1 Course outline II n Product differentiation n Advertising competition n Compatibility competition Heterogeneous goods

2 Compatibility competition n Compatibility – vertical and horizontal, – unilateral and reciprocal n Network effects n Competition with different degrees of compatibility n Competition with equal degrees of compatibility n Competition with complements n Executive summary

3 e.g.: n screws (A) and nuts (A kompl ) n coffee pads (A) and coffee machines (A kompl ) Vertical compatibility

4 Horizontal compatibility e.g. n telephones from different firms

5 Indirect horizontal compatibility A is indirectly compatible to B

6 Unilateral and reciprocal compatibility n Unilateral – Apple computer (sometimes) understand software designed for IBM-compatible PCs (A understands B kompl ) n Reciprocal – telephones

7 Network effects and compatibility n Apple Computers are less attractive to consumers because its client base is smaller than that of Microsoft and Intel. n Other examples: – Direct current versus alternating current – Typewriters’ keyboards – Cash machines

8 Network effects and expectations p x Demand function for fulfilled expectations Price effect Network effect Demand function for given expectations

9 Network goods need not be ordinary 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 n Demand function x(p, x erw ) for given expectations. n Inverse demand function p(x) for fulfilled expectations with sketch. n Stable and unstable points. n Calculate a monopolist’s profit-maximizing price. Calculate:

11 Network effects and their impact for business strategies n In case of network-effect goods the products’ attractiveness depends on the number of customers. n It may pay to build an installed base (customers that bought the product previously). n Sometimes not the best product, but the product with largest network “wins” (Example: VHS).

12 Assumptions and notation n Products are maximally differentiated. n Degree of compatibility n Advantage of compatibility for firm 1: n No cost of differentiation or compatibility n Network strength e.

13 Network size advantage, network effect n Network size for firm 1 n Network effect n Network-size advantage for firm 1 expected demand for product 1 installed base for product 1

14 Demand function for given expectations n Consumers buy product 1 if: intensity of competition consumers in case of equal prices firm 1’s price advantage firm 1’s network advantage

15 where Demand function for fulfilled expectations intensity of competition firm 1’s price advantage firm 1’s base-compatibility advantage

16 Competition with different degrees of compatibility n Fulfilled-expecations profit functions:  1  2 p 1 p 2 s 1 s 2

17 Price reaction functions n n High prices in case of – high installed base – high advantage of compatibility – compatible and differentiated products

18 Price reaction functions - graphically p 2 p 1

19 Pricing game (different degrees), 2 nd stage n Equilibrium n Equilibrium outcomes

20 Compatibility game, 1 st stage n Equilibrium (difficult to ascertain!) n Further results

21 Competition with equal degrees of compatibility n (e.g. HDTV or GSM)  1  2 p 1 p 2 s

22 Pricing game (1 st stage) and compatibility game (2 nd stage) n Equilibrium (1 st stage) n Equilibrium outcomes (1 st stage) n Results 2 nd stage: Assuming – small firm prefers s=1 – firm with high base advantage prefers s=0

23 Competition with different degrees of compatibility - Entry deterrence I Base compatibility advantage Valuated base com- patibility advantage

24 Competition with different degrees of compatibility - Entry deterrence II Dyopoly Monopoly firm 1 Monopoly firm 2 e(2  n i +  s)

25 Competition with complements n General Motors founded 1919 the „General Motors Acceptance Corporation“. n Telecommunication firms offer telephone connections and mobiles. n 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... x 1 (p 1, p 2 )=100-p 1 -p 2 x 2 (p 1, p 2 )=100-p 2 -p 1 Unit costs are constant at $20. a) Profit-maximizing prices? b) Now assume there are two monopolists selling the components independently.

27 The Microsoft case: What happened n Judge Thomas Penfield Jackson issued his final judgment in the antitrust case against Microsoft (Plaintiff: USA, Defendant: Microsoft Corporation) in June n 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) n „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.“ n 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.“

29 Illustration - complements

30 What do you think? n Operating systems and applications are complements, like the two castles. n 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. n Prices go up, but profits go down.

31 Appeals court reverses Microsoft breakup order (June 2001) n 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. n The court's…opinion…means the case now goes back to a different District Court judge for further proceedings. Source:

32 Illustration - substitutes

33 Executive summary I n 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 n Dominating a network effect market – Aggressive price policy – Homogeneous products (except compatibility) – Compatibility with old own products – Incompatibility with competitor? n Complementary goods – Develop a joint price strategy with producers of complements – Offer complements together with your origin product (bundles)