What the Internet means in terms of Economic Models

 

As previously mentioned, many proponents of the New Economy hastily proclaimed that the classic views of economics and markets didn’t apply, that the New Economy needed new rules. While that subject will always be up for debate, the current consensus is that this is not the case. Information and High Tech industries are subject to the same market forces and economics as other industries and many of the economic models developed during previous industrial revolutions work surprisingly well when applied to the current Information Revolution (Varian et al. 12).

However, one of the keys to understanding the High Tech economy is that forces that were relatively minor in the Industrial Economy turn out to be critical in the Information Economy. Effects that were uncommon in the Industrial Economy (network effects, switching costs, lock in, and unique cost structures) are the norm in the Information Economy (Varian et al. 3).

In the following sections we will discuss some more specific ways that the internet has impacted the economy in terms of the supply and demand models previously studied.

The Impact of the Internet from the Producers Point of View

In the section on supply, we learned the factors that can impact supply. One of the key factors that the internet has a hand is reducing the price of inputs for firms. The lowest price at which a firm can sell a good without losing money is the amount of money that it costs to produce it. Recall that as a firms input prices decrease; they will be willing to supply more at a lower price.

One way that this happens is B2B (business to business- when firms trade directly with one another) e-commerce. B2B e-commerce cuts companies’ costs in three ways. First, it reduces procurement costs, making it easier to find the cheapest supplier and cutting the cost of processing transactions. Second, it allows better supply-chain management. And third, it makes possible tighter inventory control, so that firms can reduce their stocks or even eliminate them. Through these three channels B2B e-commerce reduces firms’ production costs, by increasing efficiency or by squeezing suppliers’ profit margins (A Thinkers Guide).

Another way in which the internet reduces the cost of inputs for firms is the degree to which it facilitates outsourcing. For example, a Hollywood studio once employed everyone in-house from the actors to the lighting technicians. Today studios have retreated to their core competencies. For a film, they now assemble the teams of self-employed people and small businesses. The Internet is expected to push other industries in the same direction. Companies will find it easier to outsource and to use communications to develop deeper relations with suppliers, distributors and many others who might once have been vertically integrated into the firm (When Companies Connect). Recall the section on comparative advantage and trade. The principles that apply to two countries can also apply to two companies.

Another consequence of the Internet is that it enables firms to practice price discrimination, which is when firms charge different prices to different consumers for the same product. Price discrimination is very relevant to High Tech Industries for two reasons: first, due to the cost structures mentioned previously (high fixed costs, low marginal costs) price will often exceed marginal costs, meaning that the profit benefits to practicing price discrimination are very apparent. Second, Information technology allows for fine-grained observation and analysis of consumer behavior. This permits various kinds of marketing strategies that were previously extremely difficult to carry out, at least on a large scale (Varian et al. 12). For example, a seller can offer prices and goods that are differentiated by individual behavior and/or characteristics.

However, as we’ll see in the next section the ability to price discriminate is counterbalanced by the consumer’s ability to compare prices.

The Impact of the Internet from the Consumers Point of View

In the section on demand, we learned about the factors impacting demand. One of the major factors impacting demand is the price of the product, which we saw from the previous section, the Internet has a hand in lowering. At lower prices, consumers will demand more. More importantly however, is the impact of the internet in making prices more transparent. In fact, it’s been suggested that the new economy should be called the “nude economy” because the Internet makes it more transparent and exposed, in that it's easier for buyers and sellers to compare prices (A Thinkers Guide).

One of the traditional features of capitalism is information asymmetry, which is that someone (usually an expert) knows more than someone else (usually a consumer). But information asymmetries everywhere have been emaciated by the internet. The Internet is remarkably efficient at shifting information from the hands of those who have it into the hands of those who do not. Whether the case is term life insurance policies, the dealer invoice of autos, or the price of prescription medication the information existed but in a vastly scattered way. The Internet has vastly shrunk the gap between the experts and the public (Levitt and Dubner 61-62). Even in markets where there are relatively few direct online transactions such as auto sales, consumers appear to do quite a bit of information gathering before purchase.

The Impact of the Internet on the Market Itself

As mentioned previously, the economic principles of traditional markets still apply to the internet. Information is the currency of the Internet: it can be transmitted efficiently, conveniently, inexpensively, and is available to anyone. Theoretically, market friction should be reduced when information is more readily available to consumers and/or when consumer search is less costly (Elberse et al. 3). It has been found that internet markets are more efficient than conventional markets with respect to average price levels, menu costs, and price elasticity (Elberse et al. 4).

One consequence of this is a lowering of transaction costs. For instance, it’s been postulated that the potential for transactions cost savings from transition to the Internet is especially high in the health care sector, because it is so large (14 percent of GDP), so information-intensive, and so dependent on paper records (Litan and Rivlin). A lowering of transaction costs benefits both consumers and producers.

Another impact of the Internet is its ability to generate different pricing mechanisms, and in particular to allow price and product comparisons to be made and various kinds of auctions and exchanges to take place. Two things are making these possible. One is that the Internet provides a perfect medium for aggregating buyers and sellers from all around the world. The second is that the Internet offers an excellent way of comparing prices and collecting information, for example on new products, or on recent bids. Once again, to replicate this offline would be costly and time-consuming (In the Great Web Bazaar).

Thus the net effect of the internet is to lower costs for both the supplier and consumer as well as by more efficiently matching up supplies and consumers with each other. This results in a more efficient marketplace. However, despite the positive impact of the internet, internet markets are not nearly as efficient as theories would predict (Elberse et al. 5).


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Information Sources

“A Thinker’s Guide.” The Economist. March 30, 2000. http://www.economist.com/displaystory.cfm?story_id=298218

Elberse, Anita, Patrick Barwise, and Kathy Hammond. “The Impact of the Internet on Horizontal and Vertical Competition: Market Efficiency and Value Chain Reconfiguration.” The Economics of the Internet and E-Commerce. Ed. Michael R. Baye. New York: Elsevier Science. 2002. 3-5.

"In the Great Web Bazaar."  The Economist. (2000, February 26).

Levitt, Steven D. and Dubner, Stephen J. Freakonomics. New York: Harper-Collins Publishers, 2006.

Litan, Robert E. and Alice M. Rivlin, The Economy and the Internet: What Lies Ahead? 15 June 2007. The Brooking Institute.  http://www.brookings.edu/papers/2000/12technology_litan.aspx

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

“When Companies Connect”. The Economist. 26 June 1999.