1. Network Competition IS250 Spring 2010 chuang@ischool.berkeley.edu

2. John Chuang2 Network Competition  Design for Choice  Design for Competition  Loci of Competition -Who, what, and where  Models of Competition -Quantify benefits of competition

3. John Chuang3 Loci of Competition A 2x2 Network Model EdgeCore Logical/ Service Internet Service Providers (ISPs) Internet Backbone Operators PhysicalLast-mile access networks Wide-area transit networks

4. John Chuang4 Models of Competition  Monopoly  Perfect Competition  Oligopoly  Many other models to capture “messiness” of the real-world, e.g., incomplete information, asymmetric information, bounded rationality, transactional costs, externalities, …

5. John Chuang5 Preliminaries  Agents: e.g., buyers and sellers  Commodity: goods, services  Market: to facilitate trade  Utility: measure of satisfaction derived from trade  Equilibrium: predicted outcome

6. John Chuang6 Utility  Seller’s utility = profit (  ) = revenue - cost -revenue = price * quantity -cost includes fixed and marginal costs  Buyer’s utility = valuation - price -Valuation aka willingness-to-pay (WTP)  Utility maximization -Seller i sets P i and/or Q i to maximize profit -Buyer j decides which product, if any, to purchase

7. John Chuang7 Demand w q  Willingness to pay (WTP) Marginal WTP: w(q) …

8. John Chuang8 w q Amount paid (producer’s revenue) q p Consumer surplus w(q) Consumer Surplus  Not every consumer may be served, even if their WTP > 0  Results in dead-weight loss (DWL) DWL

9. John Chuang9 Supply c(q) q  Production cost function: c(q)  Fixed cost = c(0) = F F

10. John Chuang10 Marginal Cost m(q) q Total cost (excluding fixed cost) q  Marginal cost: m(q) = c’(q) Marginal cost curve

11. John Chuang11 Constant Marginal Cost q Total cost (excluding fixed cost) q  Cost function: c(q) = c(0) + m · q  Marginal cost: m(q) = c’(q) = m  Special case: if m = 0, then zero marginal cost -Common in production of information & IT m Marginal cost = m m(q)

12. John Chuang12 Producer Surplus $ q Marginal cost q  Profit = revenue - cost = p · q - c(q)  Producer surplus excludes fixed cost  Example: for constant marginal cost function: -Profit = (p-m) · q - c(0) -Producer surplus = (p-m) · q Marginal WTP m p PS

13. John Chuang13 Social Surplus w q Marginal cost q  Also known as social welfare or total surplus  SS = CS + PS Marginal WTP m p CS PS

14. John Chuang14 Surplus Maximization  Producers seek to maximize profit (or producer surplus)  What about a social planner? -Maximize social surplus? -Maximize consumer surplus? -Maximize consumer surplus subject to producer cost recovery?

15. John Chuang15 Marginal Cost Pricing $ q Marginal cost q  Setting p = m  Question: what happens to social surplus? What happens to producer surplus? Marginal WTP m p CS PS

16. John Chuang16 Monopoly v. Competition  What are the tradeoffs?

17. John Chuang17 Monopoly  Single producer -- free to set prices to maximize profit (usually at the expense of social welfare)

18. John Chuang18 Monopoly Example  Cost: c(q) = c -Zero marginal cost  Linear Demand: p(q) = 1 - q  Profit:  = p·q - c  Producer surplus: PS = p·q  Profit maximization: -Solve the equation d  /dq = 0 -q* = 1/2; p* = 1/2  = 1/4 - c  Consumer surplus, CS = 1/8  Social welfare = CS + PS = 3/8  Q: when will monopolist choose not to produce? q p 1 1 p(q) = 1 - q q* p* Dead Weight Loss (DWL) Consumer Surplus Producer Revenue

19. John Chuang19 Perfect Competition  No dominant supplier -Price determined by the market, i.e., all suppliers are price takers  Competition drives price down to marginal cost -In example: p* = MC = 0 --> q* = 1 -Profit,  = -c -Producer surplus = 0 -Consumer surplus, CS = 1/2 -Social welfare = 1/2  Perfect competition maximizes social welfare, but suppliers cannot recover fixed cost q p 1 D q*=1 p* = 0 Consumer Surplus

20. John Chuang20 Monopoly v. Competition  What are the tradeoffs?

21. John Chuang21 Oligopoly  Competitive market with small number of suppliers -Duopoly is special case, though common in many telecommunication sectors  Common oligopoly models, analyzed as games: -Bertrand competition: price competition -Cournot competition: quantity competition -Stackelberg competition: leader follower game

22. John Chuang22 Bertrand Competition  Each supplier simultaneously announces price p i  Consumers buy from lower-priced supplier  Example: two suppliers with marginal costs c 1 < c 2, known to both suppliers -What are equilibrium values for p 1, p 2 ? -What are equilibrium values for  1,  2 ?

23. John Chuang23 Cournot Competition  Single-shot game: game with a single round  Each supplier i simultaneously announces quantity, q i -Strategic decision involving commitment, e.g., build factory, provision network  Given aggregate supply q =  q i, market determines price p(q)  Each supplier realizes profit proportional to its quantity:  i = p(q)q i - c i (q i )  Equilibrium with n symmetric firms: -p(q)(1+1/n  ) = c’(q/n) -Price proportional to marginal cost c’; markup depends on demand elasticity  and converges to zero as n approaches infinity

24. John Chuang24 Stackelberg Game  Duopoly game played in two steps: -Supplier 1 (leader) first choose quantity q 1 -Given q 1, supplier 2 (follower) choose q 2 as best response  Game solved backwards, starting with supplier 2  Example: q i in [0,1], p = 1-q, c i = 0 -Supplier 2: max  2 = q 2 (1-q 1 -q 2 ) --> q 2 = (1-q 1 )/2 -Supplier 1: max  1 = q 1 (1-q 1 -q 2 ) --> q 1 = 1/2 -(q 1,q 2 ) = (1/2, 1/4) is Nash equilibrium  Q: how does this compare with the cases of monopoly and perfect competition? q p 1 1 p(q) = 1 - q q* p* Dead Weight Loss (DWL) Consumer Surplus Producer Revenue

25. John Chuang25 Summary: Monopoly, Duopoly, and Perfect Competition Q*P*Producer Surplus Consumer Surplus Total Surplus Dead Weight Loss Monopoly0.5 0.250.1250.3750.125 Duopoly (Stackelberg) 0.750.250.18750.281250.468750.03125 Perfect Competition 1000.5 0 q p 1 1 p(q) = 1 - q q* p* Dead Weight Loss (DWL) Consumer Surplus Producer Revenue

26. John Chuang26 Summary  Degree of competition matters!  Whereas perfect competition can be ruinous to industries with low marginal cost (strong economies of scale)…  Oligopolistic competition can allow providers a path to cost recovery and profitability, while also avoiding the pitfalls of a monopoly  Actual social welfare realization depends on the actual shapes of the demand and supply curves