Wylee DSL, INC[1]

US consumers purchase Internet access from a communications company (e.g., telephone, cable or satellite company) that provides a physical connection from a computer at the consumer's home to the company's network. The "bandwidth" or transmission capacity of those physical connections falls into two major categories -- "narrowband" or "broadband." Dial-up Internet using telephone modems provides a narrowband connection with limited transmission capacity and therefore slow speeds. Cable modem service, digital subscriber line technology (DSL) and satellite broadcasts provide much greater transmission capacity and therefore faster speeds. Broadband connections allow consumers improved access to video and audio content on the Internet.

By the end of May in 2006, 42% of Americans had some sort of broadband connection (50% DSL, 41% cable and the remainder from a variety of other technologies including satellite).[2] The market share of broadband has been growing in recent years and is expected to grow further in the future.

DSL technology was developed in the late 1980's but was commercially unavailable until the mid 1990's. The slow deployment of DSL was largely attributed to lack of competition in the market for Internet connectivity. The regulatory changes under the 1996 Telecommunications Act sought to encourage the rapid deployment of DSL technology by forcing existing local telephone companies to allow independent communications companies access to their phone lines. In 2004, the Federal Communications Commission (FCC) allowed the local phone companies to substantially increase the speed of their connections by re-wiring their lines with fiber optic lines.

Wylee DSL, Inc. is an independent DSL provider that rents the local telephone company's lines in order to provide Internet access to customer's homes. Getting an Internet connection requires the lines in order to provide Internet access to customer's homes. Getting an Internet connection requires the installation of equipment at both ends of the phone line to support broadband transmissions. At the customer's home, a splitter must be installed to separate the voice and data signals over a regular phone line. The other pieces of equipment required to complete the connection are a DSL modem and a network card. The modem converts audio signals into digital signals and the network card completes the connection to the customer's computer.

The other end of the connection requires connecting the existing phone line from a customer's home to Wylee's network equipment co-located at the local telephone company's central office (CO). Wylee rents this local phone line and connects it to their Internet equipment that consists of an elaborate network of servers, routers, and communications software to connect and route traffic to the Internet.

Among the Large Internet Service Providers (ISPs) are AOL, Comcast, Time-Warner Cable's Roadrunner, and SBC-Yahoo, Covad and Wylee. Some of these firms began life as narrow band ISPs (AOL and MSN), some were cable television firms (Time-Warner and Comcast), some were phone companies (SBC), while others began as independent DSL providers (Covad and Wylee). As consumers have moved to broadband some ISPs have bundled Internet connectivity with their other services. AOL bundles its software and non-technical, family-friendly version of the Internet. Cable and Satellite television companies bundle their service with their products, while local phone companies do the same with DSL. Companies like Covad and Wylee are distinct from these others in that they sell more generic Internet access.

Last year the broadband divisions of DSL providers did quite well earning an average of 10% return on sales (Net income / Sales revenue). Wylee DSL, Inc., however, is below the industry average and earned only 6.26%. The company's management is concerned and has hired your firm to advise them about strategies for improving their company's profitability in both the short and long term.

Last year the firm had an average of 204,050 customers that paid $44.44 per month. Exhibit 1 shows demand information put together by the Wylee marketing department.

Required:

Prepare a report that develops a strategy for increasing Wylee's profitability in the short and long term. Your report must address the following issues:

1.  Consider, for the moment, the near term planning horizon and develop a crude analysis of costs based on the information produced by the Wylee accounting office in Exhibit 2.

  1. Separate the costs into variable costs and fixed costs. Calculate the total amount of each type of cost.
  2. Calculate the Average Variable Cost (AVC) of serving one more user for a month. Calculate the Average Fixed Cost (AFC) of serving 204,050 customers. How would this number change if we sold to 300,000 customers.

c.  Assume that Average Variable Costs stay the same as we sell to more customers. As we lower price, the number of customers increases. This reduces average cost. How low can price go and still earn at least zero accounting profit?

2.  Calculate the annual revenue of Wylee, and then prepare a pie-chart that divides the companies revenues into the following categories listed below. Be sure to identify the connection between the cost information in Exhibit 2 and the broader categories listed below.

  1. Installing equipment
  2. Providing subscribers with an on-going connection to the Internet
  3. Marketing services
  4. General administrative support
  5. Profit

3.  The market research team at Wylee estimates their firm's inverse demand function for DSL to be P = 67.06 - Q/(9020.78). Information summarizing this relationship between Wylee's price (P) and the number of DSL subscribers purchasing from Wylee (Q) is described in Exhibit 1.

  1. If we assume that Average Variable Costs are constant as we increase the number of subscribers, then MC = AVC. Using your estimates of AVC from 1.B as a crude estimate of MC, find the profit maximizing price for Wylee to charge. What is the associated amount sold?
  2. What is the arc elasticity of demand Wylee's current price ($44.44) to a price of $43.33? What will happen to short run revenues if we cut prices?

4.  Wylee and other DSL providers will face many changes in their business environment in the coming years. For each of the situations listed below discuss the effect of the event on Wylee's profit maximizing price as well as its level of profitability with respect to a carefully drawn diagram.

  1. In 2004 the FCC decided that it would allow electric companies to sell high speed Internet Access over their lines. Since nearly every household in the United States has a high-bandwidth electric line going into the house, while many lack cable lines or DSL-capable phone lines many experts expect the entry of the electric companies to affect the market for high speed Internet access substantially.
  2. Some pundits expect the FCC to begin taxing DSL providers several cents per customer in the near future.

5.  Broadly discuss anything that Wylee DSL can do to increase its profitability in over the next few years. Are any of the strategies you discuss likely to be especially profitable over a long period of time? Are any of these strategies likely to be especially risky?



A Beginners Guide to Strategy
in Markets with Differentiated Products[3]

I.  Introduction


Many introductory economics students find the economist's emphasis on competitive markets perplexing. This concern arises from the students' tendency to focus on matters at the firm level rather than the market. A competitive firm produces a product identical to every other firm in the market and cannot, as a consequence, select its product's price. This may be an accurate description of the situation faced by farmers, but it doesn't describe well the situation faced by most firms.

Figure 1

We can correct this "problem" by focusing on a market model where firms each produce slightly different products, but are constantly under the threat of entry from other firms. Economists call this "monopolistic competition." A firm in this kind of industry must set its own price the way a monopoly would, but the firm must also worry about other firms copying anything they do that proves profitable over an extended period of time.

We will begin by considering a short run situation where some costs are fixed and the number of firms and the nature of their products cannot change. In this situation, the firm will select its profit maximizing amount to sell and price in the same way as a monopoly. In figure 1, the firm sells every unit for which the marginal revenue exceeds the marginal cost, and then stops. The firm chooses the highest price they can charge and still sell that many units. In figure 1 the profit maximizing price is P* and the amount sold is Q*.

II.  Strategic Issues

Figure 1 provides a simple description of price determination for a monopolistically competitive firm in the short run. However, broader notions of strategy for firms require that we consider all relevant issues that may affect the firm's long term profitability. Should the firm change its product slightly? Will today's pricing decisions affect the future? Should we expect other firms to begin copying our firm's strategy? We will consider each of these issues in detail.


Figure 2

A.  Increased Product Differentiation

"Product differentiation" refers to just how different one firm's product is from those offered by other firms in the mind of consumers. It describes our firm's product niche. Consumers in our niche will pay more for our product than other firm's charge for theirs because it is well suited to their tastes. In effect, increased product differentiation makes a firms demand less elastic. Figure 2 shows the effect of this. D1 is the original demand curve with very little difference between our firm's product and that of other firms, while D2 show the effect of product differentiation. Notice that differentiation allows us to raise price and substantially increase our markup of price above marginal cost.

Product differentiation can raise profitability, but there are a few caveats. Focusing on a small niche can reduce the overall level of demand even as demand is less elastic. If the group focused on is tiny enough, profitability can fall. Further, product differentiation may be costly. If costs rise sufficiently, then even the increased prices will not offset the cost increases, and profit may fall.

Product differentiation may also make short run profit last longer if it is more difficult for other firms to copy what we are doing. Some firms have extended the period of short term profit successfully by many years by keeping secret the methods used to produce a comparatively unique product.

B.  Dynamic Issues

In some kinds of markets the price and product design choices made today affect the demand and cost conditions faced by the firm in the future. Consequently, today's decisions must be modified to take this into account. This suggests that conclusions drawn from simple diagrams like Figure 1 must be modified somewhat.

i.  Network Effects

A product exhibits a "network effect" if its value to consumers depends on how many others use the product. High technology products often exhibit this characteristic. Imagine being only one of three people who had a FAX machine. The device would be nearly useless. Alternatively, if millions of people have FAX machines they are very valuable.

Products with network effects must often be priced carefully when they are introduced. The more people buying the product today, the more people who will want to buy the product in the future. Products with network effects are often offered at initially low prices or are given away for free. This maximizes the present value of expected future profit (even though today's profit could be larger) by increasing profitability in future periods.

ii.  Switching Costs

Some purchase decisions exhibit "switching costs." This happens when purchase of the product makes it difficult to switch to another product afterwards. When people purchase a Windows based computer, for example, they spend money on software and time on learning how to use it. Switching to a Macintosh for their next purchase becomes more difficult after one has invested time and money in a Windows computer.

Switching costs give firms a reason to charge less for their products to new customers than they charge to existing customers. Existing customers incur switching costs to change products, while the new customers do not. In fact, if new customers are using a competitor's product, price may have be set low enough to induce them to incur switching costs of their own.

iii.  Learning By Doing

Learning-by-doing occurs when a firm develops a new product. Initially the best methods of producing the product are not obvious. As more units are produced, the firm gets more familiar with the production process and comes up with methods of reducing costs.

Firms with new products often set very low initial prices so that they will sell a lot of products to hasten the learning-by-doing process. This strategy is somewhat risky because if the hoped for efficiencies in production do not materialize.

iv.  Durable Products

Economists call products that last a while "durable products". The more durable the product is, the longer before consumers purchase it again. This suggests that a sale today may increase current profitability, but reduce demand and profitability in the future. As a result, prices of durable products are sometimes higher than for other products.

An example will clarify the issue. Suppose the product is a light bulb. If we give away light bulbs today, then people will stockpile them. Next month we will have very few customers. Hence, today's price of a light bulb must take into account that every bulb sold today reduces future demand.

C.  All Good Things Come to an End

Economists tend to emphasize that any unusually high short run profit earned by firms will be lost in the long run as new firms copy what the old firms were doing, driving down prices and profitability. It is certainly true that if we look at the list of unusually profitable firms across long periods of time, the names at the top of the list change substantially. This suggests that unusually high profits are difficult to sustain.

Some firms, though, do maintain consistently high profit for fairly long periods -- a decade or more -- while others find their profit eliminated by competition almost immediately. The difference seems to lie in how difficult the methods used by a particular firm are to copy. For example, in the early 1960's Wal-Mart became very profitable by moving large retail stores into sparsely populated areas of the rural southeastern United States. They kept costs low by keeping inventory low in local stores and having large regional super-centers that did deliveries on a just-in-time basis. Other firms found the cost structure easy to copy, but they couldn't move into the same rural areas as Wal-Mart because there weren't enough customers to support two firms the size of Wal-Mart in those areas. Because Wal-Mart's strategy was difficult to copy, they kept profitability above industry norms for 15 years before they had to alter their strategy significantly.