1. Compare A. A. Alchian and H. Demsetz, "Production, Information Costs, and Economic Organization," American Economic Review 62 (December 1972), 777-795 and 0. E. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: The Free Press, 1975), on the desirability of user fees in profit and nonprofit organizations. 2. The desirability of two-part tariffs from the standpoint of both profits and consumers' welfare is demonstrated in R. D. Willig, "The Pareto Domination of a Uniform Price by a Non-linear Outlay Schedule," mimeo, Bell Laboratories, Holmdel, New Jersey (1976). All are taken from N. L. Henry, "Copyright, Public Policy and One can also examine the income distribution effects, if any, of the alternative means of distribution. Presentation of David Catterns to the National Commission on New Technological Uses of Copyrighted Works, Washington, D. C., December 19, 1975. Currently the rate of exchange is A$1.00 = U.S. $1.24 (September 1976). New York Times (November 5, 1975), p. 54. M. B. Line and D. N. Wood, "The Effects of a Large-Scale Photocopying Service on Journal Sales," Journal of Documentation 31:241 (1975). Ibid., 239. APPENDIX C1 ON THE OPTIMAL PROVISION OF JOURNALS QUA EXCLUDABLE by J. A. ORDOVER* and R. D. WILLIG* NEW YORK UNIVERSITY AND BELL LABORATORIES *The views presented in this paper are solely those of the authors and do not necessarily represent those of New York University or Bell Laboratories. In this paper we provide the theoretical model of a firm which produces a commodity that is sold both to individuals and to institutions. The latter extend the services of the commodity to a large collection of The focus of the paper is on the pricing rules that the firm should follow in calculating the prices for individual users and for institutional users. As the by-product of the analysis, we provide strong arguments for levying user charges on those who avail themselves of the institutionally-held unit of the commodity. In the paper we use journal publishing as a perfect example of the industry which serves both individual and multi-user (institutional) markets. As we shall see, the analysis presented here can be extended rather easily to advanced computerized scientific and technological information systems. The major problem raised in the paper is how the fixed cost component of the total production costs should be spread among the two classes of buyers. There already exists a well-established theory which bears directly on that issue. In brief, the theory prescribes that in the market in which demand is not very responsive to price changes, the price should be higher than the one charged to the buyers in the market in which the demand is highly responsive to price variations. This is known in the literature as the inverse elasticity rule, since demand elasticities are precisely the measures of responsiveness of demand to price changes. The implication of this inverse elasticity formula is that a proportionally larger share of the fixed cost should be shifted onto those buyers who do not substantially reduce their purchases when price is raised above some initial level. This rule is, however, applicable only if there are no crossmarket effects. But those effects are present whenever a change in the price charged in one of the markets affects the demand in the other market. If, for example, an increase in the institutional price leads some of the institutional buyers to discontinue their purchases, one would expect an increase in the demand by individuals. Our task in the paper is, therefore, to provide workable rules which would be applicable in the case of cross-market price effects since we believe that such effects are present in the industries which provide scientific and technical information. The value of workable pricing rules or formulas, like the inverse elasticity rule, is two-fold. First, they enable the decisionmaker to ascertain what variables in the model are of particular importance in the process of price setting. Second, they enable the decision-maker to conduct a rough test on how the current prices compare to those at which profits would be maximized. It is, of course, unrealistic that the firm could ever hope to exactly set optimal (i.e., profit-maximizing) prices. Nevertheless, using the optimal price formulae as a guide, the management can concentrate on collecting that data which will be most useful in the process of setting prices. For example, as the name suggests, the inverse elasticity formula identifies demand elasticities as being the focal points in the process of setting prices. Our analysis also uncovered additional variables which previously escaped the attention of the analysts. We find that in the model considered in the paper, the best (profit maximizing) prices are quite sensitive to the value of the variable which we term "the average number of potential subscribers" Roughly speaking, this variable measures the average number of additional private purchases that would be gained from those institutions that would discontinue their purchases in response to a small change in the institutional price of the commodity. To illustrate the concept, let us assume that an increase of one dollar in the institutional price induces six institutions to discontinue their purchases. This, in turn, induces two users from each institution to purchase the commodity. In this example, the average number of potential subscribers is two. If we were to change the hypothetical data somewhat and assume that there would be no new private buyers from four of those institutions, the value of the average number of potential subscribers would drop to two-thirds. We have been able to show that if for a wide range of prices offered in the two markets the average number of potential subscribers exceeds one, the institutional price ought to exceed the private price irrespective of the elasticities of demand in the two markets. This result is of some interest because in some situations the values of the elasticities of demand in the private and institutional markets may not be known while the firm may have some information from its marketing surveys on the numbers of potential subscribers. It must be admitted that sophisticated pricing rules like the one presented in this paper require significant amounts of information for their implementation. However, as we indicated earlier, the optimal price rules can be employed to test whether current prices can be improved upon yielding higher net income for the firm or higher net benefits for the product's users. For the purposes of this test much less detailed knowledge of market demands is required. The test is particularly simple for the firm which is not currently price discriminating between its institutional and individual customers. In this situation, it is very easy to show that in most circumstances price discrimination in favor of individual buyers would be desirable from the standpoint of profits and the welfare of the consumers as a whole. When the firm already has a two-tier price scheme, our tests enables the decision-maker to ascertain whether the current spread between the two sets of prices should be widened or narrowed. There is no need to give here a detailed exposition of the price adjustment test since the test is described at great length in the paper. It is important, however, to reiterate that the procedure for price revisions developed in the paper relies wholly on the information that should be easily available to those responsible for price decisions. If such information is not currently available, it can be obtained from the existing data, using standard econometric techniques which we have discussed elsewhere. It may be useful at this point to restate the motivation behind the analysis of Sections II and III of the paper. Our most abstract consideration was to extend the economic analysis of optimal pricing to those situations in which significant cross-market effects of pricing decisions are present. Although there are already some pricing rules which are applicable to that case, these rules are not easily interpretable even by a theorist. Furthermore, they are formulated in ways which are not particularly helpful to those who will in the end use them for actual pricing decisions. Hence, our second objective was to derive a set of guidelines to be followed by those who are responsible for deciding on prices for scientific and technical information. We strived to make a strong case for imaginative pricing and we argued that price discrimination between various classes of buyers is not only desirable for profits but perhaps paradoxically, also for the users of information as a whole. Section II of the paper presents, we believe, a strong case for allowing the producers to employ sophisticated pricing policies and to have protection via copyright for their product. If the production of sceintific and technical information did not involve a fixed cost component, then economic theory would indicate prices closely to the incremental (marginal) production costs. When fixed costs are present, however, at prices equal to marginal costs, the firm cannot cover its total costs. Consequently, prices must deviate from incremental costs. In Sections II and III, we show what directions those deviations from marginal costs should take. It would be unfortunate if the producers and disseminators of information were to be prevented from employing those sophisticated pricing rules for the purposes of recovering their fixed costs. Section V and Appendix I deal directly with the problem of whether user charges ought to be levied on those who use the institutionally owned excludable public good. This question is directly relevant to the discussion of copyright royalties. The first argument for user charges is entirely consistent with that encountered above. We argued earlier that the burden of defraying the fixed cost component of the total production costs should be allocated to the various classes of users according to well-defined principles (the inverse elasticity rule, for example). The question may be raised as to why the users of the institutionally-owned excludable public good should be exempted from sharing in that burden. The answer is, of course, that they should not. It is conceivable that those user charges should be "low". But our theory says that if those charges should be low, it is not necessarily because the cost to the society of an additional use of the institutionally owned excludable public good is also very small, perhaps even zero. Rather, the argument for no user charges ought to be based on the empirically verifiable proposition that the demand for institutional use is highly elastic with respect to user charges. (This demand should not be confused with the demand by institutions for the commodity in question. Undoubtedly, the two demands are related in some way.) When, a small increase in these charges above zero would discourage so many users |