Business of Platforms, Networks, and Two-sided Markets

Business of Platforms, Networks, and Two-sided Markets
Prof. Nicholas Economides Stern School of Business, New York University NET Institute revised 9/19/17 Copyright ©

Network industries are a large part of the world economy and some are growing very fast
Telecommunications (data, voice) Internet / world wide web Social networks on the Internet (Facebook, Twitter, etc.) Broadcasting (TV, radio) Cable television Financial networks Credit and debit card networks ATMs, bank networks; payment systems; check clearing houses Financial exchanges (equities, bonds, derivatives) Banking networks and systemic risk B2B, B2C exchanges Electricity Railroads Airlines Roads Virtual networks Computer software and hardware Information servers (yellow pages, Google, Yahoo, MSN)

A virtual network is a collection of compatible goods/components that share a common technical platform. For example, all VHS video players make up a virtual network. Similarly, all computers running Windows can be thought of as a virtual network. Compatible computer software and hardware make up a “network,” and so do computer operating systems and compatible applications. More generally, virtual networks are composed of complementary components, so they also encompass wholesale and retail networks, as well as information networks and servers such as telephone yellow pages, Yahoo, Google, etc.

Network industries often
provide necessities provide infrastructure are key to economic growth Network industries have special features

Platforms A platform provides a way for two parties to enter into mutually beneficial exchange Platforms are matchmakers Platform Side 1 Side 2 Service Uber Driver Rider Transport Visa Merchant User Payment AirBnb Apartment User Accommodation MSFT OS MS-Word User Writing

Profit maximization on a platform is complex
May be optimal to subsidize one side of the market Unlike traditional firms (say BMW) where coordination and production occurs inside the firm, in platforms production occurs by bring together two sides (driver, user) who are outside the firm

Network effect: A user will pay more to connect to a larger network
Platforms leverage network effects

Is competition different in these industries?
What are successful strategies for companies in markets and industries with network effects? Is there a special case for or against antitrust or competition policy scrutiny for network industries? What form should intervention take (if any)? Price controls? Subsidies? Structural changes (breakups, divestitures, etc.) Imposition of technical compatibility Regulation

Technological change has facilitated networks and
Telecommunications became extremely cheap Computation power rose exponentially Computation power rose exponentially. Diagram from

Effects of cheap computational power and cheap telecom
New products, new services Networks, platforms Old products/services produced differently -> disruption Big shifts in value of companies

Week 1: Introduction Requirements Subject matter Areas we will cover
Midterm exam Class participation; interactivity Final group project Groups of 4 writing an original paper Preliminary presentation of paper on week 10 Subject matter Areas we will cover

Overview: Areas we will cover
Week 1-2, pp (all approx.) Summary of basic economics of competition in non-network industries Basic Game Theory

Week 2, pp Nature and types of networks Various types of networks including virtual networks Features Network creation/expansion Superimposition of various networks

Week 3, pp Internet basics Infrastructure Basic Protocols Pricing Search algorithms and advertising “Organic” search; paid search Week 4, pp Cybersecurity and privacy issues

Week 4: pp Network structures and platforms Two-sided pricing

Week 5, pp Network structures and platforms Network properties Network effects Platforms Pricing on networks Nature of competition on networks

Weeks 6-7, pp Compatibility and interconnection Desirability Divergence of private and public incentives Public policy issues

Week 7, pp Bottlenecks and Interconnection Pricing

Week 8, pp Application: Taxi cabs as a two-sided network Application: Electric cars as a two-sided network

Week 9, pp Application: Payment Systems (credit and debit cards) Application: Mobile Money in Africa

Weeks 10, pp Application: Digital Books Week 11, pp Application: Two-sided Pricing & Network Neutrality on the Internet

Weeks 12 Bottom line, pp Additional materials Antitrust in Networks Industries, pp Bank networks formation and systemic risk, pp

References Geoffrey Parker, Marshall Van Alstyne and Sangeet Choudary, Platform Revolution. Shapiro, Carl, and Hal Varian, Information Rules, Harvard Business School Press, 1999. Chris Anderson, The Long Tail, Hyperion, New York, 2006. John Battelle, The Search, Penguin, New York, 2005. Brock, Gerald, The Telecommunications Industry: The Dynamics of Market Structure, Harvard University Press, 1981. Carlton, Dennis, and Jeff Perloff, Modern Industrial Organization, Harper Collins. Crandall, Robert, After the Breakup: US Telecommunications in a More Competitive Era, The Brookings Institute, Washington, D.C., 1991. David Easley and Jon Kleinberg, Networks, Crowds, and Markets: Reasoning About a Highly Connected World, Cambridge University Press, 2010 Laffont, Jean-Jacques, and Jean Tirole, Competition in Telecommunications, MIT Press, 2002. Mitchell, Bridger M., and Ingo Vogelsang, Telecommunications Pricing: Theory and Practice. Cambridge University Press, 1991. Owen, Bruce, and Steve Wildman, Video Economics, Harvard University Press, 1992. Specific references in each module below.

Weeks 1-2: Summary of Basic Competition Concepts
Supply and demand Definitions Costs Consumer surplus (CS) Producer surplus (PS) Total surplus (TS) For more extensive discussion, see Pindyck and Rubinfeld, Microeconomics

Demand, supply, and price determination

Cost definitions Total costs: C(q). Variable costs: V(q).
Fixed costs: F, constant. Breakdown of total costs C(q) = F + V(q). Average total cost: ATC(q) = C(q)/q. Average variable cost: AVC(q) = V(q)/q. Average fixed cost: AFC(q) = F/q. Breakdown of average costs ATC(q) = F/q + AVC(q). Incremental (marginal) cost: MC(q) = C'(q) = dC/dq = V'(q) = dV/dq.

Three cost technologies: (1) Constant Returns to Scale

Cost technologies: (2) Increasing Returns to Scale, F > 0, MC constant

Cost technologies: (3) Increasing and Then Decreasing Returns to Scale

Consumers’ surplus CS = Total willingness to pay for q units minus consumers’ expenditure = Area under demand up to q units minus consumers’ expenditure = A(q) – E(q) E(q) = pq when all units are sold at the same price q, but companies sell in many other pricing schemes Keep in mind that in network industries, the CS calculation will be different

Producers’ surplus PS = Revenue up to q units minus variable costs = Revenue minus area under marginal cost curve = pq – V Note that Variable Cost V(q) is the area under Marginal Cost MC(q)

Total surplus TS(q) = CS(q) +PS(q) = A(q) – E(q) + E(q) – V(q) = A(q) – V(q) = net contribution to society of a market for q units (excluding fixed costs) We judge markets according to contribution to TS TS is maximized at qc. Difference TS(q)-TS(qc) = dead weight loss = loss to society from less or more production than qc. Example of less production than qc: monopoly Example of more production than qc: subsidy

Total surplus is maximized at qc
TS 0 qc q Keep in mind that this will NOT be true in network industries

Price discrimination: ways to reduce consumer surplus and increase profits
Sell different units of the same good to the same buyer at different prices Sell different units of the same good to different buyers at different prices Tying: good A not sold without good B Apple was not selling Macs without an Apple monitor Mixed bundling: selling collections of goods at lower prices than a-la-carte Microsoft office bundle vs. a-la-carte Loyalty-requirement contract: Discounts are offered if the buyer commits to buying all or most of his “needs” from same seller

Price discrimination towards the same buyer
Selling different units of the same product to the same buyer at different prices Electricity bills: higher marginal price for more units In other cases, last unit sold at a lower price (quantity discount) Collecting a fixed fee with or without a variable fee Mobile, fixed telecom service bills

Price discrimination towards the same buyer
Loyalty-requirement contract: Offer a discount on some or all units only if buyer buys 90% of his “needs” from you Or offer a discount on some or all units of good A only if the buyer buys 90% of his needs of goods A & B Essentially forces buyer to buy B from dominant firm in A

Price discrimination towards the same buyer Problems of requirement contracts
What if there is a monopolist in good A but there are rivals in good B that produce superior quality of B? Under the requirement contract, rivals in B are eliminated or marginalized with significant TS loss

A multi-unit buyer has some CS left in product A even under monopoly
Price discrimination towards the same buyer Problems of requirement contracts A multi-unit buyer has some CS left in product A even under monopoly The monopolist seller can extract more CS by requiring that the product be only sold with B

Price discrimination across buyers
Example: IBM in the 1930s leased tabulating machines; required buyers to buy IBM cards Card use proportional to machine use Machine use roughly proportional to value to buyer IBM used tying to quantify the value to individual buyer IBM used tying to effectively lease different units of the tabulating machines to different buyers at different prices Often tying and bundling are illegal under antitrust law

Market organization Perfect competition Monopoly Oligopoly Many rivals
Market price is equal to incremental cost No need to take rivals into account Monopoly Single seller Market price significantly exceeds incremental cost No rivals Oligopoly Few firms Market price above cost but below monopoly Need to take rivals’ actions into account Use game theory to describe market equilibrium

Market concentration Herfindahl-Hirschman index of concentration
HHI = Σin=1 si2 Range from 1 (monopoly) to 0 (perfect competition At egalitarian equality, all si = 1/n, HHI = 1/n Lawyers multiply Σin=1 si2 by 10,000 so for them the HHI range is [0, 10000]

HHI between 1,500 and 2,500: moderately concentrated
Market classifications by HHI defined by DOJ and FTC HHI between 1,500 and 2,500: moderately concentrated HHI > 2,500: highly concentrated “Mergers that increase HHI by more than 200 in highly concentrated markets are presumed likely to enhance market power”

Game Theory Application to Oligopoly
Game in extensive form: N players; decision tree; moves; outcomes; information sets; payoffs Π1, Π2; Game in normal form: strategies Perfect information, perfect recall Complete information; Harsanyi’s analysis of incomplete information

Games in extensive form: sequential incumbent-entrant game

Games in extensive form: simultaneous games

Non-cooperative games
Non-cooperative equilibrium (Nash equilibrium, NE): A pair of strategies (s1*, s2*) such that no player can increase his payoff provided that the rival does not change his strategy Best reply: b1(s2) maximizes Π1(s1, s2) Best reply: b2(s1) maximizes Π2(s1, s2) At NE, s1* = b1(s2*), s2* = b2(s1)

Prisoners’ Dilemma Player 2 talk silent Player 1 Talk (2, 2) (6, 0) Silent (0, 6) (5, 5) Non-cooperative equilibrium is at (2, 2) even though (5, 5) maximizes total utility Players cannot commit to stay silent Other interpretations: arms race; oligopoly

Prisoners’ Dilemma as an Oligopoly Game
Player 2 high Q low Q Player 1 High Q (2, 2) (6, 0) Low Q (0, 6) (5, 5) Non-cooperative equilibrium is at (2, 2) even though (5, 5) maximizes total utility Players would like to commit to low Q, but this is a violation of antitrust law

Simultaneous Incumbent-Entrant Game
Pl. 2 (I) high Q low Q Pl. 1 (E) Enter (-3, 6) (8, 8) Stay Out (0, 18) (0, 9) There are two non-cooperative equilibria at (0, 18) and (8, 8) Notice that pl. 1 wants (8, 8) while pl. 2 wants (0, 18)

Battle of the Sexes Coordination Game
Player 2 ballet boxing Player 1 Ballet (2, 1) (1, 1) Boxing (0, 0) (1, 2) Non-cooperative equilibria at (2, 1), (1,1) and (1, 2) Which one will occur?

Matching Pennies Zero sum game
Player 2 heads tails Player 1 Heads (1, -1) (-1, 1) Tails There is no non-cooperative equilibrium Could use “mixed strategies” – probability distributions over the “pure strategies” {H, T} John Nash (1951): there exists a non-cooperative equilibrium in mixed strategies for any matrix game

Is cooperation needed? To establish a network link between A and B it needs to be profitable for both A and B

Week 2: Networks Basics Easley and Kleinberg. See to -ch24.pdf Sanjeev Goyal, Connections, Princeton University Press, Chapter 2

Networks are composed of complementary nodes and links
The crucial defining feature of networks is the complementarity between the various nodes and links A service delivered over a network requires the use of two or more network components Thus, network components are complementary to each other

Example: the Information Superhighway (1994)

Network structure Nodes: entities Edges/links: relationships
Directed or not Features/colors of nodes Features of links

Human connections networks
Co-authors Facebook Blog readers Members in organizations political parties professions How important is a specific node Strong and weak ties Cohesion issues What holds the network together? Activity on networks How does it get affected by the network structure? Is behavior influenced by network nearness? How?

Blogs in the 2008 presidential campaign

Spread of an epidemic

World trade network example from Easley and Kleinberg, Figure 1.8

Network structure: Undirected and directed graphs

Network structure: Connected components

Network structure: Breadth-first search

A Simple Social Network With Three Components
C is an isolated node D A is a node with a high degree of centrality B and E are not connected, but there is a path between them. A and E are connected. A A and D are also not connected and there is no path between them. E B

A Star (Hub & Spoke) Network
JFK SEA ORD ATL LAX

A Complete Network JFK SEA ORD ATL LAX

Competing Platforms The Ms are multi-homing; that is, they belong to both networks (connect to more than one platform). M1 C1 P1 M2 C2 M3 There is no interconnection between the networks C3 M4 C4 P2 M5 C5 The Cs are single homing; that is, they belong to just one network (connect to a single platform). M6 P1 and P2 are the platforms (e.g., payment-card networks)

Competing Platforms with Interconnection (e.g., telecom)
P1 or P2 may need to pay the other an interconnection fee C6 C1 P1 C7 C2 C8 C3 C9 C4 P2 C5 and C9’s conversation is on net. C10 C5 C5 and C6’s conversation is off net. C11

Concepts, Goyal pp. 9-24 “Neighbors” of j are those nodes with direct links to j A network is “regular” if every node has the same number of links “Degree” of node j is the number of direct connections of j = number of neighbors of j “Degree distribution” is a n-long vector of the fraction of nodes with degree k (= 1, …, n) Variance of the degree distribution Range of degrees

Concepts, Goyal pp. 9-24 Geodesic “distance” between i and j is the shortest path between them “Degree centrality” is (degree)/(n-1) “Closeness centrality” is (n-1)/(sum of distances of j from all other nodes)

Measures of importance of nodes and links
Distance “small world” phenomenon Centrality Clustering coefficient (of A) is the Probability that two randomly selected friends of A are friends with each other Methods of partitioning networks “betweenness”: what happens when a link is removed Can we apply this to bank collapses and systemic risk

Degrees of separation? 6?

Importance of Links: Neighborhood overlap =
(Number of nodes who are neighbors of both A and B)/(Number of nodes who are neighbors of either A or B) = 1/6 applied to graph below:

Densely-connected, homogeneous parts that are weakly connected to each other

Homophily p fraction of all individuals are male
q (=1 - p) fraction of all individuals are female Consider a particular edge in this network If we independently assign each node the gender male with probability p and the gender female with probability q, then both ends of the edge will be male with probability p^2, and both ends will be female with probability q^2 = (1-p)^2 If the first end of the edge is male and the second end is female, or vice versa, then we have a cross-gender edge, so this happens with probability 2pq = 2p(1-p) Test for homophily according to gender as follows: Homophily Test: If the fraction of cross-gender edges is significantly less than 2pq, then there is evidence for homophily.

Homophily example 5 of the 18 edges in the graph are cross-gender. p = 2/3, q = 1/3. We should compare the fraction of cross-gender edges to the quantity 2pq = 4/9 = 8/18. With no homophily, expect to see 8 cross-gender edges rather than 5, and so this example shows some evidence of homophily.

Week 3: The Internet Economides, Nicholas (2007), The Economics of the Internet, in The New Palgrave Dictionary of Economics, London: Macmillan. Economides, Nicholas (2006), The Economics of the Internet Backbone, in Handbook of Telecommunications. Amsterdam: Elsevier Publishers. Easley and Kleinberg, ch. 13, 14, 15.

Basics on the Internet Creation; History; Arpanet, NSF
Structure, infrastructure Transmission; TCP/IP (transmission control protocol, UDP (user datagram protocol) Commercialization Pricing: transit and peering Internet Backbone Merger of MCI with WCOM Blocked merger of MCI with Sprint Present industry structure

Originally the Internet was connecting computers of defense contractors and DoD computers
“Packet-switched” not “circuit-switched” Information is cut to small “information packets” Based on simple transmission protocols TCP/IP (transmission control protocol) Guarantees delivery but may have delays UDP (user datagram protocol) Immediate delivery, but packets may be lost Because of nuclear attack threat at the time Packets from A to B are sent in many routes Low security because nodes “knew” each other Internet basics Originally in the early 1960s, the Internet was developed by the Department of Defense as part of the ARPANET that connected computers of defense contractors and DoD computers. The network evolved and it was eventually transferred to the National Science Foundation and from the early 1990 it became commercially available. Communication on the Internet was based on simple transmission protocols. It uses “packet switching” where information/data is cut to small “information packets” which are propagated in the network using statistical bandwidth allocation techniques. This is in contrast with the traditional voice network of AT&T that (at the time) was allocating a full circuit to a phone call irrespective of the amount of information transferred “circuit switched”. The protocols of the Internet are (i) TCP/IP (transmission control protocol), that guarantees delivery but may incur delays; and (ii) UDP (user datagram protocol), which guarantees immediate delivery, but some packets may be lost. Because of nuclear attack threat during the cold war, the network was designed so that information packets from A to B are sent in many routes and are re-assembled at the destination. The Internet has low security (i) because nodes “knew” each other; (ii) as a consequence of the simplicity of the protocols; and (iii) design decisions that made the hosts became responsible for security.

DoD gave it to the National Science Foundation (NSF)
Later, in the early 1990s, commercialization Explosive growth; 1 bil devices (hosts) Backbone (long distance) network Internet Service Providers (“ISPs”) connecting to backbone Residential Business customers Upstream ISPs

Explosive growth of the Internet

Pricing by Internet Backbones (IBPs) to Internet Service Providers (ISPs)
“transit” contract, delivers the whole Internet through a virtual pipe of a maximum bandwidth “peering” allows free exchange of info packets between two ISPs X and Y or two backbones Peering is limited to traffic originating or terminating at X or Y Pricing by Internet Backbones (IBPs) to Internet Service Providers (ISPs). There are tow basic types of contracts, “transit” and “peering.” The transit contract delivers the whole Internet through a virtual pipe of a maximum bandwidth in return to a payment from the ISP to the backbone. In contrast, a peering contract allows free exchange of information packets between two ISPs X and Y or two backbones. Peering is limited to traffic originating or terminating at X or Y. Peering typically occurs across networks that consider each other equally valuable in terms of the traffic exchanged.

The existence of peering among networks of comparable value allows for a number of bilateral peering agreements across networks. In the figure, ISP2 and ISP3 have a peering agreement and that allows both of them to buy a less wide transit pipe from the backbone (IBP0).

USA has low broadband penetration and lags behind poorer countries
US #16th. OECD collects information among its members on residential Internet penetration in broadband fixed and wireless access to the Internet. The United States has lagged significantly behind many European counties as well as Korea, a developing country. It is currently #16 among OECD countries, with lower penetration than Greece, a country that went bankrupt in 2012 and has 25% unemployment. Additionally, practically all countries with higher penetration than the US have lower per capita income. Only Switzerland, Norway and Luxemburg have higher per capita income among those that higher penetration than the US. Ultimately, the low penetration in the US can be traced to relatively high prices – average price $39.50 per month. Also the data excludes some high penetration countries, such as Hong Kong, that are not OECD members.

Market Share Among All Providers Total traffic all networks
BB market structure: US Carrier Traffic in Petabytes per month, May 2005 Company Traffic Market Share Among All Providers 1Q2004 2Q2004 3Q2004 4Q2004 A (AT&T) 37.19 38.66 44.54 52.33 12.58% B 36.48 36.50 41.41 51.31 12.33% C 34.11 35.60 36.75 45.89 11.03% MCI 24.71 25.81 26.86 30.87 7.42% E 18.04 18.89 21.08 25.46 6.12% F 16.33 17.78 17.47 19.33 4.65% G 16.67 15.04 14.93 15.19 3.65% Total traffic top 7 networks 183.53 188.28 203.04 240.38 57.78% Total traffic all networks 313 353 416 The Internet backbone market is considered effectively competitive. Although public information on this market is limited, during the proceeding of the merger of AT&T with SBC and MCI with Verizon, these companies had to disclose their traffic to the Department of Justice, which is shown in this table. We see that concentration is significant but not extreme. There are two additional reasons that increase competition on the Internet backbone. First, the (long distance) connection from point A to point B (points of presence) is a homogeneous good. Second, there is a tremendous amount of “dark fiber” which has been laid in the ground and only requires the addition of electronics to be functional. Thus, homogeneity of the good and overcapacity drive down prices on the Internet backbone.

Week 3: Cybersecutity and Privacy
Nicholas Economides et al. (2010), Toward Better Usability, Security, and Privacy of Information Technology, Committee Report, National Academies of Sciences.

Issues At present, the incentives of both users and companies on usable security and privacy diverge from actions that would maximize social benefit What economic and legal policies can be implemented to change users’ and companies’ incentives so that they are closer to maximizing social benefit?

Significant deficit in usable security and privacy
Current operating systems of PCs, netbooks, mobile phones, and other devices have significant security deficiencies Interfaces defining security levels are typically very difficult to follow Users are typically unaware of their level privacy (or its lack) in computers

The Internet has multiplied security problems of connected devices and highly increased the global impact of local lack of security The Internet was designed for a small number of nodes that knew and trusted each other Presently we are almost at a billion nodes world-wide with no mutual knowledge and no trust The Internet has no centralized or Internet Service Provider (ISP)-level security Security issues have an even more severe impact in “cloud computing” Typical users have a very limited understanding of the network capabilities of their computers and the possibilities of abuse in a network setting

Perspectives of the Issue
The residential user’s point of view The business user point of view A search engine’s point of view The network’s (societal) point of view Operating systems (OSs) and computer manufacturers point of view ISP’s point of view Global issues

The user’s point of the view
Different computer communications, usage, and storage require different levels of security Does the user understand how secure or insecure his communications, usage, and storage are? Does the user understand the financial consequences to him and others of lack of security in these? How can the user’s understanding be enhanced? Does the user have sufficient economic incentives (rewards/punishments) to use sufficient security? What is the balance between the user’s desire for privacy and the user’s desire for communication in social networks? Can we improve usability of security so that users who aim for higher security are able to achieve it? How?

Private companies have diverse points of view on security and privacy
1. Some businesses (e.g. banks, stock brokers, electronic commerce firms) generally desire higher security They have found various (private) solutions attempting to make their transactions more secure 2. But advertisers and search engines generally like more disclosure of private information to be able to pitch products closer to a consumer preferences and willingness to pay A very secure Internet where users are fully aware of the impact of disclosures of their private information would cut into the profits of these companies

Private companies perspective (cont.)
3. OS companies typically grew up in the pre-Internet era OSs originally relied on third parties to beef up security OSs did not anticipate the potential for global damage created by multiple local infiltrations in a network setting in the presence of even small security flaws Ultimately, companies will act to avoid liability How should we tweak the law to change the incentives of OS and computing devices manufacturers? Bottom line: Given the diverse uses of the Internet and the various functions/roles of firms on the Internet, it is unlikely to have a consensus among companies on security and privacy

From the network’s point of view (societal point of view)
In general, the value of security is much higher for the network than for an individual user Users, left on their own, will generally tend to achieve lower security than society desires Low security at a node can lead to catastrophic network events (such as the collapse of attacked nodes or even parts of the Internet) that are much more damaging to society than to the individual node The lack of security at a node is a “negative externality” to the network

In a network setting there is a crucial divergence between private and social incentives on security
Presently most users do not have sufficient incentives to secure their computers to prevent network-wide catastrophic events Can we create sufficient economic incentives so that users aim for sufficient security? How? How can we improve usability of security so that users who aim for higher security are able to achieve it?

What incentives will induce users to more secure computing behavior?
Positive monetary incentives (pay people)? Awards and other non-monetary positive incentives? Punishments for not meeting a security benchmark? Impose on insecure nodes liability for damages created using their node? Limit access to the Internet if computer fails security test?

From the OSs’ and computer manufacturers’ point of view
How can we create incentives for computer and operating systems vendors to increase security and maintain it through the useful life of a computer?

Should we require OSs to include and automatically update for free security/antivirus/anti-phishing?
Should we impose additional liability on operating systems vendors? In the extreme, should we deny computers access to the Internet (except the security checkup and upgrade site) unless they have passed a minimal standard of security? Should we require OSs to disable (as the default) various server functions of new computers, network devices, mobile phones, etc.?

The ISPs point of view How can we induce ISPs to play a role in limiting or preventing some attacks while adhering to network openness and net neutrality?

Global Issues No matter how good security becomes within the U.S., security issues will remain because of the global nature of the Internet This underlines the importance of certification of web sites and of measures that improve security in bilateral communications (including web browsing) of requirements on computer and OS manufacturers to increase security and automatically maintain it through the useful life of consumers worldwide

Policy Changes To strengthen usable security, what legal and economic policy changes are required at the user level? at the computer and OS manufacturer level? at the web site/server level? at the Internet service provider level?

Some questions How will the society deal with the “negative externality” on the network/society created by the lack of usable security of individual nodes? How can we provide positive and negative, monetary and non-monetary incentives to users to eliminate the negative externality? What role can the OSs play? Design? Post-purchase security maintenance? What role can the search engines play in making people aware of privacy issues? What role can ISPs play?

NETWORK FORMATION Other Notes pp (to be added)

Week 4: Network structures and platforms; two-sided pricing
Economides, Nicholas The Economics of Networks, International Journal of Industrial Organization, vol. 16, no. 4, pp (October 1996). Economides, Nicholas, and Charles Himmelberg, (1995), Critical Mass and Network Evolution in Telecommunications, in Gerard Brock (ed.), Telecommunications Policy Research Conference Selected Papers 1995. Shapiro and Varian chapter 7.

Special features of markets with network effects
Increasing returns to scale in consumption (network effects) A market exhibits network effects when the value of a transaction (or subscription) is higher when more units change hands, everything else being equal

Special features of markets with network effects: complementarities
In a traditional network, network externalities arise because a typical subscriber can reach more subscribers in a larger network

Special features of markets with network effects: complementarities
Network effects arise because of complementarities When customer A makes a phone call to customer B, he uses both AS and BS Although goods “access to the switch” AS, BS, …, GS have the same industrial classification and traditional economics would classify them as substitutes, they are used as complements 111 111

In traditional networks
the number of potential transactions increases with network size If every new transaction has positive value, a larger network gives higher value to a subscriber

One-way and two-way networks
Networks where services AB and BA are distinct are called “two-way” networks Two-way networks include railroad, road, and many telecommunications networks When one of AB or BA is unfeasible, or does not make economic sense, or when there is no sense of direction in the network so that AB and BA are identical, then the network is called a one-way network In a typical one-way network, there are two types of components, and composite goods are formed only by combining a component of each type, and customers are often not identified with components but instead demand composite goods For example, radio and TV broadcasting and early paging networks are one-way networks

A long distance (two-way) network or an ATM (one-way) network

Virtual network or platform; components Di complementary with components Sj; also has network effects In a virtual network, externalities arise because larger sales of components of type D induce larger availability of complementary components S1, ..., Sn, thereby increasing the value of components of type D Examples: CPUs & monitors Users and advertisers in Yellow Pages or Internet search engines Razors and blades Cameras and film

Financial and other exchanges: network effects arise because market liquidity is desirable

Top 5 capitalization companies over time: in 2016, all tech

Top 5 also have another feature: all are platforms
Platforms are matchmakers A platform provides a way for two parties to enter into mutually beneficial exchange or transaction Example: Platform: American Express Side 1: Merchants Side 2: Cardholders Service: Payment facilitation (Amex market share 26%) Merchants pay 3%; Cardholder’s rewards 1% Profit to Amex, 1.5+% of transaction’s value

Examples of platforms Platform Side 1 Side 2 Service(s)
Uber Driver Rider Transport Airbnb Apartment User Accommodation MSFT OS MS-Word User Writing Apple iOS Phone apps User Various Google Advertiser User Ads/Search M-Pesa Money sender money receiver Cell phone Sony PS3 Game User Game playing Internet Google Search User Search Internet Netflix Video user Video Internet Kindle books Kindle app eBook YouTube Video creators Video users Video Facebook User User Discussion, live audio, video

Stylized model of a platform: money flows
A platform may collect from both sides (Airbnb) or Collect from one side and subsidize the other (Amex) Apartment owner s Platform p R Users

Platform incentives in setting fee sM to other side of the market
Content Providers sM b = value (network effect) of extra content provider to a consumer a = value (network effect) of extra consumer to a content provider Platform RM > 0 Consumers a > b  sM > 0 a < b  sM < 0 Internet consumers, access platform, and content providers Game platform consumers, game platform, and games PC users, operating system, and applications Credit card issuing banks, credit card platform, and consumers

Platforms are taking over …

Why are platforms taking over? Reason 1: network effects
Platforms leverage network effects Network effect: a user will pay more to connect to a larger network

The more Uber cabs on the road, the more riders they will attract and vice versa
Uber can increase scale and reap network effects

Winner-takes-most world
Network effects create very significant sales- and profits- inequality Successes: Windows, iPhone, Facebook, Adobe, LinkedIn, Visa, MasterCard, Amex, Alibaba Failures: Betamax, IBM OS/2, Blackberry, Discover Card

Reason 2: Platforms usually have fewer employees and less fixed investment than traditional companies

Platforms have high profits because they have less fixed investment
Uber, the largest taxi company, owns no cars Airbnb, the largest accommodation provider, has no real estate Alibaba, the most valuable retailer, has no inventory Facebook, the most popular media company, creates no content

Traditionally, the focus of the company was internal
Tweaking the value chain to make perfect products In platforms, the focus is external A platform tries to bring together as many as possible from both (or all) sides, match them and create transactions Need to minimize the conflicts among them

Platforms disrupt traditional business
Amazon displaced bookstores and is displacing retailers (and possibly grocers) Netflix displaces subscription cable TV Google, Bing displaced the “yellow pages” guides

Not easy to do it right Microsoft almost killed the Mac in the 1980s by attracting more developers to write applications for Windows Apple has almost killed Microsoft’s cellphones, but Android (Google) is taking over from Apple as dominant phone platform

Examples of technology platforms:
Technology platforms are the hubs of the value chains in technology industries Examples of technology platforms: Microsoft Windows (PC operating systems) Intel processors (PC hardware) Sony PlayStation (game consoles) A platform forms the framework on which complementary goods (applications) attach (run)

Complementarity between a multisided platform and applications
A technology platform may be proprietary or open source Platform examples: Windows, Linux, iOS Application examples: MS-Office, Open Office, iApps PLATFORM APPLIC.

Prices and fees in two-sided markets
PLATFORM APPLIC. p0 user platform price p1 , p2 , p3 user application prices s1 , s2 , s3 fees to platform (or subsidies to applications) p1 s1 p0 s s3 p p3

Two-sided pricing in markets
with network effects Firms can make money from either side of a network or from both sides from a server or a client (example: Adobe Acrobat and Adobe Reader) from a caller (typical) or a receiver (800 numbers) of a phone call or from both (cellular in U.S.) Internet backbones collect money from both parties that send and receive traffic (when not in a peering relationship) The availability of prices on both sides of the network allows for complex pricing strategies, and, depending on the dynamics and market shares on the two sides of the market, can be used strategically to enhance and leverage a firm’s strong strategic position on one side of the network

Weeks 5: Network Effects Under (Technical) Compatibility
Economides, Nicholas The Economics of Networks, International Journal of Industrial Organization, vol. 16, no. 4, pp (October 1996). Economides, Nicholas, and Charles Himmelberg, (1995), Critical Mass and Network Evolution in Telecommunications, in Gerard Brock (ed.), Telecommunications Policy Research Conference Selected Papers 1995. Shapiro and Varian chapter 7.

Stylized model for the Internet as a platform: money flows
Content / Applications Providers s Platform (ISP) p R Consumers

Complementarity and compatibility
Links on a network are potentially complementary, but it is compatibility that makes complementarity actual Some network goods and some vertically related goods are immediately combinable because of their inherent properties However, for many complex products, actual complementarity can be achieved only through the adherence to specific technical compatibility standards Thus, many providers of network or vertically-related goods have the option of making their products partially or fully incompatible with components produced by other firms This can be done through the creation of proprietary designs or the outright exclusion or refusal to interconnect with some firms As we will see, it is not always in the best interests of a firm to allow full compatibility of its products with those of its competitors

Network effects Nature How they arise Effects
Consequences on competition, market structure and profits

Sources of Network Effects (1)
In traditional non-network industries, the willingness to pay for the last unit of a good decreases with the number of units sold. This is called the law of demand, and is traditionally considered to hold for almost all goods However, the existence of network effects implies that, as more units are sold, the willingness to pay for the last unit may be higher This means that for network goods, the fundamental law of demand is violated: for network goods, some portions of the curve demand can slope upwards For some portions of the demand curve, as sales expand, people are willing to pay more for the last unit

The law of demand is still correct if one disregards the effects of the expansion of sales on complementary goods But, as increased sales of a network good imply an expansion in the sales of complementary goods, the value of the last unit increases Combining the traditional downward slopping effect with the positive effect due to network expansion can result in a demand curve that has an upward-slopping part The key reason for the appearance of network effects is the complementarity between network components

Depending on the network, the network effect may be direct or indirect When customers are identified with components, the network effect is direct Consider for example a typical two-way network, such as the local telephone network In this n-nodes 2-way network, there are n(n - 1) potential goods. An additional (n + 1th) customer provides direct network effects to all other customers in the network by adding 2n potential new goods through the provision of a complementary link to the existing links In typical one-way networks, the network effect is only indirect When there are m varieties of component A and n varieties of component B (and all A-type goods are compatible with all of B-type), there are mn potential composite goods An extra customer yields indirect network effects to other customers, by increasing the demand for components of types A and B

Exchange networks (financial networks such as the NYSE and NASDAQ, commodities, futures, and options exchanges as well as business to business “B2B” exchanges) also exhibit indirect network effects There are two ways in which these network effects arise: Network effects arise in the act of exchanging assets or goods Network effects may arise in the array of vertically related services that compose a financial transaction. These include the services of a broker, bringing the offer to the floor, matching the offer, etc. The second type of network effects are similar to other vertically-related markets The first way in which network effects arise in financial markets is more important The act of exchanging goods or assets brings together a trader who is willing to sell with a trader who is willing to buy The exchange brings together the two complementary goods, “willingness to sell at price p” (the “offer”) and “willingness to buy at price p” (the “counteroffer”) and creates a composite good, the “exchange transaction”

Networks in finance References
Economides, Network Economics with Application to Finance (1993) Economides and Schwartz, Electronic Call Market Trading (1995) Economides and Schwartz, Equity Trading Practices and Market Structure: Assessing Asset Managers’ Demand for Immediacy (1995) Lange and Economides A Parimutuel Market Microstructure for Contingent Claims Trading (2000)

The two original goods were complementary and each had no value without the other one Clearly, the availability of the counteroffer is critical for the exchange to occur Put in terms commonly used in Finance, minimal liquidity is necessary for the transaction to occur Financial and business-to-business exchanges also exhibit positive size externalities in the sense that the increasing size (or thickness) of an exchange market increases the expected utility of all participants Higher participation of traders on both sides of the market (drawn from the same distribution) decreases the variance of the expected market price and increases the expected utility of risk-averse traders Higher liquidity increases traders’ utility

Network Effects Under Compatibility and Perfect Competition (1)
Let the willingness to pay for the nth unit of the good when ne units are expected to be sold be p(n; ne) n and ne are normalized so that they represent market coverage, ranging from 0 to 1, rather than absolute quantities Willingness to pay p(n; ne) is a decreasing function of n because the demand slopes downward p(n; ne) increases in ne; this captures the network externalities effect, i.e., that the good is more valuable when the expected sales ne are higher

Network Effects Under Compatibility and Perfect Competition (2)
At a market equilibrium of the simple single-period world, expectations are fulfilled, n = ne, thus defining the fulfilled expectations demand p(n, n) Each willingness-to-pay curve p(n, nie), i = 1, 2, ..., shows the willingness to pay for a varying quantity n, given an expectation of sales ne = nie. At n = nie, expectations are fulfilled and the point belongs to p(n, n) as p(nie, nie) Thus p(n, n) is constructed as a collection of points p(nie, nie)

When there are strong network effects, demand can slope upwards
The “law of demand,” i.e., that higher output can be sold only at lower prices, is violated when there are significant network effects: demand curve can slope upwards

Economides and Himmelberg, Critical Mass and Network Evolution in Telecommunications (1995) show that the fulfilled expectations demand is increasing for small n if either one of three conditions hold: (i) the utility of every consumer in a network of zero size is zero; or (ii) there are immediate and large external benefits to network expansion for very small networks; or (iii) there is a significant number of high-willingness-to-pay consumers who are just indifferent on joining a network of approximately zero size The first condition is straightforward and applies directly to all two-way networks, such as the telecommunications and fax networks where the good has no value unless there is another user to connect to The other two conditions are a bit more subtle, but commonly observed in networks and vertically-related industries

The third condition is most common in software markets
The second condition holds for networks where the addition of even few users increases significantly the value of the network A good example of this is a newsgroup on an obscure subject, where the addition of very few users starts a discussion and increases significantly its value The third condition is most common in software markets A software application has value to a user even if no one else uses it The addition of an extra user has a network benefit to other users (because they can share files or find trained workers in the specifics of the application), but this benefit is small However, when large numbers of users are added, the network benefit can be very significant

Possibility that the demand does not start at zero
For goods that have a positive stand–alone value k without network effects, the demand starts at (0, k).

Critical Mass When the fulfilled expectations demand increases for small n, we say that the network exhibits a positive critical mass under perfect competition. If we imagine a constant marginal cost c decreasing as technology improves, the network will start at a positive and significant size no (corresponding to marginal cost co) For each smaller marginal cost, c < co, there are three network sizes consistent with marginal cost pricing: a zero size network; an unstable network size at the first intersection of the horizontal through c with p(n, n); and the Pareto optimal stable network size at the largest intersection of the horizontal with p(n, n)

Market penetration of innovations is much faster in network industries than in non-network industries Penetration time network industry Non-network industry Diffusion of an innovation with and without network effects

Multiplicity of Equilibria
The multiplicity of equilibria is a direct result of the coordination problem that arises naturally in the typical network externalities model The existence of an upward slopping part of the demand curve and the multiplicity of equilibria even under perfect competition also allows for a network to start with a small size and then expand significantly Suppose, for example, that marginal cost is at c < co and a new invention creates a new product with significant network effects Then, it is possible that the industry starts at the left intersection of the horizontal at c with p(n, n) as expectations are originally low, and later on advances suddenly and quickly to the right intersection of the horizontal at c with p(n, n) Thus, the multiplicity of equilibria in network industries can lead to sudden significant expansions of network size

Efficiency (1) In the presence of network externalities, it is evident that perfect competition is inefficient The marginal social benefit of network expansion is larger than the benefit that accrues to a particular firm under perfect competition Perfect competition (p = MC) will provide a smaller network than is socially optimal, and, for some relatively high marginal costs, perfect competition will not provide the good while it is socially optimal to provide it

Gross benefit (area under the demand) is B(n, n)
𝐵(𝑛, 𝑛)= 0 𝑛 𝑝 𝑞, 𝑛 𝑑𝑞 Marginal benefit of network expansion 𝑑𝐵 𝑛, 𝑛 𝑑𝑛 =𝑝 𝑛, 𝑛 + 0 𝑛 𝑑𝑝 𝑞, 𝑛 𝑑𝑛 𝑑𝑞 >𝑝(𝑛, 𝑛)

Efficiency (2) Since perfect competition is inefficient, state subsidization of network industries is beneficial to society The Internet is a very successful network that was subsidized by the US government for many years The subsidized Internet was aimed at promoting interaction among military research projects During the period of its subsidization, almost no one imagined that the Internet would become a ubiquitous commercial network The foundation of the Internet on publicly and freely available standards has facilitated its expansion and provided a guarantee that no firm can dominate it

Complex pricing: externalities internalized or not?
Often the additional subscriber/user is not rewarded for the benefit that he/she brings to others by subscribing Hence there may be “externalities,” i.e., benefits not fully intermediated by the market In some cases, externalities are fully intermediated through non-linear pricing Example: Cantor Fitzgerald pricing towards Salomon Brothers in secondary U.S. bonds market (before 2001) Typical trader paid $20 per $1 million face value Salomon paid $1 per $1 million face value plus a fixed fee Why? Salomon brought immense liquidity to the secondary market because it controlled 40% of the primary market 158 158

Mathematical example p(q, ne) = (1 – q)ne q: actual units sold
ne: expected size of sales Fulfilled expectations demand: p(n, n) = (1-n)n Marginal benefit of network expansion 𝒅𝑩 𝒏, 𝒏 𝒅𝒏 =𝒑 𝒏, 𝒏 + 𝟎 𝒏 𝒅𝒑 𝒒, 𝒏 𝒅𝒏 𝒅𝒒= = n(1 - n) + n(1 - n/2) = n (2 – 3n/2) Notice that dB(n, n)/dn > p.

The marginal benefit of network expansion is always higher than the willingness to pay of the last participant

If the good has a stand-alone value k > 0
p(n, ne) = (1 - n)(k + ne) p(n, ne) = c → n = 1 – c/(k + ne). Can be thought as mapping ne to n: n = 1 – c/(k + ne) With fixed point (n = ne): n*(c) = 1 – c/(k + n*(c)), i.e., n*(c) = [1-k+√((1+k)^2-4c))]/2

Fulfilled expectations

If the good has a stand-alone value k > 0 (cont.)
p(n, n) = (1 - n)(k + n) dB(n, n)/dn = (1-n)(k+n)+n(1-n/2)

Adoption S-curves from various network industries

Platforms game 1. Download Wolfram CDF Player 1Gig download; do it at a fast connection; give it some time to install 2. Download the simulation

Weeks 6-7: Technical Standards Competition and the Compatibility Decision
Paul David and Shane Greenstein (1990), The Economics of Compatibility Standards Nicholas Economides and Fredrick Flyer, (1998) Compatibility and Market Structure for Network Goods

Why is technical standards competition important?
Because of network effects Network effects create inequality Competing standards that have small market share can be marginalized When a company chooses to be incompatible, it makes a big difference where it stands in the inequality chain of incompatible firms

Technical standards competition
VHS vs. Beta Windows vs. Mac vs. Linux MP3 vs. WMA vs. RealAudio HD DVD vs. Blu-Ray iPhone vs. Android vs. Windows 8

Technical Compatibility
when various links and nodes on the network can be costlessly combined to produce demanded goods Two complementary components A and B are compatible when they can be combined to produce a composite good or service Example: we say that a VHS-format video player is compatible with a VHS-format tape Two substitute components A1 and A2 are compatible when each of them can be combined with a complementary good B to produce a composite good or service Example: two VHS tapes are compatible; two VHS video players are compatible Similarly we say that two software products are compatible (more precisely two-way compatible) when they each can read and write files in a common format Compatibility may be one-way when the files of format B1 of software A1 can be read by software A2 , but the files format B2 of software A2 cannot be read by software A1 Moreover, compatibility may be only partial in the sense that software A1 is able to read files of format B2 but unable to write files in that format.

Dichotomy in markets with network effects (1)
Full compatibility networks Voice telecommunications (by regulation) Internet data communications (by design) Fax (by design) Cars and gasoline (by market evolution) Tables and chairs (by market evolution)

Dichotomy in markets with network effects (2)
Incompatible networks Operating Systems for PCs (Windows, Mac OS X, Linux) Game platforms (Xbox, Sony, Nintendo) Digital audio formats (iPod, Windows Media Player “WMA,” MP3, RealAudio) High definition DVDs (HD-DVD, Blu-ray) Video players (Betamax, VHS) Information servers (Google, MSN, Yahoo, yellow pages) Financial and other exchanges

Path-dependence is the dependence of a system or network on past decisions of producers and consumers Today’s sales of Windows are path-dependent because they depend on the number of Windows sold earlier (the installed base Windows). The existence of an installed base of consumers favors an incumbent However, competitors with significant product advantages or a better pricing strategy can overcome the advantage of an installed base Example: VHS overcame Beta after six years of higher installed base by Beta Sony’s mistakes in disregarding network externalities and not licensing the Beta format JVC’s widespread cheap licensing of VHS A low-end, low-price VHS player can contribute as much to the network effect as a high-end high-price Beta player

Strategic Choices of Technical Standards and Compatibility In Network Industries
Standards Wars (1) A key strategic decision for a firm is the extent to which it will be compatible with other firms A network good has higher value because of the existence of network effects Different firms conforming to the same technical standard can create a larger network effect while still competing with each other in other dimensions (such as quality and price) The decision to conform to the same technical standard is a strategic one A firm can choose to be compatible with a rival and thereby create a larger network effect and share it with the rival. A firm could alternatively choose to be incompatible with the rival, but keep all the network effects it creates to itself

Standards Wars (2) Which way the decision will go depends on a number of factors: In some network industries, such as telecommunications, interconnection and compatibility at the level of voice and low capacity data transmission is mandated by law The decision will depend on the expertise that a firm has on a particular standard (and therefore on the costs that it would incur to conform to it) The choice on compatibility will depend on the relative benefit of keeping all the network effects to itself by choosing incompatibility versus receiving half of the larger network benefits by choosing compatibility. The choice on compatibility depends on the ability of a firm to sustain a dominant position in an ensuing standards war if incompatibility is chosen The compatibility choice depends on the ability of firms to leverage any monopoly power that they manage to attain in a regime of incompatibility to new markets.

Standards Wars (3) Standards may be defined by the government (as in the case of the beginning of the Internet), a world engineering body (as in the case of the FAX), an industry-wide committee, or just sponsored by one or more firms Even when industry-wide committees are available, firms have been known to introduce and sponsor their own standards Incentives of firms to choose to be compatible with others; coordination game

Standards war leading to compatibility (1)
Full compatibility at both non-cooperative equilibria Standard 1 is a non-cooperative equilibrium if a > e, b > d. Similarly, standard 2 is an equilibrium if g > c, h > f. In this game, we will assume that firm i has higher profits when “its” standard i get adopted, a > g, b < h. Profits, in case of disagreement, will depend on the particulars of the industry. One standard assumption that captures many industries is that in case of disagreement profits are lower than those of agreeing on either standard, e, c < g; d, f < b

Standards war leading to compatibility (2)
There is no guarantee that the highest joint profit standard will be adopted Since consumers surplus does not appear in the matrix, there is no guarantee of total surplus maximization at equilibrium

Standards war leading to incompatibility
Compatibility with competitors brings higher network externality benefits (“network effect”) and therefore is desirable. At the same time, compatibility makes product X a closer substitute to competing products (“competition effect”), and it is therefore undesirable. In making a choice on compatibility, a firm has to balance these opposing incentives. Firms want to differentiate their products because they want to avoid intense competition. In a network industry, the traditional decisions of output and price take special importance since higher output Inequality in market shares and profitability is a natural consequence of incompatibility Under incompatibility, network externalities act as a quality feature that differentiates the products

Markets with strong network effects where firms can choose to be incompatible are “winner-takes-most” markets In these markets, there is extreme market shares and profits inequality The market share of the largest firm can be a multiple of the market share of the second largest, the second largest firm’s market share can be a multiple of the market share of the third, and so on Example: 66%, 22%, 7%, 2.%, 1%, … Geometric sequence of market shares implies that, even for small n, the nth firm’s market share is tiny Examples: PC operating systems market; software applications markets Why? A firm with a large market share has more complementary goods and therefore its good is more valuable to consumers Why “winner-takes-most” and not “winner-takes-all”? Because to “take all” requires an undesirable cut in price

“Winner-takes-most” markets
When fixed costs are small, a very large number of firms can survive, but there is tremendous inequality in market shares, prices, and profits among them Examples of this market structure are the PC operating systems market and many software applications markets Setup of Economides and Flyer (1998) All firms produce identical products, except for what value is added to them by network effects No firm has any technical advantage in production over any other with respect to any particular platform and no production costs “Pure network goods” where there is no value to the good in the absence of network externalities Consumers are differentiated in their willingness to pay for the network good

With network effects, natural inequality: “winner-takes-most”
Markets for incompatible products have inequality Hits in blogs Hits in Internet engines Market share of firms in traditional Yellow pages Size distribution of connections of Internet hosts Because of natural inequality in the market structure of network industries, there should be no presumption that anti-competitive actions are responsible for the creation of market share inequality or very high profitability of a top firm No anti-competitive acts are necessary to create this inequality

Profits inequality and network effects under incompatibility
Profits inequality and network effects under incompatibility. k = value of the good with no network effects

Herfindahl-Hirschman (H) Index for Different Intensities of Marginal Network Externality 1/k and Numbers of Firms S Under Incompatibility No network effect .333 .2 .1 ∞ No network effect (1/k = 0) implies equal firm shares, si = 1/n and H index: H = Σin=1 si2 = 1/n

Inequality of market shares and prices under incompatibility for pure network goods (k = 0)

Profits, Consumers’ and Total Surplus under incompatibility for pure network goods (k = 0)
Ratios of profits of consecutive firms range from 15 to 20

Monopoly May Maximize Total Surplus
When here are fewer firms in the market there is more coordination and the network effects are larger As the number of firms decreases, the positive network effects increase more than the dead weight loss, so that total surplus is maximized in a monopoly! Total surplus is highest while consumers’ surplus is lowest in a monopoly This poses an interesting dilemma for antitrust authorities Should they intervene or not? In non-network industries, typically both consumers’ and total surplus are lowest in a monopoly In this network model, total maximizing consumer’s surplus would imply minimizing total surplus

No Anti-Competitive Acts are Necessary to Create Market Inequality
In network industries, free entry does not lead to perfect competition Antitrust and competition law have placed a tremendous amount of hope on the ability of free entry to spur competition, reduce prices, and ultimately eliminate profits In network industries, free entry brings into the industry an infinity of firms but it fails miserably to reduce inequality in market shares, prices and profits Entry does not eliminate the profits of the high production firms Imposing a “competitive” market structure is likely to be counterproductive

Strategic Choice of Compatibility in Duopoly
k Equilibria in a Two-Firm Industry

Competition for the market takes precedence over competition in the market
Intense competition on which firm will create the top platform and reap most of the benefits Example: Schumpeterian races for market dominance among dot-coms in Very high valuation of dominant vs. other dot-com firms in that period; Wall Street perception Strategic effect: firms advertised very intensely and subsidized consumers to achieve a dominant position

Week 7: Bottlenecks and Interconnection Pricing
Nicholas Economides, Giuseppe Lopomo and Glenn Woroch, Strategic Commitments and the Principle of Reciprocity in Interconnection Pricing, chapter 5 (pp ), in Gary Madden (ed.) The Economics of Digital Markets, Edward Elgar (2009). Nicholas Economides, Giuseppe Lopomo and Glenn Woroch, Regulatory Pricing Policies to Neutralize Network Dominance, Industrial and Corporate Change, vol. 5, no. 4, pp , (1996).

One-sided bottlenecks
The early (1900) AT&T owned links 1 (long distance) and 2 (local), but did not allow independent firms which possessed link 3 to interconnect at B and provide part of the long distance service ABC For over two decades in the beginning of the 20th century, AT&T refused to interconnect independent local telecommunications companies to its long distance network, unless they became part of the Bell System, resulting in 89% market share for AT&T by 1935 from about 50% in 1914 In the 1970s AT&T controlled 89% of local lines and almost all long distance (LD) AT&T faced competition in LD by MCI which did not have local lines AT&T provided low quality interconnection to local lines to MCI

Interconnection Pricing; Vertical Price Squeeze
Assume use of link 1 is required by links 2, 3 Goods 12 and 13 and substitutes Assume link 1 is monopolized by firm A which also owns link 2, while firm B owns link 3 Firm B owns only link 2 and needs to buy use of link 1 from A Firm A sets the price p(12) of end-to-end service 12 and the “interconnection” or “access” price p(1) of link 1 when sold to firm B The price-to-cost margin of B is p(12) – p(1), both controlled by firm A, and can be made as small as firm A wants Firm B can be marginalized of driven out of business

Two-sided bottlenecks
Each of two firms is monopolist, each with a different bottleneck, and each firm requires the other’s bottleneck to produce its output Two local telephone companies, each customer subscribes only to one local telephone company, and each company requires the other’s network to complete calls Calls originate at A1, A2 and terminate at B1, B2. Termination charges at B1, B2 for calls from the rival network can be used to disadvantage and foreclose the rival network Example: New Zealand Problem in U.S. telecommunications solved by setting equal termination fees (reciprocity); unresolved in ATM, credit card, and other unregulated networks

Leveraging of market power across markets
Various types of exclusionary arrangements Instruments: Technical standards Bundling and other pricing strategies Non-price discrimination strategies (raising rivals’ costs)

Limited effects of antitrust policy
In markets with strong network effects, once few firms are in operation, the addition of new competitors, even under free entry, does not change the market structure in any significant way Although eliminating barriers to entry can encourage competition, the resulting competition may not significantly affect market structure In markets with strong network effects, antitrust authorities may not be able to significantly affect market structure by eliminating barriers to entry

Leveraging Example In the middle 1980s, Nintendo refused to allow third party games (software) to play on its game console (hardware) unless the software manufacturers agreed not to write a similar game for two years for competing game systems Nintendo used the dominance of the game market at the time to coerce developers to write software just for its platform, and thereby to increase the value of the Nintendo virtual network (of hardware and software) Practice stopped under threat from DOJ

Issues in “after-markets” where consumers are “locked-in” in a durable good or service arises out of commitments of durable nature Examples refusal of Kodak to supply to repair companies replacement parts for Kodak photocopiers lack of address portability for ISPs lack of number portability for wireless phones long after it was feasible

Example from computing industry: subsidizing complementary goods
Firm A chooses to make its product incompatible with others Firm A subsidizes firms that produce complementary goods Alternatively, firm A subsidizes its division that sells complementary goods As a result The value of firm A’s product increase The entry hurdle of firm A’s rivals increases Possible creation of market power, but action also has pro-competitive justification

Impose compatibility? Incompatibility is a necessary condition for possible creation of market power Key to increasing social welfare: public standards, compatibility But, it is very difficult for US antitrust authorities to intervene and/or define standards Different in the EU which is trying to impose compatibility between Microsoft and Sun servers (MS and Linux servers are compatible) Imposing compatibility may reduce incentives to innovate The “dynamically incorrect” standard may be chosen If forced to choose a single standard, the FCC would have chosen TDMA or GSM at the first PCS auctions CDMA proved more efficient later on

Dynamic efficiency issues
Static efficiency may lack in dynamic efficiency Possibility of a lock-in to a technology which, when decisions taken in every period, looks optimal given past decisions, but is sub-optimal if decisions are delayed and all the decisions are taken at once Lock-in may occur as a consequence of the race to be a dominant firm in a network industry

Innovation issues Efficiency and intensity of innovation in monopoly compared to competition and oligopoly is an open question in economics

Regulation?

When should regulation be used?
Regulation it is best suited for industries with well defined and not changing products and services Regulation is not well suited in industries with rapid technological change and frequently changing product definitions Regulation can be used by the regulated companies to keep prices relatively high, as exemplified by telecommunications regulation Often regulators are very close to the interests of the regulated parties rather than to the interests of the public Often regulators are not well informed about key variables as well as changes in the industry

When should regulation be used?
Regulators at both the state and federal levels are under pressure and influence by both the executive and the legislative part of government, and cannot be as impartial as a court There is a tendency for regulators to expand their reach into related and new markets These drawbacks can create significant surplus loss due to regulation However, regulatory rules can and should be used effectively and appropriately in cases of dominance or monopolization of essential network bottlenecks to assure that firms do not leverage their monopoly to adjacent markets that prices are not too high

Week 8 Applications of platforms (a) Taxicabs, Uber, Lynx
(b) Electric cars

(a) Taxi cabs as a two-sided network
Traditionally taxicabs (yellow cabs) are hailed on the street their retail fares are regulated number of licenses is regulated little or no entry allowed

Traditional taxicabs When licenses are transferable, lack of entry while demand expands can lead to very high value of licenses (over $1mil in NYC) price of license is a fixed cost to the driver Drivers can be impoverished while license holders get rich

Parallel markets Pre-arranged rides Town cars “Black cars”
Liveries (in NYC above 96th Street and outside Manhattan) Each fleet uses incompatible dispatch systems

Reasons for entry of rivals
High fares, high potential profits Potential for better coordination / matching of supply (cars) and demand (users) through a hailing platform Of course, the latter could be implemented by yellow cabs

New entrants, direct substitute for taxicabs
Locations of cabs online using an app Customers “hail” cabs with the app based on location/distance Advantage: “see” free cabs further than the usual 2-3 blocks No price regulation Uber charges according to demand/supply imbalance Regulatory issues at some municipalities

“Price fixing” issue Uber besides matching cars to users, also sets the same price for two or more different cars responding to the same user plus destination Since the drivers are officially independent actors, Uber has been accused of price fixing, an antitrust violation

Since rival taxicab networks are incompatible
We expect very significant inequalities in market shares, prices, and profits

(b) Electric cars as a two-sided network
Network issue because electric cars have a limited range per charge and therefore need a network of charging stations Alternatives Fast charges at gas stations, home and office Replaceable batteries at gas stations Precedent in electric taxicab fleets in New York and Philadelphia Cars purchased from GE without a battery and Hartford Electric Light Company provided batteries and replacement

Compatibility issues Technical standards of charging stations and batteries

Week 8-9: (a) Payment Systems in US and EU; (b) mobile banking in Africa;
Nicholas Economides (2009), Competition Policy Issues in the Consumer Payments Industry, in Robert E. Litan and Martin Neil Baily, eds., Moving Money: The Future of Consumer Payment Brookings Institution. Alan S. Frankel and Allan L. Shampine, The Economic Effects of Interchange Fees, Antitrust Law Journal 73, no. 3: 627–73. US DOJ press release, Settlement with Visa and MasterCard; United States v. American Express. Nicholas Economides and with David Henriques (2012), To Surcharge or Not to Surcharge? A Two-Sided Market Perspective of the No-Surcharge Rule, NET Institute Working paper #11-03, August 2011

(a) Payment Systems, Electronic Transaction Facilitation in US & EU
Bank cards facilitate transactions between merchants and consumers Some cards also offer credit The market for facilitation of transactions is dominated by the card networks Visa and MasterCard Stand-alone cards American Express and Discover smaller Visa 42%, MasterCard 29%, American Express 24%, Discover 5% (US market shares) Card networks collect significant fees from merchants to facilitate transactions Cards charge (non-credit-related) fees (primarily to merchants) significantly above cost Some estimate total cost only 13-15% of revenue Fees $30-48 billion per year in U.S.

Three-parties Setup (American Express, Discover)
$100 $97 Consumer Merchant Goods worth $100

Four-parties Setup (MasterCard, Visa)
$98.5 Issuing Bank Acquiring Bank Interchange fee $100 $98 Visa network Consumer Merchant Goods worth $100

Three Markets in Sequence in Four-parties Setup
Market II Issuing Bank Acquiring Bank Interchange fee Market I Market III Visa network Consumer Merchant Goods worth $100 Market III is generally considered effectively competitive, but since the interchange fee is the marginal cost of the acquiring bank, the interchange fee is a floor to the fees merchants pay In Market II, the network sets the maximum interchange fee Practically no bank in the network deviates from it No market determination of the interchange fee in bilateral markets between an acquiring and an issuing bank Issuing banks have market power in Market I but manage to make merchants pay through markets II and III rather than make card holders pay them directly

Credit Card Networks Have High Price-to-cost Markups Despite Non-Dominant-Firm Market Shares
Very significant markup of price above cost Very unlikely that consumers receive from card networks anything approaching the fee levels charged to merchants Comparable with profit rates of Microsoft and Intel But these have an almost monopoly market share How does Visa with 42% market share and MasterCard with 29% market share achieve such high markups and market power?

Networks make sure that
the consumers do not face directly the cost of their transactions so that they cannot choose to use the lowest fee card the merchants cannot charge different prices to reflect the card fees if consumers use different cards and different cards have different fees

The card networks Impose contractual obligations on merchants that
do not allow merchants to respond to differences in fees across cards do not allow the card holders to choose which card to use based on the cost the transaction imposed on the merchant (since the merchant is not allowed to pass this along) Effects Card transactions are subsidized by cash transactions High cost card transactions are subsidized by low cost card transactions Significant market distortion

Instruments Used by Card Networks to Restrict Competition and Achieve High Fees (1)
No surcharge rule (Visa contract, 2008) A merchant can charge the same for a Visa transaction as for cash If a merchant offers a discount for cash compared to Visa, he cannot offer the same discount to a “comparable card” (MasterCard) If a merchant offers a discount to a “comparable card,” he has to offer the same discount to Visa (“most favored customer” rule) Effect of the rule: the merchant cannot offer better terms to customers who buy with MasterCard than with Visa (although it may make sense to do so if MasterCard’s fees are lower) No price flexibility allowed in the merchant’s pricing As if Coca Cola imposed the requirement that a can of Pepsi be sold at the same price as a “comparable” can of Coke Only option for the merchant is not to accept a network card if he does not like the pricing

No discrimination rule MasterCard: “Merchants may not engage in acceptance practices or procedures that discriminate against, or discourage the use of, MasterCard cards in favor of any other card brand ....”

Card networks relied on a most-favored-customer (“MFC”) rule so that all prices among “comparable network cards” were the same IO theory has established that most-favored-customer rules can be used to facilitate price increases to collusive levels, Salop (1986) Reason: Under MFC rules, a firm will lose more revenue if it cuts price to a customer than in the absence of MFC rules

High fees are also shielded through the “honor all cards” rule
Debit networks (typically with PIN verification) offer lower merchant fees Debit cards of MasterCard and Visa also offer much lower fees than the signature-based credit cards To avoid loss of profits in credit cards, the networks impose the requirement that if a merchant accepts a Visa (say debit) card, he also has to accept all Visa cards (part of “honor all cards” rule)

Networks imposed the Honor all cards rule
A merchant accepting a Visa debit card issued by Citibank also has to accept Visa Debit cards issued by any other Visa network bank Any Visa products, such as Visa credit cards (tying) Visa's rules stated that “[t]he Merchant shall promptly honor all valid Visa cards when properly presented as payment ....” Anti-competitive consequences of tying What if Microsoft said that if your corporation buys Windows, it also has to buy MS-Office Or if you buy Dell servers you also have to buy Dell laptops?

Effects of old equilibrium
Card transactions are subsidized by cash transactions High cost card transactions are subsidized by low cost card transactions Networks have incentives to keep increasing interchange fees to attract more issuers

Proposed Changes in the Market Between Merchants and Acquiring Banks (Market III)
Allow for competition between branded networks Abolish the “no surcharge” rule Abolish the “no discrimination” rule Abolish the “honor all cards” rule

Proposed Changes in the Market Between Acquiring and Issuing Banks (Market II)
Allow the market between issuers and acquirers to determine the interchange fee Bilateral negotiations between pairs of banks (issuer and acquirer) Start from a par position (zero interchange fee)

Hold-out problem An issuer with very valuable potential transactions demands monopoly fee from acquirers Not a problem if monopoly power of issuer is legitimate Isolated problem if the proposal is adopted rather than market-wide problem under present regime Competition among issuers for these valuable customers solves the problem in the long run as these customers get more than one card

Effects of Proposed Changes
Increased inter-network and intra-network competition likely to result in lower transaction facilitation fees

Australian Experience
The Reserve Bank of Australia reduced interchange fees for credit cards in Australia from 0.95% to 0.55% in 2003 and to 0.50% in November 2006 Allowed surcharging Results: merchant fees fell even more than the interchange fees the overall cost to the economy of facilitating transactions fell

More radical changes Separating authentication from payment
Large merchants eliminate acquirers?

In Sept. 2010, DOJ sued Visa, MasterCard and Amex over the no-surcharge rule
Visa and MasterCard settled, accepting to abolish the no-surcharge and no discrimination clauses of their contracts Amex said it did nothing wrong; U.S. sued Amex Impact on merchants who do not take Amex?

U.S. beats Amex at District Court
But Amex wins on Appeal U.S. appeals further up during the last days of the Obama administration States’ Attorneys General appeal to the Supreme Court DOJ does not appeal to the Supreme Court

EU actions, July 2013 EU payment market is worth 130bn euros
EU wants to cap interchange fees to a maximum of 0.3% of a transaction Debit card fees to 0.2% of a transaction See

(b) Mobile banking in Africa and other developing areas
Read: Seeking Fertile Grounds for Mobile Money Many households do not have traditional bank accounts A new (escrow) bank account can be created and attached to a mobile phone number and therefore to a mobile telecom network No other banking services (loans, mortgages, investments)

Each mobile telephone network creates its own money
Mobile banking networks are incompatible When are two mobile telecom companies, A, B, in a country, there are three types of money: State (S-) money, A- m-money, and B- m-money

Three functions of mobile banking network
To transfer money to another person or business To transport money in the very short term To save money

De facto lack of interoperability makes exchange rates crucial.
In Tanzania: Conversion from S- money to A- or B- m-money (“cashing in) is free Conversion from A- or B- m-money to S-money (“cashing out”) is expensive: fee 2-5% for an average transaction Transfer across networks, from A- money to B- money is even more expensive Transfer within a network has a low fee, 0.3% for average transactions Substantial surplus losses because of de facto lack of interoperability

In Tanzania 35% of households have at least one m-money account
three major m-banking networks Vodacom (Vodafone), 53% market share in m-money Tigo, 18% Airtel, 13% Calling and transferring money across networks is expensive, many consumers have a different phone or a different SIM for each network Tigo advertises phones that take multiple SIMs

M-money is most frequently used to send or receive remittances
Non-remittance transfers are infrequent 14% of all households made or received a non-remittance payment in the past six months using any type of cash delivery, including m-money The most common types of payments included school fees, government fees and taxes, utility bills, and salaries

Despite the zero interest rate
Half of consumers with m-money accounts use their account as a savings account 21% Vodacom M-Pesa users and 12% of users of Tigo & Airtel use m-money for business transactions

Cashing in and cashing out of m-money
is done through a network of fixed and roaming agents that act as ATM machines This is the main cost of the banking networks

Data 3 months of banking transactions from Tigo Tanzania, including
cash-in, cash-out, recharge mobile, transfer, check balance Balance, operation size, GPS location, fee During the period, there was an unanticipated price change in transfer and cash-out fees

Tanzania

Frequency of transfers

Transfer network

Transfers Cash is a close substitute to m-transfers for short distances Elasticity of demand for m-transfers decreases with distance.

Lifetime of money in network

Number of P2P transfers before leaving the network

Transfers Cash is a close substitute to m-transfers for short distances Elasticity of demand for m-transfers decreases with distance

Probability of an m-transfer increases with distance

Summary of transfer results
Long distance transfers more inelastic Transaction taxes 0.25% transaction tax lowers the propensity to transfer by 46% 10% tax on the transfer fee lowers the propensity of transfers by 13% Taxes are extracted from long distance remittances regressive tax Interoperability with zero cash-out fee would increase the propensity for m- transfers by 1%

System also used for cash-in-cash-out transactions
Transporting money without transfers Savings Interest rate in zero But starting last summer, Tigo started paying a “dividend”

Price elasticity of cash-out in cash-in-cash-out transfers

People put money in the phone rather than keep cash

People store cash on the phone to ameliorate risk

Main services of Internet finance
third-party payment Credit card networks; square cash network lending (P2P and network microcredit, Internet consumer finance) LendingClub crowdfunding Gofundme, Kickstarter, Indiegogo Internet wealth (portfolio) management BETTERMENT.COM, MARKETRIDERS.COM, PERSONALCAPITAL.COM, WEALTHFRONT.COM virtual currency Limited in the US; see Tanzania analysis

Sept. 15, 2015, the three smaller networks introduce compatibility through software interface
Largest network (Vodacom) remains incompatible Transfers across networks electronically feasible but expensive

Many users transport money through network without a transfer
to avoid carrying cash and losing their money in muggings or theft We use revealed preference to estimate the probability of getting mugged at any point of Das es Salam

Impact of telecom network
on probability of using mobile banking

Week 10: The Digital Books Market
Market Structure Distribution model of digital goods DOJ suit and EU statement of objections against Apple and five publishers US Complaint Settlement of publishers Court decision on Apple

History and Market Structure
1992 Sony sells Data Discman, an eBook reader for CDs 2000 Microsoft launches Microsoft Reader, works in Windows 2007 Amazon launches Kindle 2010 Apple launches iPad 2011 Barnes and Noble launches Nook

Book sales revenue 2012, eBooks surpass hardcover

Retail price for ebooks used to be set by retailer (Amazon, etc.)
Publisher collects price P per eBook Retailer sets price R to users Price R for most ebooks > P, but sometimes R < P Before the iPad came to market, Amazon sold “NYT bestsellers” for R = $9.99, below P

Publishers did not like low R
Even though they still collected P > R Why? Because most of the book sales were of hard copies, and the hard copy price Ph was much larger than R Publishers were worried that they may have to reduce price Ph (say $35) in the presence of an eBook price of $9.99 Before the iPad came to market, in Dec publishers retaliated against Amazon by withholding availability of “new releases” as ebooks for a few months after hard copies of new books were being sold, a practice called “windowing” But windowing encouraged piracy

In the months before the launch of the iPad
Apple was in intense negotiations with publishers attempting to convince them To adopt the “agency pricing model” To impose this model to all retailers, including Amazon To allow for ebooks of NYT bestsellers to become available at the same time as hard copies To cut the price of eBook NYT bestsellers

Once the iPad entered the market
the 5 major publishers and Apple agreed to move to the “agency pricing model” on the condition that it would apply to Amazon too Agency pricing model: Retail price R is set by publisher Retailer keeps 30% of the retail price, i.e., P = (0.7)R Similar to the way Apple sold third party software for the iPad through its virtual store

Suit of DOJ against Apple and publishers for conspiring to set eBook prices (April 2012). Defendants: Hachette Book Group, Inc. HarperCollins Publishers L.L.C. Simon & Schuster, Inc. Macmillan Penguin group The above settled; Remaining defendant Apple

Apple CEO Steve Jobs to Publisher Defendants:
“We’ll go to [an] agency model, where you set the price, and we get our 30%, and yes, the customer pays a little more, but that’s what you want anyway.” (p. 4 of US complaint)

Effects of the conspiracy
The increases at Amazon within roughly two weeks of moving to agency amounted to an average per unit eBook retail price increase of 14.2% for their New Releases, 42.7% for their NYT Bestsellers, and 18.6% across all of the Publisher Defendants’ e-books Court decision on Apple, page 94

Prices increased as a result of the conspiracy

Ebook prices before and after the conspiracy agreement

Strength of DOJ’s case Conspiracy (Section 1 of Sherman Act), no need to show anti-competitive effects) Weakness of the case Apple can claim it was imposed to it by the publishers DOJ could have brought criminal charges but did not Shows that DOJ did not believe it could win a criminal case

Settlement approved 9/7/12
Ends conspiracy among publishers Allows eBook retailers to set price (as they used to) Settling publishers agreed to refrain for two years from entering into contracts containing retail price restrictions and price commitment mechanisms to stop communicating competitively sensitive information to competitors not retaliate against retailers that exercise discounting authority not to fix terms or prices with competitors for the provision of e-books AGs of various states get $69 million damages from publishers

Similar case in EU settled
On 9/7/12, Apple and four major publishers (all US defendants except Penguin) have offered to allow retailers such as Amazon to sell e-books at a discount for two years On 11/6/12, Reuters reports that EU is about to settle on these terms

In July 2013, US District Court decision finds Apple liable
of conspiracy to restrain trade in violation of Section 1 of the Sherman Act Civil suits to follow Need additional study of prices after the end of the conspiracy

DOJ proposal on remedies: Apple is
required to end its existing eBook agreements with five major publishers and sign no new price-setting distribution contracts for five years allowed to continue to sell ebooks prohibited from retaliating against publishers for refusing to sell ebooks under terms approved by Apple required to allow other eBook sellers, such as Amazon and Barnes & Noble, to give more prominent play to their eBook stores on Apple devices, by allowing them to provide links from their eBook apps to their eBook stores prohibited from entering into agreements with suppliers of ebooks, music, movies, television shows or other content that are likely to increase the prices at which Apple's competitor retailers may sell that content See

Week 11: Two-sided Pricing & Network Neutrality
General theory Application to network neutrality Public policy References: Economides & Tag, “Network Neutrality on the Internet: A Two-sided Market Analysis,” Information Economics and Policy (2012), at Economides and Hermalin (2012), “The Economics of Network Neutrality,” forthcoming, Rand Journal of Economics, at

In networks, price discrimination schemes can be complex (1)
Because a network may have different degrees of market power on different sides of the market A firm that controls a proprietary platform sets a price strategically for its end-user products and collects a fee for complementary products to its platform sold by other firms Sony controlling its game console sets a price for the game console and charges royalties to developers of games Microsoft sells Windows to end-users provides application developers with information and resources; embeds subroutines in Windows useful to application developers makes money from licensing application development tools and support

Prices and fees in two-sided markets
PLATFORM APPLIC. p0 user platform price p1 , p2 , p3 user application prices s1 , s2 , s3 fees to platform (or subsidies to applications) p1 s1 p0 s s3 p p3

In networks, price discrimination schemes can be complex (2)
Since the creation of the Internet, there was no price (or other) discrimination based on what service or what application the bits came from (so called “net neutrality”) Now AT&T, Verizon and cable TV networks advocate price discrimination based on which application and on which provider the bits come from AT&T, Verizon and cable TV networks propose to kill net neutrality by charging both the DSL subscriber and the application provider (such as Google) where the bits originate, even when the application provider is not directly connected to AT&T or Verizon (i.e., Google’s ISP is not AT&T or Verizon) Note that the proposal is to impose price discrimination on the provider side of the market and not on the subscriber (i.e., it is a version of two-sided pricing)

Two-sided Pricing & Network Neutrality
ISP Internet Backbone Netflix Google ISP AT&T (Access Network) s : AT&T’s fee to content providers or many fees s1, s2, …, sn p R: subscription price Residential Customers

Interview with Ed Whitacre BusinessWeek November 7, 2005
How concerned are you about Internet upstarts like Google, MSN, Vonage, and others? “How do you think they're going to get to customers? Through a broadband pipe. Cable companies have them. We have them. Now what they would like to do is use my pipes free, but I ain't going to let them do that because we have spent this capital and we have to have a return on it. So there's going to have to be some mechanism for these people who use these pipes to pay for the portion they're using. Why should they be allowed to use my pipes? The Internet can't be free in that sense, because we and the cable companies have made an investment and for a Google or Yahoo! or Vonage or anybody to expect to use these pipes [for] free is nuts!”

But Both Sides Pay for “Transit” on the Internet
All hosts on the Internet pay according to bandwidth use: there is no “free lunch” on the Internet AT&T, Verizon, and others are paid by ISPs according to bandwidth use Actually Internet backbones are paid twice for any transmission, by the originator of traffic and by the terminator of traffic (through their respective ISPs)

Varying Levels Of “Network Neutrality,” from Strictest to Weakest
Referring to pricing to the “other side” of the consumer market (that is to content and applications providers): 1. Absolute non-discrimination: no quality of service variations offered for money or for free 2. Varying quality of service offered according to type of info. packet but no fees are charged 3. Tiered service allowed but each tier is offered at the same price to all; no exclusivity or identity-based discrimination 4. Identity-based discrimination allowed 5. Exclusivity allowed

Obama’s statement on NN, at http://www. barackobama
Barack Obama strongly supports the principle of network neutrality to preserve the benefits of open competition on the Internet. … Because most Americans only have a choice of only one or two broadband carriers, carriers are tempted to impose a toll charge on content and services, discriminating against websites that are unwilling to pay for equal treatment. This could create a two tier Internet in which websites with the best relationships with network providers can get the fastest access to consumers, while all competing websites remain in a slower lane. Such a result would threaten innovation, the open tradition and architecture of the Internet, and competition among content and backbone providers. It would also threaten the equality of speech through which the Internet has begun to transform American political and cultural discourse. Barack Obama supports the basic principle that network providers should not be allowed to charge fees to privilege the content or applications of some web sites and Internet applications over others. This principle will ensure that the new competitors, especially small or non-profit speakers, have the same opportunity as incumbents to innovate on the Internet and to reach large audiences.

FCC’s NPRM (2009) (1): “Subject to reasonable network management, a provider of broadband Internet access service may not 1. prevent any of its users from sending or receiving the lawful content of the user’s choice over the Internet. 2. prevent any of its users from running the lawful applications or using the lawful services of the user’s choice. 3. prevent any of its users from connecting to and using on its network the user’s choice of lawful devices that do not harm the network. 4. deprive any of its users of the user’s entitlement to competition among network providers, application providers, service providers, and content providers.”

FCC’s NPRM (2009) (2): “Subject to reasonable network management, a provider of broadband Internet access service must treat lawful content, applications, and services in a nondiscriminatory manner We understand the term “nondiscriminatory” to mean that a broadband Internet access service provider may not charge a content, application, or service provider for enhanced or prioritized access to the subscribers of the broadband Internet access service provider … We propose that this rule would not prevent a broadband Internet access service provider from charging subscribers different prices for different services.”

FCC Rule (December 2010) 1. Transparency: Fixed and mobile broadband providers must disclose the network management practices, performance characteristics, and terms and conditions of their broadband services. 2. No blocking: Fixed broadband providers may not block lawful content, applications, services, or non-harmful devices; mobile broadband providers may not block lawful websites, or block applications that compete with their voice or video telephony services. 3. No unreasonable discrimination: Fixed broadband providers may not unreasonably discriminate in transmitting lawful network traffic. Even though this regulation is weak, Verizon appealed to stop it. In Jan. 2014, Verizon won, and the FCC rules were nullified.

EU: Directive 2009/140/Ec 25 November 2009 Commission Declaration On Net Neutrality
The Commission attaches high importance to preserving the open and neutral character of the Internet, taking full account of the will of the co-legislators now to enshrine net neutrality as a policy objective and regulatory principle to be promoted by national regulatory authorities alongside the strengthening of related transparency requirements and the creation of safeguard powers for national regulatory authorities to prevent the degradation of services and the hindering or slowing down of traffic over public networks

EU: Directive 2009/140/Ec 25 November 2009, Consultation, and Kroes Speech
National Regulatory Authorities are required to promote “the ability of end-users to access and distribute information or run applications and services of their choice” National Regulatory Authorities, after consulting the Commission, can set minimum quality of service requirements Strong transparency to ensure consumers understand and get what they pay for

Residential ISPs have market power; also claim congestion
Assuming no congestion, Economides and Tag (2009) and others showed that introducing a positive price to content providers is typically welfare-inferior to NN Economides & Tag, “Network Neutrality on the Internet: A Two-sided Market Analysis,” Information Economics and Policy (2012), at ISPs claim that NN is not optimal with congestion Issue addressed in Economides and Hermalin (2012), “The Economics of Network Neutrality,” Rand Journal of Economics, at

Six Consequences of Departure from Net Neutrality
1. Introduction on the Internet of two-sided pricing where a transmission company controlling some part of the Internet (here last mile access) will charge a fee to content or application firms “on other side” of the network Economides and Tag (2012) main result: Starting to charge a positive price “s” on the “other side” of the market is desirable to an access monopolist (or duopolists) but not desirable for society – more later in the presentation

2. Introduction of prioritization which may enhance the arrival time of information packets that originate from paying content and application firms “on the other side,” and may also degrade the arrival time of information packets that originate from non-paying firms The present plans of access providers are to create a “special lane” for the information packets of the paying firms while restricting the lane of the non-payers without expanding total capacity By manipulating the size of the paying firms’ lane, the access provider can guarantee a difference in the arrival rates of packets originating from paying and non-paying firms, even if the actual improvement in arrival time for paying firms’ packets is not improved over net neutrality

3. If the access providers choose to engage in “identity-based” discrimination, they can determine which one of the firms in an industry sector on the other side of the network, say in search, will get priority and therefore win This can easily be done by announcing that prioritization will be offered to only one of the search firms, for example the one that bids the highest Thus, the determination of the winner in search and other markets on the other side will be in hands of the access providers and not determined by innovative products or services on the other side This can create very significant distortions since the surplus “on the other side” of the Internet is a large multiple of the combined telecom and cable TV revenue from residential Internet access

4. New firms with small capitalization (or those innovative firms that have not yet achieved significant penetration and revenues) will very likely not be the winners of the prioritization auction This is likely to reduce innovation. Network externalities arise because a typical subscriber can reach more subscribers in a larger network Under no net neutrality, access providers can limit the size and profitability of new firms on the “other side”

5. The access networks can favor their own content and applications rather that those of independent firms Examples: independent VOIP, video This is likely to distort competition and reduce total surplus

6. Since the Internet consists of a series of interconnected networks, any one of these, and not just the final consumer access ones, can, in principle, ask content and application providers for a fee This can result in multiple fees charged on a single transmission and lead to a significant reduction of trade on the Internet

Economides-Tag (2012) deals with two-sided pricing when there is no congestion
In terms of potential welfare reduction because of the six effects discussed above, we model the case that has the least reduction in total surplus compared with net neutrality Even though we make the best possible case for total surplus to increase when departing from net neutrality (by not focusing on factors two to six that are likely to reduce surplus), we find that typically total surplus decreases, both in monopoly and duopoly when we depart from net neutrality

Stylized model: Money flows
Content / Applications Providers s Platform (ISP) p R Consumers

Crucial Questions Does the platform want to set s >0?
Does the platform want to set s1, s2, etc.? Are consumers better/worse off at s > 0 vs. s = 0 Are consumers better/worse off at s1 > s2 > 0 vs. s = 0 Is total surplus (TS = CS + Profits of ISP + Profits of Apps) higher with s > 0 than s = 0? With s1 > s2 > 0 vs. s = 0?

Model 1 (Economides and Tag, 2012)
Network effects from the consumers to the apps and vice versa Monopolistic competition among apps Monopoly or duopoly ISP No congestion Heterogeneous consumers Heterogeneous apps Network effect from consumers to apps “a” Network effect from apps to consumers “b”

Optimal One-sided Regulation in the Presence of Monopoly on the Other Side of the Market
A regulator/planner setting a fee s to content providers expecting the platform monopolist to set his profit-maximizing subscription price p(s) maximizes the constrained total surplus function TS(p(s), s) and chooses a below-cost fee to content providers s***< 0 provided that both consumers and content providers are sufficiently differentiated Even paying the below-cost fee, the platform makes positive profits Similar results for duopoly ISPs

Economides-Hermalin assumes congestion
Examines under what conditions NN is optimal What pricing does the ISP implement?

Model 2 (Economides and Hermalin, 2012)
Assume congestion: If traffic exceeds the pipe’s capacity it gets delayed proportionately Monopoly ISP Homogeneous consumers Heterogeneous apps Below: “welfare” = “total surplus TS” TS = CS + profits of ISP + profits of apps Because the consumers are homogeneous, the ISP appropriates all CS

Define net neutrality as no division of the bandwidth
Otherwise, bandwidth is divided in lanes, and each lane is allocated to one or more apps Provided that the monopolist ISP allows (sells to) all apps: Neutrality is weakly welfare-superior to any division of the bandwidth in which all segments are allocated a positive portion of the bandwidth Neutrality is strongly welfare-superior to any division that excludes some segments

A bandwidth allocation is welfare-superior if it carries more content
Consider divisions of bandwidth in lanes Proposition 1. Given two alternative divisions of the total bandwidth, one is welfare superior to the other if and only if it results in more content being carried in equilibrium than the other. Corollary 1. Network neutrality is welfare superior to any division of the bandwidth if no division of the bandwidth leads to more content being sent in equilibrium.

Amount of content carried is a “sufficient statistic” for welfare
and how bandwidth is allocated to content does not matter Content is analogous to income, and it has the maximum positive effect on welfare when it is allocated as the consumer sees fit without restrictions Restrictions (special lanes etc.) in its allocation restrict welfare [Reminiscent of Varian (1985,9) showing that third degree price discrimination increase welfare vis-a-vis uniform pricing only if it increases the total amount of goods sold]

Exclusion reduces welfare
Proposition 2. Suppose the ISP provides a common class of service, but excludes a positive measure of content providers. In the resulting equilibrium, TS is less than it would be were no content providers excluded.

Allowing the ISP to charge a positive fee to apps will exclude some apps
Each user likes more applications When the consumer surplus is higher, the ISP (who appropriates consumer surplus) has an incentive to allow more apps Each app wants fewer (other) apps because more apps congest the network and delay delivery This externality among apps is not internalized in this model

Welfare = Total Surplus = Consumer Surplus + Profits of ISP + Profits of Apps
A necessary condition for welfare under price discrimination to exceed welfare is that the set of application providers served in equilibrium expand If the ISP serves all application providers in equilibrium under linear pricing, then any non-trivial price discrimination scheme reduces welfare

The effect of prioritization on total surplus
Depends on how the elasticity of demand with respect to transmission time varies with content type NN can maximize welfare if the elasticity of demand with respect to transmission time is invariant with respect to content But depending on how that elasticity varies with content type, to max. welfare you may want to prioritize or slow down content of high immediacy desire

Crucial issue is how many apps at the bottom are excluded when fee to apps is introduced i.e., depends on the distribution of app types Welfare can be higher or lower in price discrimination vs. linear pricing, depending on parameters Of course, higher welfare requires more total content sales

Dynamic Issues: investment in bandwidth
ISP invests more in bandwidth with single positive fee to apps than with no fee With single positive fee, ISP invests less in bandwidth compared to the welfare-maximizing amount ISP invests more in bandwidth with price discrimination than with single positive fee to apps

Distinction between static and dynamic efficiency
Example where θ (app types by desirability of immediacy) is distributed uniformly on [.05,1]. Given a fixed bandwidth, compelling ISP to serve all application providers would raise welfare by 10% Cost of bandwidth κB (unrealistic technology) Unrestricted ISP will build times as much bandwidth as it would were it constrained Greater bandwidth does not fully overcome the static inefficiency, but, once the dynamic consequences are considered, welfare with zero fee is only 2% greater than were the ISP unrestricted

In some models (Choi and Kim, Rand Journal 2010), ISP can have higher profits if it restricts bandwidth Lower bandwidth can increase the difference between the price of a good in the fast lane vs. slow lane Not in Economides-Hermalin

Conclusions on net neutrality (1)
Two-sided pricing is complex Identified conditions when prices are positive on both sides and when one side is subsidized Generally, social welfare diverges from platform profits On the Internet, net neutrality typically is welfare-maximizing

Conclusions on net neutrality (2)
Under reasonable assumptions, welfare increases in the total amount of content carried Even in the presence of congestion, NN can maximize welfare if the elasticity of demand with respect to transmission time is invariant with respect to content But depending on that elasticity, to max. welfare you may want to prioritize or slow down content of high immediacy desire Killing NN can increase bandwidth investment and reduce the static allocative distortion

Week 12: Bottom line

Companies’ strategies that were successful in network industries
1. Vertical extension of the company 2. Discount pricing based on volume to take advantage of network effects 3. Discount pricing based on volume to take advantage of dominant position and disadvantage competitors 4. Subsidizing complementary goods 5. Control of bottlenecks 6. Exclusive contracts

1. Vertical extension of the company
Example: Microsoft 92% market share in operating systems for PCs Over time, it added functions to the OS that used to be independent applications or middleware: Browser Windows Media Player Hard disk defragmenter Anti-spyware Anti-virus But MS does not go in hardware in PCs; is aware of its core competency

Advantages of extending the firm vertically
Offensive advantage Takes away value from complementary goods and adds value to own product Defensive advantage Avoids complementary goods firms creating a challenge to own product Netscape browser + Java might challenge Windows

Disadvantages of extending the firm vertically
Strategy may be illegal as in the Microsoft cases in the US and EU But strategy very likely legal if market share is < 50% in US and < 40% in EU Vertical extension could distract from the core competency of the firm

Success? Very successful for Microsoft against Netscape which saw its share going from 100% to 0%
But, so-and-so in audio players

2. Discount pricing based on volume to take advantage of network effects
Example: Cantor Fitzgerald in the secondary market for US government bonds; had 70+% share Offered per unit pricing very significantly above marginal cost to all traders except Salomon Brothers Salomon was offered marginal cost pricing plus a fixed fee Why? To get the very high liquidity of Salomon that had 40+% in primary market, and internalize the network effects

Success? Very successful for Cantor
Kept dominant position despite an inefficient trading platform (broker matching vs. electronic trading) Primary dealers had to set up their own exchanges as a threat to constrain the per-unit pricing of Cantor

3. Discount pricing based on volume to take advantage of dominant position and disadvantage competitors Example: Microsoft’s “per processor” pricing before 1995 Offered Windows at a per unit price, say $30 Also offered Windows to a PC manufacturer, say Compaq, that produced say 1 mil. units, at a flat price of $24 mil. with the right to install in all units For Compaq, the last 200,000 units effectively had zero price Compaq had a strong incentive not to buy from competitors (IBM)

Advantages When marginal cost is very low, this strategy can rapidly increase market share (as it did for Microsoft) Great success for Microsoft that marginalized DOS competitor DR-DOS; increased the market share of Windows (that faced IBM’s OS2) to 90+%

Disadvantages The strategy is likely to be illegal for a dominant firm in the US, EU, Japan, and Korea In 1995 (before the big antitrust suit) Microsoft agreed with USDOJ to stop using this strategy But, it is a legal strategy for non-dominant firms

4. Subsidizing complementary goods
Example: Microsoft It chooses to make its product (OS) incompatible with others It subsidizes firms that produce complementary goods (by including in Windows features that are useful to application developers but not to users) Alternatively, MS subsidizes its division that sells complementary goods (Office) As a result The value of MS’s product increases The entry hurdle of MS’s rivals increases

Advantages of subsidizing complementary goods
Offensive advantage The value of own product increases Defensive advantage The entry hurdle of rivals increases It can make a platform dominant Huge mistake of Apple not to adopt this strategy when Bill Gates pushed Apple to adopt it (before the creation of Windows) Refusal by Apple prompted MS to create Windows and made MS the key player in PCs

Disadvantages of subsidizing complementary goods
It costs money that may not be recoverable for some time However, as Microsoft showed, subsidizing complementary goods can create dominance in the long run with very large benefits

5. Control of bottlenecks
Is crucial for creation and maintenance of dominant market position Sometimes innovation can eliminate the bottleneck Example: software services can eliminate the bottleneck of OSs

Old software model with OS bottleneck
Windows OS Windows Application Software Windows dominant Application needs OS- specific APIs Apple OS X Mac Application Linux OS Linux Application

New software service model eliminates/reduces the bottleneck
Browser Windows OS Application as a Service Windows dominant Open standards OS market structure irrelevant for service application market Apple OS Linux OS Based on browser’s open standards

6. Exclusive contracts Example: Microsoft
Exclusive contracts with AOL and other ISPs on adoption of Internet Explorer Successful but illegal for a dominant firm

Some Big Upheavals in Network Industries
1. Google in Internet search/advertising 2. iPod big success in digital audio 3. VHS killing Betamax 4. Internet Explorer displacing Netscape 5. Alternating current displacing direct current in electricity

Being first is no guarantee of long run success
Examples Google in Internet search Arrived very late Used a different algorithm for search Based its revenue on advertising Apple’s iPod Also arrived very late Hardware-software combination More liberal contract on legal copies (at the time)

Betamax/VHS: Sony’s strategic error
VHS video recorder (JVC/Matsushita) Came later than Betamax (Sony) Was widely licensed; low price Betamax was not widely licensed; high price Much bigger network effects of VHS After 5 years, Betamax withdraws from the USA Strategic error of Sony Originally video recorders were used for time-shifting (like Tivo) – there were no network effects Only later movies for rental appeared -- crucial complementary good creating network effects Sony’s managers missed the transition …

Internet Explorer displaces Netscape
Originally Netscape (based on Mosaic of the Univ. of Illinois) was dominant with 90+% market share Microsoft makes a huge effort to write better browser from scratch IE3 was significantly better than Netscape Microsoft uses exclusive contracts and bundling in Windows to boost IE’s market share

Alternating current displacing direct current in electricity
Originally electricity generation and distribution was developed as direct current (DC) by Edison Significant municipal networks (New York City, Philadelphia) were created based on DC Light bulbs last much longer on DC Westinghouse pushed AC because its motors run much more efficiently on AC AC won because of the efficiency of its long distance transportation (Niagara Falls to NYC)

Bottom line (1) 1. Incompatibility is key
2. Under incompatibility, “winner-takes-most” 3. Crucial to have the top market share 4. Competition for the market more important than competition in the market; make early sacrifices 5. Extend the firm vertically without going outside core competences

Bottom line (2) 6. Use price discrimination to
a. take advantage of network effects b. take advantage of or create dominant position c. disadvantage competitors 7. Subsidize complementary goods to create a dominant platform 8. Try to keep control of bottlenecks; create new bottlenecks if possible 9. May use exclusive contracts if legal

Weeks 12: Antitrust in Networks Industries
3 Microsoft cases The Microsoft Antitrust Case For MBA Students NYU conference on US v. MS, including streaming video of all presentations featuring (among others) Assistant Attorney General for Antitrust Doug Melamed, NY Assistant Attorney General for Antitrust Harry First, Microsoft counsel Rick Rule and Former Solicitor General Boyden Gray Discussion on US v. MS on PBS TV with host Jim Goodale, Prof. Nicholas Economides, and Prof. Eleanor Fox, in streaming video, first broadcast on November 16, 2000 Story in Wired magazine on Microsoft’s proposal for Apple allow clones Nicholas Economides & Ioannis Lianos, A Critical Appraisal of Remedies in the EU Microsoft Cases, Columbia Business Law Review 2010/2: (2010). Nicholas Economides & Ioannis Lianos, The Quest for Appropriate Remedies in the Microsoft Antitrust EU Cases: A Comparative Appraisal, Microsoft on Trial: Legal and Economic Analysis of a Transatlantic Antitrust Case, Luca Rubini (ed.). Edward Elgar (2010). Nicholas Economides & Ioannis Lianos, The Elusive Antitrust Standard on Bundling in Europe and in the United States at the Aftermath of the Microsoft Cases, Antitrust Law Journal 76/3: (2009). Investigations of Google

Microsoft Antitrust Calendar: Early Fights
: FTC investigates MS twice, but does takes action : DOJ’s investigation ends in a 1995 settlement Key provisions: 1. Microsoft agrees to end “per-processor” (zero marginal price) contracts with OEMs but can use unrestricted quantity discounts 2. “Microsoft shall not enter into any License Agreement in which the terms of that agreement are expressly or impliedly conditioned upon the licensing of any other Covered Product, Operating System Software product or other product (provided, however, that this provision in and of itself shall not be construed to prohibit Microsoft from developing integrated products); or the OEM not licensing, purchasing, using or distributing any non-Microsoft product.” That is, no product bundling allowed by contract, but Microsoft can keep expanding the functions of its products, including Windows

Main U.S. Fight (1) 1997: Senator Orin Hatch (R-Utah) holds congressional hearings on Microsoft featuring Gates, Barksdale, Dell. Sen. Hatch takes the position that if present antitrust law cannot deal with Microsoft, Congress should change or enhance the antitrust laws Sun, Oracle, IBM, Netscape, and Novell form a loose coalition lobbying for antitrust action 1997: DOJ alleges anti-competitive bundling of IE with Windows (violation of 1995 decree) Dec. 1997: Judge Thomas Penfield Jackson issues preliminary injunction barring bundling of IE with Windows 98 May 12, 1998: Court of Appeals (DC Circuit) decides that 1995 decree doesn’t apply to Windows 98, which was shipped with integrated IE May 18, 1998: DOJ and 20 states and the District of Columbia file the main antitrust case Oct – June 1999: Microsoft trial takes place with an accelerated schedule

Main (U.S.) Fight (2) Nov. 5, 1999: Judge Jackson issues “findings of fact,” siding very strongly with the plaintiffs Dec. 1999: Prominent antitrust scholar, Judge Richard Posner appointed mediator for settlement discussions April 1, 2000: Settlement talks break down after States hold out in proposed agreement. April 3, 2000: Judge Jackson issues “conclusions of law” June 7, 2000: Judge Jackson orders breakup of Microsoft in two companies February 27, 2001: DC appeals court hears appeal June 28, 2001: DC appeals court reverses breakup September 6, 2001: DOJ seeks quick settlement without breakup November 2, 2001: DOJ and Microsoft propose settlement; nine states settle and nine do not March 18, 2002: Nine litigating states start remedies trial in front of Judge Colleen Kollar-Kotelly November 1, 2002: Judge Colleen Kollar-Kotelly rules that the proposed settlement serves the public's interest and rejects positions of litigating states November 29, 2002: All states except Massachusetts and West Virginia accept the settlement; eventually, both Massachusetts and West Virginia agree with the settlement

Microsoft’s business then
Software Operating systems for PC (Windows 95, 98, NT, 2000) Operating systems for local network and Internet servers (Windows NT, 2000) “Back-office” products for network and Internet servers Internet Clients Internet Servers Desktop applications (Office, Word, Excel, Access, PowerPoint, MS-Money, etc.) Games Programming languages (Visual Basic, Java) Hardware Mice, keyboards Services Internet service (MSN, WebTV) Internet content (MSN) Product support

The allegations. Microsoft accused of:
1. Monopolization of the market for operating systems (“OSs”) for PCs; (¶ 2, Sherman Act) 2. Anti-competitive contractual arrangements with various vendors of related goods such as with computer manufacturers and Internet Service Providers (“ISPs”) and other actions taken to preserve and enhance its monopoly; (¶ 2, Sherman Act) 3. Attempting monopolize the market for Internet browsers (but failing to succeed); (¶ 2, Sherman Act) 4. Anti-competitive bundling of the Internet Explorer (“IE”), with the Windows operating systems; (¶ 1, Sherman Act)

“Monopolization” under ¶ 2 of the Sherman Act is illegal
if the offender took anti-competitive actions to acquire, preserve, or enhance its monopoly Sherman Act ¶ 2: “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.” Modern interpretation: For “monopolization,” plaintiffs have to prove that the defendant 1. Possesses market power 2. Willfully acquired or maintained this monopoly power as distinguished from acquisition through a superior product, business acumen, or historical accident

“Attempting to monopolize” is illegal (Sherman Act, ¶ 2)
Bundling, and, more generally, price discrimination could be illegal if it has anti-competitive consequences Exclusionary contracts could be illegal if they have anti-competitive effects To prove “attempting to monopolize” (under Sherman Act ¶ 2), plaintiffs have to prove that the defendant 1. Engaged in predatory or anti-competitive conduct 2. with specific intent to monopolize 3. and that there was a “dangerous probability” that the defendant would succeed in achieving monopoly power

Findings of fact and conclusions of law
The judge’s “findings of fact” (Nov. 1999) and “conclusions of law” (April 2000) found for the plaintiffs (US DOJ and 19 States) in almost all the allegations against MS The judge found: Microsoft has a monopoly in the PC operating systems market (for Intel-based computers) “where it enjoys a large and stable market share” Microsoft used its monopoly power in the PC operating systems market and harmed competitors Microsoft hobbled the innovation process Microsoft actions harmed consumers Various Microsoft contracts had anti-competitive implications, but MS is not guilty of anti-competitive exclusive dealing contracts hindering the distribution of Netscape

On June 7, 2000, after an extremely short hearing, Judge Jackson issues his remedies decision:
split Microsoft into two companies, one for operating systems (Windows 98, NT, and 2000), and one for all the rest, including applications (MS-Office, etc.) impose business conduct restrictions

Judge decided that MS has monopoly power in the OS market for Intel compatible PCs
Problem: Low price of OS; if Microsoft is able to exercise monopoly power, why does it not exercise it through price? If the price of PC hardware is pH and the demand elasticity is |ε|, the monopoly price of Windows is pW = pH/(|ε| - 1) If pH = $1,800 and |ε| = 2, pW = $1,800, while the actual price to OEMs was $40-60 Requires a very large demand elasticity of |ε| = 31 to get a monopoly price of pW = $60

Possible explanations for the low price of Windows
To hook consumers … but when will MS increase the price? Competition from installed base of Windows … but (i) very difficult to uninstall Windows (ii) consumers buy much better new PCs faster than traditional obsolescence rates would imply (iii) Windows price is small compared to the PC+Windows bundle To reduce pirating … but why is then MS-Office price high? Because it allows for higher prices of complementary goods …but MS does not monopolize all the complementary goods markets, therefore it would be optimal to charge the monopoly price on Windows Because of the existence of actual and potential competition

Monopoly may maximize social surplus
when there are network externalities present under conditions of incompatibility; value of de facto standardization

Microsoft appealed, and was granted a stay of all parts of the District Court decisions until the appeal is heard Summary of court of appeals decision: Microsoft’s breakup and other remedies imposed by the District Court were vacated Microsoft was found liable of monopolization of the operating systems market for PCs Microsoft was found not liable of bundling Microsoft was found not liable of attempting to monopolize the Internet browser market The district court judge Thomas Penfield Jackson was taken out of the case for improper behavior The case was remanded to the District Court for remedies determination for the monopolization charge

Bundling issue The Appeals Court instructed the District Court to examine the bundling of IE and Windows (if plaintiffs bring it up) under “a rule of reason” where the consumer benefits of bundling are balanced against the damage of anti-competitive actions In face of the Appeals Court decision, DOJ decided not to pursue the bundling issue and announces that it will not ask for a breakup of Microsoft

The Settlement: On November 6, 2001
the United States, the states of New York, Illinois, North Carolina, Kentucky, Michigan, Louisiana, Wisconsin, Maryland and Ohio, and Microsoft announced a settlement California, Connecticut, Iowa, Massachusetts, Minnesota, West Virginia, Florida, Kansas, Utah, and the District of Columbia pursued the suit further to a full remedies trial (started March 11, 2002) in front of U.S. District Judge Colleen Kollar-Kotelly These States proposed making the source code of Windows and IE public, “freezing Windows” so that additional functionality would be sold as an additional good, making all APIs public, and other severe remedies. On November 12, 2002, Judge Colleen Kollar-Kotelly imposed the final judgment that had only small differences from the original proposed settlement

Settlement terms A. Provisions seen as favorable to Microsoft
1. No breakup 2. Microsoft can expand functions of Windows 3. No general restrictions on bundling 4. No mandatory disclosure of source code B. Provisions seen as favorable to the plaintiffs 1. Broad scope of definition of middleware products (including browser, clients, media players, instant messaging software, etc.)

Settlement terms (cont.)
2. Requirement to partially disclose middleware interfaces Microsoft is required to provide software developers with the interfaces used by Microsoft's middleware to interoperate with the operating system 3. Requirement to partially disclose server protocols The settlement imposes interoperability between Windows and non-Microsoft servers of the same level as between Windows and Microsoft servers.

4. Freedom to install middleware software Computer manufacturers and consumers will be free to substitute competing middleware software on Microsoft's operating system. 5. Ban on retaliation Microsoft prohibited from retaliating against computer manufacturers or software developers for supporting or developing certain competing software

6. Uniform pricing of Windows for same volume sale Microsoft will be required to license its operating system to key computer manufacturers on uniform terms for five years. Microsoft will be allowed to provide quantity discounts. 7. Ban on exclusive agreements; contract restrictions Microsoft will be prohibited from entering into agreements requiring the exclusive support or development of certain Microsoft software

Multi-year investigation of MS by the EU on
interoperability between non-Microsoft servers and Windows clients bundling of Windows Media Player with Windows The EU (i) Found Microsoft liable on both issues (ii) Imposed a $609 million fine (iii) Required MS to produce a version of Windows without WMP (called Windows-N) but without a requirement to sell it for less than Windows (iv) Required MS to make public and license at a low price the communications protocols between Windows clients and non-Windows servers Less than 2000 copies of Windows-N were sold

Second EU case on browser
In December 2007, Opera (an Internet browser) brings the issue of Microsoft bundling IE with Windows to the EU In January 2009, the EU issues a “statement of objections” to Microsoft, alleging a violation of Article 82 EC for tying IE to Windows Given the previous decision on WMP, liability of Microsoft seems certain Microsoft offers to sell Windows 7 without any browser pre-installed (users would use FTP to download browser) Proposal rejected by the EU in favor of a “choice screen” approach

Choice screen Is imposed through Windows update on all users in the EU who are using IE as a default (on all Windows products) Will allow users choice among IE, Firefox, Safari, Opera, and Chrome On December 16, 2009, the Commission accepted the final choice screen proposal, and the matter ended In my opinion, the choice screen should have been made available to all, not just IE users Present solution gives incentives to “bribe” OEMs to choose a non-IE default browser, so the choice screen does not appear Benefits the non-open-source non-IE browsers (Chrome)

Investigations of Google
FTC investigation, leaked two weeks before presidential election to create the impression that Obama was tough on antitrust EU investigations Both, mainly on placement in organic search Aggregators Placement of search results of Google affiliates Agreements with Android manufacturers

US investigation fizzled
FTC accepted proposed commitment Google proposed to clearly label the links of its affiliates (A joke!) EU Investigation continuing and recently got extended

4/15/2015, EU sues Google Sent Google a “Statement of Objections”
Allegations: Google favors its own comparison shopping services (for airline tickets, hotels, etc.) by placing them on top of the first organic search page Vertical issue, may be hard for EU to win

Allegations cont. Google demoted placement of “aggregators” such as Foundem

EU launched Android investigation. Allegations:
Google required that smartphone and tablet manufacturers exclusively pre-install Google applications on their devices Prevented the success of rival apps by bundling its own apps and services on Android devices with other Google applications Prevented manufacturers who want to use Google apps from developing and marketing modified and potentially competing versions of Android on other devices

Week 12: Bank Networks Formation and Systemic Risk

Network Structure and Collapse
The network gets formed in anticipation of “good” and “bad” times Bad times eliminate nodes with prob. Pb As Pb increases, banks form ex ante more dense networks expecting more widespread collapses in bad times Pb increase is more costly to the each bank because it has to create a more dense network ex ante If Pb is underestimated, the prob. of collapse of any node of the formed network increases

Possibilities of Collapse (= Node Leaving the Network)
Individual nodes can collapse both in good and bad times Collapse of Bi increases the probability of collapse of a connected node Bj There can be cascading collapses For the same network structure, cascading collapses increase as the probability of shocks increases

Network Structure It pays to have more connections because more connections make it more likely to find a trading partner (to diversify risk (Allen and Gale)) and therefore less likely for any node to collapse In “bad” times, there are fewer nodes to connect to, so less diversification of risk But fewer connections could restrict a cascading collapse to only a cluster of nodes by limiting the propagation of the financial distress (Battiston et at.) Higher connectedness could also degrade credit worthiness and increase financial distress

Public Policy to Reduce Impact of Collapses in “Bad” Times
Network-specific recommendations Collect data on interconnected banks (and other institutions that have similar functions) and identify the network structure Analyze the banking sector as a network structure Assess the risk to a bank from further-away neighbors in the network Identify central nodes whose collapse can have very significant impact on the network

Systemic Risk as a Network Issue Our Model
First, banks B1, B2, …, Bn form a network by checking the credit worthiness of each other at a cost and in anticipation of subsequent trading Second, the state of the world is revealed, Good = “g” or Bad = “b” Let Pg < Pb be the prob. of unacceptably high credit risk A bank (node) with unacceptably high credit risk collapses (or, equivalently, no one trades with it) Third, in each of M periods, each bank receives a positive or negative shock with prob. q If, in the same period, directly connected banks Bi and Bj receive opposite shocks they trade at low cost If banks Bi and Bj are not connected directly but only through other nodes they trade at a higher cost, and the intermediate nodes benefit too If bank Bi receives a positive or negative shock and cannot find anyone to trade with, it trades with the Fed at a high cost

Business of Platforms, Networks, and Two-sided Markets

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