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Information Complements, Substitutes Strategic Product Design Geoffrey Parker Tulane University [email protected] Marshall Van Alstyne University of Michigan [email protected] Sponsored by NSF Career Award #9876233 © 2002 Parker & Van Alstyne. All rights reserved. Why should firms invest substantial sums in products they intend to give away? To whom do they really intend to give these products anyway? Can freebies be used strategically to protect turf, raise barriers to entry, or foreclose markets for competitors? How does a free good relate to bundling theory? © 2002 Parker & Van Alstyne Why do profit making firms like ... give away... • • • • • • • • • • Adobe RedHat Microsoft Fidelity Wolfram Bungie/ID Intel Kodak Lexis / Nexis Sun Microsystems Acrobat Reader Linux Internet Explorer Retirement Planner Mathematica Reader Game Level Editors Video Morphing Software Digital Camera Scripts Law Student Access Star Office © 2002 Parker & Van Alstyne Typically these are compound goods Firm Adobe Content Editor PDF Distiller* Content PDF Documents Reader/Player PDF Reader Level Editor Game Levels Game Engine* Compression* Compressed Doc Decompression Microsoft Sys Dvpr Toolkit Applications Windows OS* Real Audio Recorder/Host* Sound File Player Bungie/ID StuffIt Companies choose different free goods markets and premium goods markets. Here “*” indicates the premium good. © 2002 Parker & Van Alstyne Traditional Linear Supply Chain parts cars Ford Parts Supplier $ sales & svc Dealer Consumer $ $ Nontraditional Supply Network level editor ID engine $ Content levels Provider Consumer reputation, ego, $ distiller Content Provider ego, $, reputation $ Adobe pdf files reader Consumer © 2002 Parker & Van Alstyne Which Myth II level is original, this... © 2002 Parker & Van Alstyne ...or this? © 2002 Parker & Van Alstyne Original Myth Game Level © 2002 Parker & Van Alstyne 3rd Party Myth II Conversion (Civil War) © 2002 Parker & Van Alstyne 3D Myth II Terrain Model © 2002 Parker & Van Alstyne To Model Complements Market Two Price Price Market One p1 p2 q1 q2 Quantity Q1 q1 Q1 p1 V1 Quantity Q2 q2 Q2 p2 V2 Use simple linear demand functions © 2002 Parker & Van Alstyne To Model Complements Market Two Price Price Market One p1 p2 q1 q2 Quantity Q1 q1 Q1 e21q2 p1 V1 Quantity Q2 q2 Q2 e12 q1 p2 V2 Add Katz & Shapiro network externality terms eij Inter-network externality goes both directions © 2002 Parker & Van Alstyne An inter-network externality (or 2-sided network externality) is a demand economy of scale that crosses coupled heterogeneous markets. Examples include: • consumers & developers co-dependent on the same operating system • card-holders & merchants that accept the same credit card • content consumers & creators (e.g. PDF, MP3 streaming video) • players & game developers For coupled networks, expect to see an intermediary try to manage price pairs regardless of whether the intermediary is independent or managed by one side of the network. Parker & Van Alstyne © 2002 Parker & Van Alstyne Consider profits in two markets Price Market Two (Acrobat Distiller) Price Market One (Acrobat Reader) p1 p2 q1 q2 Quantity Quantity Initially, there are profits to be made in both markets. © 2002 Parker & Van Alstyne Consider profits in two markets Market Two (Acrobat Distiller) Price Price Market One (Acrobat Reader) p2 p1 q1 Quantity q2 Quantity Initially, there are profits to be made in both markets. But subsidizing market one with a free good can increase demand and profits in market two more than the loss in market one. © 2002 Parker & Van Alstyne Choosing which markets to charge Pdeveloper Adobe Pd0, Pc0 I Magazine Pd0, Pc0 Pconsumer II Pd0, Pc0 IV III ID Region I -- Subsidize C, charge D Region II -- Charge C & charge D Region III -- Charge C, subsidize D Region IV – Subsidize both (bad idea) © 2002 Parker & Van Alstyne So which market is subsidized? Price Developer Market Price Consumer Market p1 p2 q1 q2 Quantity Quantity Consider which market creates more surplus. © 2002 Parker & Van Alstyne So which market is subsidized? Developer Market Price Price Consumer Market p2 p1 q1 Quantity q2 Quantity Consider which market creates more surplus. Subsidize the one that creates more surplus in the cross market. © 2002 Parker & Van Alstyne So which market is subsidized? Developer Market Price Price Consumer Market p1 q1 Quantity p2 q2 Quantity Consider which market creates more surplus. Subsidize the one that creates more surplus in the cross market. © 2002 Parker & Van Alstyne So which market is subsidized? Developer Market Price Price Consumer Market p1 q1 Quantity p2 q2 Quantity Consider which market creates more surplus. Subsidize the one that creates more surplus in the cross market. Here > so subsidize developers. © 2002 Parker & Van Alstyne Now introduce competition Competitive Complement Company A sells complementary products in markets {1, 2}. So e12AA> 0. Company B sells a competing product in only market {1}. Motivating Example: Netscape sells Navigator in mkt 1. Microsoft sells Explorer in mkt 1 and Windows, PowerPoint, Word, or Excel in mkt 2. Competitive Substitute Company B offers an information good in mkt 1 that curtails consumption of BA A’s good in mkt 2, such that e12 < 0. Motivating Example: By including Sun’s Java virtual machine in Navigator, Netscape threatened to commoditize operating systems. Under “Write once, Run anywhere,” Windows enjoys no advantage. © 2002 Parker & Van Alstyne Economics of Product Competition Beer Sugar Cereal Sports Car Democrat Firm A Wine Healthy Cereal Family Car Republican Firm B Profit=P*Q Firms can max Profit by either building (1) market power high P (2) market share high Q © 2002 Parker & Van Alstyne To Gain Market Power P Firm A Q Firm B Differentiate your product from the competitor © 2002 Parker & Van Alstyne To Gain Market Share P Firm A Q Firm B Position between competitor and largest block of consumers © 2002 Parker & Van Alstyne Competitive Complement P Q P Firm A Q Firm B Product complementarity justifies seeking market share because a price of zero increases profits in the coupled market. © 2002 Parker & Van Alstyne Competitive Complement P Q P Firm A Q Firm B Examples: Competitor MS Office Netscape MediaPlayer Freebie Complement Star Office Explorer QuickTime Workstations/OS MS Office/ActiveX Macs © 2002 Parker & Van Alstyne To Model Substitutes Competitor’s Price Price Your product p1 p2 q1 q2 Quantity Quantity Instead of complementarity that is positive… Q1 q1 Q1 - e21q2 p1 V1 Q2 q2 Q2 - e12 q1 p2 V2 Design the cross product effect to be negative. © 2002 Parker & Van Alstyne To Model Substitutes Competitor’s Price Price Your product p1 p2 q1 q2 Quantity Quantity Instead of complementarity that is positive… Design the cross product effect to be negative. © 2002 Parker & Van Alstyne Competitive Substitute P P Q Q P P Q Firm A Q Firm B Product substitutability justifies seeking market share because a price of zero decreases competitive interference on another product. © 2002 Parker & Van Alstyne Competitive Substitute P P Q Q P P Q Firm A Q Firm B Examples: Competitor1 MediaServer MS Windows E-Bay buyer Competitor2 MediaPlayer Sys. Dvpr Toolkit E-Bay Seller Freebie Complement RealAudio Sys. Dvpr Toolkit Yahoo auction seller RealServer Mac OS Yahoo buyer © 2002 Parker & Van Alstyne Strategic Outcome • The product design results are almost identical. Firm B chooses P1 0 - the market with competition- in order to create a free goods barrier to entry. • The reason, however, is different. For complementary goods, Firm B sells more. For substitute goods, Firm B stems losses. “Microsoft would not have given IE away …, nor would it have taken on the high cost of enlisting firms in its campaign to maximize IE’s usage share and limit Navigator’s, had it not been focused on protecting the applications barrier [to its operating system]” Judge Thomas Penfield Jackson Findings of Fact, 11-5-99 © 2002 Parker & Van Alstyne Are consumers worse off under monopoly? Price Market Two (Acrobat Distiller) Price Market One (Acrobat Reader) p1 p2 q1 q2 Quantity Quantity Consumer surplus is the gold right triangle. © 2002 Parker & Van Alstyne Are consumers worse off under monopoly? Market Two (Acrobat Distiller) Price Price Market One (Acrobat Reader) p2 p1 q1 Quantity q2 Quantity Consumer surplus is the gold right triangle. At least one market is strictly better off (generally both) And the sum is always greater across both markets. © 2002 Parker & Van Alstyne The effect of bundling p1 V1 r1V2 q1 Let r1[0,1] be the amount that Mkt 1 values the Mkt 2 good. Find Mkt 1 demand for the Mkt 2 good scaled by r1. Convolve both curves to find Mkt 1 demand for both goods. © 2002 Parker & Van Alstyne To Bundle or not to Bundle 1 b>u 0.8 Bundle 0.6 rj 0.4 0.2 Region b< u 0.2 Equal UnBundle 0.4 0.6 0.8 1 rc © 2002 Parker & Van Alstyne Further Applications Temporal Complements -- Markets 1 & 2 represent the same good in time, e12 0, e21 = 0. Lexis gives law students free access then charges law firms. Upgrades -- Markets 1 & 2 represent novice and professional versions , e12 0, e21 = 0. Firms like Ventana give their simulators free to students and charge $1200 for the full-featured version. Temporal Substitutes -- Markets 1 & 2 are current and future complements while 1 is a substitute for a competitor’s future good. Although Microsoft introduced IE after Netscape introduced Navigator, it could potentially have introduced IE in anticipation of competition. Tangible Complements -- Market 1 is a tangible good e12 = 0, market 2 an information good with high network externality e21 0. Firms like Kodak and Intel give away camera scripts and video morphing software because friends and family share scripts and video eats CPU cycles. Advertising -- Markets 1 & 2 represent consumer & ad buyers, eca 0, eac < 0. Qualcomm gives away Eudora in sponsored mode. © 2002 Parker & Van Alstyne Product Category Mkt 1 Product Intermediary Mkt 2 Product Portable Documents Document reader* Adobe Document Writer Credit Cards Consumer credit* Issuing bank Merchant Processing Operating Systems Complementary Applications Microsoft, Apple, Sun Systems Developer Toolkits* Plug-Ins Applications Software Microsoft, Adobe Systems Developer Toolkits* Ladies’ Nights Men’s Admission Bars, Restaurants Women’s Admission* TV Format Color UHF, VHF, HDTV* Sony, Phillips, RCA Broadcast Equipment Advertisements Content* Magazines, TV, Radio Advertisers Computer games Game Engine/ Player Games Publishers Level Editors* Auctions Buyers* E-bay, Christie’s, Sotheby’s Sellers Streaming Audio/Video Content* RealPlayer, Microsoft, Apple Servers * Indicates which market is discounted, free or subsidized. Source: Parker & Van Alstyne 2002 © 2002 Parker & Van Alstyne Contributions • Uses standard economics models of tangible goods to explain information goods • Different from tying and price discrimination • Articulates space of products and tipping conditions for which markets are charged • Indicates how strategic product design can be used to expand demand or close markets • Explains when to bundle and when to unbundle © 2002 Parker & Van Alstyne “Information Complements, Substitutes & Strategic Product Design” and “Unbundling in the Presence of Internetwork Externalities” Parker & Van Alstyne URL: ggparker.net/gparker/papers/InfoComplements.html © 2002 Parker & Van Alstyne
