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Summary

In the previous chapter, we analysed the consumers’ adoption decision in the presence of network effects. The emphasis was on expectations, on coordination problems and on reinforcing mechanisms. We also studied the provision of network goods in various contexts and showed how prices and capacities are adjusted in the presence of network effects.

In this chapter, we want to explore further the decision making on the supply side of network markets. As a matter of fact, the particular features of demand resulting from network effects drive firms to make additional strategic choices and to develop specific strategic instruments. We start in Section 21.1 by examining firms’ choices with respect to compatibility. As the competition between incompatible network goods is likely to lead to a ‘winner-takes-all’ situation, firms have first to choose how to compete: choosing compatibility means competing in the market, while choosing incompatibility means competing for the market. We examine under which conditions one or the other situation is likely to emerge as an equilibrium.

When firms choose to compete for the market, they engage in what is called a ‘standards war’. In Section 21.2, we describe and analyse a number of strategic instruments that firms can resort to in order to win such a standards war: building an installed base for pre-emption, choosing between backward compatibility and performance, and managing consumers’ expectations in one's favour.

Finally, in Section 21.3, we discuss whether public interventions are able to correct, or at least alleviate, the market failures that may occur both on the demand and supply sides of network markets. We distinguish between ex ante interventions, by which the public authorities take an active part in the competition process among network goods, and ex post interventions, by which the public authorities do not try to influence the competition process, but aim to safeguard it by controlling firms’ conduct. We explain why both types of intervention are fraught with major difficulties.

Summary

Introduction to Part I: Getting started

Most economic transactions take place through markets. Markets thus play a central role in the allocation of goods in the economy. Moreover, the existence and nature of markets affect production decisions. Industrial Organization: Markets and Strategies is an attempt to present the role of imperfectly competitive markets for private and social decisions.

The array of issues related to markets and strategies is extremely large. To convince yourself, log in to the website of any newspaper or magazine and start a search for these two keywords: markets and strategies. The search engine will provide you with a long list of articles concerning a huge variety of sectors, companies and business practices. As an illustration, here follows a selection of recent articles that were returned by the New York Times search engine (international.nytimes.com) in July 2014.

‘Though generic medicines are far cheaper to bring to market than brand-name drugs because they involve little research and development, they also are priced lower because generics typically face intense competition. But Dr. Aaron Kesselheim, a professor of health economics at the Harvard School of Public Health, noted, Studies show it is not until you have four or five generics in the market that the prices really are down.’

‘Dashride [a cloud-based mobile dispatching platform that simplifies ride management operations for the livery industry] is just one of several web-based start-ups with a mission of empowering small, local businesses often in struggling, traditional industries by equipping them with tools and strategies that could help them keep up with changing times.’

‘Prospective deals in the single-digit billions are already a dime a dozen. And colossal ones like Comcasts planned $45 billion merger with Time Warner and AT&Ts $48.5 billion bid for DirecTV are practically commonplace. Even when deals fail, they can mean big fees for lawyers, bankers and consultants. Yet is deal-making fever good for shareholders?’

Summary

Introduction to Part IV: Pricing strategies and market segmentation

Consider the book you have in your hands and suppose, for now, that this is the only IO textbook on the market, so that we, the authors, are in a monopoly position. To introduce this part, we want to illustrate here how the profit we (or, more correctly, our publisher) can make by selling our book depends on the information we have about our potential consumers, and on the range of instruments we can use to design our tariffs. With limited information and instruments, the best we can do is to set a ‘one-size-fits-all’, uniform price for all our potential consumers. However, more information and instruments allow us to increase our profit.

Regarding the information about the consumers, it is not enough to know that consumers differ in their willingness to pay for our book; the crucial issue is to know who is willing to pay what. Armed with such knowledge, we can increase profit by setting different prices to different consumers, a practice generally known as price discrimination, presuming that resale is not possible or sufficiently costly. In some situations, the consumers’ willingness to pay can be directly inferred from some observable characteristics. Ideally, we would like to know exactly how much each potential consumer is willing to pay for the book; we would then make a personalized take-it-or-leave-it offer to each of them by quoting a price just below the consumer's reservation price; we would thereby appropriate the entire consumer surplus. More realistically, we can use market data analysis to segment our market in several groups, with the consumers in each group sharing some common characteristics and correlated willingness to pay. For instance, we can segment the market on a geographical basis and sell the book at different prices, say, in the USA and in Europe if market research reveals that those two markets exhibit different demand functions. In other situations, however, there is no direct way to segment the market based on some observable characteristics. In such cases, we can still increase our profit by using an incentive-compatible mechanism whereby consumers reveal their willingness to pay to us.

Summary

In this chapter, we introduce a number of concepts that will prove useful in the rest of the book. We also clarify the main assumptions underlying the analytical frameworks that we will use throughout the book. We start by describing the two types of actor that interact on markets, namely the firms and the consumers. How do we represent them? How are they assumed to behave? How do we measure their well-being? These are the questions we address in Section 2.1. We turn next to market interaction itself. In this book the form of market interaction we are interested in is imperfect competition. To delineate the scope of imperfect competition, it is useful to understand first two extreme market structures where interaction among firms is limited or non-existent. Section 2.2 describes these two market structures, namely perfect competition and monopoly. Finally, in Section 2.3, we present ways to define a market and to measure its performance.

Firms and consumers

In this section, we describe how firms and consumers are usually modelled in the theory of industrial organization and throughout this book. In Subsection 2.1.1, we explain that firms are essentially associated with a programme of profit maximization and we examine the component of profit that is specific to the firm, namely its cost function. Total revenues, the other component of profit, depend on the consumers’ preferences (which determine demand) and on the type of market interaction; these two elements are examined respectively in Subsection 2.1.3 and in Section 2.2.

This simplified representation of the firm proves very useful when considering strategic interaction between firms, which is the main concern of this book. However, its main shortcoming is that it abstracts away all the relationships among the economic agents composing the firm. To assess the scope of the simplified representation of the firm, we look inside the black box of the firm in Subsection 2.1.2. Acknowledging that the firm may be composed of agents with different information and potentially conflicting objectives, we examine if and how those objectives can be aligned. We also study the determinants of the firm's boundaries: what does the firm decide to make and what does it prefer to buy?

Summary

So far in this part, we have only considered models that are static, in the sense that firms simultaneously take their decision at a single point in time. This is clearly a simplified representation of reality but it helped us a great deal to understand the basic principles of oligopoly competition. Now, we want to extend the analysis by incorporating the time dimension. First, in Section 4.1, we examine situations in which firms do not take their decisions simultaneously but sequentially. One firm might indeed have the opportunity to choose its price or its quantity before the other firms in the industry, and it is important to investigate whether such opportunity benefits or hurts the firm. Second, in Section 4.2, we endogenize the number of firms in the industry; that is, assuming that the only impediment to entry is a fixed set-up cost, we analyse the entry decision that precedes price or quantity competition. Our main concern is to compare the number of firms that freely enter the industry, so as to exhaust all profit opportunities, with the number of firms that a social planner would choose. Third, in Section 4.3, we first distinguish endogenous from exogenous sunk cost industries and analyse how market size affects market concentration. We then sketch a stochastic dynamic model of firm turnover that allows us to analyse the effect of market size on the number of firms, their efficiency levels and firm turnover.

Sequential choice: Stackelberg

In the models of the previous chapter, firms were assumed to make their strategic decisions in a simultaneous way. The term ‘simultaneous’ does not have to be taken in its literal sense, though. What is meant by simultaneous decision-making is not that decisions are made at the exact same moment, but rather that firms are not able to observe each other's decision before making their own. While this assumption is reasonable in a large number of market environments, there exist situations where some firms have the possibility to act before their competitors, who are then in a position to observe those firms' previous choices. Take the pharmaceutical industry as an illustration. Because of patent protection, firms set the price of their patented drugs before producers of generic drugs enter the market and set their own price.

Summary

A classic example of asymmetric information problems is the market for used cars. The current owner has private information about product characteristics, whereas buyers only have a vague idea. This asymmetric information problem may result in the breakdown of the market: only lemons (i.e., used cars of poor quality)may be offered for sale or, worse, all sellers may withdraw from the market. Alternatively, if sellers can disclose their information, asymmetric information may result in full information disclosure, so that the asymmetric information is solved. What is the likely outcome and why? This is what we explore in Section 12.1. We start by analysing hidden information problems, where firms do not control the quality of their product but observe the realization of quality, whereas consumers cannot observe quality before buying the product. We also examine hidden action problems that arise when firms are able to invest in the quality of their products; in that case, we explore the impact asymmetric information has on the private investment incentives.

When producers, like car manufacturers, are not able to credibly disclose some relevant information, they will try to use strategic variables to convince consumers that their products are of high quality. In Section 12.2, we focus on advertising and price signalling in a monopoly setting. Wasteful advertising and prices which are distorted away from their full information level may serve as a means to make consumers believe in high product quality. We first analyse the two signals separately and then we investigate how they can be used jointly. Finally, in Section 12.3, we examine how imperfect competition affects the use of prices as a signal of quality. In particular, we show that a high price can signal product quality also under competition.

Asymmetric information problems

When consumers do not observe product quality or other characteristics whereas firms do, market participants face a situation of asymmetric information. In particular, if quality or other characteristics are not controlled by the firm but are realizations of some random variable, we are confronted with a hidden information problem. Otherwise, that is, if the firm chooses quality or product characteristics itself, market participants face a hidden action problem. We consider the two types of problem in turn.

Summary

In the previous chapter, we focused on the positive aspects of R&D by examining the interplay between market structure and innovation. In consequence, we were not too specific about the exact regime of IP protection. In this chapter, we want to adopt a more normative point of view and study how IP protection should optimally be organized. This chapter also provides the reader with a broad description of the realm of IP.

In Section 19.1, we study the link between innovation and IP in an essentially nontechnical way. We describe the appropriability problem of innovation and we consider several ways to close the wedge that this problem drives between social and private rates of return from innovation. We start with the main policy instrument that has been designed to promote innovation, namely the institution of intellectual property and its legal protection (through IP rights such as patents and copyrights). We explain that the main rationale of IP rights is to provide incentives to produce information and knowledge by conferring a monopoly right to the producer. We then compare this institution to other public and private responses (namely rewards and secrecy), and we examine which of these solutions innovators tend to choose in practice.

In Section 19.2, we address some of the previous issues in a more formal way. First, we study the optimal design of IP rights. We start by arguing that the negative impacts that monopolies have on welfare call for limitations on the legal protection conferred by IP rights. What types of limitation? We examine two adjustable dimensions: the length and the breadth. The length simply refers to the duration of the protection, while the breadth refers to the usage the innovator can make of his rights with respect to competitors. Second, we compare the relative merits of rewards, secrecy and patents as mechanisms to encourage innovation and diffusion.

Summary

In this short introductory chapter, we give a broad presentation of the book and indicate how we think it is best to use it. We start by explaining the title of the book: what do we mean by ‘markets’ and by ‘strategies’, and why do we associate the two terms? We argue that it is market power and the exercise of it that relate markets and strategies to one another. Next, we outline the approach that we adopt in this book: we believe in formal modelling, which explains that the book is theory-based; yet, we also believe that it is important not to overload readers with techniques and to motivate the analysis with real-life cases; our aim is thus to blend up-to-date theoretical developments and real-life applications in a rigorous and concise manner. Finally, we describe the level, the scope and the organization of the book.

Markets

Markets allow buyers and sellers to exchange goods and services in return for a monetary payment. Markets come in a myriad of different varieties. Examples are your local farmers’ markets (local) and the market for passenger jets (global), the market for computer software (product) and software support (service), the market for electricity (homogeneous product) and markets for highly specialized steel (differentiated product). These markets may exist in physical or virtual space.

We mostly consider markets in which a small number of sellers set price or quantity strategically, as well as possible other variables, whereas buyers mostly come in large numbers so that they non-strategically react to supply conditions. The reverse situation applies to some procurement markets in which a small number of buyers faces a large number of sellers.We mainly use examples of markets in which buyers are final consumers; however, the formal investigation relies on certain characteristics of markets that also apply to other markets in which buyers are not final consumers but, for example, small retailers, service providers or manufacturers.

Summary

Introduction to Part IV: Product quality and information

So far in this book, we have mainly been dealing with search goods, that is, products or services with features and characteristics that can easily be evaluated before purchase. In contrast, this part of the book examines products and services with characteristics that can only be ascertained upon consumption because they are difficult to observe in advance. We talk here of experience goods.

Managing experience goods is the day-to-day concern of large firms selling consumer goods, such as Nestlė Procter&Gamble or Unilever. These firms frequently introduce new branded products. They are always interested in not only making consumers aware of the product (e.g., through advertising as we have analysed in Chapter 6) but also convincing consumers that the new product satisfies their wants. Perhaps the main challenge when launching a new product is that consumers do not observe the quality of the product, as is typically the case with experience goods. Similarly, firms that enter an otherwise perfectly competitive industry with a patented product (or, alternatively, open new markets with a proprietary technology) often produce an experience good.

These markets are characterized by asymmetric information as consumers have less information than the producers about product quality. In such markets, firms have to convince consumers that their products are of high quality. To this end, firms can use a variety of marketing instruments. This is the topic of the following two chapters. We mostly focus on markets in which a single firm has market power; situations in which multiple firms have market power are more challenging and will not be analysed systematically in this context.

In Chapter 12, we analyse the basic problem of asymmetric information. Adverse selection may lead to a breakdown of quality in the market. If a firm has initially to invest in quality, the effect of asymmetric information on quality provision is ambiguous. In response to an asymmetric information problem, the firm may also choose from an arsenal of marketing devices. Here, we focus on price and advertising signals of quality, both in isolation and in combination.

Summary

This chapter is organized as follows. In Section 8.1, we start by defining formally the three types of price discrimination, which we will refer to as personalized pricing, group pricing, and menu pricing. We cover the latter type in the next chapter. Here, we consider jointly the first two types because, as we will argue, personalized pricing is nothing but an extreme form of group pricing, where the market segmentation is so fine that each separate ‘group’ consists of a single consumer. Both practices rely on the existence of observable and verifiable indicators of the consumers’ willingness to pay. Coupled with the absence of resale among consumers (i.e., arbitrage), this allows the firms to make a specific and unique price offer to each separate group of consumers. The better the information about consumers, the finer the partition of the consumers into groups and the larger the possibilities for firms to extract consumer surplus. If the firm is a monopoly, as we assume in Section 8.2, this is clearly the only effect at play. We thus observe that the discriminating monopolist's profits increase with the quality of the information it has about the willingness to pay of its consumers.

In an oligopoly setting, however, the previous conclusion may not hold because a second effect comes into play. As we show in Section 8.3, price discrimination gives firms more flexibility to respond to their rivals’ actions, which tends to exacerbate price competition and, thereby, to lower profits. Choosing to discriminate becomes thus a strategic decision. As we show below, the balance between the two contrasting forces (surplus extraction and fiercer competition) depends on the quality of the information about consumers and on the relative importance of the different groups of consumers.

Price discrimination

In this section, we first propose a general typology of price discrimination practices. We then describe how firms manage to segment the market into well-recognized groups of consumers and sometimes, to acquire information about individual reservation prices.

Summary

Introduction to Part VII: R&D and intellectual property

Early March 2014, one could read in the press that Twitter had paid IBM $36 million for 900 patents in order to avoid a lawsuit (Wired.com, March 7), that a German company had won the EU's €2 million inducement prize for innovative vaccine technology (European Commission, March 10), that SanDisk had filed lawsuits against its competitor SK Hynix, alleging misappropriation of confidential trade secrets related to flash memory technology (PCWorld, March 13), that the US Supreme Court was considering making software ineligible for patent protection (Forbes, March 16), that Viacom and YouTube had settled a copyright violations battle out of court, seven years after their dispute began (The New York Times, March 18) and that Nissan and its French partner Renault were planning to integrate their research and development functions (The Japan News, March 19).

What do these events have in common, except that they occurred at about the same time? They all involve intangible assets (i.e., assets that do not have a physical or financial embodiment), which consist of human knowledge and ideas and to which a legal entitlement, called intellectual property (IP), is usually attached. Intangible assets of this kind become increasingly crucial in our economies. In some countries, the investment in intangible assets now matches or even exceeds investment in tangible assets (such as machinery, buildings and equipment). The causes have to be found in the growing importance of service industries, in globalization and in the fast development of information and communication technologies (ICTs).

A clear manifestation of this trend is that firms are increasingly seeking patents, attempting to extend their scope, granting more licences, litigating more and transforming their business models around intellectual property. At the same time, highly reliable open-source software is collectively produced by a decentralized crowd of developers who do not seek any immediate monetary compensation for their efforts; commercial software vendors are contributing to these projects and, even more surprisingly, they do sometimes initiate open-source projects by releasing part of their proprietary source code.

Summary

Introduction to Part IX: Market Intermediation

Most products and services are not sold directly from the producer to the final consumer but pass through intermediaries. Intermediaries and the services they offer are the focus of this last part of the book. We distinguish between the following four major roles of intermediaries.

Summary

Introduction to Part VI: Theory of competition policy

So far in this book, our approach has been mostly positive: we have been concerned with describing and explaining the workings of imperfectly competitive markets. The first chapters helped us to understand what market power is, where it comes from and how it is exerted. In some specific situations, we also compared the outcome that results from the interaction among firms with the social surplus-maximizing outcome. Yet, such comparisons did not give rise to recommendations for a competition authority.

In this part of the book, we change our perspective and adopt a normative approach: now that we understand what is, we can express views about what ought to be, that is, we provide guidance for competition policy. To the extent that competition authorities follow the rules spelled out under this normative approach, this analysis is again helpful to address positive questions: it may help explain why firms choose certain actions when they foresee the reaction of competition authorities.

The basic postulate for competition policy is that competition is desirable as it is a fundamental force to deliver economic efficiency. The problem, as we have already noticed in the previous chapters, is that firms may be tempted to suppress competition as it makes their lives easier. It is thus necessary to edict and enforce a set of rules in order to maintain competition. This is exactly how Neelie Kroes, the European Commissioner for Competition Policy until 2009, defines her role:

The Single Market [i.e., the integrated European market] is a precious achievement, and the best way to keep it functioning effectively is to ensure competition between companies. My job is about acting as a referee of this process. If we think of the European economy as a football match: I set and enforce the rules of the game, in conjunction with the other Commissioners. We make sure it is a fair match, and that there is punishment for people and companies that break the rules and spoil the game for others.

Summary

Intermediation can play an important role in the process through which consumers obtain information. Section 23.1 deals with a number of situations where consumers can access and process information more efficiently if they use the services of an intermediary. First, we consider situations in which consumers may suffer from information overload and in which an information gatekeeper is valuable for consumers. Second, we analyse the role of gatekeepers who provide price information in search markets. Third, we turn to the possibility that the intermediary, through the installation of a recommender system, allows consumers to perform directed search. This potentially allows consumers to drastically reduce their search efforts to obtain the products they like.

In Section 23.2, we turn to asymmetric information problems. We first analyse whether and how an intermediary can alleviate asymmetric information problems between firms and consumers. Possibly, the intermediary can act as a certifier. There is, however, the risk that the intermediary simply extracts rents from the market without providing any services. We then turn to the analysis of reputation systems, where it is not the intermediary's information disclosure but the previous experience of other consumers that allows consumers to make better-informed choices, thereby alleviating asymmetric information problems.

Intermediation and information

Intermediaries that act as information distributors play an increasingly important role, since consumers are limited in their capability to process information. In this section we take a look at consumers with limited information-processing capabilities and the role of ‘infomediaries’ in this context. Instead of relying on an infomediary as a filtering device, consumers may do the filtering themselves. This can be interpreted as an open-access platform from which a consumer has to (randomly) pick some of the information that is provided.

Information overload

Consumers have to be selective when it comes to processing information. This is a critical issue for marketing departments at firms. They have to figure out how they can raise consumers’ interest in their adverts. They can increase the chance of being successful by targeting particular media that address consumers who tend to be more interested in the particular product. Consumers may then have a larger attention span for such media because they anticipate the expected benefit.

Summary

Introduction to Part VIII: Networks, standards and systems

Information products and technologies are rarely used in isolation or just for their own sake. Take the example of instant messaging (IM) services, whose primary functionality is to allow you to exchange text messages with other users over the Internet in real time. The first IM services (like AOL Instant Messenger, Yahoo! Messenger or Windows Live Messenger) were used on computers and often bundled with a particular web browser. With the advent of smartphones, instant messaging became increasingly mobile and a number of IM applications (like Whatsapp, WeChat, Line, Viber, Kakao Talk, etc.) were made compatible with the major smartphone platforms (Android, iOS, BlackBerry, Windows Phone).

Regardless of the supporting technology, adopting a particular IM service involves for users a larger set of considerations than the purchase of, say, a bag of potatoes. In particular, a user of an IM service must care about what other users are doing. The benefits of using the service come, indeed, from two sources: first and foremost, the ability to chat with other users and potentially, the additional features that can be used within the IM application (such as editing pictures, recording down moments of your life, following accounts of celebrities or obtaining discounts from tied-up partners).

What is important to stress is that the benefits for an individual user increase with the number of other users of the service: either directly for the communication benefits (a larger base of users directly increases the number of potential contacts any user can have via the IM service), or indirectly for the benefits related to additional features (a larger base of users induces providers to supply more and/or better features to be combined with the IM service, which in turn raises the attractiveness of the service). We use the term network to describe the community of users whose benefits are made interdependent by the nature of the product they use. By analogy, we call goods like IM services network goods.

Summary

In this chapter, our goal is to examine the interplay between market structure and innovation. This is clearly a two-way relationship: on the one hand, firms’ incentives to invest in R&D depend on the structure of the product market they are acting in (i.e., on the number of rival firms and on the way they compete); on the other hand, firms are likely to use R&D to shape the structure of their market (e.g., by using R&D to increase their market share or to keep potential competition at bay). As the two effects are complex and intertwined, we simplify the analysis by assuming that firms can somehow appropriate the return from their R&D investments (we analyse how they actually manage to do so in the next chapter).We also break down the analysis into separate issues.

In Section 18.1, we assess how market structure affects the incentives for conducting R&D, which are measured by the profit increase that the innovator gains from the innovation. First, incentives to innovate are compared in the two market structures where strategic considerations are absent, namely monopoly and perfect competition. It is shown that the latter generates larger incentives to innovate than the former. Next, we extend the analysis to include strategic interaction by considering oligopolies. We reach an ambiguous result: a higher intensity of competition may increase or decrease the incentives to innovate depending on the initial starting point, the size of the innovation and the way competition is increased. Finally, we study the possibility for the innovator to obtain additional revenues by licensing its innovation to other firms, be it inside or outside its own industry.

In Section 18.2, we reverse our point of view by investigating how innovation may influence market structure. First, we reconsider a monopolist's incentives to innovate in situations where a competing firm threatens to enter the market. We show that the incumbent firm is often keener to invest in R&D than the entrant. Monopoly is thus likely to prevail over time, which indicates that innovation does indeed drive market structure. Second, we enrich the previous analysis by incorporating explicitly the time dimension. Indeed, a firm's main motivation when investing in R&D is often to be the first to come up with an innovation.

Summary

In the previous chapter, we have looked at advertising and prices as two strategic variables that might be used to overcome asymmetric information problems. In this chapter, we will look at additional instruments that belong to the toolbox of a firm, such as a car manufacturer, which is confronted with asymmetric information. We focus on two broad classes of instrument, namely warranties (in Section 13.1) and branding (in Section 13.2).

Warranties can be an effective tool to separate high- from low-quality products. A potential drawback is that consumers may not handle products with care if they hold a full warranty. This leads to a double moral hazard problem and makes this option possibly rather unattractive.

Branding is another important tool for producers of experience goods. It is an essential success factor for many companies since they want to be recognized over time and across products. Firms can then rely on their brand, which stems from repeated interaction over time and on the use of one brand for several products so that consumers can correlate their beliefs about product quality across products – this latter practice is known as umbrella branding. An additional insight is that competition may substantially affect the logic of branding.

Warranties

Warranties are an everyday feature of experience goods. For instance, cars, consumer electronics and appliances typically come with warranties. Warranties establish liability between the manufacturer and the buyer in the event that an item fails (i.e., if the item is unable to perform satisfactorily its intended function when properly used). Usually, the warranty contract specifies both the performance that is to be expected and the redress available to the buyer if a failure occurs. Warranties serve many purposes. These include protecting manufacturers and buyers, assuring buyers against items which do not perform as promised, and helping dispute resolution between buyer and manufacturer. To meet these objectives, public authorities have formulated legislation imposing minimal warranties.

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