The economics of information
I. What is it?
• Characteristics of information
• The information supply chain
II. The information marketplace
• How it works
• Market failure and government regulations
• Taxing the internet
Introduction to Informatics - Fall 02
I. The economics of information
• What is it?
Characteristics of information
It is an asset for those who possess it
It can be easily shared
The marginal cost of production is near zero for the
second copy
It has value
It can be bought, sold, and traded in an information
marketplace
Introduction to Informatics - Fall 02
Information as an economic good has three properties that
seem to cause difficulties for market transactions
Experience good
An information good must be experienced before you
know what it is
Common techniques include:
Previewing and browsing
Providing reviews
Relying on reputation
Varian, H. (1998). Markets for Information Goods
http://www.sims.berkeley.edu/~hal/Papers/japan/index.html
Introduction to Informatics - Fall 02
Returns to scale
Information products have a different type of cost
structure
It has a high fixed cost of production and a low marginal
cost of reproduction
The costs for information goods are also sunk costs
These costs typically must be incurred prior to
production
They usually are not recoverable in case of failure
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Competition pushes prices towards marginal costs
making the sale of information difficult
The lack of entry restrictions tends to force profits to
zero over time
How can fixed costs be recovered?
The market structure for information goods is one of
monopolistic competition
Producers seek to recover fixed costs through creative
pricing and marketing arrangements
Price discrimination for information is common
Different groups of consumers pay different prices and
quality discrimination is commonplace
Introduction to Informatics - Fall 02
Public goods
They are non-rival and sometimes non-excludable
Non-rival: one person’s consumption doesn’t diminish
the amount available to other people
The same amount is available to everyone
Non-excludable: one person cannot exclude another
person from consuming the good in question
Exclusion is a social choice
It is sometimes more expensive to exclude people from
access to information
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Does information want to be free?
Is it public or private information?
What were the costs involved in creating, organizing,
and providing access to the information?
Financing intellectual property
Patronage: information producers, processors or
archivists work within fully funded institutions
Procurement: information is purchased from
independent contractors
Property rights: information production by independent
entrepreneurs who seek compensation for their labor on
an open market
Introduction to Informatics - Fall 02
The economics of information assumes that information
known by one person is potentially of value to another
These include ideas, expression of ideas, or facts
The utility of this information product to others can be as
an instrument to an end or as an end in itself
Read the paper to make stock decisions
Read for enjoyment
What matters is that someone other than the creator will
value having access to the information
The source of value to others is not a crucial distinction
National Research council (2000). The digital dilemma: Intellectual
property in the information age
http://www.nap.edu/html/digital_dilemma/appD.html
Introduction to Informatics - Fall 02
Compensating information creators
Most expect to get paid for information products
The amount should cover the first-copy cost
It should be enough to justify spending time and
resources and induce their creative effort
Figuring the amount
Setting the price above the cost of duplication and
distribution
The surplus above the costs can be paid to the creator
Pay the author a royalty based on the sales revenue of
the product
Introduction to Informatics - Fall 02
Figuring the amount
Using payments from a granting agency to offset first-
copy costs
A government research grant to a university to
undertake basic research
Combining the product with some other product and
selling the two in combination
Media products is combined with advertising that may
pay for first-copy and distribution costs
Each approaches is likely to be economically inefficient
Royalties raise the price above the marginal social cost
of producing and distributing it
The price of a novel includes a payoff for the writer
Introduction to Informatics - Fall 02
Grants transfer risks and financial responsibility away from
the producers of new information to the granting agency
This increases the incentive to produce new information
that the market would value
However, grants are based on cost reimbursement rather
than on the value of the output
This weakens the incentive of the contractor to manage
the project efficiently to minimize cost
Combining information and ancillary products
The main source of support for some sites is advertising
Viewers are attracted the content and their attention is
sold to advertisers
Advertising revenue can be used to cover first-copy costs
Introduction to Informatics - Fall 02
Lessons
No system for compensation can provide a perfect
solution to three economic problems
Adequately compensating information creators
Maximizing dissemination and use of new information
Selecting the most valuable information to be produced
Information policy inevitably involves trade-offs between
these three objectives
The royalty approach is effective in selecting the products
that users value
It fails to distribute the products as widely as needed to
satisfy economic efficiency criteria
Introduction to Informatics - Fall 02
The grants approach is capable of solving the distribution
problem efficiently
It lacks an incentive to ensure that users obtain the
products that generate the greatest net benefit to them
The ancillary product solution is better than the royalty
approach and worse than the grants approach on
grounds of economically efficient distribution
It is better than the grants approach and worse than the
royalty approach when it comes to selecting the
products that users want
Introduction to Informatics - Fall 02
• The information supply chain
Creation --> Distribution --> Consumption
Creation
The creation of information is a public good
It includes the activities needed to develop information
products so that they can be distributed to others
The cost of generating new information is independent
of the number of people who gain access to it
These are “first-copy costs” that are incurred in
preparing and distributing copies of the original
expression
Introduction to Informatics - Fall 02
Distribution
These include the costs of delivering the information
product to consumers
This activity entails two main steps:
Reproducing the physical embodiment of the expression
Delivering it to the consumer
Distribution costs vary widely according to the medium
Distribution costs are proportional to the number of
people who receive the product
Printed material, audio and video recordings
Introduction to Informatics - Fall 02
Distribution
Distribution costs depend on the size of the geographic
area to which the signal is transmitted
Broadcasting (television stations, radio stations, or
direct broadcast satellites)
Distribution of digital documents, music, and pictures
over the net is nearly costless
The actual costs of the transmissions are often well
below one cent
These costs are so low that they are typically not worth
monitoring and billing on a per-transmission basis
Introduction to Informatics - Fall 02
Consumption
We incur costs to use information products in addition
to the purchase price
Equipment needed to use an information product
TV, radio, an audio system, a computer/modem,
transportation to the theater
Consumption costs are highly variable across types of
information products
We pay more to use the net to read the newspaper at
home than to read the paper version
Electronic distribution reduces distribution and
storage costs but increases other consumption costs
Introduction to Informatics - Fall 02
The economics of information
I. What is it?
• Characteristics of information
• The information supply chain
II. The information marketplace
• How it works
• Market failure and government regulations
• Taxing the internet
Introduction to Informatics - Fall 02
II. The information marketplace
• How it works
The basic problem is how to allocate scarce information
resources
In a competitive marketplace, there is an “invisible hand”
Markets will reach efficient levels of production and
consumption
Goods and services are allocated throughout the
market
The optimum state is when people be better off
without making others worse off
Introduction to Informatics - Fall 02
This assumes that our decisions are economically rational
If the cost is greater than the benefits we think we should
receive from the product, we don’t buy it
If the marketplace is working, this should lead to price
reductions
If the product is good, we are typically willing to pay a
premium
This allows producers to raise prices
It also assumes that we act with perfect information
We know all we need to know about products, prices, and
benefits
Introduction to Informatics - Fall 02
• Market failure and government regulations
Market failure occurs when the market does not allocate
information resources efficiently
There are many reasons why this happens
The cost of reproducing the information product is less
than the cost of purchasing it
This occurs because information is a public good and
can be used by many simultaneously
Because the creator is not compensated, there is little
incentive to continue to produce it
Introduction to Informatics - Fall 02
The supply of information grows exponentially and the
amount that is consumed grows at best linearly
Our ability and time available to process information are
constrained
The ratio of information produced to that consumed is
moving towards zero
Varian argues that bad information crowds out good
Cheap, low quality information causes problems for
providers of high-quality information
Bad information should sell at a discount
Good information should sell at a premium
The problem for the commercial providers is to convince
us that they have high-quality information to sell
Introduction to Informatics - Fall 02
The common remedy is government intervention
Laws and regulations are typical means by which the
government tries to correct market allocation
Copyright laws attempt to ensure that the creators of
information products are fairly compensated for their
work
This creates incentives for continued creation
Patent, trademark, and trade secret laws have the same
purpose
Introduction to Informatics - Fall 02
Government intervention can also lead to market failure
Protection of intellectual property can lead to monopoly
This is an inefficient marketplace
The monopolist’s price is greater than the benefits the
consumer would receive
The problem is that the the benefits from the product
exceed the costs of production
If they do not purchase the product, the marketplace is
not allocating resources in the most efficient way
Introduction to Informatics - Fall 02
• Taxing the net: state level
According to the US Department of Commerce, US B2C
amounted to USD6.373 billion in the third quarter of 2000
This is an annual figure of ~$26 billion
http://www.census.gov/mrts/www/current.html
The debate focuses on goods shipped into a state by out-
of-state etailers
These goods are not subject to state and local sales
taxes
This has led to an estimated $5 billion in sales tax
revenue lost last year, according to pro-tax forces
The National Governors' Association estimates that by
2003, states will lose $10 billion in annual sales taxes
Introduction to Informatics - Fall 02
The pressure: 46 states collectively get 48% of their
revenue from sales and gross receipts taxes
National Governors’ Association
The problem: The 1998 Internet Tax Freedom Act (ITFA),
mandates a 3 year moratorium on special, multiple and
discriminatory taxes on ecommerce
Note that the law makes no specific mention of state and
local sales taxes
The issue: Existing state tax systems are not easily
applied to net-based ecommerce
Etailers, taxpayers, and taxing authorities are unsure
of the tax effects of ecommerce transactions
Introduction to Informatics - Fall 02
A 1999 KPMG survey of US financial executives at
ecommerce companies found that more than 2/3 felt that
state and local tax laws governing ecommerce were
ambiguous
More than half say that this ambiguity is inhibiting their
involvement in ecommerce
In the near term, states can be expected to aggressively
apply existing, though antiquated, laws to these
transactions or devise new revenue raising methods
Introduction to Informatics - Fall 02
State
boundary Business
Business
ISPs ISPs
Users Users
Users
Users
Ecommerce is a three-party virtual marketplace without
an identifiable physical location
It is within this framework that states are increasingly
being forced to apply a dated set of tax laws to quickly
evolving business transactions
Introduction to Informatics - Fall 02
What’s happening now?
States are responding to the net by targeting ISPs, a
relatively narrow segment of the ecommerce
marketplace
Tennessee is notifying ISPs that Internet access
services constitute interstate telecomm services, as
defined by Tenn. law, and are subject to sales tax
Some of the service providers receiving the notices
have no connection with Tennessee other than the
presence of customers within the state
Connecticut, Texas, Illinois, and Washington are
following similar strategies
Introduction to Informatics - Fall 02
Some states have special telecom taxes that they use to
include the provision of net services
These are typically imposed on the vendor of telecom
services and are measured by gross receipts
Texas is imposing its telecom tax on ISPs for services
accessed by calling a Texas telephone number or that
are accessed from within Texas by dialing a toll-free
number
Six other states, New York, Ohio, Louisiana, West
Virginia, South Carolina and Washington, are now
imposing similar telecom-type taxes on ISPs
Introduction to Informatics - Fall 02
Enforcing compliance on ISPs for these taxes will
increase administrative burdens for ISPs
The basic legal requirement for imposing taxes has
been that the interstate phone call originates or
terminates within the taxing state and must be billed to a
service address within that state
Traditional telecom vendors can track the origin and
termination of a long distance call and the billing
address
ISPs will not likely have this information available to
them, without having to pay for it
This makes it difficult to determine whether a state is
constitutionally permitted to impose these taxes
Introduction to Informatics - Fall 02
State and local income taxes also will present complicated
issues for ecommerce
States typically require multi-state providers of services
to source receipts to the state having the greatest
proportion of income-producing activity, measured by
costs of performance
This will be a difficult calculation for vendors of services
over the Internet
The principal taxes here are sales and transactions taxes,
imposed by 45 states and the District of Columbia
Does a vendor source its sales to the state where its
headquarters is located, its database is located, or where
its ISP is located?
Introduction to Informatics - Fall 02
The controversy continues:
The Advisory Commission on Electronic Commerce
chaired by Republican Virginia Gov. James Gilmore
examined the issue of net taxation in 1999
They recommended to Congress in April that the 3
year moratorium on net taxation be extended 5 more
years (2006)
40 governors wrote to Congress arguing that not
being able to tax the net will cost their states at least
$25 billion annually and will imperil education funds
They asked the federal government to leave these tax
decisions to the states
Introduction to Informatics - Fall 02
There are constitutional issues
In Complete Auto Transit, Inc. v. Brady, (1977) the
Supreme Court set a four-prong test for determining
whether a state tax is constitutional
(1) the tax must be applied to a taxpayer having
substantial nexus with the state;
(2) the tax must be fairly apportioned;
(3) the tax must not discriminate against interstate
commerce; and
(4) the tax must be fairly related to services
provided by the state
Introduction to Informatics - Fall 02
As ecommerce evolves, the first two parts of the test
should raise the greatest number of constitutional
issues
“Substantial nexus” is the connection between the
taxpayer and the state that gives rise to a tax
obligation
In Quill Corp. v. North Dakota (1992) , the Court set a
bright line nexus standard:
A taxpayer must have physical presence in the taxing
state before the taxpayer has “substantial nexus”
The court blocked North Dakota’s bid to impose a
sales tax on a Delaware mail order firm because it was
a barrier to interstate commerce
Introduction to Informatics - Fall 02
In Goldberg v. Sweet, a 1989 telecom tax case, the Court
stated that
“[w]e doubt that states through which the telephone
call’s electronic signals merely pass have a sufficient
nexus to tax the call”
This makes it more difficult for states to argue that
businesses using the net for ecommerce will have
“nexus” in states where they do not have physical
presence
Introduction to Informatics - Fall 02
What states may do is to use innovative and aggressive
approaches to collect net taxes
For example, they may construe the activities of ISPs
as those of an in-state representative
In Scripto, Inc. v. Carson (1960), the Supreme Court held
that an out-of-state seller with no in-state physical
presence was subject to a “use tax” collection
responsibility based on the presence of in-state sales
brokers who were not employed by the taxpayer
This allows the activities and nexus of the brokers to be
attributed to the taxpayer (ISPs), no matter where they
may be
Introduction to Informatics - Fall 02
The in-state presence of an ISP could be attributed to the
seller of goods using the net
Access providers have computer locations in many
states
States may attribute nexus to merchants based on
these nodes
Electronic malls are becoming more prevalent
States could argue that the independent contractor,
in this case the ISP or electronic mall, is assisting the
vendor create and maintain market share
Business people would be required to analyze, assess,
and monitor the presence of their ISPs or electronic
malls - this is difficult burden
Introduction to Informatics - Fall 02
The Constitutional requirement of “fair apportionment” is
also muddled by ecommerce.
In Oklahoma Tax Commission v. Jefferson Lines (1995),
the Supreme Court held that sales tax imposed on the
sale of interstate bus tickets need not be apportioned
among the states in which travel occurs
It ruled that because the agreement, payment, and
delivery of some services occurred in the taxing state,
no other state could claim the same combination of
events, and therefore no double taxation would result
Therefore, the Court did not require the apportionment of
the sales price and allowed Oklahoma to tax the entire
sale
Introduction to Informatics - Fall 02
Online ordering, payment, sales, and delivery of goods
and services, including information and financial
services, may not take place in the same jurisdiction
For instance, the agreement may be sent, payment
may be made, and delivery tendered electronically
making it difficult, if not impossible, to determine the
location of these events
As technology improves, digital music and videos will
create further confusion as to sourcing of transactions
This will create confusion for vendors, suppliers, the
customers, and the states which try to tax them
Introduction to Informatics - Fall 02