Theories of Tying and Implications for TelecomICT - PowerPoint PPT Presentation

Title: Theories of Tying and Implications for TelecomICT


1
Theories of Tying and Implications for Telecom/ICT

• By
• Jay Pil Choi
• Michigan State University

2
Motivation

• Digital Convergence in Information, Communication
  and Entertainment Industries.
• Triple Play Providing Integrated Package of
  Telephony, Internet Access, and TV
• Implications for Antitrust/Regulatory Policies?

3
Plan of Talk

• Theories of Bundling
• Different Horses for Different Courses
• Due to contributions such as Choi and Stefanadis
  (2001), Carlton and Waldman (2002,2006) and
  Nalebuff (2004), we now have a much richer
  understanding of why firms bundle.
• Optimal Antitrust Policy less progress on this
• Applications to Telecom/ICT Industries

4
Reasons for Tying

• Efficiency Arguments
• Price Discrimination including the Metering
  Argument
• Exclusionary Argument (the Leverage Theory)
• Other Strategic Motivations

5
Efficiency Rationales (1)

• Transactions Costs
• right shoes/left shoes
• cars and radios
• almost every product can be thought to have
  transaction cost reducing tying
• Reducing search and sorting (Kenney and Klein
  (1983))
• De Beers and diamonds
• potentially other applications

6
Efficiency Rationales (2)

• Variable Proportions (Malella and Nahata (1980))
• eliminates inefficient input substitution when
  one product is characterized by market power
• Tirole (1988) shows how this can explain
  aftermarket monopolization by a durable goods
  monopolist

7
Price Discrimination Arguments

• Main Intuition Homogeneous Consumers Make It
  Easier to Extract Consumer Surplus.
• Example with 2 Consumers
• Cost of Production 0
• Scenario 1 v1 100, v260
• ? p60, Profit 120
• Scenario 2 v1 80, v280
• ? p80, Profit160

8
Reduce DispersionPrice separate or together?
Profits With Bundling 440 Without 400
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Reservation Prices
v2
For example, Consumer A is willing to pay up to
3.25 for good 1 and up to 6 for good 2.
v1
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Consumption Decisions WhenProducts are Sold
Separately
v2
Consumers fall into four categories based on
their reservation price.
v1
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Consumption Decisions When Products are Bundled
v2
Consumers buy the bundle whenv1 v2 gt PB (PB
bundle price). PB v1 v2 or v2 PB -v1 Region
1 v1 v2 gt PB Region 2 v1 v2 lt PB
v1
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Consumption DecisionsWhen Products are Bundled

• The effectiveness of bundling depends upon the
  degree of negative correlation between the two
  demands.
• Best when consumers who have high reservation
  price for good 1 have a low reservation price for
  good 2 and vice versa
• Can see graphically looking at positively and
  negatively correlated prices

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Reservation Prices
If the demands are perfectly positively correlate
d, the firm will not gain by bundling. It would
earn the same profit by selling the goods
separately.
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Reservation Prices
v2
If the demands are perfectly negatively
correlated bundling is the ideal strategy all
the consumer surplus can be extracted and a
higher profit results.
v1
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Bundling as Price Discrimination

• Homogenizing Preferences with Negative
  Correlation of Values (Stigler (1968))
• But negative correlation is not required (McAfee,
  McMillan, and Whinston (1989))
• Example Individuals with four valuations of
  equal probability - (13,13), (13,7), (7,13),
  (7,7) - and no costs.
• selling individual products yields Profit 56
• selling a bundle yields Profit 60

16
PD- Metering Arguments

• Metered Sales (classic argument explored formally
  in Chen and Ross (1993) and Klein (1993))
• In this argument the firm takes advantage of
  variable proportions to price discriminate.
• Example Group 1 VM2000, use 100 cards Group
  2 VM3000, use 200 cards no costs
• PM100PC2000 PM200PC3000
• --gt PM1000 , PC10,
• As for most price discrimination schemes, social
  welfare implications are ambiguous.

17
Tying as Exclusionary Device(Leverage Theory)

• Chicago School Critique that Shows Why Bundling
  is Not a Profitable Strategy as an Exclusionary
  Device
• New Developments in the Leverage Theory that
  Respond to Critique
• Complements
• Non-Complements

18
Chicago School Critique

• Complement goods
• ? competition in the B market
• makes A good more attractive
• raises profit for M
• ? M has no incentive to
• reduce competition in B market

A B
M
C
C
Demand
q D(pApB)
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Chicago School Argument-Example(Independent
Goods)

• Market A Market B
• (Monopolized by Firm 1)
• Reservation values 10 10
• Costs 5 cB1 5 and cB2 2
• Without Bundling
• P1 (10- 5) 0 5
• With Bundling
• 10 10 P ? 10 2 ?
• P 12, Profit 12 (55) 2

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Chicago School Critique (Independent Goods)

• Market A Market B
• (Monopolized by Firm 1)
• Reservation values vA vB
• Costs cA cB1 and cB2
• Without Bundling
• P1 (vA- cA) max cB2 cB1, 0

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Chicago School Argument, contd

• With Bundling
• vA vB P ? vB cB2 ?? P vA cB2
• max (vA - cA) (cB2 cB1), 0
• (vA- cA) max cB2 cB1, 0 P1
• ?Bundling is Not a Profitable Strategy

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The Revival of the Leverage Theory

• Response to the critique
• Two lines of arguments
• Non complements
• Scale Economies and Imperfect Competition
• Complements
• entry in the adjacent market B may facilitate
  entry in the monopolized market A

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Tying as Exclusionary Device

• Independent goods Whinston (1990)
• Assumption commitment to sell A and B only as a
  bundle
• ? M becomes a very aggressive competitor if C
  enters B market
• Conclusions
• tie-in costly if C enters/stays in market,
• tie-in tends to discourage entry (commitment to
  being aggressive)
• tie-in may be profitable if deters entry,

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Whinston (1990)

• Fixed Cost/Entry Cost K
• Three Stage Game
• 1. Bundling Decision (Irreversible)
• 2. Entry Decision
• 3. Price Competition if Entry
• Assume Klt cB1 cB2 lt (vA- cA)
• ? Entry is Deterred and Bundling is Profitable.

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Intuition

• The tying firm behaves as if its cost in market B
  were cB1 - (vA- cA) instead of cB1
• Competition is intensified. Without exit by the
  rival firm, tying is not a profitable strategy
• ? Entry Deterrence or Exit by the Rival Firm is
  Crucial to Whinstons Model

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Modified Example with Entry Cost

• Market A Market B
• (Monopolized by Firm 1)
• Reservation values vA 10 vB10
• Costs 5 cB1 5 and cB2 2
• K2 Klt cB2 - cB1 lt (vA- cA)
  
• Without Bundling
• P1 (10- 5) 0 5, P2 (5- 2) - 2 1
• With Bundling? No Entry
• Profit 20 (55) 10

27
The Effects of Tying with Differentiated Goods
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Exclusionary Tying for Complementary Products

• Monopolist has strong interest in low price, high
  quality for complementary (tied) products
• increases demand for tying product (e.g.,
  low-cost, high-quality applications increase
  demand for PC operating system)

Demand for Tied Produces
Demand for Tying Product
29
Tying with Complements

• Protecting home market
• Tying is used to reduce entry probabilities in
  each of multiple markets (Choi and Stefanadis,
  2001)
• tying is used to preserve monopoly in the primary
  market in the future (Carlton and Waldman, 2002)

30
Carlton and Waldman (2002)

• Two-Stage Entry Story
• Entry into Both Components Simultaneously is More
  Costly
• Inter-temporal Economies of Scope
• The basic argument here in some sense formalizes
  the US Justice Department argument in the
  Microsoft/Netscape browser case

31
Product Differentiation Rationale

• Tying can be used as a product differentiation
  device (Carbajo, De Meza, and Seidman (1990) and
  Chen (1997))
• A and B are independent products
• Monopolized A Market and Competitive B Market
• Because the two firms produce exactly the same B
  product, the two firms earn zero profits in the B
  market if the monopolist does not tie.
• Tying implicitly creates product differentiation
  in the B market
• The effect on social welfare is ambiguous.

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SUMMARY OF TYING RATIONALES AND SOCIAL WELFARE
EFFECTS

• Efficiency Rationales
• social welfare typically rises due to tying
• Price Discrimination
• social welfare effects are ambiguous
• Exclusionary Tying
• social welfare typically falls due to tying (but
  is not guaranteed to do so)
• Product Differentiation
• tying for product differentiation purposes has
  ambiguous welfare consequences
• ?Tying should not be condemned as per se
  illegal, but should be subject to the rule of
  reason approach

33
Optimal Antitrust Policy

• Tying should be allowed when
• courts conclude the motivation is efficiency
• courts conclude the motivation is price
  discrimination (price discrimination has
  ambiguous welfare effects and price
  discrimination is typically not a prohibited
  activity)
• courts conclude the motivation is product
  differentiation (again ambiguous social welfare
  effects)
• Courts are unsure of motivation but primary
  market is competitive

34
Competition Policy Implications

• In contrast to the Chicago School argument, there
  are various settings in which tying is used to
  exclude competition.
• However, a policy of aggressive intervention may
  be misplaced.
• The existence of an anticompetitive rationale
  should not be enough to justify intervention. The
  evidence should clearly support the
  anticompetitive rationale.
• Another reason for caution is that this is a
  topic in which theory is still evolving and given
  the prevalence of efficient tying it makes sense
  to intervene rarely.

35
Applicability to Telecom/ICT
36
Applications to Telecom/ICT

• The anticompetitive effects of bundling are most
  relevant when only one firm can bundle.
• Bundle vs. Bundle or Bundle vs. Components?
• If the market ends up with bundle vs. bundle,
  consumers usually benefit.

37
Example 1

• Product A Product B AB
• Firm 1 3 7 10
• Firm 2 7 3 10
• Without Bundling, pA pB 7. Consumers pay P
  pA pB 14
• With Bundling, consumers pay P 10
• Consumers prefer competition with bundling.
• However, inefficient production!

38
Example 1, contd

• Product A Product B AB
• Firm 1 3 7 10
• Firm 2 7 3 10
• Without bundling, each firm gets a profit of
  4(7-3).
• With bundling, each firm gets a profit of 0.
• No Incentive to Bundle!

39
Issues Raised by the Example

• If bundling takes place, consumers are better
  off, but it is socially inefficient ?What should
  be the objective of competition policy
  authorities? Consumer Welfare or Total Social
  Welfare?
• No Need to Worry about Exclusionary Bundling? ?
  With dynamic considerations such as RD
  investment, the results can differ.

40
Dynamic Leverage Theory

• Tying and Innovation (Choi, 2004)
• Typically, the tying firms RD investment
  increases whereas competitors RD investment
  decreases.
• The overall effects of tying on total economic
  welfare are ambiguous in the technological
  competition model.
• Incentives for Exclusive Media Content?

41
Trade-offs in RD
42
Example 2

• Product A Product B AB
• Firm 1 3 7 10
• Firm 2 7 3 10
• Firm 3 4 4 8
• Without bundling, pA pB 4. Consumers pay P
  pA pB 8
• With bundling by every firm, consumers pay P 10
• Consumers prefer competition without bundling.
• Once again, inefficient production!

43
Other things to Consider

• How realistic for specialist firms to form
  strategic alliances to counter bundling by the
  incumbent?
• ATT and DirecTV to offer Triple Play
• Balancing Pro and Anticompetitive Effects
• Economies of Scope in Marketing, Customer
  Acquisition, and Billing
• We also need to be aware that even exclusionary
  bundling can have pro-competitive effects and
  vice versa.

44
Check List

• Significant Market Share?
• High Entry/Switching Costs?
• A Larger Portfolio of Products than Competitors?
• Bundle of a New Product with an Established One?
• Standard Industry Practice? Defensive or
  Offensive?
• Steep Discounts (Predatory)?

45
Related Issues

• Exclusive Dealing
• Apple iPhone and ATT
• Compatibility Choice
• iTunes Music Store and iPod
• Switching costs/Network Effects
• Asymmetric Regulation?
• Multi-Homing (Relevant to Software and Payment
  Card Industries)

46
Merger with (Mixed) Bundling

• Pre-Merger Situation
• sij pi qj

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Post-Merger Situation

A
A

A


1
2
1
(
)
(


)







(

s
)

B

B
B


1
1
2

(

(

)



)


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The Effects of Mergers with Mixed Bundling

• The price of the bundle post-merger is lower than
  the sum of the pre-merger component prices (
  )
• The independent firms also cut their prices
• The merged firms prices for individual
  components are higher with mixed bundling

49
Comparison of Pre- and Post-Merger Equilibrium
50
Pre-Merger Demand Pattern
51
Post-Merger Demand Pattern
52
Implications for Profits
53
Pure Bundling/Compatibility Choice and Foreclosure

• The merged firm will not practice pure bundling
  since mixed bundling yields higher profits as
  accommodation strategy.
• Pure bundling may be used as a foreclosure device
  if
• The Possibility of Ripple Effects