Switching costs n In the middle of the 1980s AT&T succeeded in becoming the supplier of digital switches (5ESS) to Bell Atlantic. From then on, all the changes in Bell Atlantic’s telephone system had to be provided by, and negotiated with, AT&T. n My tax consultant closed his office and sold his customer data to another tax consultant. n My bank closed the office I used to frequent.

Network effects and compatibility n Apple Computer 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

Installed bases n If switching costs are present, old customers (repeat customers) are locked in and can be exploited. n In case of network effects the products’ attractiveness depends on the number of both old customers and new customers. n It may pay to build an installed base (customers that bought the product previously).

Competitive situations new customers only old customers only new and old customers (no switching costs) (switching costs) (switching costs) homogeneous goods heterogeneous goods heterogeneous network effect goods

Fundamental assumptions n Two firms, 1 and 2 n Constant, identical marginal costs c n The sum of sales is given. Each customer (old or new) buys one and only one unit of good 1 or of good 2.

1: Homogeneous goods, no SC n The buyers’ decisions depend on prices only. n n It nearly always pays to underbid the rival. n Equilibrium:

2: Homogenous goods, SC, I n Installed base (number of old customers) for firm 1 is equal to b 1. No new customers, repeat customers only. n Customers have to incur switching costs amounting to w in the case of buying good 2 rather than good 1. n Only prices and switching costs are relevant for the purchasing decisions.

2: Homogenous goods, SC, II n Demand functions: n Equilibrium : n Profit of firm 1:

3: The Hotelling model n t are costs of transport per unit of distance – t=0: homogeneous goods – t>0: heterogeneous goods n Consumers are distributed evenly along the Hotelling space. 1 0 h

3: Heterogeneous goods, no SC n The buyers’ decisions are made in terms of the prices and the costs of transport. n Demand for good 1: – Goods are ordinary. – Product differentiation reduces competition intensity. n Equilibrium:

4: Network-effect goods, no SC, I n Only new customers consume, old customers of firm 1 form installed base. n Expected network size: n Expected network effects : Product of network effect strength e and expected network size.

4: network-effect goods, no SC, II n Purchasing decisions depend on prices, costs of transport and expected network effects. n Demand for given expectations: – Self-fulfilling prophecy effective. – Compatibility reduces expected advantage of network size.

4: network-effect goods, no SC, III n Demand for fulfilled expectations – In case of fulfilled expectations network effects increase competition intensity. – If network effects are important, the goods could be non- ordinary (demand depends positively on price). – Compatibility decreases competition intensity. n Equilibrium :

5: Network-effects goods, SC, I n Installed base (number of old customers) of firm 1 is equal to b b 1 new customers enter the market. n Equilibrium :

5: New customers´ segment n In equilibrium, firm 2 sells – Fat cat effect (firm 1 is the fat cat): In case of relatively slight network effects firm 2’s market share rises with the value of firm 1’s installed base. – Top dog effect (firm 1 is the top dog): In case of relatively high network effects, firm 2’s market share depends negatively on the value of the installed base.

6: Hardware and Software I n Two computer firms, A and B offer computer A or computer B, respectively. n Prices for computers: p A and p B, respectively. Consumers are uniformly distributed (indexed by h  ) on the interval [0,1] according to their preference towards product B: 1 0 h More A-oriented More B-oriented

6: Hardware and Software II n Each consumer spends Y on one computer and on software packages compatible with the computer bought. n Each software package costs 1. Therefore: E i =Y-p i is the number of software packages the user of computer i can afford. n Utility function

6: Hardware and Software III n Consumer h will by computer A, if n Demand functions:

6: Hardware and Software IV n Assume that firms have identical constant unit costs of c. n We find a symmetric equilibrium

Exercise (Software supply) Let N i be the number of different software packages supplied for computer i. Software production takes place in firms other than A and B. Realistically, N i will depend on the expenditures for software packages for computer i, x i E i. We assume N i = x i E i. n Is the following statement correct: If the price of computer B goes up, the software supply for computer A users goes up. n For any given p A determine firm B’s prohibitive price for its computer.

Exercise (IT expenditure) Suppose p A > p B. If the expenditures for IT technology double for all the consumers, what is the effect on the hardware market shares?

Exercise (network effects I) 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 x erw is the expected demand. How do you charac- terize consumers with low values of h? n Derive the demand function x(p, x erw ) for given expectations. Can you identify the workings of the self-fulfilling prophecy?

Exercise (network effects II) n Derive the indirect demand function p(x) for fulfilled expectations. Sketch it and determine which points are stable and which are not. n Assume there is only one firm offering the network-effect good. Calculate its profit maximizing price.

Business strategy: how to overcome the critical mass n Expectations and self-fulfilling prophecy – vapor ware (non-realized sales, channel stuffing), – preannouncement. n Price differentiation – Low prices for pioneer customers, – Low prices for targeted groups (students). n Complementary goods – Invite competition for hardware production, – Produce software yourself.