Economics of Information

Economics of Information

Sam Choon Yin (2004)

Availability of information enhances one’s ability to make more rational and informed decisions. Shapiro and Varian (1999) define information as ‘anything that can be digitised – encoded as a stream of bits’ (p. 3).[i] But information need not necessary be presented in digital forms. Books and magazines for example are presented in text forms. Information can also be transmitted in broadcasted and audio forms through the television and radio respectively. Economic theory assumes that individuals have perfect information to work with. In reality, this is often not the case. Information may not be readily available at times. They may be costly to obtain and not easily deciphered because of their technicality. Even if they are available, a typical person is subject to cognitive limits in which case a typical person may be contented with less than optimal choices. 

            Despite the presence of imperfect information, one cannot deny the importance of information in the everyday life. An informed person is able to decide more superiorly how he/she can allocate his/her resources in an efficient manner. Facing the scarcity problem, everyone has to make hard choices. It is with adequate, timely and accurate information which enables a person to make more informed choices for the overall betterment of the society in general and the person in particular. The study on information is rejuvenated to some extent because the flow of information has become more rapid thanks to the advancement in technology. For example, with more advanced machines, books can be printed at a faster rate. News can be transmitted from anywhere so much faster today than in the past. With the Internet, one can access to news all day round at reasonably low costs. Messages can be sent and received electronically in less than a minute as compared to the case where letters and reports had to be sent through the normal post.

But information is so abundant nowadays that what is in shortage, as some observers claimed, is ‘attention’. As Nobel Prize Winner Herbert Simon says: ‘What information consumes is rather obvious: it consumes the attention of its recipients. Hence a wealth of information creates a poverty of attention, and a need to allocate the attention efficiently among the overabundance of information course that might consume it’.[ii] The quality of information contents matters without a doubt. It is quality information which one really desires, and not just any information. With so many things to read and learn, and with limited time to spare, there is a great demand for technology, software or tools (in general) to summarize, sort and search the information for the users.

Information is relatively costly to produce. Writing a book for example takes a substantial amount of time and attention from the author. But information is relatively cheap to reproduce. Binding another copy of the book for example costs little. With the advancement of technology, the contents of the book can be moved around online at an even lower cost. In Economics, we say that production of information generates high fixed cost and low variable cost. Accordingly, the marginal cost of producing information is very small. Also, variable cost per unit is generally constant meaning that the unit cost of producing the 10th unit is more or less similar to the unit cost of producing the 10,000th unit. Over time, the unit cost declines, as better tools are developed to ‘produce’ information products. For example, transmitting and reading the book contents online costs much lesser that reprinting and binding the book. The supporting tools are also becoming cheaper over time thanks to competition. The price of floppy discs and videotapes for example has fallen tremendously over the years.

There are several implications related to the cost structure of information. First, information producers are in a very good position to reap substantial economies of scale, defined as the reduction in the average cost of production as output rises. The reason being that the fixed cost of producing information is relatively high. Thus, with more output, the fixed cost per unit falls. Moreover, with the low marginal cost of production, there is incentive for the producers to expand their scale of production. This is being observed in reality. Making a movie for example is a relatively expensive project to undertake. Most of the fixed cost is in the form of sunk cost which cannot be recovered. Expenditures on props, costumes and actors’ fees for example cannot be recovered even if the movie flops in the box-office. But reproducing the movie is cheap. The movie contents can be copied easily and cheaply into compact discs and videos for further distribution and viewing. The same movies can be shown many times (re-runs) domestically and abroad and in different forms like in theatres and videos. Doing so allows the movie studios to reap economies of scale more substantially. The same thing applies to news providers like Bloomberg and Reuters. Writing the stories takes time and effort which translates to high fixed (sunk) cost of production. But once they are completed, the cost of reproducing the information is very small. Thus, it pays for the news providers to find whatsoever means they can to expand their production volume so that their news can reach a larger audience. Value adding services like sorting the stories; selling them to various newspapers around the world and compiling the stories for specific buyers are common.

Second, the characteristics of information provide a case for its producers to compete through non-pricing strategies. Sellers in other words have certain power to control prices. While it is true that entering to and exiting from the virtual world is relatively easy and usually unlimited, the case for the information market to be perfectly competitive may not be easily realized. In the perfect competitive markets, the sellers are essentially price takers. They have to accept the price as determined in the electronic market place. Competition will drive down costs such that in the long run, all the firms in the perfect competitive markets can earn only normal profits. But such events may not be realized in the case of the electronic market place. Information sellers can add value to the information they provide. After all, the prices that buyers are willing to pay are linked to the information value, and not costs. By adding value to the information provided, the sellers can differentiate themselves from the rests, thus allowing them to charge a premium to the information goods and services provided. As I have mentioned earlier, with abundance information, what customers want is to have some tools to facilitate the transmission of information like providing sorting, summarizing and searching services. A seller can do just that to distinguish itself from the rest.

A classic case of production differentiation can be linked to the downfall of Britannia Encyclopaedia. The company faced stiff competition from providers of encyclopaedia content (like Microsoft) in the multimedia form. In 1992, Microsoft entered into the encyclopaedia business by buying the rights of Funk and Wagnalls, a second-tier encyclopaedia. It created the encyclopaedia CDs with easy-to-use functions. They cost a fraction of what Britannia was selling to its customers. Buyers were responsive to the price and electronic gadgets that come along with the CDs. Britannia’s sales performance fell as a result. Britannia tried to venture into the electronic business but never recovered. The company’s main competitor appeared to be the computer. With it, the users were willing to do away with the solidly bounded copies. To the parents, the information content appeared to be of secondary importance. Having a computer is deemed more necessary perhaps because of the complementary uses that the computer can bring to the child. Of course, price matters too. What Microsoft did is to compete through cost leadership. Because of the low cost of reproducing, Microsoft is willing to cut the selling price of the CDs and hoping that it can gain through volume growth. Microsoft also offered a differentiated product. Users have a new way of obtaining information as compared to the past where flipping of pages on the thick and bind books was common.

The key is to find out what consumers want so that information can be customized to the customer needs. Information providers can know more about the customers when the latter make registrations and pay their bills. The service providers can also observe the websites consumers searched to understand more about them. Hotmail applied this strategy.  Because of the free e-mail addresses it provides, many consumers are willing to open accounts with Hotmail. All they have to do is to fill up a form online. But the details found in the forms provide very useful and valuable information which information providers would pay substantial amounts to acquire. It is not surprising thus for Hotmail to provide free e-mails to you and me. They cost the company virtually nothing to have an additional user. In the process, it can sell its customers’ details to others. The company benefits as a result. In the case of Hotmail, because of the heavy traffic flows, and thus its possession of valuable information about the consumers, Microsoft acquired the firm for an estimated US300 million to US400 million. Of course, Hotmail also earns revenue through the advertisements it posted on its website.

There are other examples where production differentiation is practiced. Information like news is bundled in various forms to suit the users’ taste. They can be grouped in specific categories and cater to those who demand specifics and in-depth news. Gartner Group and Forrester Research for example provide such services. Information goods like computers and television are also differentiated each containing different functions to suit the needs of their respective users.

The demand for information is thus relatively price inelastic such that the sellers can charge a lower price to sell more of its goods and services. Because of its ability to offer a differentiated product, it can also sell the information at a higher price without losing a substantial number of its clients. This is true even in cases which may resemble quite closely to the perfect competitive markets like Hotmail and Yahoo. The degree of user-friendliness in using these services for example can differ. With some monopoly power, it makes sense for the information sellers to practice price discrimination to increase and maximize the producer surplus in the present value terms.

To understand more about price discrimination in the information economy, it is useful to appreciate the ‘lock-in’ concept. Locking in the consumers is essential in this context because information is an experience good. Users usually require to have first hand experience of the information before deciding whether to continue acquiring it or otherwise. Magazines and on-line information providers are often willing to offer their information at low prices for first-time users (earlier, I talked about Hotmail offering free of charge e-mail services to create the traffic flows). Once the consumers are locked in and realize the benefits of using the ‘information’, say because of the superior information content and ease of transferring files, printing documents and searching, they are more likely to continue with the subscriptions. Because of the low marginal cost of producing the information, the revenue generated from the users can easily exceed the costs incurred.[iii] What the producers really want is to increase the number of people making use of their information. They go for ‘quantity’. Moreover, the renewal rates for lock-in consumers do not have to change. The sellers do not have to resort to offering benefits like free gifts to entice them to stay on if the current users are willing to subscribe to the information. Of course, when the users decide to leave, the sellers can and should resort to offering gifts to entice them. Value added services could also be offered to the current subscribers to entice them to continue subscribing to the information. News providers usually practice this.  

There are other ways to price discriminate. Information providers can price their products according to the users’ willingness to pay. Libraries for example are usually more willing to pay higher prices for a similar good (like journals and magazines) than a single user because of the greater number of users using the information product. Likewise, a single subscriber to statistical information (like TREND from Singapore’s Department of Statistics) is less willing to pay than say an organization where information sharing is possible. The subscription fees thus should be lower for the former. Avid readers are usually more willing to pay for hardcover while those who are willing to wait a little longer will go for the cheaper paperback version.

Lock-in is more common if the switching costs are high. The most often-quoted example perhaps is the computer software. Microsoft Office for instance is so commonly used nowadays because many have started using the software since they began using computers. Basically, Microsoft wants to lock-in the consumers when they are ‘young’. To lock-in the users, Microsoft provides free computers with its software to schools so that the students become used to the way the ‘computer system’ works. The other reason why people remain loyal to Microsoft products is that it can be problematic to transfer files from one computer to another if different software is used. The issue of compatibility is relevant here.

A related phenomenon is network externality. It says that the value of the good (which defines the users’ willingness to pay) depends on how many other users are using this particular good. Microsoft Office for example has a large network externality because of the ease to transfer files among those who are also using the software. Larger externalities translate to higher switching costs. The product’s demand in this case tends to be more price inelastic than others. Without significant competitors in the market, monopoly prices may be charged to reap larger producer surplus. Telephones, e-mails, computer keyboards, fax machines and computer software are examples of goods that possess very high network externalities.

The challenge to producers selling these goods is to obtain a critical mass. Once this is achieved, the market will grow by itself. Sellers are willing to offer free samples to reach the critical mass. When the competitors introduce substitutes, the incumbents should not hesitate to make pre-release announcements to deter users from switching to the competitors’ products. While this may prevent consumers from switching, the strategy unfortunately may cannibalise the current information product(s) supplied since the users might choose to wait for the new product to release. There is thus a downside to it. It is also important that the incumbent seller provides a new product that is compatible with previous versions (like between Microsoft 95 and 97 versions) for ease of ‘transporting’ and also stick to its promise to deliver a product that is, by right, relatively more superior.

Advancement in technology has facilitated the flow of information. More information can be digitised which makes them easier to move across borders. The study on technology is not a new thing. In the operations function for example, it is well known how advancement in technology has facilitated works done in the transformation process. Production areas have become more efficient than before as more can be done with less. Some of the common technologies used include computer-aided design (CAD), computer-aided manufacturing (CAM), robotics and numerical controlled (NC) machines. In service organizations, computers, automatic teller machines and cashier machines are commonly used so that work can be done in a more effective and efficient manner.

Because more information can move across nations to reach wider groups of people, how businessmen conduct their businesses has been drastically changed. Thanks mainly to the expansion of the Internet, businesses can be carried out on-line, a practice commonly known as electronic commerce (e-commerce). David Vanhoose defines e-commerce as ‘any process that entails exchanging ownership of or rights to use goods and services via electronically linked devices that communicate interactively within networks’ (VanHoose, 2003, p. 7).[iv]  Firms can purchase and sell goods and services over the Internet, a kind of transaction known a Business-to-Business (B2B). Consumers too can buy and sell on-line. They can buy from firms (known as Business-to-Consumers – B2C). They can also sell to firms (Consumers-to-Business; C2B) or other consumers (Consumers-to-Consumers; C2C) through auction websites (like e-bay).

The Internet was initially developed in the 1960s for defence purpose. It enabled computers to be connected but transmission of files and e-mailing without the web server was not very friendly. In 1991, Tim Berners-Lee released the first World Wide Web software which together with the web browser, Mosaic[v], allowed for easier communication of the computers to websites. This is done by simply keying in the domain name. But the browser alone is not sufficient to link someone to the virtual world. The browser is attached, and normally provided along with the personal computer. To link to the web, the users need to apply for the ‘pass’ from the Internet Service Providers (ISPs like Singnet). The purpose is to acquire the Internet Protocol (IP), which is a common communication language for computers to interact with one another and for transmissions across networks in the virtual environment. Connecting with ISP requires the users to apply the right address scheme (known as Universal Resource Locator – URL). A common URL is http (Hypertext Transfer Protocol). 

The usefulness of the Web is discussed succinctly in Samuelson and Varian (2001).[vi] They wrote:

 

‘This Web put a friendly face on the Internet, providing an interface that a 10-year old, or even a 50-year old, could easily understand. Perhaps more importantly, the back-end protocols for authoring and distributing Web pages (HTML and HTTP) were easy to understand and use as well, facilitating the rapid deployment of Web Servers. The first Web sites were in universities and research centres, but other organizations soon followed’ (p. 3).

 

            Selling through the Internet offers numerous business opportunities to firms. It is not surprising therefore to see many high technological companies emerged in 1998-1999 leading to booms in the stock exchange for technology stocks. The bubble burst though in 2000. Nevertheless, innovative ideas came along. Venture capitalists tapped on the ideas and made them possible commercially. Software developers, computer games, online music, online movies and pornographic sites grew in numbers. Microsoft’s Bill Gates became the world’s richest man (he focused on the software). Intel Corporation, established in 1968, worked on the hardware and developed the popular Pentium chips. The brand name is currently a household name.

With the Internet explosion, markets are expanded although challenges exist. One of the challenges involves the exchange of money with digital or information products. Safety and privacy of delicate information must be assured so that the consumers and firms feel more comfortable trading in the electronic market place. It should be noted that not all steps involved in the transactions are in digital forms. Consider the purchase of a book from the Amazon.com. The book is not in a digitised form. Neither is the delivery service. Payments however are in the digital form. So is the overall process of visiting the firm on-line, and searching and placing an order for the book.

The second challenge involves the willingness of one to display, sell and share information in the electronic form. How much one is willing to do so depends on the strength of the intellectual property rights. As Varian (1995) notes:

 

‘If intellectual property protection is too lax, there may be an inadequate incentives to produce new electronic works; conversely, if protection is too strict, it may impede the free flow and fair use of information. A compromise position must be found somewhere between those who suggest that all information should be fee and those who advocate lows against the electronic equivalent of browsing at a magazine rack’[vii]

           

            It remains to be seen how the intellectual property rights and other issues (like e-commerce taxation and internet crime) are to develop. In the current state, the Internet seems to have provided more pros than cons. Information is more abundant thus assisting persons to make more rational and informed decisions. People are more aware of issues around them. Governments have a low-cost way to reach out to the people. With on-line information, corruption problem can become less severe as there is lesser need for householders and firms to bypass government officers to get things done for them. But asymmetric information remains. A company agent for example has hidden action and knowledge that can still be unknowable to others thus allowing them to reap private benefits at the expense of the principals.



[i] Shapiro, Carl and Varian, Hal (1999) Information Rules: A Strategic Guide to the Network Economy, Harvard Business School Press (United States).

[ii] Extracted from Varian, Hal (1995) ‘The Information Economy: How much will two bits be worth in the digital marketplace?’, Scientific American, September 1995 (pp. 200-201).

[iii] This is not applicable to Hotmail or Yahoo since e-mail services are provided free of charge. These companies earn revenue through other means.

[iv] VanHoose, David (2003) E-Commerce Economics, South-Western Thomson Learning (United States). To learn more about the Internet and how it works, refer to VanHoose (2003), p. 11-14).

[v] The creator of the web browser Mosaic, Marc Andreesson, became one of the founders of Netscape Communications Corporation, established in 1994.

[vi] Samuelson, Pamela and Varian, Hal (2001) The New Economy and Information Technology Policy, mimeo.

[vii] Varian, Hal (1995) ‘The Information Economy: How much will two bits be worth in the digital marketplace?’, Scientific American, September 1995 (pp. 200-201).