Network Competition Business Strategy, Industry Structure IS250 Spring 2010

John Chuang2 Summary  Market segmentation, service differentiation, and bundling strategies can improve producer revenue, but raise questions on “neutrality” of the network  Vertical integration and horizontal mergers are driven by scale and/or scope economies, but may increase market concentration to the detriment of competition and consumer welfare

John Chuang3 Recap: Monopoly, Duopoly, and Perfect Competition Q*P*Producer Surplus Consumer Surplus Total Surplus Dead Weight Loss Monopoly Duopoly (Stackelberg) Perfect Competition q p 1 1 p(q) = 1 - q q* p* Dead Weight Loss (DWL) Consumer Surplus Producer Revenue

John Chuang4 Telco Business Strategy  Imagine being the CEO of a telco, cable company, or ISP: -Convergence means more competitors -Service increasingly commoditized (which leads to more intense price competition) -Fixed costs as high as ever  Life as a regulated monopoly was so much easier!

John Chuang5 How to Increase Revenue?  Price discrimination -Market segmentation -E.g., business vs. residential -Personalized pricing  Service differentiation -E.g., video vs. data  The debate on “Network Neutrality”  Implications to consumer, producer and social welfare q p 1 1 p(q) = 1 - q

John Chuang6 Comparisons Q*P*Producer Surplus Consumer Surplus Total Surplus Dead Weight Loss Uniform pricing (Monopoly) Personalized pricing Market segmentation† , Duopoly (Stackelberg) q p 1 1 p(q) = 1 - q q* p* Dead Weight Loss (DWL) Consumer Surplus Producer Revenue †: specific example from previous slide, with two market segments of 50% each

John Chuang7 Bundling  Multi-product pricing  Rationale: reduce dispersion in WTP for bundle  Example: voice, video, data (triple-play) -Consumer 1 WTP: $40, $40, $40 -Consumer 2 WTP: $10, $10, $100 -Sell voice, video at $40 each, data at $100 --> Revenue = $180 -Sell bundle at $120 --> Revenue = $240 Source: Bakos and Brynjolfsson, 2000 q p q p + =

John Chuang8 Management Control  Vertical integration  Horizontal merger  Determinants: -Technological efficiencies (+) -Transactional efficiencies (+) -Market imperfections (-)

John Chuang9 Vertically Related Markets  Upstream/downstream relationship  Examples: -Steel: ore & coal mines; steel mills -Software: OS; applications -Telephony: local access; long distance -Internet: physical transport; internet access; content/services

John Chuang10 Vertical Integration  Good: -economies of scope savings -internalize transaction costs -reduce prices & increase total welfare  Bad: -if one component is monopolistic; possibility of foreclosing competition in other component

John Chuang11 Vertical Integration Example  Telephony was vertically-integrated industry -AT&T (Ma Bell) offered end-to-end solution  Divestiture in Local service (the seven baby bells) -Long distance service (AT&T)  (Re-)Integration in 2005: -SBC acquired AT&T ($16B) -Verizon acquired MCI ($7B; Qwest had rival offer)

John Chuang12 Horizontal Merger  Proposition: Economies of scale  Objection: concentration leads to market power and reduction in competition -No network externality benefits (all networks are interconnected anyway) -Larger network has less incentive to interconnect, or to maintain a high quality interconnection, with smaller networks -Larger network has negotiation power over smaller networks

John Chuang13 Horizontal Merger  Example 1: Local Telephony  Seven Baby Bells Merging -AT&T: SBC + Pacific Bell + Ameritech + Bell South -Verizon: Nynex + Bell Atlantic (+ GTE) -Qwest: US West  Facilities-based competition -e.g., wireless, cable, satellite, fiber, PLC, …

John Chuang14 Horizontal Merger Source: Kende 2000  Example 2: Internet Backbone -MCI-WorldCom (Sept 1998; $37B; MCI backbone divested to Cable & Wireless) -WorldCom-Sprint (Oct 1999; $129B; rejected by DoJ and EU 2000) Fiber system route miles (UUNET)

John Chuang15 Summary  Market segmentation, service differentiation, and bundling strategies can improve producer revenue, but raise questions on “neutrality” of the network  Vertical integration and horizontal mergers are driven by scale and/or scope economies, but may increase market concentration to the detriment of competition and consumer welfare