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Course outline II
Product differentiation Advertising competition Compatibility competition
Heterogeneousgoods
2
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
3
e.g.: screws (A) and nuts
(Akompl) coffee pads (A) and
coffee machines (Akompl)
Vertical compatibility
A
komplA
6
Unilateral and reciprocal compatibility Unilateral
– Apple computer (sometimes) understand software designed for IBM-compatible PCs (A understands Bkompl)
Reciprocal– telephones
7
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
8
Network effects and expectations
p
x
Demand function for fulfilled expectations
Priceeffect
Networkeffect
Demand function for given expectations
9
Network goods need not be ordinary
x
p
10
30erwx
20 30
20erwx10erwx
strong network effects shift demand rightwards
10
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
11
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
14
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
15
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
17
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
19
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
23
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
24
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)
25
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
26
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
27
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.
28
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.“
30
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.
31
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
33
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
34
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)