Amie Street is a music website with a difference — the prices for downloading songs are not fixed, but are determined by their popularity. The price for a song varies between free and 98 US cents. Unpopular songs are free, and the price rises the more popular they get. This seems like a very clever idea to me. The biggest problem for new musicians is getting noticed. If your songs are free, that can help to offset (to some extent) the fact that you’re unknown. This pricing model also gives users an incentive to search out the best music, since if you can find a great song before it becomes popular you can get it for free or very cheap. For other users the price of a song is a good guide to its popularity — the price is high only because enough people have been willing to buy it previously. You can also earn credits on the site by recommending songs.

One complaint I have is that the pricing formula isn’t disclosed. This makes the price information less useful. Is a 60 cent song twice as popular as a 30 cent song? As a musician, how popular do I have to get before I receive 98 cents per song? I also wonder if prices are allowed to fall once they have gone up, if a song becomes unpopular, as it is bound to do? Or do prices just go up and stay up forever? Regardless, it looks like a very interesting system, both for musicians and listeners.

Another post on the Google public policy blog attempts to put a positive spin on Google’s acquisition of DoubleClick, a placement service for online ads. Google also sells online ads through its Adsense/Adwords service. Google claims that this will not harm consumers, advertisers or website publishers. Whether or not that is true, I cannot say based on the limited information that I have. However, I think at best the Google public policy people are confused about what ‘competition’ really means, and at worst they are trying to confuse their blog readers.

Google writes:

Just yesterday, for example, Microsoft announced that it had added 20 new advertising clients after closing its acquisition of aQuantive, a DoubleClick competitor. We see this as yet more evidence that companies are competing in the online advertising space and the free market.

To me, this looks like another acquisition by one advertising provider (Microsoft) of another. I do not see how this is ‘evidence of competition’. It is evidence that the market is consolidating and usually that means less competition. Let me explain exactly why. Suppose a market is supplied by only two independent firms. Each firm receives some demand and therefore some revenues based on the price that it sets and the price that its competitor sets. Suppose a firm is thinking about cutting its price. When making this decision, it will take into account two facts: (i) it will gain some customers, and (ii) its existing customers will pay less. Thus it faces a tradeoff, which may or may not make it worthwhile to cut the price. However, most importantly, what the firm does not take into account is the fact that cutting its price also reduces the demand for its competitor’s product. Each firm only cares about its own profits, and does not care if its actions reduce the profits of its competitor.

Now suppose the two firms merge into one. In this case, when making the decision whether to cut price, the firm will care about the entire demand in the market, and not the two independent demands that were faced by the previously separate firms. To illustrate, suppose the two previous firms operate as two divisions in the merged firm and keep setting two separate prices, but suppose the firm cares about the overall profits across both divisions. For example, one division might sell banner ads (DoubleClick) and the other division might sell context-related text ads (Adsense), and there’s a separate price for each type of ad. Now, when one division thinks about cutting its price, it will have to take account of the negative effects that this will have on the other division’s sales. To the extent that the products of the two divisions are substitutes, cutting price in one division will reduce sales of the other. As I explained above, this negative effect is not taken account of when the firms are separate and set prices independently, but it is taken account of when they are merged. Thus the incentives to cut prices are weaker when the firms are merged compared to when they operate independently.

What this means is that the number of independent firms who set independent prices in a market affects the prices that arise. For simplicity the above example took the case of two firms merging into one. However, the same basic logic holds if there are many firms in the market and only two or a few of them merge. Any kind of merger or acquisition between competitors that produce substitute products results in some of the negative ’spillover’ effects that I talked about being taken into account (’internalised’) by the combined firm. This weakens incentives to set lower prices, and price rise, which will be harmful to the consumers in the market. This is the reason why competition authorities pay careful attention to mergers and acquisitions.

To sum up, I really can’t see how Google can justify mergers or acquisitions among competitors as being good for competition. Certainly, they provide no explanation on their blog. The rest of the blog post is a series of quotes from various people mostly supporting the argument that Google and DoubleClick’s services are in fact not substitutes. This is a different and more difficult issue. If two firms merge that produce entirely independent products, then none of the negative spillover effects that I mentioned will exist, because the price of one product will not affect the demand for the other. In this case a merger or acquisition will not lead to higher prices. If the firms produce products that are complements (consumers like to consume them together, like coffee and sugar) then prices could even go down as a result of a merger or acquisition. However, at first glance it appears that Google’s advertising services and DoubleClick’s are substitutes to some extent, at least from the point of view of an advertiser. The onus is on Google to prove that they are not.

Recently there was some controversy on the Flickr photo sharing site about their decision to censor (ie remove from their site) someone’s photo of a child smoking a cigarette. Flickr (which is owned by Yahoo) has a policy of not allowing images of children smoking on its site. This seems sensible — smoking is bad and most people don’t want to encourage children to do it or glamourise it. Except in this case the photo in question was of a photojournalistic nature, showing realistic images of how children are affected by poverty. Should such an image be banned or not? It’s not an easy thing to decide.

That debate is too controversial, so I don’t want to get into it. But it did get me thinking about what “Web 2.0″ sites like Flickr, Facebook and others actually produce, in an economic sense. They don’t regular goods like apples and cars. They produce communities. An essential part of any community is the standards or ‘rules’ by which its members must abide. Therefore, the following two activities are essential features of the production process of a Web 2.0 business:

1. Set the rules
2. Enforce the rules

Both of these things could be somewhat complex tasks, and are likely to significantly affect the costs and revenues (and hence the profits) of such a business. In terms of setting the rules, different potential users of the community (ie its potential customers) will have different preferences about the rules. Some people won’t mind seeing pictures of children smoking, while others will hate it, and others will fall somewhere in between. In some sense this is a similar problem to a regular business choosing the quality of its product — some people prefer high quality even if it means a high price, while others prefer low quality at a low price. However, there is a crucial difference for a business that creates an online community. What people really care about is probably not the rules per se, but the activities of others in the community. Thus the community operator cannot just simply say “no photos of children smoking” unless it also enforces that rule. In other words, the operator can set whatever rules it likes, but the standard of behaviour that actually arises will be determined by how well it enforces those rules (the standard of behaviour is endogenous, if you want to use a fancy word).

Thus the value of a community to its users, and how much they are willing to pay for it if it charges subscriptions like Flickr does, depends not only on the rules that the community operator sets, but also the enforcement of these rules. In terms of rules, we could think of them lying along a continuum from “anything goes” to “very strict”. Under “anything goes”, anything at all would be allowed and no enforcement would be required. This is the policy of the infamous Japanese 2channel Internet forum, where people can post messages anonymously and without fear of censorship. As the rules become more strict, enforcement costs are likely to rise, as the rules need to be monitored by system administrators somehow, and appropriate actions taken. For example, Flickr and eBay have staffs of people dedicated to policing the rules on their sites.

However, as rules become very strict, enforcement costs might decline again. The reason is that relatively ambiguous rules leave more room for interpretation, and are more likely to lead to disputes. In the case of the Flickr picture of the kid smoking, after people protested on its site, Flickr reversed its decision to ban the photo in question. However, leaving interpretation of the rules open to judgment like this is more likely to lead to controversial decisions, which may be time-consuming and costly to resolve. Strict rules may be easier to enforce — just delete all pictures of children smoking with no further discussion entered into. So the costs of enforcement as a function of the strictness of the rules might look something like this:

In terms of implementing enforcement, online communities have a range of options. An interesting question is how much of the enforcement should be ‘centralised’ and done by the system operator’s staff, and how much should be ‘decentralised’ to the community members themselves. For example, in addition to its in-house ‘police force’, eBay relies on user reports via its feedback mechanism to help prevent fraud. As long as members care about their reputation on the site, this kind of reputation system allows the operator to ‘outsource’ some of its enforcement of the rules, and probably reduce the costs involved. The downside is that reputation systems may be susceptible to gaming or manipulation by the members themselves.

To sum up, Web 2.0 sites produce communities. Part of this process (part of the “production function” in economic jargon) is to decide the rules for standards of behaviour by community members, and to enforce the rules. The rules that are set will affect the costs of enforcement, and the level of enforcement that the operator chooses will affect the actual behaviour that occurs, which will in turn affect users’ willingness to pay to use the site, or the willingness of advertisers to pay to advertise on the site. In addition, some or all of the enforcement function can be “outsourced” (or “crowdsourced”) to the community members by using a reputation or feedback mechanism. Since the production of communities departs from production of ordinary goods and services in significant ways, I think it will be an interesting area for economic research.

Dani Rodrik uses my economics blog ranking to explore the relationship between a blogger’s academic ranking, measured by citations of his/her research papers and the ranking of his/her blog. He finds a weak but statistically significant positive correlation. More discussion is on this post at his blog.

One of the questions that has come out of the recent product quality related scares and recalls in China is exactly how much people are willing to pay for quality. After all, there is a tradeoff between quality and price — higher quality is generally more expensive to produce. But how much quality are people willing to sacrifice for lower prices?

In Japan at least it seems that willingness to pay for quality of food is very high. This article describes how sales of imported matsutake mushrooms from China have fallen in Japan by more than 50 percent this year, despite no evidence that their quality is poor, and despite domestically grown mushrooms selling for five to ten times the price of imported ones. Incidents like this suggest that Chinese producers may have underestimated people’s desire for quality, particularly in rich countries. In the end, everything should work out more or less ok, as Chinese producers will rationally respond to the reduction in demand that they are now experiencing by increasing the quality of the goods that they produce.