Externality Managerial Economics Jack Wu Externalities one party

Externalities one party directly conveys benefit or cost to others � positive � negative

Saks: Fifth Avenue vs Mall New York, NY: 611 Fifth Avenue Stamford, CT: Town

Sak’s Positive Externalities Marginal benefit/cost (Hundred thousand dollars) 15 13. 4 group marginal benefit

Sak’s Negative Externalities Marginal benefit/cost (Hundred thousand dollars) 10 marginal benefit profit gain from

Silicon Valley Stanford University Xerox Palo Alto Research Center Hewlett-Packard Cisco Systems 3 Com

Financial Centers • • London: The City New York: Wall Street Hong Kong: Central

Resolving Externalities Economic inefficiency ® opportunity for profit merger collective action

Intel Inside Cooperative advertising resolves positive externality from one retailer to other retailers Externalities

Network Externality where benefit/cost depends on total number in network English language Internet email

Network Effect benefit/cost depends on total number in network through market, not directly conveyed

Critical Mass definition: number of users at which demand becomes positive

Network Effects: Demand Elasticity highly elastic around tipping point highly inelastic at low demand

Public Good Non-rival consumption -- one person’s increase does not reduce quantity to others

Television Distinguish content delivery Externalities (c) 1999 -2001, Ivan Png

Rivalness congestible private good rival consumption public good non-rival consumption

Efficiency in Public Good Marginal benefit/cost ($ per minute) 10 8. 9 vertical sum

Excludability Provider can exclude particular consumer law technology

Excludability: Law patent – product or process copyright – artistic expression

Intellectual Property trade-off benefit from usage incentive for future creation Externalities (c) 1999 -2001,

Discussion Let b represent marginal benefit and q the amount of Sogo’s investment in

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Externality Managerial Economics Jack Wu

Externalities one party directly conveys benefit or cost to others � positive � negative benchmark: collective marginal benefit = collective marginal cost

Sak’s Positive Externalities Marginal benefit/cost (Hundred thousand dollars) 15 13. 4 group marginal benefit 10 Sak’s marginal benefit 9 florist’s marginal benefit 4 3. 6 profit gain from additional investment 1 0. 8 marginal cost 0 1 shoe store’s marginal benefit 5 9 10 Hundred thousand dollars of investment

Sak’s Negative Externalities Marginal benefit/cost (Hundred thousand dollars) 10 marginal benefit profit gain from reducing investment group marginal cost b a 2 Sol’s marginal cost 1 0 c 5 7. 5 9 Sak’s marginal cost 10 Hundred thousand dollars of investment

Resolving Externalities Economic inefficiency ® opportunity for profit merger collective action

Network Externality where benefit/cost depends on total number in network English language Internet email international telephone service

Network Effect benefit/cost depends on total number in network through market, not directly conveyed resolved by producer or service provider

Critical Mass definition: number of users at which demand becomes positive

Network Effects: Demand Elasticity highly elastic around tipping point highly inelastic at low demand levels

Public Good Non-rival consumption -- one person’s increase does not reduce quantity to others q extreme economy of scale

Rivalness congestible private good rival consumption public good non-rival consumption

Efficiency in Public Good Marginal benefit/cost ($ per minute) 10 8. 9 vertical sum of marginal benefits 5. 6 marginal cost 5 4 3. 6 Alan Mary 1 0. 8 0 Peter 1 4 5 Minutes of fireworks 10

Excludability Provider can exclude particular consumer law technology

Excludability: Law patent – product or process copyright – artistic expression

Discussion Let b represent marginal benefit and q the amount of Sogo’s investment in the new Zhong. Xiao Fushing store. Suppose that the investment generates marginal benefis, b=10 -q for Sogo, b=4 -0. 4 q for the florist, and b=1 -0. 2 q for the shoe store. Given the marginal cost of 1, calculate the profit-maximizing quantity of Sogo’s investment and the economically efficient quantity of Sogo’s investment.