Third Edition

Competing for Monopoly: The Economics of Network Goods

Competing for Monopoly: The Economics of Network Goods

Chapter 16

Outline

� Network goods are usually sold by monopolies and oligopolies.

� The “best” products may not always win.

� Competition is “for the market” instead of “in the market”.

� Antitrust and network goods.

� Music is a network good.

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Introduction

� As of 2014, there were 1.4 billion active users on Facebook.

� Match.com, the largest internet dating service, has over 20 million users.

� Facebook and Match.com are examples of network goods.

� The value to a user depends on how many other people use it.

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Definition

Network good:

a good whose value to one consumer

increases the more other consumers

use the good.

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Self-Check

Which of the following is a network good?

a. Chairs used in a classroom.

b. Software used to create and read documents.

c. Chocolate chip cookies.

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Answer: b

Markets for Network Goods

Features:

1. Usually sold by monopolies or oligopolies.

2. The “best” product may not always win.

3. Competition is “for the market” instead of “in the market”.

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Markets for Network Goods

1. Sellers are Oligopolies or Monopolies

� Most people want to use software that is compatible with others

� Pressure of coordination creates a near-monopoly

�Example: Microsoft

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Markets for Network Goods

1. Sellers are Oligopolies or Monopolies

� Sometimes more than one firm can compete on different features, specialized niches

�Examples: Match.com, Jdate.com, OKCupid, eHarmony

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Self-Check

Why are network goods usually sold by monopolies or oligopolies?

a. Pressure to be compatible.

b. Pressure to be the cheapest.

c. Pressure to provide the best product.

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Answer: a

Markets for Network Goods

2. Best Product May not Win

� A market may lock in on an inferior product or network

� Lock-in can be shown with a coordination game

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Definition

Coordination Game:

A game in which the players are better

off if they choose the same strategies,

but there is more than one strategy on

which to coordinate.

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Coordination Game

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Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

Alex and Tyler can choose either Apple or Microsoft software

Alex’s choices are the rows.

Tyler’s choices are the columns.

Coordination Game

Alex’s payoff

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Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

Tyler’s payoff

Coordination Game

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Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

If they use different software, it is difficult to work together (low payoffs).

Coordination Game

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Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

If they use the same software, it is easier to work together (high payoffs).

Coordination Game

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Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

If both choose the same software, neither has an incentive to change.

Definition

Other examples in standards wars:

VHS vs Betamax

Blu-Ray vs HD_DVD

Before the Blu-Ray standard was adopted, the benefits of the market were largely unrealized

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Sony

HD-DVD Blu-Ray

ToshibaHD-DVD (10, 8) (0, 0)

Blu-Ray (0, 0) (8,10)

Definition

Nash Equilibrium:

A situation in which no player has an

incentive to change his or her strategy

unilaterally.

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Coordination Game

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Tyler

Apple Microsoft

AlexApple (11, 11) (3, 3)

Microsoft (3, 3) (10, 10)

With TWO equilibria, the choice is often determined by “accidents of history”.

Nash Equilibrium

Cell Phone Duopoly

� Smalltown has 140 residents

� The “good”: cell phone service with

unlimited anytime minutes and free

phone

� Smalltown’s demand schedule at left

� Two firms: T-Mobile, Verizon

(duopoly: an oligopoly with two firms)

� Each firm’s costs: FC = $0, MC = $1020

P Q

$0 140

5 130

10 120

15 110

20 100

25 90

30 80

35 70

40 60

45 50

Nash Equilibrium

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Competitive outcome:

P = MC = $10

Q = 120

Profit = $0

Competitive outcome:

P = MC = $10

Q = 120

Profit = $0

Monopoly outcome:

P = $40

Q = 60

Profit = $1,800

Monopoly outcome:

P = $40

Q = 60

Profit = $1,800

Nash Equilibrium

T-Mobile and Verizon could agree to each produce half of the monopoly output:

For each firm: Q = 30, P = $40, profits = $900

Does anyone have an incentive to cheat?

What if Verizon increases Q to 40?

Market demand curve now has Q = 70 � P = $35

Verizon profit = TR – TC = 40*$35 - ($10* 40) = $1000

T-Mobile profit = (30*$35) – ($10*30) = 750

Verizon gains profit, T-Mobile loses profit

Will Verizon cheat? Why wouldn’t they? Profits increase22

Nash Equilibrium

What will T-Mobile do in response? Will it gain if it cheats?

Suppose T-Mobile increases its Q to 40

Now market Q = 80 and market price falls to $30

What is T-Mobile’s profit? (40*$30) – (40*10) = $800

Will T-Mobile increase its Q?

Yes, since its profits increase from $750 to $800

Note that Verizon’s profits fall from $1000 to $800

Verizon cheats and increase profits, T-Mobile profits fall

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Nash Equilibrium

�Is there an incentive to cheat at this point?

�Suppose Verizon increases output to 50Q

�Market Q rises to 90 and market price falls to $25

�What is Verizon’s profit?

• (50 * $25) – (50 * $10) = $750 (down from $800)

�Does Verizon have any incentive to cheat? No

�Does T-Mobile have any incentive to cheat? No

�What if either company cuts production to 40Q?

�Both companies are worse off if they move away from producing 40Q.

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Nash Equilibrium

Verizon and T-Mobile are now at a Nash equilibrium

A Nash equilibrium is a situation in which no player has an incentive to change their strategy unilaterally

� By cooperating (30 Q each) they could have made more profit

� Both companies are in a less profitable position

� Prisoner’s dilemma

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Markets for Network Goods

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� The current QWERTY keyboard may not be the best design

� QWERTY came first and got locked in

The Dvorak keyboard, developed in the 1930s

TOSHIK/SHUTTERSTOCK

Markets for Network Goods

Product Design in Network Markets:

� Ensure product fits into rest of the market

� Make it easy to use for as many people as possible

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Self-Check

When there are two equilibria in a network market, the winner is usually decided by:

a. Democratic vote.

b. Who produces at the lowest cost.

c. Accidents of history.

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Answer: c

Markets for Network Goods

3. Competition “for the market”

� Consumer loyalties can switch quickly

� A monopoly can easily change hands

� 1988: Lotus 1-2-3 had 70% of the spreadsheet market

� 1998: Excel had 70% of the market

� Results in serial monopolies

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Definition

Contestable Market:

A market in which the threat of potential

competition is enough to make it

behave competitively.

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Contestable Market:

Markets are more contestable when:

1. Fixed costs of market entry are low, relative to potential revenue.

2. There are few or no legal barriers to entry.

3. The incumbent has no unique, hard-to-replicate resource.

4. Consumers are open to the prospect of dealing with a new competitor.

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Contestable Market:

� Large market share does not necessarily mean the firm’s position is safe…

� How contestable is Facebook’s market?

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Self-Check

Which of the following is most likely to operate in a contestable market?

a. Railroad.

b. Pharmaceutical company.

c. Restaurant.

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Answer: c

Markets for Network Goods

3. Competition “for the market”

� In a contestable market, a new competitor could take away business

� This threat forces firms to make choices in light of potential competition

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Switching Costs

� Incumbent firms often try to limit the contestability of the market

� One way is to increase switching costs

• Example: Apple makes it easy to download content to iPad

• Difficult to export to other systems

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Antitrust

Regulating Network Markets:

� Market for network goods will be dominated by a few firms

� Not monopoly vs. competition, but one monopoly vs. another

� Important that competition for the market is not impeded

� Normal market share percentages analysis does not apply

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Music is a Network Good

� The more downloads a song has, the more people want to download it

� Bands often get popular quickly

� Popularity feeds on itself even if they’re not the “best”

� Easily dethroned by the next new band

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Takeaway

� Network goods are usually sold by monopolies or oligopolies

� Sometimes customers will get locked in to the wrong network

� There is a coordination problem in switching from one network to another

� Contestable markets force incumbents to act competitively

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