Complementary Goods Suppose that you need to have both left and right shoes. When you have both left and right shoes, your satisfaction is 10. What is the difference between the following three price sets? (1) Left and right sells each at 5 (2) Left sells at 8, and right sells at 2 (3) Left sells at 2, and right sells at 8.

Answer Ans: All are the same. The important one is a total price, not a price structure.

Complementary Goods Suppose that you are the monopolist of components A and B. Consumers must have both A and B and are willing to pay $10 for the combination of A and B. Each unit of A and B cost 2, respectively. What is your optimal pricing of A and B? What is your profit?

Complementary Goods Questions: Suppose that other firms enter into component B. From now on, you are the monopolist in only sector A, not in sector B any more. Is it good or bad for your company?

Q Their competition makes the price of B at 3. What is the best response of your firm? What is the profit?

Q Their competition makes the price of B at 1. So you can’t sell component B. Is it good or bad? What is your optimal price? What is your new profit level?

Monopoly power in CPU Keyboard, Mice, Monitor Software, etc One Monopolist.

IBM ’ s Early Conduct Pricing in Response to Entry In 1967, many small firms began to sell individual pieces of “plug-compatible IBM equipment” at much lower prices

IBM ’ s Early Conduct IBM responded by Large price increases on its CPU to recoup lost revenues Redesigning certain equipment to reduce the attractiveness of the use of non-IBM equipment

Adam’s Card Game Suppose that there are 3 red cards and 3 black cards. In a classroom, there are 3 students and one faculty member, Adam. Each student has one red card, and Adam has all of the three black cards. If someone hands in one red and one black card to the dean, the dean will pay you one hundred dollars. So students and Adam have an incentive to combine their red and black cards.

Adam’s Card Game The problem is how they will divide the $100. They will do bargaining on how to divide it. Bilateral bargaing usually leads to 50:50 split. The total pie is $300, and Adam will get $150.

What would happen if Adam burns one of his black cards? The total pie becomes $200. Now what is the Adam’s share? After two matching, what is the value of the remaining red card?

Then, what is the value of red cards when there are two cards?

Then, what is the value of red cards when there are three cards?

Adam’s Card Game Implication Create bottleneck on your side. Make your product crucial.

How about two monopolists? MS vs Intel Movie Studio vs. Rental Shop

Question Books Main cost: paper; paper industry has 3%-4% accounting profit margin. Do you need to buy a paper company ?

First, 3-4% profit margin is high ? What are interest rates? Normal profit

There is a high fluctuation in price of paper. Do you want to have a paper company to stable the price of paper? For simplicity, suppose that a ton of paper costs either 1 or 5. Unstable input price

Vertical Structure There are two key inputs for a product. Firms 1 and 2 produce key inputs 1 and 2, respectively. Firm 1 sells a key input to firm 2. Firm 2 combines the two inputs and sells the final output to a customer. So firms 1 and 2 have a kind of monopoly power each other.

Vertical Structure A consumer’s demand is Q = 4-P2. Suppose that production cost is zero. Firm 1’s profit is P1(4-P2). Firm 2’s profit is (P2-P1)(4-P2).

Double Markup A Firm 2 set the final price. Any decision by firm 2 affects firm 1’s demand. However, firm 2 does not internalize the impact. The second firm faces a marginal cost for their input. Firm 2 treats P1 as cost. However, in terms of vertical structure, it is not real cost.

The joint profit is P 1 (4-P 2 ) + (P 2 –P 1 )(4-P 2 ). That is, the joint profit function is P 2 *(4-P 2 ). (The global profit is maximized when P 2 =2.)

However, when firm 2 sets its price, its optimal price p 2 =2+1/2(p 1 ). Since p 1 >0, the final price gets higher under two monopolists. Double-mark-up Higher price/Lower firms’ profits

“What is wore than a monopoly? A chain of monopolies.” Actually, it is one of the defenses for Microsoft: why MS must be a single monopoly of O/S and web browser. How can we achieve the global profit maximization?

Vertical Integration Firms 1 and 2 become the same company. The objective of vertical integration is to avoid the double price distortion that occurs when each firm sets its own price separately.

Commoditization Firm 2 supports other firms in the market of input 1. There is a high competition in the market of product 1, which will reduce the price of input 1 to zero. Example. MS supports another CPU producer. Intel also supports another O/S manufacturers.

Price Squeeze As long as you are ‘bottleneck’ or, you are the crucial part of the system, you can capture all surpluses If other firms compete more fiercely, and the price of B gets lower, what would happen to your firm’s profit? Price Squeeze.

Contemporary Examples of Vertical Competition The arrival of internet as a commercially promising technology provided the step-up to set off epochal vertical competition Netscape’s entrance to client-side browser market, which later extended to server-side applications

- E.g., Microsoft invested in Windows Hardware Quality Lab, which pushes for standard and compatibility in hardware. It has invested in AMD. Intel, on the other hand, has invested in Red Hat Linux. - E.g., Compaq, Dell, HP, and IBM have invested in Linux companies and offered computers with Linux pre-installed. That is creating a second source to reduce the chokehold of Microsoft.

Contemporary Examples of Vertical Competition Entry Initiatives on the Client Side Microsoft client-side dominant position is inherited from its dominant position in PC software (In Network computing, PCs are relabeled “clients” and are connected to powerful “servers”)

Contemporary Examples of Vertical Competition Anti-Microsoft Initiatives: Thin Clients From the network computer to JAVA/RMI, all the thin client initiatives aim to removal of the MS client bottleneck Weakening of MS influence on network standards setting