The Economics of e-Commerce and the Internet



The Economics of e-Commerce and the Internet

Edward J. Deak, Ph.D.

Ch. 9 – Answers for Discussion and Review Questions

1. In what ways did the Internet and Web pose a threat to the market power and profits of Microsoft? How did Microsoft react strategically to this threat of creative destruction?

The source of Microsoft’s market power and financial strength is the Windows operating system that controls the inner workings of most desktop and laptop computers. Net appliances, using a browser, would allow users to connect to the Internet and conduct business without the use of Windows. This bypass of Windows threatened the future of Microsoft, so the firm introduced its own browser, Internet Explorer (IE), to compete with Netscape Navigator (NN). Microsoft reasoned that if it could control the browser market it could control access to the Internet. To ensure the dominance of IE, the product was bundled along with the Windows product, effectively making the browser available for free. This bundling and pricing strategy raised the market share of IE and ended the dominant role of Navigator in the browser market.

2. Describe the nature of the economic tension that exists between defending the use of private property to encourage risk taking and innovation, while ensuring that the use of the property does not inhibit competition or the ability to compete. How is this tension demonstrated with the bundling aspect of the Microsoft antitrust case?

Private property allows the holder to potentially reap the rewards of entrepreneurial risk taking and innovation. However, society can be worse off if the property is used in such a way as to inhibit or eliminate competitors or the ability to compete. Microsoft has been richly rewarded for putting forth the DOS and Windows operating system that has standardized computer interconnections. This has been of great benefit to society. But the use of the operating standard to bundle Internet Explorer and crush Netscape Navigator has potentially lessened competitive benefits in the browser market.

3. Cite evidence in support of both sides of the first-mover advantage strategy, that it is real and sustaining, as opposed to the view that it is simply part of the e-commerce folklore.

Being first to the market with a new product or process is thought to covey substantial benefits to the first mover. They are the first to launch and learn from the new product, with the ability to improve upon it quickly. Second, they can get-big-fast and build up economies of scale that render the first mover as the low cost firm. Third they can establish their brand name in the mind of the consumer and make their brand synonymous with the identity of the product. is thought of a being one example of a very prominent and effective first mover.

However, not all first movers survive and come to dominate the market. was not the first search engine, nor was the first e-commerce travel site. Having a strong fast second strategy of learning from the mistakes of the first mover or seeing unfilled gaps in the market may make the imitator the eventual winner. For example, AOL saw a better way to provide Internet service and soon replaced first mover Prodigy as the leading firm in the market.

4. What are the strategies that e-commerce first movers have used to establish themselves in the marketplace? Are such strategies always successful? Why?

First, some have pursued a launch-and-learn strategy, where a first version of a product is introduced into the market place and then quickly modified on the basis of the feedback from users. Second, some have followed a get-big-fast strategy where they increase their volume of sales in the hope that the extra output will lower unit costs and lead to longer-term profitability. Third, some have followed an advertising strategy, where they repeatedly place their brand name in front of the consumer, hoping to create an overwhelming awareness advantage. Such strategies are not always successful because the dynamics of the market may be so rapid that imitators have an ability to overcome any first mover advantages.

5. What is the difference between tangible and intangible assets that allows a first mover to sustain a competitive advantage? Which asset form creates a potentially more lasting advantage? Why?

Tangible assets involve the capital resources, such as buildings, machinery and computers, that contribute to the operating efficiency of a business. These are important in creating a competitive advantage but can be duplicated by rivals. Intangible assets include the knowledge base, brand name, experience and service quality that provide a value added shopping experience to the customer. These are harder to duplicate and tend to convey a more lasting advantage when used properly.

6. What is meant by a “fast second strategy”? How can this strategy help a copying firm to be as, or possibly even more, successful than the first mover?

A fast second strategy involves seeing the success of the first mover and stepping in quickly to duplicate and improve upon the strategy of the first mover. The imitator saves the cost and doesn’t bear the risk of creating the idea and the product market. They also have the ability to see unfilled gaps in the market and tailor their version of the product to fill those gaps. Lastly, recall Schumpeter’s admonishing that it is not the owner of the stagecoach line who builds railroads. First movers can become fat, dumb and lazy as they wallow in their good fortune and forget about improving the product that is currently so successful.

7. Explain the process of how related and supporting firms have grown up around eBay. Why doesn’t eBay just buy up all of these firms and supply the services internally as they did with PayPal? Conversely, why doesn’t eBay create its own competing division to offer each of these services?

Ebay has grown to become one of the largest e-commerce firms with millions of transactions conducted over its global auction sites. The size of the operation allows for numerous specialized firms to arise and provide services in support of eBay transactions. PayPal the money transfer firm became so potentially profitable and important to the fluid functioning of eBay that it was purchased by the eBay. Ebay’s expertise is in the operation of the auction site. It would be spreading its resources very thin if it bought up and operated all of the ancillary services. Conversely, if it created internal competitors to these independent sites eBay would run the risk of alienating them and their expertise, with the possibility that they might provide better services to eBay’s small but potentially significant rivals.

8. How have eBay and acting as intermediaries, provided a profitable exception to the e-commerce trend of direct buyer-seller connection and the elimination of the intermediary function? How does their intermediation improve economic efficiency?

At one time it was thought that the Internet would lead to universal disintermediation, with sellers able to contact and interact with buyers directly and efficiently. However, it is becoming apparent that this direct contact has limitations in terms of the seller having the ability and desire to deal profitably with many small buyers. Also, there is an expertise in being able to provide a satisfactory, value added buying experience for Internet customers. Amazon and eBay have been highly successful in bringing buyers and sellers together efficiently through high volume, low cost operations.

9. Show graphically and explain why a money-losing price below average total cost is still economically efficient in response to competitive pricing pressures. Why is a money-losing price below average variable cost both inefficient and evidence of predatory behavior?

As long as the price is above average variable cost in the short run, it is efficient to price the product below average total cost. Only variable costs influence short run decisions to produce and sell. However if the price is below average variable cost then it is inefficient to produce the product and offer it for sale. To do so could be interpreted as being predatory in that the low price could not be justified on the basis of efficient pricing to meet the price of a competitor.

10. What assumptions are necessary for price discrimination to be a profit-enhancing behavioral strategy for an e-commerce firm? How does the Web enhance an e-commerce firm’s ability to engage in price discrimination?

The effectiveness of price discrimination as a diversionary pricing strategy first involves the assumption that different consumers have different price elasticities of demand. It also assumes that these consumers can be divided into separate markets without the ability of consumers in the higher priced markets to cross over and purchase the item in the lower price market. It also helps if the buyers in one market do not have the ability to find out the prices that are being paid by consumers in the other market. Price discrimination is sometimes referred to a dynamic pricing in that the seller varies the price among the different buyers. The Web facilitates dynamic pricing because buyers usually reside at isolated computer terminals and have minimal opportunity to connect with other buyers at the same instant to determine if the same or different prices are being quoted. In point of fact, firms such as pride themselves on being able to charge different customers different prices for the same item. And the customers love it, with each one thinking that they are smart enough and skilled enough at bargaining to gain the lowest price.

11. Why did nine state’s attorneys general object to the penalty provisions in the proposed agreement between the DOJ and Microsoft? What penalties or conduct remedies did they want to see imposed?

The attorneys general saw the provisions of the negotiated settlement as being to lenient. They wanted to shift the penalties from being directed at controlling past practices and redirect attention towards creating remedies aim at controlling the future actions of Microsoft. They wanted an order requiring Microsoft to produce a modular version of Windows that would easily allow original equipment manufacturers to remove various Microsoft applications and to substitute competitors programs on the opening screen or desktop. Second, they want an order requiring Microsoft to auction off licenses for its Office applications software and allow it to be run on competing operating systems such as Linux. Lastly, they wanted a court order requiring Microsoft to release the source code for the browser Internet Explorer to allow independent programmers to more easily write programs that would interact smoothly with IE.

12. Explain how leverage and exclusion can be used to limit competition in e-commerce and the Internet.

Leverage involves using market power in one market to dominate a second market. For example, Microsoft dominates the operating system market and bundles its browser and music player software with Windows to become the dominant firm in the browser and music player markets. Exclusion, sometimes known as foreclosure, involves a dominant firm in one stage of the market using that power to dominate at an earlier or later stage of the market. For example, some local telephone firms have been accused of using their power in the communications services delivery market to dominate the market for digital subscriber line (DSL) services that provide high-speed Internet connections over phone lines.

13. Identify the nature of the tension that arises as the antitrust authorities try to evaluate the economic consequences of B2B e-commerce exchanges. Have the authorities supported or rejected the establishment of these exchanges to date?

The antitrust authorities are concerned about the potential for exclusion, leveraging or cartel pricing as normally independent and competitive firms join together in cooperative B2B exchanges. Cooperation on one front may create too close a relationship that could lead to collusive behavior. To date, the authorities have been cautious but positive in their support of new B2B exchanges such as Covisint in the auto industry and Orbitz in the e-travel industry.

14. What does it mean to identify a firm as a neutral common carrier? How does this concept arise as part of the discussion of e-commerce and the Internet?

A neutral common carrier is a firm that makes its services available to any and all potential customers on equal terms. At times, the courts have required service firms to provide equal access on the basis of the determination that they are essential carriers. These concepts relate to e-commerce and the Internet in terms of open access of cable and DSL service firms to any and all Internet Service Providers. Must the providers of the pipes to the Internet allow equal access to any ISP or can pipe owners limit the contact of customers to the Internet to just the ISP that is linked to or favored by the pipe owners?

15. Identify the nature of the enforcement problem that the court created for itself in requiring just and reasonable terms as the basis for resolving the U.S. v. Terminal Railroad Association case in 1912. How is enforcement better handled within the Associated Press case of 1945? Why?

If rates must be just and reasonable, then someone such as the court must be responsible for continually monitoring the rates that have been set and the conditions to which they apply. Today’s just and reasonable rate can become tomorrow’s unjust or unreasonable rate by virtue of a change in circumstances. In the Associated Press Case, the court issued an objective standard calling for blanket openness rather than a subjective standard such as just and reasonable. As such, there was no ongoing need to monitor behavior.

16. Identify and distinguish between the arguments of advocates and opponents to open Internet access. Considering the importance and characteristics of the Internet, which side of the argument seems more persuasive? Why?

Advocates of open access base their position on two points. The first is a First Amendment argument saying that individuals should have the right to exchange comments and ideas without having the method of that contact dictated to them. Second, they feel that mandating open access is the best use of private property. Open access will more readily stimulate research, innovation and new ideas. The opponents of open access counter these claims with the following objections. First, open access will suppress rather than encourage innovation. Who will take on the risks of innovation if others can benefit equally in an unrestrained manner? Second, open access means that regulators will have to judge the correct price to be paid for the access. Competitive prices are best because they reflect the most efficient use of the resources and change the quickest to mirror altering conditions. Regulated prices lack these features and can stifle innovation as well as change.

17. How has the court distinguished between cable TV access and Internet access in resolving the issue of open access to the Internet via cable TV connections?

The court has ruled that cable TV access is a franchise that is subject to local franchise rules and control. However, Internet access is a telecommunications service under the terms of the Cable TV Act of 1984, and therefore subject to regulation by the FCC.

18. How might the multiple international Internet regulatory reviews and cases work to keep one or more firms from dominating key aspects of the system?

Multiple international Internet regulators introduce the potential for a wide range of Internet access issues to be heard and decided. The numerous ways of treating the Internet should allow a best practice to appear. Perhaps that practice might involve little or no regulation at all. With multiple jurisdictions to satisfy, it is less likely that one firm or small group of firms will rise up to dominate the Internet.

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