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Course outline II

Product differentiation Advertising competition Compatibility competition

Heterogeneousgoods

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Compatibility competition

Compatibility – vertical and horizontal,– unilateral and reciprocal

Network effects Competition with different degrees of

compatibility Competition with equal degrees of compatibility Competition with complements Executive summary

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e.g.: screws (A) and nuts

(Akompl) coffee pads (A) and

coffee machines (Akompl)

Vertical compatibility

A

komplA

4

Horizontal compatibility

e.g. telephones from different firms

A B

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Indirect horizontal compatibility

A is indirectly

compatible to BA

komplA

B

komplB

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Unilateral and reciprocal compatibility Unilateral

– Apple computer (sometimes) understand software designed for IBM-compatible PCs (A understands Bkompl)

Reciprocal– telephones

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Network effects and compatibility

Apple Computers are less attractive to consumers because its client base is smaller than that of Microsoft and Intel.

Other examples:– Direct current versus alternating current – Typewriters’ keyboards– Cash machines

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Network effects and expectations

p

x

Demand function for fulfilled expectations

Priceeffect

Networkeffect

Demand function for given expectations

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Network goods need not be ordinary

x

p

10

30erwx

20 30

20erwx10erwx

strong network effects shift demand rightwards

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Exercise (Given and fulfilled expectations)The potential consumers of a network-effect product are uniformly distributed on the interval [0,1]. Consumer h (0 h 1) has the utility

Demand function x(p, xerw ) for given expectations. Inverse demand function p(x) for fulfilled expectations with

sketch. Stable and unstable points. Calculate a monopolist’s profit-maximizing price.

otherwise. , 0

unit, one buys he if ,)1( phxU

erwh

Calculate:

92

32 ,and1:S. MM pxxxxp

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Network effects and their impact for business strategies In case of network-effect goods the products’

attractiveness depends on the number of customers.

It may pay to build an installed base

(customers that bought the product previously). Sometimes not the best product, but the product

with largest network “wins” (Example: VHS).

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Assumptions and notation

Products are maximally differentiated. Degree of compatibility Advantage of compatibility for firm 1:

No cost of differentiation or compatibility Network strength e.

.1,0 21 ss

21 sss

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Network size advantage, network effect

Network size for firm 1

Network effect Network-size advantage for firm 1

iierwerwierwierw xsxxsxxxsxxn 211211221111

expected demand for product 1

installed base for product 1

ine

advantagenexpectatio

advantagebase

122211

122211

21

erwerwerwerwerw

iiiii

erwi

xsxxsxn

xsxxsxn

nnnnn

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Demand function for given expectations Consumers buy product 1 if:

21211*

12

22

212

1

21

,,,:21

21

1

ssppxhneppt

h

enhtpenthp

pp effeff

intensity of competition

consumers in case of equal prices

firm 1’s price advantage

firm 1’s network advantage

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erwerw xxxx 2211 and

sneppssx i2

21

,21

12211

21

21 221

,sset

ss

where

Demand function for fulfilled expectations

intensity of competition

firm 1’s price advantage

firm 1’s base-compatibility advantage

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Competition with different degrees of compatibility

Fulfilled-expecations profit functions:

1

2

p 1

p 2

s 1

s 2

sneppsscp

sneppsscp

ssppxcp

i

i

22

1,

2

1

22

1,

2

1

,,,

122122

12211

2121111

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Price reaction functions

High prices in case of– high installed base – high advantage of compatibility– compatible and differentiated products

sne

cppp

sne

cp

pppp

iR

i

p

R

222

1

2

1

222

1

2

1

,maxarg

112

2

211211

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Price reaction functions - graphically

p 2

p 1

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Pricing game (different degrees), 2nd stage Equilibrium

Equilibrium outcomes

sne

cp

sne

cp

iB

iB

262

1

262

1

2

1

snessx iB 26

1

2

1, 211

2

211

23361

,sne

ssi

B

20

Compatibility game, 1st stage

Equilibrium (difficult to ascertain!)

Further results

121 NN ss

t

xx

tcpp

BB

BB

BB

21

21

21

21

21

21

Competition with equal degrees of compatibility

(e.g. HDTV or GSM)

1

2

p 1

p 2

s

21 sss

setsset

sss

sxxxsxxsxn iiiiiii

121

221

0

1

21

21

21122211

22

Pricing game (1st stage) and compatibility game (2nd stage)

iBiB ne

csspne

cssp 32

1, and

321

, 21

iB nessx 31

21

,1

Equilibrium (1st stage)

Equilibrium outcomes (1st stage)

Results 2nd stage: Assuming– small firm prefers s=1– firm with high base advantage prefers s=0

2

1

23361

,i

B ness

)1(0 21 sandxxn iii

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Competition with different degrees of compatibility - Entry deterrence I

21

212

2233

2

026

1

2

1,

ssetsne

snessx

i

iB

Base compatibility advantage

Valuated base com- patibility advantage

advantageity compatibil baselimit 3

e

base)(limit

1

1233

2

1212

1 s

sxsset

x

i

i

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Competition with different degrees of compatibility - Entry deterrence II

0.50.40.30.20.10

20

10

0

-10

-20

Dyopoly

Monopoly firm 1

Monopoly firm 2

e(2n i+s)

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Competition with complements

General Motors founded 1919 the „General Motors Acceptance Corporation“.

Telecommunication firms offer telephone connections and mobiles.

Smart has problems because the number of garages (a complementary good to the automobile) is to small

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Exercise (bundle)

A monopolist sells a bundle ...

x1(p1, p2)=100-p1-p2

x2(p1, p2)=100-p2-p1

Unit costs are constant at $20.

a) Profit-maximizing prices?

b) Now assume there are two monopolists selling the components independently.

80)70):S.

21

21

ppbppa

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The Microsoft case: What happened

Judge Thomas Penfield Jackson issued his final judgment in the antitrust case against Microsoft (Plaintiff: USA, Defendant: Microsoft Corporation) in June 2000.

Microsoft shall submit a proposed plan of divestiture. The Plan shall provide for ... [the] separation of the Operating Systems Business from the Applications Business.

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Krugman‘s parable (New York Times, April 26, 2000) „Baron Wilhelm von Gates was the lord of two castles,

each commanding a strategic bottleneck along the Rhine. From these castles he was able to demand money from all the travelers who passed by. ... Eventually the Holy Roman Emperor ... split up the Gates domain, giving one of the castles to the baron‘s nephew.“

Result: „Not only did [travelers] now face the nuisance of dealing with two different robber barons, but they said they were paying more for each trip than they had before.“

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Illustration - complements

0

,

0 ,

1

212

!

1

211

p

pp

p

pp

BB

BB

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What do you think?

Operating systems and applications are complements, like the two castles.

After the breakup, positive externalities going from one castle to the other, from the operating systems business to the applications business, cannot be internalized any more.

Prices go up, but profits go down.

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Appeals court reverses Microsoft breakup order (June 2001) Although the U.S. Court of Appeals for the

District of Columbia found that Microsoft engaged in illegal conduct in order to maintain its operating system monopoly, it ruled that Judge Thomas Penfield Jackson created an impression in out-of-court comments that he was biased against the company.

The court's…opinion…means the case now goes back to a different District Court judge for further proceedings.

Source:http://www.computerworld.com

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Illustration - substitutes

0

,

0 ,

1

212

!

1

211

ppp

ppp

BB

BB

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Executive summary I

Solving the start-up problem / Entering into a market with network products– Vapor ware (non-realized sales, channel stuffing)– Preannouncement– Low prices for pioneer customers– Low prices for targeted groups (students)– Product differentiation– (Unilateral) compatibility

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Executive summary II

Dominating a network effect market – Aggressive price policy– Homogeneous products (except compatibility)– Compatibility with old own products– Incompatibility with competitor?

Complementary goods– Develop a joint price strategy with producers of

complements– Offer complements together with your origin product

(bundles)