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Key Terms of Internet Economics

Cost Structures

Cost structures are an area in which the Information Economy differs from previous eras. Recall that fixed costs refers to sunk costs such as the cost of setting up an auto factory and marginal costs refers to the cost to produce an additional unit, like an auto. For instance, in terms of cost structures for physical goods the idea of constant fixed costs and zero marginal costs would be absurd. For Information goods however, this isn’t simply common, it is the rule rather than the exception. Take the development of software for instance; once the software is coded, distributing it electronically via the internet is virtually free. Even the cost of copying it onto a blank disk is virtually negligible. This is true not just for pure information goods like software, but for physical goods like silicon chips. A chip fabrication plant can cost several billion to construct but producing an incremental chip costs only a few dollars (Varian et al. 3).

Network Effects

Network Effects refers to a situation where the more people that use a good the more valuable and useful it is to you. For example, a single fax machine is useless in that there are no other machines it can communicate with. If a few more people have fax machines it becomes a little more useful. However, if many people and firms use fax machines then consumers have a high incentive to own one. The power of network effects is also illustrated by auction sites. The more people that use them, the more useful they are. That also confers a potentially bigger first-mover advantage on auction sites than on electronic retailers—an advantage eBay is so bent on preserving that it has triggered antitrust inquiries into its efforts to stop rivals logging into its site for price and bidding data (In the Great Web Bazaar).

Switching Costs and Lock In

Switching Costs are the costs associated with changing to a different version of the same type of good. This can include not only the cost of the good but also the time that must be taken to learn how to use it. For instance, if you were to switch from a Ford to a Chevrolet the switching costs would be very low; the controls on a Ford are very similar to the controls on a Chevrolet. However, if you were to switch from Windows to Linux, the cost could be substantial. You may have to change document formats, applications software, and most importantly, you will have to invest substantial time and effort in the new operating environment (Varian et al. 21).

The term “Lock in” refers to a situation where the switching costs are so high that a seller is unable to offer them a price sufficiently low to persuade a consumer to switch. At first glance it may seem that switching costs and lock in benefit the established producers so much that consumer’s surplus is whittled away and monopolies are immanent. However, when lock-in, switching costs, and network effects are factors, the market will adapt. On both sides of the transaction, there is an incentive to find ways round the problem. On the demand side, groups of consumers can get together and co-ordinate their choices. On the supply side, producers can start by selling their superior new product at a loss: if it really is superior, the market will adopt it and move across. Or they can spend heavily on advertising. Or they can help newcomers to switch by promising compatibility, as when cable-television companies offer to convert old televisions to the new system (Lock and Key).

Back to What the Internet Means in Terms of Economic Models

Information Sources

“In the Great Web Bazaar.”  The Economist. Feb. 26. 2000.

“Lock and Key.” The Economist. Sept 16. 1999.

Varian, Hal R., Joseph Farrell, and Carl Shapiro. The Economics of Information Technology. Cambridge: University Press. 2004
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