Information Complements Substitutes Strategic Product Design Geoffrey Parker

Information Complements, Substitutes Strategic Product Design Geoffrey Parker Tulane University gparker@tulane. edu Marshall Van Alstyne University of Michigan mvanalst@umich. edu 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 Red. Hat 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 Companies choose different free goods markets and premium goods

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 $ Adobe pdf files ego, $, reputation reader Consumer © 2002 Parker & Van Alstyne

Which Myth II level is original, this. . . © 2002 Parker & Van

. . . or this? © 2002 Parker & Van Alstyne

Original Myth Game Level © 2002 Parker & Van Alstyne

3 rd Party Myth II Conversion (Civil War) © 2002 Parker & Van Alstyne

3 D Myth II Terrain Model © 2002 Parker & Van Alstyne

To Model Complements Market Two Price Market One p 1 p 2 q 1 Quantity q 2 Quantity 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, MP 3 streaming video) • players & game developers For coupled networks, expect to see an intermediary 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) p 1 p 2 q 1 Quantity q 2 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 Market One (Acrobat Reader) p 2 p 1 q 1 Quantity q 2 Quantity Initially, there are profits to be made in both markets. But subsidizing market one with a free good can increase demand profits in market two more than the loss in market one. © 2002 Parker & Van Alstyne

Choosing which markets to charge 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 p 1 p

So which market is subsidized? Developer Market Price Consumer Market p 2 p 1 q 1 Quantity q 2 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 Consumer Market p 1 q 1 Quantity p 2 q 2 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 Consumer Market p 1 q 1 Quantity p 2 q 2 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 AA Company A sells complementary products in markets {1, 2}. So e 12 > 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, Power. Point, Word, or Excel in mkt 2. Competitive Substitute Company B offers an information good in mkt 1 that curtails BA consumption of A’s good in mkt 2, such that e 12 < 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 © 2002 Parker & Van Alstyne no advantage.

Economics of Product Competition Beer Sugar Cereal Sports Car Democrat Firm A Firm B Wine Healthy Cereal Family Car Republican 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

To Gain Market Share P Firm A Q Firm B Position between competitor and

Competitive Complement P Q P Firm A Q Firm B Product complementarity justifies seeking

Competitive Complement P Q P Firm A Q Firm B Examples: Competitor MS Office Netscape Media. Player Freebie Complement Star Office Explorer Quick. Time Workstations/OS MS Office/Active. X Macs © 2002 Parker & Van Alstyne

To Model Substitutes Competitor’s Price Your product p 1 p 2 q 1 Quantity q 2 Quantity Instead of complementarity that is positive… - - Design the cross product effect to be negative. © 2002 Parker & Van Alstyne

To Model Substitutes Competitor’s Price Your product p 1 p 2 q 1 Quantity q 2 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: Competitor 1 Media. Server MS Windows E-Bay buyer Competitor 2 Media. Player Sys. Dvpr Toolkit E-Bay Seller Freebie Complement Real. Audio Sys. Dvpr Toolkit Yahoo auction seller Real. Server Mac OS Yahoo buyer © 2002 Parker & Van Alstyne

Strategic Outcome • The product design results are almost identical. Firm B chooses P 1 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) p 1 p 2 q 1 Quantity q 2 Quantity Consumer surplus is the gold right triangle. © 2002 Parker & Van Alstyne

Are consumers worse off under monopoly? Market Two Market One (Acrobat Distiller) Price (Acrobat Reader) p 2 p 1 q 1 Quantity q 2 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 p 1 V 1 r 1 V 2 q 1 Let r 1 [0, 1] be the amount that Mkt 1 values the Mkt 2 good. Find Mkt 1 demand for the Mkt 2 good scaled by r 1. Convolve both curves to find Mkt 1 demand for both goods. © 2002 Parker & Van Alstyne

To Bundle or not to Bundle Un. Bundle © 2002 Parker & Van Alstyne

Further Applications Temporal Complements -- Markets 1 & 2 represent the same good in time, e 12 0, e 21 = 0. Lexis gives law students free access then charges law firms. Upgrades -- Markets 1 & 2 represent novice and professional versions , e 12 0, e 21 = 0. Firms like Ventana give their simulators free to students and charge $1200 for the fullfeatured 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 e 12 = 0, market 2 an information good with high network externality e 21 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. 2002 Parker & Van e Advertising -- Markets 1 & 2 represent consumer©& ad buyers, 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* Real. Player, 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/Info. Complements. html © 2002 Parker & Van Alstyne