Introduction
Should a bank allow customers of other banks to access its ATMs? Should an apparel company open an exclusive outlet or should it sell through multi-brand retailers? What will be the impact of number mobility on the mobile industry? How can the government ensure universal provision of telecommunications while at the same time ensuring competition? Why are large firms like IBM supporting free and open source Linux rather than their own proprietary operating systems? Why does Microsoft give away some software development tools for free? Was it a good idea for Apple to let iPods play MP3s?
Each of these questions deals with a situation where consumers demand goods or services made up of subcomponents which are complementary to each other: bank accounts and ATMs, marketing and retailing, call origination and call termination, hardware and software, operating systems and applications. There are a number of firms competing to produce each subcomponent. But at the same time there are many firms producing more than one type of subcomponent. Banks run both account services and ATMs. Phone companies supply both call origination and call termination. Microsoft sells both Windows and Office.
In markets like these, firms face three kinds of specific strategic choices. First, should they allow the components they produce to be compatible with the components produced by their competitors? If IBM hardware can run only IBM software, then every computer that IBM's hardware division sells creates a virtual monopoly for the software division to exploit. On the flip side, the limited availability of software reduces the value of IBM hardware to costumers and hence the price they would be willing to pay for it. Today no one would subscribe to a mobile phone service that did not allow you to call subscribers of other phone networks-though once upon a time AT&T had exactly that policy in the US. But we still have tariff plans that charge different prices for calls within a network and calls to other networks.
Second, if a firm can charge a price for allowing compatibility, how high should it be? There are many examples of such charges: charges imposed by one bank on another for allowing customers access to ATMs, charges imposed by one mobile company on another for allowing roaming customers to use their network, or the price charged by power generation companies from power distribution companies. Such charges cannot be set by just looking at the direct profits alone, they must also take into account the effect on the sales of competitors. A high roaming charge that is passed on to customers might discourage roaming usage and decrease profits on that head, but it might also increase the sale of new connections to people on long visits.
Third, a firm that supplies multiple subcomponents must decide on the price of each subcomponent simultaneously to maximize total profits. Stories of firms that gave away razors to sell blades or of supermarkets that use loss leaders to increase footfalls are familiar to all students to marketing. However, there are a number of interesting twists to such stories. First is the issue of compatibility-if competitors can make blades for your razors or cartridges for your inkjet or if your customers can walk away after buying just the loss-leader product then such strategies fail. Second, sometimes the same product sold to different segments should be treated like complementary subproducts. The classic case is that of matchmakers. A successful match depends on the matchmaker finding a bride and a groom suitable for each other among her clients. Depending on market characteristics the matchmaker might choose to subsidize the enrollment of grooms in order to earn high fees from brides who want greater choice. Same goes for a B2B portal. The third complexity comes when different subproducts are offered at different points of time-buyers of a BluRay DVD player would want to be assured that there will be enough movies released in that format. In such a situation a seller might subsidize early adopters in order to build up a critical mass.
The existence of markets with both complementarities and monopoly power also poses challenges for regulators. They must impose compatibility standards and access charges keeping social welfare in mind while at the same time ensuring that regulations can be enforced effectively based on information available to regulators. The problem has become sharper with many erstwhile 'natural monopolies' like power and telecommunications being privatized and deregulated.
Objectives
- To enable students to recognize situations where product complementarity is a significant strategic factor and the alternatives available to managers in these situations
- To introduce students to relevant tools from economic theory, particularly from the area of industrial organization
- To familiarize students with relevant national and international industrial experience.
Pedagogy
Lectures, term-paper on an industry of the student's choice to be presented in class.
Topics
INTRODUCTION & TOOLS
Overview
Review of Game Theory
Nash equilibrium in pure strategies, extensive form games and subgame perfection, informal discussion of repeated games.
Review of Monopoly and Oligopoly Theory
Equilibrium of a monopolist, different degrees of price discrimination, welfare cost of monopoly, effects of taxes and subsidies on a monopolist,monopolistic competition, product variety, Bertrand, Cournot and Stackelberg duopolists
COMPETITIVE STRATEGY
Mix and Match: Deciding on Product Compatibility
Consumers build systems from components. Components are supplied by competing firms. Should these firms make their components compatible with each other?
Adapters and Converters
If firms must incur a cost for providing compatibility (say by manufacturing adapters that connect their equipment with that of competitors) when should they do so? What if these adapters provide only one-way compatibility?
Interconnection Charges
When firms can charge their competitors for compatibility, how should they go about fixing these charges?
Network Effects: Monopoly and Perfect Competition
If the benefit of a good or service to the consumer depends on how many other consumers there are, can a perfectly competitive market ensure the socially optimal supply of the good? Can a monopoly?
Network Effects: Duopoly and Dynamics
If there are two networks competing for customers, can both coexist? If only one can survive, how is the winner decided? Is there a first-mover advantage? Is there a second-mover advantage? How do consumers form expectations of future sales and what can firms do to influence these expectations?
Lock-in and Switching Costs
How can firms lock in customers so they cannot switch to rival networks? What can the rivals do about it? Does the existence of switching costs actually lead to greater profits for firms?
Standardization
What if firms have different ways of being compatible? How is the technology that becomes the standard chosen? Formal, informal and de facto standards. The role of intellectual property
A Coasian Warning
Do network effects always lead to externalities and market failure? The distinction between pecuniary and real externalities. Can more sophisticated pricing and price discrimination help?
Tying, Bundling and Exclusivity
Firms selling more than one product can create artificial switching costs by selling their products as a package. Firms selling to customers over time may require them to sign exclusive contracts. When is it possible to do so? Do consumers necessarily lose from these arrangements?
Durable goods
Firms selling durable goods, whether it be automobiles or operating systems, compete not just against other firms but also their own product which they had sold in earlier periods. Should they make the new version compatible with the older version? Do they gain by selling or leasing? How do consumer expectations matter and how can they be influenced by firms?
Two-sided markets
Some firms are in the business of providing platforms on which different parties can transact (game console makers vis-a-vis game programmers and gamers, matchmakers vis-a-vis brides and grooms, shopping malls vis-a-vis retailers and shoppers). How should such firms decide on the prices they charge to the two classes of transactors? What if there are competing platforms? What if customers can become part of more than one platform?
REGULATION
Regulation First-best and second-best outcomes. 'Natural monopolies'. Regulations of access prices and standards. Experience of the telecommunication industry.
Readings
Detailed handouts; surveys of research; excerpts from the business press; selected chapters from:
- [Var]
- Varian,Hal and Shapiro, Carl. Information Rules: A Strategic Guide to the Network Economy, Harvard Business School Press, 1998.
- [Lie]
- Liebowitz,Stan. Re-Thinking the Network Economy: The True Forces that Drive the Digital Marketplace, AMACOM/American Management Association, 2002
- [Pin]
- Pindyk, Robert S. and Rubinfeld, Daniel L., Microeconomics, 5th ed, Prentice Hall of India, 2003
JEP: Journal of Economic Perspectives, RJE: The Rand Journal of Economics, AER: American Economic Review
| Session | Topic | Readings | Optional References |
| A:INTRODUCTION AND TOOLS | |||
| 1. | Overview | [Var] Ch. 1, [Lie] Ch. 1–2 Porter, M.E. 'Strategy and the Internet', Harvard Business Review, March 2001 Arthur. B.W. 'Increasing returns and the new world of business', Harvard Business Review, July/August 1996> |
|
| 2. | Review of Game Theory | [Pin], Ch. 10.1–10.4, 11.1–11.2, 12.1–12.3, 13.1–13.6 | Gibbons R., Game Theory for Applied Economists, PUP, 1992, Chapters 1–2 |
| 3. | Review of Monopoly and Oligopoly Theory | ||
| B: COMPETITIVE STRATEGY | |||
| 4–5. | Mix and Match: Deciding on Product Compatibility | Handout | Matutes, C. and Regibeau, P. '"Mix and match": product compatibility without network externalities', RJE, 19(2), Summer 1988 |
| 6. | Adapters and Converters | Handout | Farell, J. and Saloner, G. 'Converters, compatibility and the control of interfaces', The Journal of Industrial Economics, XL(1), March 1992 |
| 7. | Interconnection Charges | Handout | Laffont J.-J., and Tirole J., Competition in Telecommunications, MIT Press, 2002, Ch. 3 |
| 8. | Network Effects: Monopoly and Perfect Competition |
[Var], Ch. 5–9, Katz, M.L. and Shapiro, C. 'System Competition and Network Effects', JEP, 8(2), Spring 1994 Besen, S.M. and Farrell, J. 'Choosing How to Compete: Strategies and Tactics in Standardization', JEP, 8(2), Spring 1994 David, P.A. 'Clio and the Economics of QWERTY', AER, 75(2), May 1985 Dranove, D. and Gandal M. 'The DVD-vs.-DiVX standard war: evidence of network effects and preannouncement effects', Journal of Economics & Management Strategy, 12(3), Fall 2003 |
Farrell, J. and Klemperer, P. 'Coordination and Lock-in: Competition with Switching Costs and Network Effects' in Armstrong, M. and Porter, R. (ed.) Handbook of Industrial Organization, Volume 3, Elsevier, 2007 |
| 9–10. | Network Effects: Duopoly and Dynamics | ||
|
11. |
Lock-in and Switching Costs | ||
| 12. | Standardization | ||
| 13. | A Coasian Warning |
[Pin], Ch. 18.1–18.3 [Lie], Ch. 3, Liebowitz, S.J. and Margolis, S.E. 'Network Externality: An Uncommon Tragedy', JEP, 8(2), Spring 1994 Mayer, C. and Sinai, T. 'Network effects, Congestion Externalities and Air Traffic Delays: or why not all delays are evil', AER, 93(4), November 2003 |
Coase, R. 'The Problem of Social Cost', Journal of Law & Economics, October 1960 |
| 14. | Tying, Bundling and Exclusivity |
Pepall, L. et al., Industrial Organization: Contemporary Theory and Practice, South Western College Publishing, Ch. 4 Whinston, M.D., 'Exclusivity and Tying in US v. Microsoft: What We Know, and Don't Know', JEP, 15(2), Spring 2001 |
Whinston, M.D., 'Tying, Foreclosure and Exclusion', The American Economic Review, 80(4), Sep. 1990 |
| 15. | Durable goods | Waldman, M. 'Durable Goods Theory for Real World Markets', Journal of Eco. Perspectives, 17(1), Winter 2005 | |
| 16–17. | Two-sided markets | Handout Hunt, R.M. 'An Introduction to the Economics of Payment Card Networks', Review of Network Economics, 2(3), June 2003 |
Rochet, J.-C. and Tirole, J. 'Two-sided markets: a progress report', RJE, 37(3), Autumn 2006 |
| C: REGULATION | |||
| 18. | Regulation | Handout | Laffont J.-J., and Tirole J., Competition in Telecommunications, MIT Press, 2002, Ch. 4 |
