good or service allows for the producer to become more efficient and closer to perfection.[3]

Complex labor-intensive activities tend to take advantage of learning economies more than simple manufacturing activities. For example, preparing food is more likely to take advantage of learning economies than producing plastic bottles. This is not to say that learning economies are not possible when producing plastic bottles but through some research and the right equipment a bottle can be made. Preparing food takes more advantage of learning economies because as the cook learns, they will use less food, produce more and operate faster. Therefore in this case there is more opportunity for learning in preparing food.

ReferencesEdit

  1. Varian, Hal (2010). Intermediate Microeconomics: A Modern Approach (8 ed.). New York: W.W. Norton & Company. pp. 373. 
  2. Of course, even the most rigid limits are a matter of costs, since it should be possible to find extra-terrestrial gold, but the cost makes it currently not worthwhile.
  3. Besanko, David; Dranove, David; Shanley, Mark; Schaefer, Scott (2004). Economics of Strategy (3 ed.). John Wiley & Sons. pp. 95-101. 
Last modified on 17 May 2012, at 22:20