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									       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

                        Deak e-Commerce Answers Ch.9, Page 1
   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

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

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.

                       Deak e-Commerce Answers Ch.9, Page 2
   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

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.

                        Deak e-Commerce Answers Ch.9, Page 3
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,

                       Deak e-Commerce Answers Ch.9, Page 4
   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?

                        Deak e-Commerce Answers Ch.9, Page 5
   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

                       Deak e-Commerce Answers Ch.9, Page 6

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