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Business of  Platforms, Networks, Business of  Platforms, Networks,

Business of Platforms, Networks, - PowerPoint Presentation

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Business of Platforms, Networks, - PPT Presentation

and Twosided Markets Prof Nicholas Economides Stern School of Business New York University httpwwwsternnyuedunetworks NET Institute httpwwwNETinstorg mailto economidessternnyuedu ID: 760349

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Slide1

Business of Platforms, Networks, and Two-sided Markets

Prof. Nicholas EconomidesStern School of Business, New York Universityhttp://www.stern.nyu.edu/networks/NET Institute http://www.NETinst.org/mailto:economides@stern.nyu.edurevised 9/19/17Copyright ©

Slide2

2

Telecommunications (data, voice)Internet / world wide webSocial networks on the Internet (Facebook, Twitter, etc.)Broadcasting (TV, radio)Cable televisionFinancial networksCredit and debit card networksATMs, bank networks; payment systems; check clearing housesFinancial exchanges (equities, bonds, derivatives)Banking networks and systemic riskB2B, B2C exchangesElectricityRailroadsAirlinesRoadsVirtual networksComputer software and hardwareInformation servers (yellow pages, Google, Yahoo, MSN)

Network industries are a large part of the world economy and some are growing very fast

Slide3

A virtual network

is a collection of compatible goods/components that share a common technical platform. For example, all VHS video players make up a virtual network. Similarly, all computers running Windows can be thought of as a virtual network. Compatible computer software and hardware make up a “network,” and so do computer operating systems and compatible applications. More generally, virtual networks are composed of complementary components, so they also encompass wholesale and retail networks, as well as information networks and servers such as telephone yellow pages, Yahoo, Google, etc.

3

Slide4

4

Network industries often

provide necessities

provide infrastructure

are key to economic growth

Network industries have special features

Slide5

Platforms

A platform provides a way for two parties to enter into mutually beneficial exchangePlatforms are matchmakersPlatform Side 1 Side 2 ServiceUber Driver Rider TransportVisa Merchant User PaymentAirBnb Apartment User AccommodationMSFT OS MS-Word User Writing

5

Slide6

Profit maximization on a platform is complex

May be optimal to subsidize one side of the marketUnlike traditional firms (say BMW) where coordination and production occurs inside the firm, in platforms production occurs by bring together two sides (driver, user) who are outside the firm

6

Slide7

Network effect:

7

A user will pay more to connect to a larger networkPlatforms leverage network effects

Slide8

8

Is competition different in these industries? What are successful strategies for companies in markets and industries with network effects?Is there a special case for or against antitrust or competition policy scrutiny for network industries?What form should intervention take (if any)?Price controls? Subsidies?Structural changes (breakups, divestitures, etc.)Imposition of technical compatibilityRegulation

Slide9

Technological change has facilitated networks and

Telecommunications became extremely cheapComputation power rose exponentially

9

Slide10

Effects of cheap computational power and cheap telecom

New products, new servicesNetworks, platformsOld products/services produced differently -> disruptionBig shifts in value of companies

10

Slide11

Week 1: Introduction

RequirementsMidterm examClass participation; interactivityFinal group projectGroups of 4 writing an original paperPreliminary presentation of paper on week 10Subject matterAreas we will cover

11

Slide12

Overview: Areas we will cover

Week 1-2, pp. 24-55 (all approx.)Summary of basic economics of competition in non-network industriesBasic Game Theory

12

Slide13

Overview: Areas we will cover

Week 2, pp. 56-80Nature and types of networksVarious types of networks including virtual networksFeatures Network creation/expansionSuperimposition of various networks

13

Slide14

Overview: Areas we will cover

Week 3, pp. 81-89Internet basicsInfrastructureBasic ProtocolsPricingSearch algorithms and advertising“Organic” search; paid searchWeek 4, pp. 90-107Cybersecurity and privacy issues

14

Slide15

Overview: Areas we will cover

Week 4: pp. 108-134Network structures and platformsTwo-sided pricing

15

Slide16

Overview: Areas we will cover

Week 5, pp. 135-165Network structures and platformsNetwork propertiesNetwork effectsPlatforms Pricing on networksNature of competition on networks

16

Slide17

Overview: Areas we will cover

Weeks 6-7, pp. 166-189Compatibility and interconnectionDesirability Divergence of private and public incentives Public policy issues

17

Slide18

Overview: Areas we will cover

Week 7, pp. 190-204Bottlenecks and Interconnection Pricing

18

Slide19

Overview: Areas we will cover

Week 8, pp. 205-214Application: Taxi cabs as a two-sided networkApplication: Electric cars as a two-sided network

19

Slide20

Overview: Areas we will cover

Week 9, pp. 215-263Application: Payment Systems (credit and debit cards)Application: Mobile Money in Africa

20

Slide21

Overview: Areas we will cover

Weeks 10, pp. 264-280Application: Digital BooksWeek 11, pp. 281-322Application: Two-sided Pricing & Network Neutrality on the Internet

21

Slide22

Overview: Areas we will cover

Weeks 12 Bottom line, pp. 323-347Additional materialsAntitrust in Networks Industries, pp. 348-375Bank networks formation and systemic risk, pp. 376-381

22

Slide23

References

Geoffrey Parker, Marshall Van Alstyne and Sangeet Choudary, Platform Revolution. Shapiro, Carl, and Hal Varian, Information Rules, Harvard Business School Press, 1999. Chris Anderson, The Long Tail, Hyperion, New York, 2006. John Battelle, The Search, Penguin, New York, 2005. Brock, Gerald, The Telecommunications Industry: The Dynamics of Market Structure, Harvard University Press, 1981. Carlton, Dennis, and Jeff Perloff, Modern Industrial Organization, Harper Collins. Crandall, Robert, After the Breakup: US Telecommunications in a More Competitive Era, The Brookings Institute, Washington, D.C., 1991. David Easley and Jon Kleinberg, Networks, Crowds, and Markets: Reasoning About a Highly Connected World, Cambridge University Press, 2010 Laffont, Jean-Jacques, and Jean Tirole, Competition in Telecommunications, MIT Press, 2002. Mitchell, Bridger M., and Ingo Vogelsang, Telecommunications Pricing: Theory and Practice. Cambridge University Press, 1991. Owen, Bruce, and Steve Wildman, Video Economics, Harvard University Press, 1992. Specific references in each module below.

23

Slide24

Weeks 1-2: Summary of Basic Competition Concepts

Supply and demandDefinitionsCosts Consumer surplus (CS)Producer surplus (PS)Total surplus (TS)For more extensive discussion, see Pindyck and Rubinfeld, Microeconomics

24

Slide25

Demand, supply, and price determination

25

Slide26

Cost definitions

Total costs: C(q).Variable costs: V(q).Fixed costs: F, constant.Breakdown of total costs C(q) = F + V(q).Average total cost: ATC(q) = C(q)/q.Average variable cost: AVC(q) = V(q)/q.Average fixed cost: AFC(q) = F/q.Breakdown of average costs ATC(q) = F/q + AVC(q).Incremental (marginal) cost: MC(q) = C'(q) = dC/dq = V'(q) = dV/dq.

26

Slide27

Three cost technologies:(1) Constant Returns to Scale

27

Slide28

Cost technologies: (2) IncreasingReturns to Scale, F > 0, MC constant

28

Slide29

Cost technologies: (3) Increasing and Then Decreasing Returns to Scale

29

Slide30

Consumers’ surplus

CS = Total willingness to pay for q units minus consumers’ expenditure = Area under demand up to q units minus consumers’ expenditure = A(q) – E(q)E(q) = pq when all units are sold at the same price q, but companies sell in many other pricing schemesKeep in mind that in network industries, the CS calculation will be different

30

Slide31

31

Slide32

Producers’ surplus

PS = Revenue up to q units minus variable costs = Revenue minus area under marginal cost curve = pq – VNote that Variable Cost V(q) is the area under Marginal Cost MC(q)

32

Slide33

33

Slide34

Total surplus

TS(q) = CS(q) +PS(q) = A(q) – E(q) + E(q) – V(q) = A(q) – V(q) = net contribution to society of a market for q units (excluding fixed costs)We judge markets according to contribution to TSTS is maximized at qc.Difference TS(q)-TS(qc) = dead weight loss = loss to society from less or more production than qc.Example of less production than qc: monopolyExample of more production than qc: subsidy

34

Slide35

35

Slide36

Total surplus is maximized at qc

36

TS

0 qc q

Keep in mind that this will NOT be true in network industries

Slide37

Price discrimination: ways to reduce consumer surplus and increase profits

Sell different units of the same good to the same buyer at different pricesSell different units of the same good to different buyers at different pricesTying: good A not sold without good BApple was not selling Macs without an Apple monitorMixed bundling: selling collections of goods at lower prices than a-la-carteMicrosoft office bundle vs. a-la-carteLoyalty-requirement contract: Discounts are offered if the buyer commits to buying all or most of his “needs” from same seller

37

Slide38

Price discrimination towards the same buyer

Selling different units of the same product to the same buyer at different pricesElectricity bills: higher marginal price for more units In other cases, last unit sold at a lower price (quantity discount)Collecting a fixed fee with or without a variable feeMobile, fixed telecom service bills

38

Slide39

Price discrimination towards the same buyer

Loyalty-requirement contract:Offer a discount on some or all units only if buyer buys 90% of his “needs” from youOr offer a discount on some or all units of good A only if the buyer buys 90% of his needs of goods A & BEssentially forces buyer to buy B from dominant firm in A

39

Slide40

Price discrimination towards the same buyerProblems of requirement contracts

What if there is a monopolist in good A but there are rivals in good B that produce superior quality of B?Under the requirement contract, rivals in B are eliminated or marginalized with significant TS loss

40

Slide41

Price discrimination towards the same buyer Problems of requirement contracts

A multi-unit buyer has some CS left in product A even under monopolyThe monopolist seller can extract more CS by requiring that the product be only sold with B

41

Slide42

Price discrimination across buyers

Example: IBM in the 1930s leased tabulating machines; required buyers to buy IBM cardsCard use proportional to machine useMachine use roughly proportional to value to buyerIBM used tying to quantify the value to individual buyerIBM used tying to effectively lease different units of the tabulating machines to different buyers at different pricesOften tying and bundling are illegal under antitrust law

42

Slide43

Market organization

Perfect competitionMany rivalsMarket price is equal to incremental costNo need to take rivals into accountMonopolySingle sellerMarket price significantly exceeds incremental costNo rivalsOligopolyFew firmsMarket price above cost but below monopolyNeed to take rivals’ actions into accountUse game theory to describe market equilibrium

43

Slide44

Market concentration

Herfindahl-Hirschman index of concentrationHHI = Σin=1 si2 Range from 1 (monopoly) to 0 (perfect competitionAt egalitarian equality, all si = 1/n, HHI = 1/nLawyers multiply Σin=1 si2 by 10,000 so for them the HHI range is [0, 10000]

44

Slide45

Market classifications by HHI defined by DOJ and FTC http://www.justice.gov/atr/public/guidelines/hhi.html

HHI between 1,500 and 2,500: moderately concentratedHHI > 2,500: highly concentrated“Mergers that increase HHI by more than 200 in highly concentrated markets are presumed likely to enhance market power”

45

Slide46

Game TheoryApplication to Oligopoly

Game in extensive form: N players; decision tree; moves; outcomes; information sets; payoffs Π1, Π2; Game in normal form: strategiesPerfect information, perfect recallComplete information; Harsanyi’s analysis of incomplete information

46

Slide47

Games in extensive form: sequential incumbent-entrant game

47

Slide48

Games in extensive form: simultaneous games

48

Slide49

Non-cooperative games

Non-cooperative equilibrium (Nash equilibrium, NE): A pair of strategies (s1*, s2*) such that no player can increase his payoff provided that the rival does not change his strategy Best reply: b1(s2) maximizes Π1(s1, s2)Best reply: b2(s1) maximizes Π2(s1, s2)At NE, s1* = b1(s2*), s2* = b2(s1)

49

Slide50

Prisoners’ Dilemma

Player 2talksilentPlayer 1Talk(2, 2)(6, 0)Silent(0, 6)(5, 5)

50

Non-cooperative equilibrium is at (2, 2) even though (5, 5) maximizes total utility

Players cannot commit to stay silent

Other interpretations: arms race; oligopoly

Slide51

Prisoners’ Dilemma as an Oligopoly Game

Player 2high Qlow QPlayer 1High Q(2, 2)(6, 0)Low Q(0, 6)(5, 5)

51

Non-cooperative equilibrium is at (2, 2) even though (5, 5) maximizes total utility

Players would like to commit to low Q, but this is a violation of antitrust law

Slide52

Simultaneous Incumbent-Entrant Game

Pl. 2 (I)high Qlow QPl. 1 (E)Enter(-3, 6)(8, 8)Stay Out(0, 18)(0, 9)

52

There are two non-cooperative equilibria at (0, 18) and (8, 8)

Notice that pl. 1 wants (8, 8) while pl. 2 wants (0, 18)

Slide53

Battle of the SexesCoordination Game

Player 2balletboxingPlayer 1Ballet(2, 1)(1, 1)Boxing(0, 0)(1, 2)

53

Non-cooperative equilibria at (2, 1), (1,1) and (1, 2)

Which one will occur?

Slide54

Matching PenniesZero sum game

Player 2headstailsPlayer 1Heads(1, -1)(-1, 1)Tails(-1, 1)(1, -1)

54

There is no non-cooperative equilibrium

Could use “mixed strategies” – probability distributions over the “pure strategies” {H, T}

John Nash (1951): there exists a non-cooperative equilibrium in mixed strategies for any matrix game

Slide55

Is cooperation needed?

To establish a network link between A and B it needs to be profitable for both A and B

55

Slide56

Week 2: Networks Basics

Easley and Kleinberg. See http://www.stern.nyu.edu/networks/E&K/networks-book-ch01.pdf to -ch24.pdf Sanjeev Goyal, Connections, Princeton University Press, 2007. Chapter 2

56

Slide57

Networks are composed of complementary nodes and links

The crucial defining feature of networks is the complementarity between the various nodes and linksA service delivered over a network requires the use of two or more network componentsThus, network components are complementary to each other

57

Slide58

Example: the Information Superhighway (1994)

58

Slide59

Network structure

59

Nodes: entities

Edges/links: relationships

Directed or not

Features/colors of nodes

Features of links

Slide60

Human connections networks

60

Co-authors

Facebook

Blog readers

Members in

organizations

political parties

professions

How important is a specific node

Strong and weak ties

Cohesion issues

What holds the network together?

Activity on networks

How does it get affected by the network structure?

Is behavior influenced by network nearness? How?

Slide61

Blogs in the 2008 presidential campaign

61

Slide62

Spread of an epidemic

62

Slide63

World trade network example from Easley and Kleinberg, Figure 1.8

63

Slide64

Network structure:Undirected and directed graphs

64

Slide65

Network structure: Connected components

65

Slide66

Network structure:Breadth-first search

66

Slide67

A Simple Social NetworkWith Three Components

67

C

D

A

E

B

A and E are

connected

.

B and E are

not

connected, but there is a

path

between them.

A and D are also

not

connected and there is

no

path

between them.

C is an

isolated node

A is a node with a high degree of

centrality

Slide68

A Star (Hub & Spoke) Network

68

JFK

ATL

LAX

ORD

SEA

Slide69

A Complete Network

69

JFK

ATL

LAX

ORD

SEA

Slide70

Competing Platforms

70

C

3

P

2

P

1

C

2

C

5

C

4

C

1

M

6

M

5

M

4

M

3

M

2

M

1

The Cs are

single homing;

that is, they belong to just one network (connect to a single platform).

P

1

and P

2

are the

platforms

(

e.g.

, payment-card networks)

The Ms are

multi-homing;

that is, they belong to both networks (connect to more than one platform).

There is

no interconnection

between the networks

Slide71

Competing Platforms with Interconnection (e.g., telecom)

71

C

3

P

2

P

1

C

2

C

5

C

4

C

1

C

11

C

10

C

9

C

8

C

7

C

6

C

5

and C

9

’s conversation is

on net

.

C

5

and C

6

’s conversation is

off net

.

P

1 or P2 may need to pay the other an interconnection fee

Slide72

Concepts, Goyal pp. 9-24

“Neighbors” of j are those nodes with direct links to jA network is “regular” if every node has the same number of links“Degree” of node j is the number of direct connections of j = number of neighbors of j“Degree distribution” is a n-long vector of the fraction of nodes with degree k (= 1, …, n)Variance of the degree distributionRange of degrees

72

Slide73

Concepts, Goyal pp. 9-24

Geodesic “distance” between i and j is the shortest path between them“Degree centrality” is (degree)/(n-1)“Closeness centrality” is (n-1)/(sum of distances of j from all other nodes)

73

Slide74

Measures of importance of nodes and links

Distance“small world” phenomenonCentralityClustering coefficient (of A) is theProbability that two randomly selected friends of A are friends with each otherMethods of partitioning networks“betweenness”: what happens when a link is removedCan we apply this to bank collapses and systemic risk

74

Slide75

Degrees of separation? 6?

75

Slide76

Importance of Links:Neighborhood overlap =

(Number of nodes who are neighbors of both A and B)/(Number of nodes who are neighbors of either A or B) = 1/6 applied to graph below:

76

Slide77

77

Slide78

Densely-connected, homogeneousparts that are weakly connected to each other

78

Slide79

Homophily

p fraction of all individuals are maleq (=1 - p) fraction of all individuals are femaleConsider a particular edge in this networkIf we independently assign each node the gender male with probability p and the gender female with probability q, then both ends of the edge will be male with probability p^2, and both ends will be female with probability q^2 = (1-p)^2If the first end of the edge is male and the second end is female, or vice versa, then we have a cross-gender edge, so this happens with probability 2pq = 2p(1-p)Test for homophily according to gender as follows:Homophily Test: If the fraction of cross-gender edges is significantly less than 2pq, then there is evidence for homophily.

79

Slide80

Homophily example

5 of the 18 edges in the graph are cross-gender. p = 2/3, q = 1/3. We should compare the fraction of cross-gender edges to the quantity 2pq = 4/9 = 8/18. With no homophily, expect to see 8 cross-gender edges rather than 5, and so this example shows some evidence of homophily.

80

Slide81

Week 3: The Internet

Economides, Nicholas (2007), The Economics of the Internet, in The New Palgrave Dictionary of Economics, London: Macmillan. Economides, Nicholas (2006), The Economics of the Internet Backbone, in Handbook of Telecommunications. Amsterdam: Elsevier Publishers. Easley and Kleinberg, ch. 13, 14, 15.

81

Slide82

Basics on the Internet

Creation; History; Arpanet, NSFStructure, infrastructureTransmission; TCP/IP (transmission control protocol, UDP (user datagram protocol)CommercializationPricing: transit and peeringInternet BackboneMerger of MCI with WCOMBlocked merger of MCI with SprintPresent industry structure

82

Slide83

Originally the Internet was connecting computers of defense contractors and DoD computers

“Packet-switched” not “circuit-switched”Information is cut to small “information packets”Based on simple transmission protocolsTCP/IP (transmission control protocol)Guarantees delivery but may have delaysUDP (user datagram protocol)Immediate delivery, but packets may be lostBecause of nuclear attack threat at the timePackets from A to B are sent in many routesLow security because nodes “knew” each other

83

Slide84

DoD gave it to the National Science Foundation (NSF)

Later, in the early 1990s, commercializationExplosive growth; 1 bil devices (hosts)Backbone (long distance) networkInternet Service Providers (“ISPs”) connecting to backboneResidentialBusiness customersUpstream ISPs

84

Slide85

Explosive growth of the Internet

85

Slide86

Pricing by Internet Backbones (IBPs) to Internet Service Providers (ISPs)

“transit” contract, delivers the whole Internet through a virtual pipe of a maximum bandwidth“peering” allows free exchange of info packets between two ISPs X and Y or two backbonesPeering is limited to traffic originating or terminating at X or Y

86

Slide87

87

Slide88

USA has low broadband penetration and lags behind poorer countries

88

Slide89

BB market structure: US Carrier Traffic in Petabytes per month, May 2005

 Company TrafficMarket Share Among All Providers 1Q20042Q20043Q20044Q20044Q2004A (AT&T)37.1938.6644.5452.3312.58%B36.4836.5041.4151.3112.33%C34.1135.6036.7545.8911.03%MCI24.7125.8126.8630.877.42%E18.0418.8921.0825.466.12%F16.3317.7817.4719.334.65%G16.6715.0414.9315.193.65%Total traffic top 7 networks183.53188.28203.04240.3857.78% Total traffic all networks 313313353416 

89

Slide90

Week 3: Cybersecutity and Privacy

Nicholas Economides et al. (2010), Toward Better Usability, Security, and Privacy of Information Technology, Committee Report, National Academies of Sciences.

90

Slide91

Issues

At present, the incentives of both users and companies on usable security and privacy diverge from actions that would maximize social benefitWhat economic and legal policies can be implemented to change users’ and companies’ incentives so that they are closer to maximizing social benefit?

91

Slide92

Significant deficit in usable security and privacy

Current operating systems of PCs, netbooks, mobile phones, and other devices have significant security deficienciesInterfaces defining security levels are typically very difficult to followUsers are typically unaware of their level privacy (or its lack) in computers

92

Slide93

The Internet has multiplied security problems of connected devices and highly increased the global impact of local lack of security

The Internet was designed for a small number of nodes that knew and trusted each otherPresently we are almost at a billion nodes world-wide with no mutual knowledge and no trustThe Internet has no centralized or Internet Service Provider (ISP)-level securitySecurity issues have an even more severe impact in “cloud computing”Typical users have a very limited understanding of the network capabilities of their computers and the possibilities of abuse in a network setting

93

Slide94

Perspectives of the Issue

The residential user’s point of viewThe business user point of viewA search engine’s point of viewThe network’s (societal) point of viewOperating systems (OSs) and computer manufacturers point of viewISP’s point of viewGlobal issues

94

Slide95

The user’s point of the view

Different computer communications, usage, and storage require different levels of securityDoes the user understand how secure or insecure his communications, usage, and storage are?Does the user understand the financial consequences to him and others of lack of security in these? How can the user’s understanding be enhanced?Does the user have sufficient economic incentives (rewards/punishments) to use sufficient security?What is the balance between the user’s desire for privacy and the user’s desire for communication in social networks?Can we improve usability of security so that users who aim for higher security are able to achieve it? How?

95

Slide96

Private companies have diverse points of view on security and privacy

1. Some businesses (e.g. banks, stock brokers, electronic commerce firms) generally desire higher securityThey have found various (private) solutions attempting to make their transactions more secure2. But advertisers and search engines generally like more disclosure of private information to be able to pitch products closer to a consumer preferences and willingness to payA very secure Internet where users are fully aware of the impact of disclosures of their private information would cut into the profits of these companies

96

Slide97

Private companies perspective (cont.)

3. OS companies typically grew up in the pre-Internet eraOSs originally relied on third parties to beef up securityOSs did not anticipate the potential for global damage created by multiple local infiltrations in a network setting in the presence of even small security flawsUltimately, companies will act to avoid liabilityHow should we tweak the law to change the incentives of OS and computing devices manufacturers? Bottom line: Given the diverse uses of the Internet and the various functions/roles of firms on the Internet, it is unlikely to have a consensus among companies on security and privacy

97

Slide98

From the network’s point of view (societal point of view)

In general, the value of security is much higher for the network than for an individual userUsers, left on their own, will generally tend to achieve lower security than society desiresLow security at a node can lead to catastrophic network events (such as the collapse of attacked nodes or even parts of the Internet) that are much more damaging to society than to the individual nodeThe lack of security at a node is a “negative externality” to the network

98

Slide99

In a network setting there is a crucial divergence between private and social incentives on security

Presently most users do not have sufficient incentives to secure their computers to prevent network-wide catastrophic eventsCan we create sufficient economic incentives so that users aim for sufficient security? How?How can we improve usability of security so that users who aim for higher security are able to achieve it?

99

Slide100

What incentives will induce users to more secure computing behavior?

Positive monetary incentives (pay people)?Awards and other non-monetary positive incentives?Punishments for not meeting a security benchmark?Impose on insecure nodes liability for damages created using their node?Limit access to the Internet if computer fails security test?

100

Slide101

From the OSs’ and computer manufacturers’ point of view

How can we create incentives for computer and operating systems vendors to increase security and maintain it through the useful life of a computer?

101

Slide102

Should we require OSs to include and automatically update for free security/antivirus/anti-phishing?

Should we impose additional liability on operating systems vendors? In the extreme, should we deny computers access to the Internet (except the security checkup and upgrade site) unless they have passed a minimal standard of security?Should we require OSs to disable (as the default) various server functions of new computers, network devices, mobile phones, etc.?

102

Slide103

The ISPs point of view

How can we induce ISPs to play a role in limiting or preventing some attacks while adhering to network openness and net neutrality?

103

Slide104

Global Issues

No matter how good security becomes within the U.S., security issues will remain because of the global nature of the InternetThis underlines the importance of certification of web sites and of measures that improve security in bilateral communications (including web browsing)of requirements on computer and OS manufacturers to increase security and automatically maintain it through the useful life of consumers worldwide

104

Slide105

Policy Changes

To strengthen usable security, what legal and economic policy changes are required at the user level?at the computer and OS manufacturer level?at the web site/server level?at the Internet service provider level?

105

Slide106

Some questions

How will the society deal with the “negative externality” on the network/society created by the lack of usable security of individual nodes?How can we provide positive and negative, monetary and non-monetary incentives to users to eliminate the negative externality?What role can the OSs play? Design? Post-purchase security maintenance?What role can the search engines play in making people aware of privacy issues?What role can ISPs play?

106

Slide107

NETWORK FORMATION

Other Notes pp. 40-84 (to be added)

107

Slide108

Week 4: Network structures and platforms; two-sided pricing

Economides, Nicholas The Economics of Networks, International Journal of Industrial Organization, vol. 16, no. 4, pp. 673-699 (October 1996). Economides, Nicholas, and Charles Himmelberg, (1995), Critical Mass and Network Evolution in Telecommunications, in Gerard Brock (ed.), Telecommunications Policy Research Conference Selected Papers 1995. Shapiro and Varian chapter 7.

108

Slide109

109

Special features of markets with network effects

Increasing returns to scale in consumption (network effects)

A market exhibits

network

effects

when the value of a transaction (or subscription) is higher when more units change hands, everything else being equal

Slide110

110

Special features of markets with network effects: complementarities

In a traditional network, network externalities arise because a typical subscriber can reach more subscribers in a larger network

Slide111

111

Special features of markets with network effects: complementarities

Network effects arise because of complementaritiesWhen customer A makes a phone call to customer B, he uses both AS and BSAlthough goods “access to the switch” AS, BS, …, GS have the same industrial classification and traditional economics would classify them as substitutes, they are used as complements

111

Slide112

In traditional networks

the number of potential transactions increases with network sizeIf every new transaction has positive value, a larger network gives higher value to a subscriber

112

Slide113

One-way and two-way networks

Networks where services AB and BA are distinct are called “two-way” networksTwo-way networks include railroad, road, and many telecommunications networks When one of AB or BA is unfeasible, or does not make economic sense, or when there is no sense of direction in the network so that AB and BA are identical, then the network is called a one-way networkIn a typical one-way network, there are two types of components, and composite goods are formed only by combining a component of each type, and customers are often not identified with components but instead demand composite goodsFor example, radio and TV broadcasting and early paging networks are one-way networks

113

Slide114

A long distance (two-way) network or an ATM (one-way) network

114

Slide115

Virtual network or platform; components Di complementary with components Sj; also has network effects

115

In a

virtual network,

externalities arise because larger sales of components of type D induce larger availability of complementary components S

1

, ..., S

n

, thereby increasing the value of components of type D

Examples:

CPUs & monitors

Users and advertisers in Yellow Pages or Internet search engines

Razors and blades

Cameras and film

Slide116

Financial and other exchanges: network effects arise because market liquidity is desirable

116

Slide117

Top 5 capitalization companies over time: in 2016, all tech

117

Slide118

Top 5 also have another feature: all are platforms

Platforms are matchmakersA platform provides a way for two parties to enter into mutually beneficial exchange or transactionExample: Platform: American ExpressSide 1: MerchantsSide 2: CardholdersService: Payment facilitation (Amex market share 26%)Merchants pay 3%; Cardholder’s rewards 1%Profit to Amex, 1.5+% of transaction’s value

118

Slide119

Examples of platforms

119

Platform

Side 1

Side 2

Service(s)

Uber Driver Rider Transport

Airbnb Apartment User Accommodation

MSFT OS MS-Word User Writing

Apple iOS Phone apps User Various

Google Advertiser User Ads/Search

M-Pesa Money sender money receiver Cell phone

Sony PS3 Game User Game playing

Internet Google Search User Search

Internet Netflix Video user Video

Internet Kindle books Kindle app eBook

YouTube Video creators Video users Video

Facebook User User Discussion, live audio, video

Slide120

120

Stylized model of a platform: money flows

Platform

Users

Apartment owner

s

p

R

A platform may collect from both sides (Airbnb)

or

Collect from one side and subsidize the other (Amex)

Slide121

121

Platform incentives in setting fee sM to other side of the market

Platform

Consumers

a = value (network effect) of extra consumer to a content provider

s

M

R

M

> 0

b = value (network effect) of extra content provider to a consumer

a > b

s

M

> 0

Internet consumers, access platform, and content providers

Game platform consumers, game platform, and games

a < b

sM < 0

PC users, operating system, and applicationsMerchants, credit card platform, and consumers

Content Providers

Slide122

Platforms are taking over …

122

Slide123

Why are platforms taking over? Reason 1: network effects

123

Platforms leverage network effectsNetwork effect: a user will pay more to connect to a larger network

Slide124

The more Uber cabs on the road, the more riders they will attract and vice versa

124

Uber can increase scale and reap network effects

Slide125

Winner-takes-most world

Network effects create very significant sales- and profits- inequalitySuccesses: Windows, iPhone, Facebook, Adobe, LinkedIn, Visa, MasterCard, Amex, AlibabaFailures: Betamax, IBM OS/2, Blackberry, Discover Card

125

Slide126

Reason 2: Platforms usually have fewer employees and less fixed investment than traditional companies

126

Slide127

Platforms have high profits because they have less fixed investment

Uber, the largest taxi company, owns no carsAirbnb, the largest accommodation provider, has no real estateAlibaba, the most valuable retailer, has no inventoryFacebook, the most popular media company, creates no content

127

Slide128

Traditionally, the focus of the company was internal

Tweaking the value chain to make perfect productsIn platforms, the focus is externalA platform tries to bring together as many as possible from both (or all) sides, match them and create transactionsNeed to minimize the conflicts among them

128

Slide129

Platforms disrupt traditional business

Amazon displaced bookstores and is displacing retailers (and possibly grocers)Netflix displaces subscription cable TVGoogle, Bing displaced the “yellow pages” guides

129

Slide130

Not easy to do it right

Microsoft almost killed the Mac in the 1980s by attracting more developers to write applications for WindowsApple has almost killed Microsoft’s cellphones, butAndroid (Google) is taking over from Apple as dominant phone platform

130

Slide131

131

Technology platforms are the hubs of the value chains in technology industries

Examples of technology platforms:

Microsoft Windows (PC operating systems)

Intel processors (PC hardware)

Sony PlayStation (game consoles)

A platform forms the framework on which complementary goods (applications) attach (run)

Slide132

132

Complementarity between a multisided platform and applications

A technology platform may be proprietary or open sourcePlatform examples: Windows, Linux, iOSApplication examples: MS-Office, Open Office, iApps

Slide133

133

Prices and fees in two-sided markets

p

1 s1 p0s2 s3p2 p3

p

0

user platform price

p

1

,

p

2

,

p

3

user application prices

s

1

,

s

2

,

s

3

fees to platform (or subsidies to applications)

Slide134

134

Firms can make money from either side of a network or from both sidesfrom a server or a client (example: Adobe Acrobat and Adobe Reader)from a caller (typical) or a receiver (800 numbers) of a phone call or from both (cellular in U.S.)Internet backbones collect money from both parties that send and receive traffic (when not in a peering relationship)The availability of prices on both sides of the network allows for complex pricing strategies, and, depending on the dynamics and market shares on the two sides of the market, can be used strategically to enhance and leverage a firm’s strong strategic position on one side of the network

Two-sided pricing in markets

with network effects

Slide135

Weeks 5: Network Effects Under (Technical) Compatibility

Economides, Nicholas The Economics of Networks, International Journal of Industrial Organization, vol. 16, no. 4, pp. 673-699 (October 1996). Economides, Nicholas, and Charles Himmelberg, (1995), Critical Mass and Network Evolution in Telecommunications, in Gerard Brock (ed.), Telecommunications Policy Research Conference Selected Papers 1995. Shapiro and Varian chapter 7.

135

Slide136

136

Stylized model for the Internet as a platform: money flows

Platform

(ISP)

Consumers

Content /

Applications

Providers

s

p

R

Slide137

137

Platform incentives in setting fee sM to other side of the market

Platform

Consumers

a = value (network effect) of extra consumer to a content provider

s

M

R

M

> 0

b = value (network effect) of extra content provider to a consumer

a > b

s

M

> 0

Internet consumers, access platform, and content providers

Game platform consumers, game platform, and games

a < b

sM < 0

PC users, operating system, and applicationsCredit card issuing banks, credit card platform, and consumers

Content Providers

Slide138

Complementarity and compatibility

Links on a network are potentially complementary, but it is compatibility that makes complementarity actualSome network goods and some vertically related goods are immediately combinable because of their inherent properties However, for many complex products, actual complementarity can be achieved only through the adherence to specific technical compatibility standardsThus, many providers of network or vertically-related goods have the option of making their products partially or fully incompatible with components produced by other firms This can be done through the creation of proprietary designs or the outright exclusion or refusal to interconnect with some firmsAs we will see, it is not always in the best interests of a firm to allow full compatibility of its products with those of its competitors

138

Slide139

Network effects

NatureHow they ariseEffects Consequences on competition, market structure and profits

139

Slide140

Sources of Network Effects (1)

In traditional non-network industries, the willingness to pay for the last unit of a good decreases with the number of units sold. This is called the law of demand, and is traditionally considered to hold for almost all goodsHowever, the existence of network effects implies that, as more units are sold, the willingness to pay for the last unit may be higherThis means that for network goods, the fundamental law of demand is violated: for network goods, some portions of the curve demand can slope upwardsFor some portions of the demand curve, as sales expand, people are willing to pay more for the last unit

140

Slide141

Sources of Network Effects (2)

The law of demand is still correct if one disregards the effects of the expansion of sales on complementary goodsBut, as increased sales of a network good imply an expansion in the sales of complementary goods, the value of the last unit increasesCombining the traditional downward slopping effect with the positive effect due to network expansion can result in a demand curve that has an upward-slopping partThe key reason for the appearance of network effects is the complementarity between network components

141

Slide142

Sources of Network Effects (3)

Depending on the network, the network effect may be direct or indirectWhen customers are identified with components, the network effect is direct Consider for example a typical two-way network, such as the local telephone networkIn this n-nodes 2-way network, there are n(n - 1) potential goods. An additional (n + 1th) customer provides direct network effects to all other customers in the network by adding 2n potential new goods through the provision of a complementary link to the existing linksIn typical one-way networks, the network effect is only indirect When there are m varieties of component A and n varieties of component B (and all A-type goods are compatible with all of B-type), there are mn potential composite goodsAn extra customer yields indirect network effects to other customers, by increasing the demand for components of types A and B

142

Slide143

Sources of Network Effects (4)

Exchange networks (financial networks such as the NYSE and NASDAQ, commodities, futures, and options exchanges as well as business to business “B2B” exchanges) also exhibit indirect network effectsThere are two ways in which these network effects arise:Network effects arise in the act of exchanging assets or goods Network effects may arise in the array of vertically related services that compose a financial transaction.These include the services of a broker, bringing the offer to the floor, matching the offer, etc. The second type of network effects are similar to other vertically-related markets The first way in which network effects arise in financial markets is more importantThe act of exchanging goods or assets brings together a trader who is willing to sell with a trader who is willing to buyThe exchange brings together the two complementary goods, “willingness to sell at price p” (the “offer”) and “willingness to buy at price p” (the “counteroffer”) and creates a composite good, the “exchange transaction”

143

Slide144

Networks in finance

ReferencesEconomides, Network Economics with Application to Finance (1993) Economides and Schwartz, Electronic Call Market Trading (1995)Economides and Schwartz, Equity Trading Practices and Market Structure: Assessing Asset Managers’ Demand for Immediacy (1995)Lange and Economides  A Parimutuel Market Microstructure for Contingent Claims Trading (2000)

144

Slide145

Sources of Network Effects (5)

The two original goods were complementary and each had no value without the other oneClearly, the availability of the counteroffer is critical for the exchange to occurPut in terms commonly used in Finance, minimal liquidity is necessary for the transaction to occurFinancial and business-to-business exchanges also exhibit positive size externalities in the sense that the increasing size (or thickness) of an exchange market increases the expected utility of all participantsHigher participation of traders on both sides of the market (drawn from the same distribution) decreases the variance of the expected market price and increases the expected utility of risk-averse tradersHigher liquidity increases traders’ utility

145

Slide146

Network Effects Under Compatibility and Perfect Competition (1)

Let the willingness to pay for the nth unit of the good when ne units are expected to be sold be p(n; ne)n and ne are normalized so that they represent market coverage, ranging from 0 to 1, rather than absolute quantitiesWillingness to pay p(n; ne) is a decreasing function of n because the demand slopes downwardp(n; ne) increases in ne; this captures the network externalities effect, i.e., that the good is more valuable when the expected sales ne are higher

146

Slide147

Network Effects Under Compatibility and Perfect Competition (2)

At a market equilibrium of the simple single-period world, expectations are fulfilled, n = ne, thus defining the fulfilled expectations demand p(n, n)Each willingness-to-pay curve p(n, nie), i = 1, 2, ..., shows the willingness to pay for a varying quantity n, given an expectation of sales ne = nie. At n = nie, expectations are fulfilled and the point belongs to p(n, n) as p(nie, nie)Thus p(n, n) is constructed as a collection of points p(nie, nie)

147

Slide148

Critical mass under perfect competition

c, p

n

n = actual market share

ne = expected market share

p = willingness to pay, c =marginal cost

E2

0.3

1

Connect all points where n = ne resulting in the

fulfilled expectations demand p(n, n).

As c decreases because of tech. change, p = c has no solution for c > 0.25. At c = 0.25, the network starts at the

critical mass no = 0.4.

0.4

0.2

0.2

0.3

0.4

E3

E4

0.25

For lower c (e.g. c = 0.18), three solutions of p = c: 0, 0.2, 0.8

0.18

0.8

Slide149

When there are strong network effects, demand can slope upwards

The “law of demand,” i.e., that higher output can be sold only at lower prices, is violated when there are significant network effects: demand curve can slope upwards

149

Slide150

Economides and Himmelberg, Critical Mass and Network Evolution in Telecommunications (1995) show that

the fulfilled expectations demand is increasing for small n if either one of three conditions hold: (i) the utility of every consumer in a network of zero size is zero; or (ii) there are immediate and large external benefits to network expansion for very small networks; or (iii) there is a significant number of high-willingness-to-pay consumers who are just indifferent on joining a network of approximately zero sizeThe first condition is straightforward and applies directly to all two-way networks, such as the telecommunications and fax networks where the good has no value unless there is another user to connect toThe other two conditions are a bit more subtle, but commonly observed in networks and vertically-related industries

150

Slide151

The second condition holds for networks where the addition of even few users increases significantly the value of the networkA good example of this is a newsgroup on an obscure subject, where the addition of very few users starts a discussion and increases significantly its value The third condition is most common in software marketsA software application has value to a user even if no one else uses it The addition of an extra user has a network benefit to other users (because they can share files or find trained workers in the specifics of the application), but this benefit is smallHowever, when large numbers of users are added, the network benefit can be very significant

151

Slide152

Possibility that the demand does not start at zero

For goods that have a positive stand–alone value k without network effects, the demand starts at (0, k).

152

Slide153

Critical Mass

When the fulfilled expectations demand increases for small n, we say that the network exhibits a positive critical mass under perfect competition.If we imagine a constant marginal cost c decreasing as technology improves, the network will start at a positive and significant size no (corresponding to marginal cost co)For each smaller marginal cost, c < co, there are three network sizes consistent with marginal cost pricing: a zero size network; an unstable network size at the first intersection of the horizontal through c with p(n, n); and the Pareto optimal stable network size at the largest intersection of the horizontal with p(n, n)

153

Slide154

154

Market penetration of innovations is much faster in network industries than in non-network industries

Penetration

time

Diffusion of an innovation with and without network effects

Non-network industry

network industry

Slide155

Multiplicity of Equilibria

The multiplicity of equilibria is a direct result of the coordination problem that arises naturally in the typical network externalities modelThe existence of an upward slopping part of the demand curve and the multiplicity of equilibria even under perfect competition also allows for a network to start with a small size and then expand significantlySuppose, for example, that marginal cost is at c < co and a new invention creates a new product with significant network effects Then, it is possible that the industry starts at the left intersection of the horizontal at c with p(n, n) as expectations are originally low, and later on advances suddenly and quickly to the right intersection of the horizontal at c with p(n, n)Thus, the multiplicity of equilibria in network industries can lead to sudden significant expansions of network size

155

Slide156

Efficiency (1)

In the presence of network externalities, it is evident that perfect competition is inefficient The marginal social benefit of network expansion is larger than the benefit that accrues to a particular firm under perfect competitionPerfect competition (p = MC) will provide a smaller network than is socially optimal, and, for some relatively high marginal costs, perfect competition will not provide the good while it is socially optimal to provide it

156

Slide157

Gross benefit (area under the demand) is B(n, n)

Marginal benefit of network expansion

 

157

Slide158

Efficiency (2)

Since perfect competition is inefficient, state subsidization of network industries is beneficial to societyThe Internet is a very successful network that was subsidized by the US government for many yearsThe subsidized Internet was aimed at promoting interaction among military research projects During the period of its subsidization, almost no one imagined that the Internet would become a ubiquitous commercial networkThe foundation of the Internet on publicly and freely available standards has facilitated its expansion and provided a guarantee that no firm can dominate it

158

Slide159

159

Complex pricing: externalities internalized or not?

Often the additional subscriber/user is not rewarded for the benefit that he/she brings to others by subscribingHence there may be “externalities,” i.e., benefits not fully intermediated by the marketIn some cases, externalities are fully intermediated through non-linear pricingExample: Cantor Fitzgerald pricing towards Salomon Brothers in secondary U.S. bonds market (before 2001)Typical trader paid $20 per $1 million face valueSalomon paid $1 per $1 million face value plus a fixed feeWhy? Salomon brought immense liquidity to the secondary market because it controlled 40% of the primary market

159

Slide160

Mathematical example

p(q, ne) = (1 – q)neq: actual units soldne: expected size of salesFulfilled expectations demand: p(n, n) = (1-n)nMarginal benefit of network expansion= n(1 - n) + n(1 - n/2) = n (2 – 3n/2)Notice that dB(n, n)/dn > p.

 

160

Slide161

161

The marginal benefit of network expansion is always higher than the willingness to pay of the last participant

Slide162

If the good has a stand-alone value k > 0

p(n, ne) = (1 - n)(k + ne)p(n, ne) = c → n = 1 – c/(k + ne).Can be thought as mapping ne to n:n = 1 – c/(k + ne)With fixed point (n = ne): n*(c) = 1 – c/(k + n*(c)), i.e., n*(c) = [1-k+√((1+k)^2-4c))]/2

162

Slide163

Fulfilled expectations

163

Slide164

If the good has a stand-alone value k > 0 (cont.)

p(n, n) = (1 - n)(k + n)dB(n, n)/dn = (1-n)(k+n)+n(1-n/2)

164

Slide165

165

Adoption S-curves from various network industries

Slide166

Platforms game

1. Download Wolfram CDF Playerhttp://www.wolfram.com/cdf-player/1Gig download; do it at a fast connection; give it some time to install2. Download the simulationhttp://www.stern.nyu.edu/networks/Graphical%20Profits%20-%20No%20Math%20Game%201.1.cdf

166

Slide167

Weeks 6-7: Technical Standards Competition and the Compatibility Decision

Paul David and Shane Greenstein (1990), The Economics of Compatibility StandardsNicholas Economides and Fredrick Flyer, (1998) Compatibility and Market Structure for Network Goods

167

Slide168

Why is technical standards competition important?

Because of network effectsNetwork effects create inequalityCompeting standards that have small market share can be marginalizedWhen a company chooses to be incompatible, it makes a big difference where it stands in the inequality chain of incompatible firms

168

Slide169

Technical standards competition

VHS vs. BetaWindows vs. Mac vs. LinuxMP3 vs. WMA vs. RealAudioHD DVD vs. Blu-RayiPhone vs. Android vs. Windows 8

169

Slide170

Technical Compatibility

when various links and nodes on the network can be costlessly combined to produce demanded goodsTwo complementary components A and B are compatible when they can be combined to produce a composite good or serviceExample: we say that a VHS-format video player is compatible with a VHS-format tapeTwo substitute components A1 and A2 are compatible when each of them can be combined with a complementary good B to produce a composite good or service Example: two VHS tapes are compatible; two VHS video players are compatibleSimilarly we say that two software products are compatible (more precisely two-way compatible) when they each can read and write files in a common format Compatibility may be one-way when the files of format B1 of software A1 can be read by software A2 , but the files format B2 of software A2 cannot be read by software A1Moreover, compatibility may be only partial in the sense that software A1 is able to read files of format B2 but unable to write files in that format.

170

Slide171

171

Dichotomy in markets with network effects (1)

Full compatibility networks

Voice telecommunications (by regulation)

Internet data communications (by design)

Fax (by design)

Cars and gasoline (by market evolution)

Tables and chairs (by market evolution)

Slide172

172

Dichotomy in markets with network effects (2)

Incompatible networksOperating Systems for PCs (Windows, Mac OS X, Linux)Game platforms (Xbox, Sony, Nintendo)Digital audio formats (iPod, Windows Media Player “WMA,” MP3, RealAudio)High definition DVDs (HD-DVD, Blu-ray)Video players (Betamax, VHS)Information servers (Google, MSN, Yahoo, yellow pages)Financial and other exchanges

Slide173

173

Path-dependence is the dependence of a system or network on past decisions of producers and consumers

Today’s sales of Windows are path-dependent because they depend on the number of Windows sold earlier (the installed base Windows).

The existence of an installed base of consumers favors an incumbent

However, competitors with significant product advantages or a better pricing strategy can overcome the advantage of an installed base

Example: VHS overcame Beta after six years of higher installed base by Beta

Sony’s mistakes in disregarding network externalities and not licensing the Beta format

JVC’s widespread cheap licensing of VHS

A low-end, low-price VHS player can contribute as much to the network effect as a high-end high-price Beta player

Slide174

Strategic Choices of Technical Standards and Compatibility In Network Industries

Standards Wars (1)A key strategic decision for a firm is the extent to which it will be compatible with other firmsA network good has higher value because of the existence of network effectsDifferent firms conforming to the same technical standard can create a larger network effect while still competing with each other in other dimensions (such as quality and price)The decision to conform to the same technical standard is a strategic oneA firm can choose to be compatible with a rival and thereby create a larger network effect and share it with the rival. A firm could alternatively choose to be incompatible with the rival, but keep all the network effects it creates to itself

174

Slide175

Standards Wars (2)

Which way the decision will go depends on a number of factors:In some network industries, such as telecommunications, interconnection and compatibility at the level of voice and low capacity data transmission is mandated by lawThe decision will depend on the expertise that a firm has on a particular standard (and therefore on the costs that it would incur to conform to it)The choice on compatibility will depend on the relative benefit of keeping all the network effects to itself by choosing incompatibility versus receiving half of the larger network benefits by choosing compatibility.The choice on compatibility depends on the ability of a firm to sustain a dominant position in an ensuing standards war if incompatibility is chosenThe compatibility choice depends on the ability of firms to leverage any monopoly power that they manage to attain in a regime of incompatibility to new markets.

175

Slide176

Standards Wars (3)

Standards may be defined by the government (as in the case of the beginning of the Internet), a world engineering body (as in the case of the FAX), an industry-wide committee, or just sponsored by one or more firmsEven when industry-wide committees are available, firms have been known to introduce and sponsor their own standardsIncentives of firms to choose to be compatible with others; coordination game

176

Slide177

Standards war leading to compatibility (1)

Full compatibility at both non-cooperative equilibriaStandard 1 is a non-cooperative equilibrium if a > e, b > d. Similarly, standard 2 is an equilibrium if g > c, h > f. In this game, we will assume that firm i has higher profits when “its” standard i get adopted, a > g, b < h. Profits, in case of disagreement, will depend on the particulars of the industry. One standard assumption that captures many industries is that in case of disagreement profits are lower than those of agreeing on either standard, e, c < g; d, f < b

177

Slide178

Standards war leading to compatibility (2)

There is no guarantee that the highest joint profit standard will be adoptedSince consumers surplus does not appear in the matrix, there is no guarantee of total surplus maximization at equilibrium

178

Slide179

Standards war leading to incompatibility

Compatibility with competitors brings higher network externality benefits (“network effect”) and therefore is desirable. At the same time, compatibility makes product X a closer substitute to competing products (“competition effect”), and it is therefore undesirable. In making a choice on compatibility, a firm has to balance these opposing incentives. Firms want to differentiate their products because they want to avoid intense competition.In a network industry, the traditional decisions of output and price take special importance since higher outputInequality in market shares and profitability is a natural consequence of incompatibilityUnder incompatibility, network externalities act as a quality feature that differentiates the products

179

Slide180

180

Markets with strong network effects where firms can choose to be incompatible are “winner-takes-most” markets

In these markets, there is extreme market shares and profits inequalityThe market share of the largest firm can be a multiple of the market share of the second largest, the second largest firm’s market share can be a multiple of the market share of the third, and so onExample: 66%, 22%, 7%, 2.%, 1%, … Geometric sequence of market shares implies that, even for small n, the nth firm’s market share is tinyExamples: PC operating systems market; software applications marketsWhy? A firm with a large market share has more complementary goods and therefore its good is more valuable to consumersWhy “winner-takes-most” and not “winner-takes-all”?Because to “take all” requires an undesirable cut in price

Slide181

“Winner-takes-most” markets

When fixed costs are small, a very large number of firms can survive, but there is tremendous inequality in market shares, prices, and profits among themExamples of this market structure are the PC operating systems market and many software applications marketsSetup of Economides and Flyer (1998)All firms produce identical products, except for what value is added to them by network effectsNo firm has any technical advantage in production over any other with respect to any particular platform and no production costs“Pure network goods” where there is no value to the good in the absence of network externalitiesConsumers are differentiated in their willingness to pay for the network good

181

Slide182

182

With network effects, natural inequality: “winner-takes-most”

Markets for incompatible products have inequality

Hits in blogs

Hits in Internet engines

Market share of firms in traditional Yellow pages

Size distribution of connections of Internet hosts

Because of

natural inequality

in the market structure of network industries, there should be no presumption that anti-competitive actions are responsible for the creation of market share inequality or very high profitability of a top firm

No anti-competitive acts are

necessary

to create this inequality

Slide183

Profits inequality and network effects under incompatibility. k = value of the good with no network effects

183

Slide184

Herfindahl-Hirschman (H) Index for Different Intensities of Marginal Network Externality 1/k and Numbers of Firms S Under Incompatibility

∞ .463No network effect (1/k = 0) implies equal firm shares, si = 1/n and H index:H = Σin=1 si2 = 1/n

No network effect 0 .333.2.1 0

184

Slide185

185

Inequality of market shares and prices under incompatibility for pure network goods (k = 0)

Slide186

Profits, Consumers’ and Total Surplus under incompatibility for pure network goods (k = 0)

Ratios of profits of consecutive firms range from 15 to 20

186

Slide187

Monopoly May Maximize Total Surplus

When here are fewer firms in the market there is more coordination and the network effects are largerAs the number of firms decreases, the positive network effects increase more than the dead weight loss, so that total surplus is maximized in a monopoly! Total surplus is highest while consumers’ surplus is lowest in a monopolyThis poses an interesting dilemma for antitrust authoritiesShould they intervene or not? In non-network industries, typically both consumers’ and total surplus are lowest in a monopolyIn this network model, total maximizing consumer’s surplus would imply minimizing total surplus

187

Slide188

No Anti-Competitive Acts are Necessary to Create Market Inequality

In network industries, free entry does not lead to perfect competitionAntitrust and competition law have placed a tremendous amount of hope on the ability of free entry to spur competition, reduce prices, and ultimately eliminate profits In network industries, free entry brings into the industry an infinity of firms but it fails miserably to reduce inequality in market shares, prices and profitsEntry does not eliminate the profits of the high production firmsImposing a “competitive” market structure is likely to be counterproductive

188

Slide189

Strategic Choice of Compatibility in Duopoly

Equilibria in a Two-Firm Industry

k

189

Slide190

190

Intense competition on which firm will create the top platform and reap most of the benefitsExample: Schumpeterian races for market dominance among dot-coms in 1999-2000Very high valuation of dominant vs. other dot-com firms in that period; Wall Street perceptionStrategic effect: firms advertised very intensely and subsidized consumers to achieve a dominant position

Competition for the market takes precedence over competition in the market

Slide191

Week 7: Bottlenecks and Interconnection Pricing

Nicholas Economides, Giuseppe Lopomo and Glenn Woroch, Strategic Commitments and the Principle of Reciprocity in Interconnection Pricing, chapter 5 (pp. 62-99), in Gary Madden (ed.) The Economics of Digital Markets, Edward Elgar (2009).Nicholas Economides, Giuseppe Lopomo and Glenn Woroch, Regulatory Pricing Policies to Neutralize Network Dominance, Industrial and Corporate Change, vol. 5, no. 4, pp. 1013-1028, (1996).

191

Slide192

192

One-sided bottlenecks

The early (1900) AT&T owned links 1 (long distance) and 2 (local), but did not allow independent firms which possessed link 3 to interconnect at B and provide part of the long distance service ABCFor over two decades in the beginning of the 20th century, AT&T refused to interconnect independent local telecommunications companies to its long distance network, unless they became part of the Bell System, resulting in 89% market share for AT&T by 1935 from about 50% in 1914 In the 1970s AT&T controlled 89% of local lines and almost all long distance (LD)AT&T faced competition in LD by MCI which did not have local linesAT&T provided low quality interconnection to local lines to MCI

Slide193

Interconnection Pricing;Vertical Price Squeeze

Assume use of link 1 is required by links 2, 3Goods 12 and 13 and substitutes Assume link 1 is monopolized by firm A which also owns link 2, while firm B owns link 3Firm B owns only link 2 and needs to buy use of link 1 from AFirm A sets the price p(12) of end-to-end service 12 and the “interconnection” or “access” price p(1) of link 1 when sold to firm BThe price-to-cost margin of B is p(12) – p(1), both controlled by firm A, and can be made as small as firm A wantsFirm B can be marginalized of driven out of business

193

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194

Two-sided bottlenecks

Each of two firms is monopolist, each with a different bottleneck, and each firm requires the other’s bottleneck to produce its outputTwo local telephone companies, each customer subscribes only to one local telephone company, and each company requires the other’s network to complete callsCalls originate at A1, A2 and terminate at B1, B2.Termination charges at B1, B2 for calls from the rival network can be used to disadvantage and foreclose the rival network

Example: New ZealandProblem in U.S. telecommunications solved by setting equal termination fees (reciprocity); unresolved in ATM, credit card, and other unregulated networks

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195

Leveraging of market power across markets

Various types of exclusionary arrangements

Instruments:

Technical standards

Bundling and other pricing strategies

Non-price discrimination strategies (raising rivals’ costs)

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196

Limited effects of antitrust policy

In markets with strong network effects, once few firms are in operation, the addition of new competitors, even under free entry, does not change the market structure in any significant way

Although eliminating barriers to entry can encourage competition, the resulting competition may not significantly affect market structure

In markets with strong network effects, antitrust authorities may not be able to significantly affect market

structure

by eliminating barriers to entry

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197

Leveraging Example

In the middle 1980s, Nintendo refused to allow third party games (software) to play on its game console (hardware) unless the software manufacturers agreed not to write a similar game for two years for competing game systemsNintendo used the dominance of the game market at the time to coerce developers to write software just for its platform, and thereby to increase the value of the Nintendo virtual network (of hardware and software) Practice stopped under threat from DOJ

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198

Issues in “after-markets” where consumers are “locked-in” in a durable good or service arises out of commitments of durable nature

Examples

refusal of Kodak to supply to repair companies replacement parts for Kodak photocopiers

lack of email address portability for ISPs

lack of number portability for wireless phones long after it was feasible

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199

Example from computing industry: subsidizing complementary goods

Firm A chooses to make its product incompatible with others

Firm A subsidizes firms that produce complementary goods

Alternatively, firm A subsidizes its division that sells complementary goods

As a result

The value of firm A’s product increase

The entry hurdle of firm A’s rivals increases

Possible creation of market power, but action also has pro-competitive justification

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200

Incompatibility is a necessary condition for possible creation of market powerKey to increasing social welfare: public standards, compatibilityBut, it is very difficult for US antitrust authorities to intervene and/or define standardsDifferent in the EU which is trying to impose compatibility between Microsoft and Sun servers (MS and Linux servers are compatible)Imposing compatibility may reduce incentives to innovateThe “dynamically incorrect” standard may be chosenIf forced to choose a single standard, the FCC would have chosen TDMA or GSM at the first PCS auctionsCDMA proved more efficient later on

Impose compatibility?

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201

Dynamic efficiency issues

Static efficiency may lack in dynamic efficiency

Possibility of a lock-in to a technology which, when decisions taken in every period, looks optimal given past decisions, but is sub-optimal if decisions are delayed and all the decisions are taken at once

Lock-in may occur as a consequence of the race to be a dominant firm in a network industry

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202

Innovation issues

Efficiency and intensity of innovation in monopoly compared to competition and oligopoly is an open question in economics

Slide203

Regulation?

203

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204

When should regulation be used?

Regulation it is best suited for industries with well defined and not changing products and servicesRegulation is not well suited in industries with rapid technological change and frequently changing product definitionsRegulation can be used by the regulated companies to keep prices relatively high, as exemplified by telecommunications regulationOften regulators are very close to the interests of the regulated parties rather than to the interests of the publicOften regulators are not well informed about key variables as well as changes in the industry

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205

When should regulation be used?

Regulators at both the state and federal levels are under pressure and influence by both the executive and the legislative part of government, and cannot be as impartial as a court

There is a tendency for regulators to expand their reach into related and new markets

These drawbacks can create significant surplus loss due to regulation

However, regulatory rules can and should be used effectively and appropriately in cases of dominance or monopolization of essential network bottlenecks to assure

that firms do not leverage their monopoly to adjacent markets

that prices are not too high

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Week 8

Applications of platforms(a) Taxicabs, Uber, Lynx(b) Electric cars

206

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(a) Taxi cabs as a two-sided network

Traditionally taxicabs (yellow cabs)are hailed on the streettheir retail fares are regulatednumber of licenses is regulatedlittle or no entry allowed

207

Slide208

Traditional taxicabs

When licenses are transferable, lack of entry while demand expands can lead to very high value of licenses (over $1mil in NYC)price of license is a fixed cost to the driverDrivers can be impoverished while license holders get rich

208

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Parallel markets

Pre-arranged ridesTown cars“Black cars”Liveries (in NYC above 96th Street and outside Manhattan)Each fleet uses incompatible dispatch systems

209

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Reasons for entry of rivals

High fares, high potential profitsPotential for better coordination / matching of supply (cars) and demand (users) through a hailing platformOf course, the latter could be implemented by yellow cabs

210

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New entrants, direct substitute for taxicabs

Locations of cabs online using an appCustomers “hail” cabs with the app based on location/distanceAdvantage: “see” free cabs further than the usual 2-3 blocksNo price regulationUber charges according to demand/supply imbalanceRegulatory issues at some municipalities

211

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“Price fixing” issue

Uber besides matching cars to users, also sets the same price for two or more different cars responding to the same user plus destinationSince the drivers are officially independent actors, Uber has been accused of price fixing, an antitrust violation

212

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Since rival taxicab networks are incompatible

We expect very significant inequalities in market shares, prices, and profits

213

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(b) Electric cars as a two-sided network

Network issue because electric cars have a limited range per charge and therefore need a network of charging stationsAlternativesFast charges at gas stations, home and officeReplaceable batteries at gas stationsPrecedent in electric taxicab fleets in New York and PhiladelphiaCars purchased from GE without a battery and Hartford Electric Light Company provided batteries and replacement

214

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Compatibility issues

Technical standards of charging stations and batteries

215

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Week 8-9: (a) Payment Systems in US and EU; (b) mobile banking in Africa;

Nicholas Economides (2009), Competition Policy Issues in the Consumer Payments Industry, in Robert E. Litan and Martin Neil Baily, eds., Moving Money: The Future of Consumer Payment Brookings Institution. Alan S. Frankel and Allan L. Shampine, The Economic Effects of Interchange Fees, Antitrust Law Journal 73, no. 3: 627–73. US DOJ press release, Settlement with Visa and MasterCard; United States v. American Express. Nicholas Economides and with David Henriques (2012), To Surcharge or Not to Surcharge? A Two-Sided Market Perspective of the No-Surcharge Rule, NET Institute Working paper #11-03, August 2011

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217

(a) Payment Systems, Electronic Transaction Facilitation in US & EU

Bank cards facilitate transactions between merchants and consumers

Some cards also offer credit

The market for facilitation of transactions is dominated by the card

networks

Visa and MasterCard

Stand-alone cards American Express and Discover smaller

Visa 42%, MasterCard 29%, American Express 24%, Discover 5% (US market shares)

Card networks collect significant fees from merchants to facilitate transactions

Cards charge (non-credit-related) fees (primarily to merchants) significantly above cost

Some estimate total cost only 13-15% of revenue

Fees $30-48 billion per year in U.S.

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218

Three-parties Setup (American Express, Discover)

American Express

Merchant

Consumer

Goods worth $100

$97

$100

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219

Four-parties Setup (MasterCard, Visa)

Acquiring Bank

Issuing Bank

Merchant

Consumer

Goods worth $100

$98

$98.5

$100

Interchange fee

Visa network

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220

Three Markets in Sequence in Four-parties Setup

Acquiring Bank

Issuing Bank

Merchant

Consumer

Goods worth $100

Market I

Interchange fee

Visa network

Market II

Market III

Market III is generally considered effectively competitive, but since the interchange fee is the marginal cost of the acquiring bank, the interchange fee is a floor to the fees merchants pay

In Market II,

the network

sets the maximum interchange fee

Practically no bank in the network deviates from it

No market determination of the interchange fee in bilateral markets between an acquiring and an issuing bank

Issuing banks have market power in Market I but manage to make merchants pay through markets II and III rather than make card holders pay them directly

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221

Credit Card Networks Have High Price-to-cost Markups Despite Non-Dominant-Firm Market Shares

Very significant markup of price above cost

Very unlikely that consumers receive from card networks anything approaching the fee levels charged to merchants

Comparable with profit rates of Microsoft and Intel

But these have an almost monopoly market share

How

does Visa with 42% market share and MasterCard with 29% market share achieve such high markups and market power?

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222

Networks make sure that

the consumers do not face directly the cost of their transactions so that they cannot choose to use the lowest fee card

the merchants cannot charge different prices to reflect the card fees if consumers use different cards and different cards have different fees

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223

The card networks

Impose contractual obligations on merchants that

do not allow merchants to respond to differences in fees across cards

do not allow the card holders to choose which card to use based on the cost the transaction imposed on the merchant (since the merchant is not allowed to pass this along)

Effects

Card transactions are subsidized by cash transactions

High cost card transactions are subsidized by low cost card transactions

Significant market distortion

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224

Instruments Used by Card Networks to Restrict Competition and Achieve High Fees (1)

No surcharge rule

(Visa contract, 2008)

A merchant can charge the same for a Visa transaction as for cash

If a merchant offers a discount for cash compared to Visa, he cannot offer the same discount to a “comparable card” (MasterCard)

If a merchant offers a discount to a “comparable card,” he has to offer the same discount to Visa (“most favored customer” rule)

Effect of the rule: the merchant cannot offer better terms to customers who buy with MasterCard than with Visa (although it may make sense to do so if MasterCard’s fees are lower)

No price flexibility allowed in the merchant’s pricing

As if Coca Cola imposed the requirement that a can of Pepsi be sold at the same price as a “comparable” can of Coke

Only option for the merchant is not to accept a network card if he does not like the pricing

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225

Instruments Used by Card Networks to Restrict Competition and Achieve High Fees (2)

No discrimination rule

MasterCard:

“Merchants may not engage in acceptance practices or procedures that discriminate against, or discourage the use of, MasterCard cards in favor of any other card brand ....”

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226

Instruments Used by Card Networks to Restrict Competition and Achieve High Fees (3)

Card networks relied on a most-favored-customer (“MFC”) rule so that all prices among “comparable network cards” were the same

IO theory has established that most-favored-customer rules can be used to facilitate price increases to collusive levels, Salop (1986)

Reason: Under MFC rules, a firm will lose more revenue if it cuts price to a customer than in the absence of MFC rules

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227

High fees are also shielded through the “honor all cards” rule

Debit networks (typically with PIN verification) offer lower merchant fees

Debit cards of MasterCard and Visa also offer much lower fees than the signature-based credit cards

To avoid loss of profits in credit cards, the networks impose the requirement that if a merchant accepts a Visa (say debit) card, he also has to accept

all

Visa cards (part of “honor all cards” rule)

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228

Networks imposed the

Honor all cards rule

A merchant accepting a Visa debit card issued by Citibank also

has to accept

Visa Debit cards issued by any other Visa network bank

Any

Visa products, such as Visa credit cards (tying)

Visa's rules stated that “[t]he Merchant shall promptly honor all valid Visa cards when properly presented as payment ....”

Anti-competitive consequences of tying

What if Microsoft said that if your corporation buys Windows, it also has to buy MS-Office

Or if you buy Dell servers you also have to buy Dell laptops?

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229

Effects of old equilibrium

Card transactions are subsidized by cash transactionsHigh cost card transactions are subsidized by low cost card transactionsNetworks have incentives to keep increasing interchange fees to attract more issuers

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230

Proposed Changes in the Market Between Merchants and Acquiring Banks (Market III)

Allow for competition between branded networks

Abolish the “no surcharge” rule

Abolish the “no discrimination” rule

Abolish the “honor all cards” rule

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231

Proposed Changes in the Market Between Acquiring and Issuing Banks (Market II)

Allow the market between issuers and acquirers to determine the interchange fee

Bilateral negotiations between pairs of banks (issuer and acquirer)

Start from a par position (zero interchange fee)

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232

Hold-out problem

An issuer with very valuable potential transactions demands monopoly fee from acquirers

Not a problem if monopoly power of issuer is legitimate

Isolated problem if the proposal is adopted rather than market-wide problem under present regime

Competition among issuers for these valuable customers solves the problem in the long run as these customers get more than one card

Slide233

233

Effects of Proposed Changes

Increased inter-network and intra-network competition likely to result in lower transaction facilitation fees

Slide234

234

Australian Experience

The Reserve Bank of Australia reduced interchange fees for credit cards in Australia from 0.95% to 0.55% in 2003 and to 0.50% in November 2006

Allowed surcharging

Results:

merchant fees fell even more than the interchange fees

the overall cost to the economy of facilitating transactions fell

Slide235

235

More radical changes

Separating authentication from payment

Large merchants eliminate acquirers?

Slide236

In Sept. 2010, DOJ sued Visa, MasterCard and Amex over the no-surcharge rule

Visa and MasterCard settled, accepting to abolish the no-surcharge and no discrimination clauses of their contractsAmex said it did nothing wrong; U.S. sued AmexImpact on merchants who do not take Amex?

236

Slide237

U.S. beats Amex at District Court

But Amex wins on AppealU.S. appeals further up during the last days of the Obama administration States’ Attorneys General appeal to the Supreme CourtDOJ does not appeal to the Supreme Court

237

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EU actions, July 2013

EU payment market is worth 130bn eurosEU wants to cap interchange fees to a maximum of 0.3% of a transactionDebit card fees to 0.2% of a transactionSee http://www.bbc.co.uk/news/business-23431543

238

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(b) Mobile banking in Africa and other developing areas

Read: Seeking Fertile Grounds for Mobile MoneyMany households do not have traditional bank accountsA new (escrow) bank account can be created and attached to a mobile phone numberand therefore to a mobile telecom networkNo other banking services (loans, mortgages, investments)

239

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240

Each mobile telephone network creates its own moneyMobile banking networks are incompatibleWhen are two mobile telecom companies, A, B, in a country, there are three types of money: State (S-) money, A- m-money, and B- m-money

Slide241

Three functions of mobile banking network

To transfer money to another person or businessTo transport money in the very short termTo save money

241

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242

Conversion from S- money to A- or B- m-money (“cashing in) is freeConversion from A- or B- m-money to S-money (“cashing out”) is expensive: fee 2-5% for an average transactionTransfer across networks, from A- money to B- money is even more expensiveTransfer within a network has a low fee, 0.3% for average transactionsSubstantial surplus losses because of de facto lack of interoperability

De facto

lack of interoperability makes exchange rates crucial.

In Tanzania:

Slide243

In Tanzania 35% of households have at least one m-money account

three major m-banking networksVodacom (Vodafone), 53% market share in m-moneyTigo, 18%Airtel, 13%Calling and transferring money across networks is expensive, many consumers have a different phone or a different SIM for each networkTigo advertises phones that take multiple SIMs

243

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M-money is most frequently used to send or receive remittances

Non-remittance transfers are infrequent14% of all households made or received a non-remittance payment in the past six months using any type of cash delivery, including m-moneyThe most common types of payments included school fees, government fees and taxes, utility bills, and salaries

244

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Frequency of service by type

Service typeFrequencyCash-in23%Cell phone top up21%Cash-out19%P2P transfer17%Purchases13%Bill pay5%Other2%

245

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Cash-out fees

Amount500-39994000-49995000-999910000-1999920000-2999930000-3999940000-4999950000-99999100000-199999Fee500600750120013501500175020002500

246

Slide247

Transfer brackets

20,000-29,99930,000-49,99940,000-99,99949,000-99,000100,000-199,999In-network transfer price one week before July 5th 2014300350350400500In-network transfer price one week after July 5th 2014350350350500600In-network transfer price one week before September 15th 2015350350350500600In-network transfer price one week after September 15th 2015350350350500600Out-network transfer price one week after September 15th 201517001850210025003100

247

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Despite the zero interest rate

Half of consumers with m-money accounts use their account as a savings account21% Vodacom M-Pesa users and 12% of users of Tigo & Airtel use m-money for business transactions

248

Slide249

Cashing in and cashing out of m-money

is done through a network of fixed and roaming agents that act as ATM machinesThis is the main cost of the banking networks

249

Slide250

Cash-in and cash-out commissions paid to agents (marginal cost)

Amount1000-29993000-39994000-49995000-69997000-999910000-1999919999-5000050000-99999100000-199999Cash-in agent commission4570100125150225275350600Cash-out agent commission 200200200200200200300400600

250

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Data

3 months of banking transactions from Tigo Tanzania, includingcash-in, cash-out, recharge mobile, transfer, check balanceBalance, operation size, GPS location, feeDuring the period, there was an unanticipated price change in transfer and cash-out fees

251

Slide252

Tanzania

252

Slide253

Frequency of transfers

253

Slide254

Transfer network

254

Slide255

Transfers

255

Cash is a close substitute to m-transfers for short distances

Elasticity of demand for m-transfers decreases with distance.

Slide256

Lifetime of money in network

256

Slide257

Number of P2P transfers before leaving the network

257

Slide258

Transfers

258

Cash is a close substitute to m-transfers for short distancesElasticity of demand for m-transfers decreases with distance

Slide259

Probability of an m-transfer increases with distance

259

Slide260

Summary of transfer results

Long distance transfers more inelasticTransaction taxes 0.25% transaction tax lowers the propensity to transfer by 46%10% tax on the transfer fee lowers the propensity of transfers by 13%Taxes are extracted from long distance remittancesregressive tax Interoperability with zero cash-out fee would increase the propensity for m- transfers by 1%

260

Slide261

System also used for cash-in-cash-out transactions

Transporting money without transfers SavingsInterest rate in zeroBut starting last summer, Tigo started paying a “dividend”

261

Slide262

Price elasticity of cash-out in cash-in-cash-out transfers

262

Slide263

People put money in the phone rather than keep cash

263

Slide264

People store cash on the phone to ameliorate risk

264

Slide265

Many users transport money through network without a transfer

to avoid carrying cash and losing their money in muggings or theftWe use revealed preference to estimate the probability of getting mugged at any point of Das es Salam

265

Slide266

Sept. 15, 2015, the three smaller networks introduce compatibility through software interface

Largest network (Vodacom) remains incompatibleTransfers across networks electronically feasible but expensive

266

Slide267

Impact of telecom network

on probability of using mobile banking

267

Slide268

Main services of Internet finance

third-party paymentCredit card networks; square cashnetwork lending (P2P and network microcredit, Internet consumer finance)LendingClubcrowdfundingGofundme, Kickstarter, IndiegogoInternet wealth (portfolio) management BETTERMENT.COM, MARKETRIDERS.COM, PERSONALCAPITAL.COM, WEALTHFRONT.COM virtual currencyLimited in the US; see Tanzania analysis

268

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Week 10: The Digital Books Market

Market StructureDistribution model of digital goodsDOJ suit and EU statement of objections against Apple and five publishersUS ComplaintSettlement of publishersCourt decision on Apple

269

Slide270

History and Market Structure

1992 Sony sells Data Discman, an eBook reader for CDs2000 Microsoft launches Microsoft Reader, works in Windows2007 Amazon launches Kindle2010 Apple launches iPad2011 Barnes and Noble launches Nook

270

Slide271

Book sales revenue 2012, eBooks surpass hardcover

271

Slide272

Retail price for ebooks used to be set by retailer (Amazon, etc.)

Publisher collects price P per eBookRetailer sets price R to usersPrice R for most ebooks > P, but sometimes R < PBefore the iPad came to market, Amazon sold “NYT bestsellers” for R = $9.99, below P

272

Slide273

Publishers did not like low R

Even though they still collected P > RWhy?Because most of the book sales were of hard copies, and the hard copy price Ph was much larger than RPublishers were worried that they may have to reduce price Ph (say $35) in the presence of an eBook price of $9.99Before the iPad came to market, in Dec. 2009 publishers retaliated against Amazon by withholding availability of “new releases” as ebooks for a few months after hard copies of new books were being sold, a practice called “windowing”But windowing encouraged piracy

273

Slide274

In the months before the launch of the iPad

Apple was in intense negotiations with publishers attempting to convince themTo adopt the “agency pricing model”To impose this model to all retailers, including AmazonTo allow for ebooks of NYT bestsellers to become available at the same time as hard copiesTo cut the price of eBook NYT bestsellers

274

Slide275

Once the iPad entered the market

the 5 major publishers and Apple agreed to move to the “agency pricing model” on the condition that it would apply to Amazon tooAgency pricing model:Retail price R is set by publisherRetailer keeps 30% of the retail price, i.e., P = (0.7)RSimilar to the way Apple sold third party software for the iPad through its virtual store

275

Slide276

Suit of DOJ against Apple and publishers for conspiring to set eBook prices (April 2012). Defendants:

Hachette Book Group, Inc.HarperCollins Publishers L.L.C.Simon & Schuster, Inc.MacmillanPenguin groupThe above settled; Remaining defendantApple

276

Slide277

Apple CEO Steve Jobs to Publisher Defendants:

“We’ll go to [an] agency model, where you set the price, and we get our 30%, and yes, the customer pays a little more, but that’s what you want anyway.” (p. 4 of US complaint)

277

Slide278

Effects of the conspiracy

The increases at Amazon within roughly two weeks of moving to agency amounted to an average per unit eBook retail price increase of 14.2% for their New Releases, 42.7% for their NYT Bestsellers, and 18.6% across all of the Publisher Defendants’ e-booksCourt decision on Apple, page 94

278

Slide279

Prices increased as a result of the conspiracy

279

Slide280

Ebook prices before and after the conspiracy agreement

280

Slide281

Strength of DOJ’s case

Conspiracy (Section 1 of Sherman Act), no need to show anti-competitive effects)Weakness of the caseApple can claim it was imposed to it by the publishersDOJ could have brought criminal charges but did notShows that DOJ did not believe it could win a criminal case

281

Slide282

Settlement approved 9/7/12

Ends conspiracy among publishersAllows eBook retailers to set price (as they used to)Settling publishers agreedto refrain for two years from entering into contracts containing retail price restrictions and price commitment mechanismsto stop communicating competitively sensitive information to competitorsnot retaliate against retailers that exercise discounting authoritynot to fix terms or prices with competitors for the provision of e-booksAGs of various states get $69 million damages from publishers

282

Slide283

Similar case in EU settled

On 9/7/12, Apple and four major publishers (all US defendants except Penguin) have offered to allow retailers such as Amazon to sell e-books at a discount for two yearsOn 11/6/12, Reuters reports that EU is about to settle on these terms

283

Slide284

In July 2013, US District Court decision finds Apple liable

of conspiracy to restrain trade in violation of Section 1 of the Sherman Act Civil suits to followNeed additional study of prices after the end of the conspiracy

284

Slide285

DOJ proposal on remedies: Apple is

required to end its existing eBook agreements with five major publishers and sign no new price-setting distribution contracts for five years allowed to continue to sell ebooksprohibited from retaliating against publishers for refusing to sell ebooks under terms approved by Applerequired to allow other eBook sellers, such as Amazon and Barnes & Noble, to give more prominent play to their eBook stores on Apple devices, by allowing them to provide links from their eBook apps to their eBook storesprohibited from entering into agreements with suppliers of ebooks, music, movies, television shows or other content that are likely to increase the prices at which Apple's competitor retailers may sell that contentSee http://www.computerworld.com/s/article/9241316/DOJ_AGs_propose_remedies_for_Apple_in_e_book_price_fixing?source=CTWNLE_nlt_pm_2013-08-02

285

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Week 11: Two-sided Pricing & Network Neutrality

General theoryApplication to network neutralityPublic policyReferences:Economides & Tag, “Network Neutrality on the Internet: A Two-sided Market Analysis,” Information Economics and Policy (2012), at http://www.stern.nyu.edu/networks/Economides_Tag_Net_Neutrality.pdfEconomides and Hermalin (2012), “The Economics of Network Neutrality,” forthcoming, Rand Journal of Economics, at http://www.stern.nyu.edu/networks/Economides-Hermalin_Economics_of_Network_Neutrality.pdf

286

Slide287

287

In networks, price discrimination schemes can be complex (1)

Because a network may have different degrees of market power on different sides of the market

A firm that controls a proprietary platform

sets a price strategically for its end-user products

and collects a fee for complementary products to its platform sold by other firms

Sony controlling its game console sets a price for the game console and charges royalties to developers of games

Microsoft

sells Windows to end-users

provides application developers with information and resources; embeds subroutines in Windows useful to application developers

makes money from licensing application development tools and support

Slide288

288

Prices and fees in two-sided markets

p

1 s1 p0s2 s3p2 p3

p

0

user platform price

p

1

,

p

2

,

p

3

user application prices

s

1

,

s

2

,

s

3

fees to platform (or subsidies to applications)

Slide289

289

In networks, price discrimination schemes can be complex (2)

Since the creation of the Internet, there was no price (or other) discrimination based on what service or what application the bits came from (so called “net neutrality”)Now AT&T, Verizon and cable TV networks advocate price discrimination based on which application and on which provider the bits come fromAT&T, Verizon and cable TV networks propose to kill net neutrality by charging both the DSL subscriber and the application provider (such as Google) where the bits originate, even when the application provider is not directly connected to AT&T or Verizon (i.e., Google’s ISP is not AT&T or Verizon)Note that the proposal is to impose price discrimination on the provider side of the market and not on the subscriber (i.e., it is a version of two-sided pricing)

Slide290

290

Two-sided Pricing & Network Neutrality

Internet Backbone

AT&T(Access Network)

Netflix

Google

Residential Customers

R

: subscription price

s

: AT&T’s fee to content providers or many fees s1, s2, …, sn

ISP

ISP

p

Slide291

291

Interview with Ed WhitacreBusinessWeek November 7, 2005

How concerned are you about Internet upstarts like Google, MSN, Vonage, and others?

“How do you think they're going to get to customers? Through a broadband pipe. Cable companies have them. We have them. Now

what they would like to do is use my pipes free, but I ain't going to let them do that

because we have spent this capital and we have to have a return on it. So there's going to have to be some mechanism for these people who use these pipes to pay for the portion they're using. Why should they be allowed to use my pipes?

The Internet can't be free in that sense, because we and the cable companies have made an investment and for a Google or Yahoo! or Vonage or anybody to expect to use these pipes [for] free is nuts!”

Slide292

292

But Both Sides Pay for “Transit” on the Internet

All hosts on the Internet pay according to bandwidth use: there is no “free lunch” on the InternetAT&T, Verizon, and others are paid by ISPs according to bandwidth useActually Internet backbones are paid twice for any transmission, by the originator of traffic and by the terminator of traffic (through their respective ISPs)

Slide293

293

Varying Levels Of “Network Neutrality,” from Strictest to Weakest

Referring to pricing to the “other side” of the consumer market (that is to content and applications providers):

1. Absolute non-discrimination: no quality of service variations offered for money or for free

2. Varying quality of service offered according to type of info. packet but no fees are charged

3. Tiered service allowed but each tier is offered at the same price to all; no exclusivity or identity-based discrimination

4. Identity-based discrimination allowed

5. Exclusivity allowed

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Obama’s statement on NN, at http://www.barackobama.com/pdf/issues/technology/Fact_Sheet_Innovation_and_Technology.pdf

Barack Obama strongly supports the principle of network neutrality to preserve the benefits of open competition on the Internet. …Because most Americans only have a choice of only one or two broadband carriers, carriers are tempted to impose a toll charge on content and services, discriminating against websites that are unwilling to pay for equal treatment. This could create a two tier Internet in which websites with the best relationships with network providers can get the fastest access to consumers, while all competing websites remain in a slower lane.Such a result would threaten innovation, the open tradition and architecture of the Internet, and competition among content and backbone providers. It would also threaten the equality of speech through which the Internet has begun to transform American political and cultural discourse. Barack Obama supports the basic principle that network providers should not be allowed to charge fees to privilege the content or applications of some web sites and Internet applications over others. This principle will ensure that the new competitors, especially small or non-profit speakers, have the same opportunity as incumbents to innovate on the Internet and to reach large audiences.

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FCC’s NPRM (2009) (1): “Subject to reasonable network management, a provider of broadband Internet access service may not

1. prevent any of its users from sending or receiving the lawful content of the user’s choice over the Internet.2. prevent any of its users from running the lawful applications or using the lawful services of the user’s choice.3. prevent any of its users from connecting to and using on its network the user’s choice of lawful devices that do not harm the network.4. deprive any of its users of the user’s entitlement to competition among network providers, application providers, service providers, and content providers.”

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FCC’s NPRM (2009) (2): “Subject to reasonable network management, a provider of broadband Internet access service

must treat lawful content, applications, and services in a nondiscriminatory mannerWe understand the term “nondiscriminatory” to mean that a broadband Internet access service provider may not charge a content, application, or service provider for enhanced or prioritized access to the subscribers of the broadband Internet access service provider … We propose that this rule would not prevent a broadband Internet access service provider from charging subscribers different prices for different services.”

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FCC Rule (December 2010)

1. Transparency: Fixed and mobile broadband providers must disclose the network management practices, performance characteristics, and terms and conditions of their broadband services.2. No blocking: Fixed broadband providers may not block lawful content, applications, services, or non-harmful devices; mobile broadband providers may not block lawful websites, or block applications that compete with their voice or video telephony services.3. No unreasonable discrimination: Fixed broadband providers may not unreasonably discriminate in transmitting lawful network traffic.Even though this regulation is weak, Verizon appealed to stop it. In Jan. 2014, Verizon won, and the FCC rules were nullified.

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EU: Directive 2009/140/Ec 25 November 2009 Commission Declaration On Net Neutrality

The Commission attaches high importance to preserving the open and neutral character of the Internet, taking full account of the will of the co-legislators now to enshrine net neutrality as a policy objective and regulatory principle to be promoted by national regulatory authorities alongside the strengthening of related transparency requirements and the creation of safeguard powers for national regulatory authorities to prevent the degradation of services and the hindering or slowing down of traffic over public networks

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EU: Directive 2009/140/Ec 25 November 2009, Consultation, and Kroes Speech

National Regulatory Authorities are required to promote “the ability of end-users to access and distribute information or run applications and services of their choice”National Regulatory Authorities, after consulting the Commission, can set minimum quality of service requirementsStrong transparency to ensure consumers understand and get what they pay for

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Residential ISPs have market power; also claim congestion

Assuming no congestion, Economides and Tag (2009) and others showed that introducing a positive price to content providers is typically welfare-inferior to NN

Economides & Tag, “Network Neutrality on the Internet: A Two-sided Market Analysis,” Information Economics and Policy (2012), at

http://www.stern.nyu.edu/networks/Economides_Tag_Net_Neutrality.pdf

ISPs claim that NN is not optimal with congestion

Issue addressed in Economides and Hermalin (2012), “The Economics of Network Neutrality,”

Rand Journal of Economics

, at

http://www.stern.nyu.edu/networks/Economides-Hermalin_Economics_of_Network_Neutrality.pdf

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Six Consequences of Departure from Net Neutrality

1. Introduction on the Internet of

two-sided pricing

where a transmission company controlling some part of the Internet (here last mile access) will charge a fee to content or application firms “on other side” of the network

Economides and Tag (2012) main result: Starting to charge a positive price “s” on the “other side” of the market is desirable to an access monopolist (or duopolists) but

not

desirable for society – more later in the presentation

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Six Consequences of Departure from Net Neutrality

2. Introduction of prioritization which may enhance the arrival time of information packets that originate from paying content and application firms “on the other side,” and may also degrade the arrival time of information packets that originate from non-paying firms

The present plans of access providers are to create a “special lane” for the information packets of the paying firms while restricting the lane of the non-payers without expanding total capacity

By manipulating the size of the paying firms’ lane, the access provider can guarantee a difference in the arrival rates of packets originating from paying and non-paying firms, even if the actual improvement in arrival time for paying firms’ packets is not improved over net neutrality

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Six Consequences of Departure from Net Neutrality

3. If the access providers choose to engage in “identity-based” discrimination, they can determine which one of the firms in an industry sector on the other side of the network, say in search, will get priority and therefore win

This can easily be done by announcing that prioritization will be offered to only one of the search firms, for example the one that bids the highest

Thus, the determination of the winner in search and other markets on the other side will be in hands of the access providers and not determined by innovative products or services on the other side

This can create very significant distortions since the surplus “on the other side” of the Internet is a large multiple of the combined telecom and cable TV revenue from residential Internet access

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Six Consequences of Departure from Net Neutrality

4. New firms with small capitalization (or those innovative firms that have not yet achieved significant penetration and revenues) will very likely not be the winners of the prioritization auction

This is likely to reduce innovation.

Network externalities arise because a typical subscriber can reach more subscribers in a larger network

Under no net neutrality, access providers can limit the size and profitability of new firms on the “other side”

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Six Consequences of Departure from Net Neutrality

5. The access networks can favor their own content and applications rather that those of independent firms

Examples: independent VOIP, video

This is likely to distort competition and reduce total surplus

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Six Consequences of Departure from Net Neutrality

6. Since the Internet consists of a series of interconnected networks, any one of these, and not just the final consumer access ones, can, in principle, ask content and application providers for a fee

This can result in multiple fees charged on a single transmission and lead to a significant reduction of trade on the Internet

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Economides-Tag (2012) deals with two-sided pricing when there is no congestion

In terms of potential welfare reduction because of the six effects discussed above, we model the case that has the least reduction in total surplus compared with net neutrality

Even though we make the best possible case for total surplus to increase when departing from net neutrality (by not focusing on factors two to six that are likely to reduce surplus), we find that typically total surplus decreases, both in monopoly and duopoly when we depart from net neutrality

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Stylized model: Money flows

Platform

(ISP)

Consumers

Content /

Applications

Providers

s

p

R

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Crucial Questions

Does the platform want to set s >0?Does the platform want to set s1, s2, etc.?Are consumers better/worse off at s > 0 vs. s = 0 Are consumers better/worse off at s1 > s2 > 0 vs. s = 0Is total surplus (TS = CS + Profits of ISP + Profits of Apps) higher with s > 0 than s = 0? With s1 > s2 > 0 vs. s = 0?

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Model 1 (Economides and Tag, 2012)

Network effects from the consumers to the apps and vice versaMonopolistic competition among appsMonopoly or duopoly ISPNo congestionHeterogeneous consumersHeterogeneous appsNetwork effect from consumers to apps “a”Network effect from apps to consumers “b”

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Platform incentives in setting fee sM to other side of the market

Platform

Consumers

a = value (network effect) of extra consumer to a content provider

s

M

R

M

> 0

b = value (network effect) of extra content provider to a consumer

a > b

s

M

> 0

Internet consumers, access platform, and content providers

Game platform consumers, game platform, and games

a < b

sM < 0

PC users, operating system, and applicationsCredit card issuing banks, credit card platform, and consumers

Content Providers

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Optimal One-sided Regulation in the Presence of Monopoly on the Other Side of the Market

A regulator/planner setting a fee s to content providers expecting the platform monopolist to set his profit-maximizing subscription price p(s) maximizes the constrained total surplus function TS(p(s), s) and chooses a below-cost fee to content providers s***< 0 provided that both consumers and content providers are sufficiently differentiatedEven paying the below-cost fee, the platform makes positive profitsSimilar results for duopoly ISPs

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Economides-Hermalin assumes congestion

Examines under what conditions NN is optimalWhat pricing does the ISP implement?

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Model 2 (Economides and Hermalin, 2012)

Assume congestion: If traffic exceeds the pipe’s capacity it gets delayed proportionatelyMonopoly ISPHomogeneous consumersHeterogeneous appsBelow: “welfare” = “total surplus TS”TS = CS + profits of ISP + profits of appsBecause the consumers are homogeneous, the ISP appropriates all CS

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Define net neutrality as no division of the bandwidth

Otherwise, bandwidth is divided in lanes, and each lane is allocated to one or more appsProvided that the monopolist ISP allows (sells to) all apps:Neutrality is weakly welfare-superior to any division of the bandwidth in which all segments are allocated a positive portion of the bandwidthNeutrality is strongly welfare-superior to any division that excludes some segments

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A bandwidth allocation is welfare-superior if it carries more content

Consider divisions of bandwidth in lanes

Proposition 1

. Given two alternative divisions of the total bandwidth, one is welfare superior to the other if and only if it results in more content being carried in equilibrium than the other.

Corollary 1

. Network neutrality is welfare superior to any division of the bandwidth if no division of the bandwidth leads to more content being sent in equilibrium.

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Amount of content carried is a “sufficient statistic” for welfare

and

how

bandwidth is allocated to content does not matter

Content is analogous to income, and it has the maximum positive effect on welfare when it is allocated as the consumer sees fit without restrictions

Restrictions (special lanes etc.) in its allocation restrict welfare

[Reminiscent of Varian (1985,9) showing that third degree price discrimination increase welfare vis-a-vis uniform pricing only if it increases the total amount of goods sold]

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Exclusion reduces welfare

Proposition 2

. Suppose the ISP provides a common class of service, but excludes a positive measure of content providers. In the resulting equilibrium, TS is less than it would be were no content providers excluded.

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Each user likes more applicationsWhen the consumer surplus is higher, the ISP (who appropriates consumer surplus) has an incentive to allow more appsEach app wants fewer (other) appsbecause more apps congest the network and delay deliveryThis externality among apps is not internalized in this model

319

Allowing the ISP to charge a positive fee to apps will exclude some apps

Slide320

Welfare = Total Surplus = Consumer Surplus + Profits of ISP + Profits of Apps

A necessary condition for welfare under price discrimination to exceed welfare is that the set of application providers served in equilibrium expandIf the ISP serves all application providers in equilibrium under linear pricing, then any non-trivial price discrimination scheme reduces welfare

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The effect of prioritization on total surplus

Depends on how the elasticity of demand with respect to transmission time varies with content typeNN can maximize welfare if the elasticity of demand with respect to transmission time is invariant with respect to contentBut depending on how that elasticity varies with content type, to max. welfare you may want to prioritize or slow down content of high immediacy desire

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Crucial issue

is how many apps at the bottom are excluded when fee to apps is introduced i.e., depends on the distribution of app typesWelfare can be higher or lower in price discrimination vs. linear pricing, depending on parametersOf course, higher welfare requires more total content sales

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Dynamic Issues: investment in bandwidth

ISP invests more in bandwidth with single positive fee to apps than with no feeWith single positive fee, ISP invests less in bandwidth compared to the welfare-maximizing amountISP invests more in bandwidth with price discrimination than with single positive fee to apps

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Distinction between static and dynamic efficiency

Example where θ (app types by desirability of immediacy) is distributed uniformly on [.05,1].Given a fixed bandwidth, compelling ISP to serve all application providers would raise welfare by 10%Cost of bandwidth κB (unrealistic technology)Unrestricted ISP will build 1.649 times as much bandwidth as it would were it constrainedGreater bandwidth does not fully overcome the static inefficiency, but, once the dynamic consequences are considered, welfare with zero fee is only 2% greater than were the ISP unrestricted

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In some models (Choi and Kim, Rand Journal 2010), ISP can have higher profits if it restricts bandwidthLower bandwidth can increase the difference between the price of a good in the fast lane vs. slow laneNot in Economides-Hermalin

325

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Conclusions on net neutrality (1)

Two-sided pricing is complex

Identified conditions when prices are positive on both sides and when one side is subsidized

Generally, social welfare diverges from platform profits

On the Internet, net neutrality typically is welfare-maximizing

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Conclusions on net neutrality (2)

Under reasonable assumptions, welfare increases in the total amount of content carriedEven in the presence of congestion, NN can maximize welfare if the elasticity of demand with respect to transmission time is invariant with respect to contentBut depending on that elasticity, to max. welfare you may want to prioritize or slow down content of high immediacy desireKilling NN can increase bandwidth investment and reduce the static allocative distortion

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Week 12: Bottom line

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329

Companies’ strategies that were successful in network industries

1. Vertical extension of the company

2. Discount pricing based on volume to take advantage of network effects

3. Discount pricing based on volume to take advantage of dominant position and disadvantage competitors

4. Subsidizing complementary goods

5. Control of bottlenecks

6. Exclusive contracts

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330

1. Vertical extension of the company

Example: Microsoft92% market share in operating systems for PCs Over time, it added functions to the OS that used to be independent applications or middleware:BrowserWindows Media PlayerHard disk defragmenterAnti-spywareAnti-virusBut MS does not go in hardware in PCs; is aware of its core competency

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Advantages of extending the firm vertically

Offensive advantage

Takes away value from complementary goods and adds value to own product

Defensive advantage

Avoids complementary goods firms creating a challenge to own product

Netscape browser + Java might challenge Windows

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Disadvantages of extending the firm vertically

Strategy may be illegal as in the Microsoft cases in the US and EU

But strategy very likely legal if market share is < 50% in US and < 40% in EU

Vertical extension could distract from the core competency of the firm

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333

Success? Very successful for Microsoft against Netscape which saw its share going from 100% to 0%

But, so-and-so in audio players

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334

2. Discount pricing based on volume to take advantage of network effects

Example: Cantor Fitzgerald in the secondary market for US government bonds; had 70+% share

Offered per unit pricing very significantly above marginal cost to all traders except Salomon Brothers

Salomon was offered marginal cost pricing plus a fixed fee

Why? To get the very high liquidity of Salomon that had 40+% in primary market, and internalize the network effects

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335

Success?

Very successful for Cantor

Kept dominant position despite an inefficient trading platform (broker matching vs. electronic trading)

Primary dealers had to set up their own exchanges as a threat to constrain the per-unit pricing of Cantor

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336

3. Discount pricing based on volume to take advantage of dominant position and disadvantage competitors

Example: Microsoft’s “per processor” pricing before 1995

Offered Windows at a per unit price, say $30

Also offered Windows to a PC manufacturer, say Compaq, that produced say 1 mil. units, at a flat price of $24 mil. with the right to install in all units

For Compaq, the last 200,000 units effectively had zero price

Compaq had a strong incentive not to buy from competitors (IBM)

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Advantages

When marginal cost is very low, this strategy can rapidly increase market share (as it did for Microsoft)

Great success for Microsoft that marginalized DOS competitor DR-DOS; increased the market share of Windows (that faced IBM’s OS2) to 90+%

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Disadvantages

The strategy is likely to be illegal for a dominant firm in the US, EU, Japan, and Korea

In 1995 (before the big antitrust suit) Microsoft agreed with USDOJ to stop using this strategy

But, it is a legal strategy for non-dominant firms

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4. Subsidizing complementary goods

Example: Microsoft

It chooses to make its product (OS) incompatible with others

It subsidizes firms that produce complementary goods (by including in Windows features that are useful to application developers but not to users)

Alternatively, MS subsidizes its division that sells complementary goods (Office)

As a result

The value of MS’s product increases

The entry hurdle of MS’s rivals increases

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Advantages of subsidizing complementary goods

Offensive advantage

The value of own product increases

Defensive advantage

The entry hurdle of rivals increases

It can make a platform dominant

Huge mistake of Apple not to adopt this strategy when Bill Gates pushed Apple to adopt it (before the creation of Windows)

Refusal by Apple prompted MS to create Windows and made MS the key player in PCs

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Disadvantages of subsidizing complementary goods

It costs money that may not be recoverable for some time

However, as Microsoft showed, subsidizing complementary goods can create dominance in the long run with very large benefits

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5. Control of bottlenecks

Is crucial for creation and maintenance of dominant market position

Sometimes innovation can eliminate the bottleneck

Example: software services can eliminate the bottleneck of OSs

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343

Old software model with OS bottleneck

Windows OS

Windows Application

Software

Windows dominantApplication needs OS-specific APIs

Apple OS X

Mac Application

Software

Linux OS

Linux Application

Software

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344

New software service model eliminates/reduces the bottleneck

Browser

Windows OS

Application as a Service

Windows dominant

Open standards

OS market structure irrelevant for service application market

Apple OS

Linux OS

Based on browser’s open standards

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6. Exclusive contracts

Example: Microsoft

Exclusive contracts with AOL and other ISPs on adoption of Internet Explorer

Successful but illegal for a dominant firm

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Some Big Upheavals in Network Industries

1. Google in Internet search/advertising

2. iPod big success in digital audio

3. VHS killing Betamax

4. Internet Explorer displacing Netscape

5. Alternating current displacing direct current in electricity

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Being first is no guarantee of long run success

ExamplesGoogle in Internet searchArrived very lateUsed a different algorithm for searchBased its revenue on advertisingApple’s iPod Also arrived very lateHardware-software combinationMore liberal contract on legal copies (at the time)

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Betamax/VHS: Sony’s strategic error

VHS video recorder (JVC/Matsushita)

Came later than Betamax (Sony)

Was widely licensed; low price

Betamax was not widely licensed; high price

Much bigger network effects of VHS

After 5 years, Betamax withdraws from the USA

Strategic error of Sony

Originally video recorders were used for time-shifting (like Tivo) – there were no network effects

Only later movies for rental appeared -- crucial complementary good creating network effects

Sony’s managers missed the transition …

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Internet Explorer displaces Netscape

Originally Netscape (based on Mosaic of the Univ. of Illinois) was dominant with 90+% market share

Microsoft makes a huge effort to write better browser from scratch

IE3 was significantly better than Netscape

Microsoft uses exclusive contracts and bundling in Windows to boost IE’s market share

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350

Alternating current displacing direct current in electricity

Originally electricity generation and distribution was developed as direct current (DC) by Edison

Significant municipal networks (New York City, Philadelphia) were created based on DC

Light bulbs last much longer on DC

Westinghouse pushed AC because its motors run much more efficiently on AC

AC won because of the efficiency of its long distance transportation (Niagara Falls to NYC)

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Bottom line (1)

1. Incompatibility is key

2. Under incompatibility, “winner-takes-most”

3. Crucial to have the top market share

4. Competition

for the market

more important than competition

in the market

; make early sacrifices

5. Extend the firm vertically without going outside core competences

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Bottom line (2)

6. Use price discrimination to

a. take advantage of network effects

b. take advantage of or create dominant position

c. disadvantage competitors

7. Subsidize complementary goods to create a dominant platform

8. Try to keep control of bottlenecks; create new bottlenecks if possible

9. May use exclusive contracts if legal

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Weeks 12: Antitrust in Networks Industries

3 Microsoft casesThe Microsoft Antitrust Case For MBA Students NYU conference on US v. MS, including streaming video of all presentations featuring (among others) Assistant Attorney General for Antitrust Doug Melamed, NY Assistant Attorney General for Antitrust Harry First, Microsoft counsel Rick Rule and Former Solicitor General Boyden Gray Discussion on US v. MS on PBS TV with host Jim Goodale, Prof. Nicholas Economides, and Prof. Eleanor Fox, in streaming video, first broadcast on November 16, 2000 Story in Wired magazine on Microsoft’s proposal for Apple allow clones Nicholas Economides & Ioannis Lianos, A Critical Appraisal of Remedies in the EU Microsoft Cases, Columbia Business Law Review 2010/2:346-420 (2010).Nicholas Economides & Ioannis Lianos, The Quest for Appropriate Remedies in the Microsoft Antitrust EU Cases: A Comparative Appraisal, Microsoft on Trial: Legal and Economic Analysis of a Transatlantic Antitrust Case, Luca Rubini (ed.). Edward Elgar (2010).Nicholas Economides & Ioannis Lianos, The Elusive Antitrust Standard on Bundling in Europe and in the United States at the Aftermath of the Microsoft Cases, Antitrust Law Journal 76/3:483-567 (2009).Investigations of Google

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Microsoft AntitrustCalendar: Early Fights

1991-93: FTC investigates MS twice, but does takes action1994-95: DOJ’s investigation ends in a 1995 settlementKey provisions:1. Microsoft agrees to end “per-processor” (zero marginal price) contracts with OEMs but can use unrestricted quantity discounts2. “Microsoft shall not enter into any License Agreement in which the terms of that agreement are expressly or impliedly conditioned upon the licensing of any other Covered Product, Operating System Software product or other product (provided, however, that this provision in and of itself shall not be construed to prohibit Microsoft from developing integrated products); or the OEM not licensing, purchasing, using or distributing any non-Microsoft product.”That is, no product bundling allowed by contract, but Microsoft can keep expanding the functions of its products, including Windows

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1997: Senator Orin Hatch (R-Utah) holds congressional hearings on Microsoft featuring Gates, Barksdale, Dell.Sen. Hatch takes the position that if present antitrust law cannot deal with Microsoft, Congress should change or enhance the antitrust lawsSun, Oracle, IBM, Netscape, and Novell form a loose coalition lobbying for antitrust action1997: DOJ alleges anti-competitive bundling of IE with Windows (violation of 1995 decree)Dec. 1997: Judge Thomas Penfield Jackson issues preliminary injunction barring bundling of IE with Windows 98May 12, 1998: Court of Appeals (DC Circuit) decides that 1995 decree doesn’t apply to Windows 98, which was shipped with integrated IEMay 18, 1998: DOJ and 20 states and the District of Columbia file the main antitrust caseOct. 1998 – June 1999: Microsoft trial takes place with an accelerated schedule

Main U.S. Fight (1)

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Main (U.S.) Fight (2)

Nov. 5, 1999: Judge Jackson issues “findings of fact,” siding very strongly with the plaintiffs

Dec. 1999: Prominent antitrust scholar, Judge Richard Posner appointed mediator for settlement discussions

April 1, 2000: Settlement talks break down after States hold out in proposed agreement.

April 3, 2000: Judge Jackson issues “conclusions of law”

June 7, 2000: Judge Jackson orders breakup of Microsoft in two companies

February 27, 2001: DC appeals court hears appeal

June 28, 2001: DC appeals court reverses breakup

September 6, 2001: DOJ seeks quick settlement without breakup

November 2, 2001: DOJ and Microsoft propose settlement; nine states settle and nine do not

March 18, 2002: Nine litigating states start remedies trial in front of Judge Colleen Kollar-Kotelly

November 1, 2002: Judge Colleen Kollar-Kotelly rules that the proposed settlement serves the public's interest and rejects positions of litigating states

November 29, 2002: All states except Massachusetts and West Virginia accept the settlement; eventually, both Massachusetts and West Virginia agree with the settlement

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Microsoft’s business then

Software

Operating systems for PC (Windows 95, 98, NT, 2000)

Operating systems for local network and Internet servers (Windows NT, 2000)

“Back-office” products for network and Internet servers

Internet Clients

Internet Servers

Desktop applications (Office, Word, Excel, Access, PowerPoint, MS-Money, etc.)

Games

Programming languages (Visual Basic, Java)

Hardware

Mice, keyboards

Services

Internet service (MSN, WebTV)

Internet content (MSN)

Product support

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The allegations.Microsoft accused of:

1. Monopolization of the market for operating systems (“OSs”) for PCs; (¶ 2, Sherman Act)2. Anti-competitive contractual arrangements with various vendors of related goods such as with computer manufacturers and Internet Service Providers (“ISPs”) and other actions taken to preserve and enhance its monopoly; (¶ 2, Sherman Act)3. Attempting monopolize the market for Internet browsers (but failing to succeed); (¶ 2, Sherman Act)4. Anti-competitive bundling of the Internet Explorer (“IE”), with the Windows operating systems; (¶ 1, Sherman Act)

358

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359

“Monopolization” under ¶ 2 of the Sherman Act is illegal

if the offender took anti-competitive actions to acquire, preserve, or enhance its monopoly

Sherman Act ¶ 2: “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony.”

Modern interpretation: For “monopolization,” plaintiffs have to prove that the defendant

1. Possesses market power

2. Willfully acquired or maintained this monopoly power as distinguished from acquisition through a superior product, business acumen, or historical accident

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“Attempting to monopolize” is illegal (Sherman Act, ¶ 2)

Bundling, and, more generally, price discrimination could be illegal if it has anti-competitive consequencesExclusionary contracts could be illegal if they have anti-competitive effectsTo prove “attempting to monopolize” (under Sherman Act ¶ 2), plaintiffs have to prove that the defendant 1. Engaged in predatory or anti-competitive conduct 2. with specific intent to monopolize 3. and that there was a “dangerous probability” that the defendant would succeed in achieving monopoly power

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Findings of fact and conclusions of law

The judge’s “findings of fact” (Nov. 1999) and “conclusions of law” (April 2000) found for the plaintiffs (US DOJ and 19 States) in almost all the allegations against MSThe judge found:Microsoft has a monopoly in the PC operating systems market (for Intel-based computers) “where it enjoys a large and stable market share”Microsoft used its monopoly power in the PC operating systems market and harmed competitorsMicrosoft hobbled the innovation processMicrosoft actions harmed consumersVarious Microsoft contracts had anti-competitive implications, but MS is not guilty of anti-competitive exclusive dealing contracts hindering the distribution of Netscape

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362

On June 7, 2000, after an extremely short hearing, Judge Jackson issues his remedies decision:

split Microsoft into two companies, one for operating systems (Windows 98, NT, and 2000), and one for all the rest, including applications (MS-Office, etc.)

impose business conduct restrictions

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363

Problem: Low price of OS; if Microsoft is able to exercise monopoly power, why does it not exercise it through price?If the price of PC hardware is pH and the demand elasticity is |ε|, the monopoly price of Windows is pW = pH/(|ε| - 1)If pH = $1,800 and |ε| = 2, pW = $1,800, while the actual price to OEMs was $40-60Requires a very large demand elasticity of |ε| = 31 to get a monopoly price of pW = $60

Judge decided that MS has monopoly power in the OS market for Intel compatible PCs

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Possible explanations for the low price of Windows

To hook consumers … but when will MS increase the price?

Competition from installed base of Windows … but

(i) very difficult to uninstall Windows

(ii) consumers buy much better new PCs faster than traditional obsolescence rates would imply

(iii) Windows price is small compared to the PC+Windows bundle

To reduce pirating … but why is then MS-Office price high?

Because it allows for higher prices of complementary goods …but MS does not monopolize

all the

complementary goods markets, therefore it would be optimal to charge the monopoly price on Windows

Because of the existence of actual and potential competition

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Monopoly may maximize social surplus

when there are network externalities present under conditions of incompatibility; value of de facto standardization

Slide366

Microsoft appealed, and was granted a stay of all parts of the District Court decisions until the appeal is heard

Summary of court of appeals decision:Microsoft’s breakup and other remedies imposed by the District Court were vacatedMicrosoft was found liable of monopolization of the operating systems market for PCsMicrosoft was found not liable of bundlingMicrosoft was found not liable of attempting to monopolize the Internet browser marketThe district court judge Thomas Penfield Jackson was taken out of the case for improper behaviorThe case was remanded to the District Court for remedies determination for the monopolization charge

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Bundling issue

The Appeals Court instructed the District Court to examine the bundling of IE and Windows (if plaintiffs bring it up) under “a rule of reason” where the consumer benefits of bundling are balanced against the damage of anti-competitive actionsIn face of the Appeals Court decision, DOJ decided not to pursue the bundling issue and announces that it will not ask for a breakup of Microsoft

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The Settlement: On November 6, 2001

the United States, the states of New York, Illinois, North Carolina, Kentucky, Michigan, Louisiana, Wisconsin, Maryland and Ohio, and Microsoft announced a settlementCalifornia, Connecticut, Iowa, Massachusetts, Minnesota, West Virginia, Florida, Kansas, Utah, and the District of Columbia pursued the suit further to a full remedies trial (started March 11, 2002) in front of U.S. District Judge Colleen Kollar-KotellyThese States proposed making the source code of Windows and IE public, “freezing Windows” so that additional functionality would be sold as an additional good, making all APIs public, and other severe remedies.On November 12, 2002, Judge Colleen Kollar-Kotelly imposed the final judgment that had only small differences from the original proposed settlement

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Settlement terms

A. Provisions seen as favorable to Microsoft 1. No breakup 2. Microsoft can expand functions of Windows 3. No general restrictions on bundling 4. No mandatory disclosure of source codeB. Provisions seen as favorable to the plaintiffs 1. Broad scope of definition of middleware products (including browser, e-mail clients, media players, instant messaging software, etc.)

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Settlement terms (cont.)

2. Requirement to partially disclose middleware interfacesMicrosoft is required to provide software developers with the interfaces used by Microsoft's middleware to interoperate with the operating system3. Requirement to partially disclose server protocolsThe settlement imposes interoperability between Windows and non-Microsoft servers of the same level as between Windows and Microsoft servers.

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Settlement terms (cont.)

4. Freedom to install middleware softwareComputer manufacturers and consumers will be free to substitute competing middleware software on Microsoft's operating system.5. Ban on retaliationMicrosoft prohibited from retaliating against computer manufacturers or software developers for supporting or developing certain competing software

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Settlement terms (cont.)

6. Uniform pricing of Windows for same volume saleMicrosoft will be required to license its operating system to key computer manufacturers on uniform terms for five years. Microsoft will be allowed to provide quantity discounts.7. Ban on exclusive agreements; contract restrictionsMicrosoft will be prohibited from entering into agreements requiring the exclusive support or development of certain Microsoft software

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Multi-year investigation of MS by the EU on

interoperability between non-Microsoft servers and Windows clientsbundling of Windows Media Player with WindowsThe EU (i) Found Microsoft liable on both issues (ii) Imposed a $609 million fine (iii) Required MS to produce a version of Windows without WMP (called Windows-N) but without a requirement to sell it for less than Windows (iv) Required MS to make public and license at a low price the communications protocols between Windows clients and non-Windows serversLess than 2000 copies of Windows-N were sold

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Second EU case on browser

In December 2007, Opera (an Internet browser) brings the issue of Microsoft bundling IE with Windows to the EUIn January 2009, the EU issues a “statement of objections” to Microsoft, alleging a violation of Article 82 EC for tying IE to WindowsGiven the previous decision on WMP, liability of Microsoft seems certainMicrosoft offers to sell Windows 7 without any browser pre-installed (users would use FTP to download browser)Proposal rejected by the EU in favor of a “choice screen” approach

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Choice screen

Is imposed through Windows update on all users in the EU who are using IE as a default (on all Windows products)Will allow users choice among IE, Firefox, Safari, Opera, and ChromeOn December 16, 2009, the Commission accepted the final choice screen proposal, and the matter endedIn my opinion, the choice screen should have been made available to all, not just IE usersPresent solution gives incentives to “bribe” OEMs to choose a non-IE default browser, so the choice screen does not appearBenefits the non-open-source non-IE browsers (Chrome)

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Investigations of Google

FTC investigation, leaked two weeks before presidential election to create the impression that Obama was tough on antitrustEU investigationsBoth, mainly on placement in organic searchAggregatorsPlacement of search results of Google affiliatesAgreements with Android manufacturers

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US investigation fizzled

FTC accepted proposed commitmentGoogle proposed to clearly label the links of its affiliates(A joke!)EU Investigation continuing and recently got extended

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4/15/2015, EU sues Google

Sent Google a “Statement of Objections”Allegations:Google favors its own comparison shopping services (for airline tickets, hotels, etc.) by placing them on top of the first organic search pageVertical issue, may be hard for EU to win

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Allegations cont.

Google demoted placement of “aggregators” such as Foundem

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EU launched Android investigation. Allegations:

Google required that smartphone and tablet manufacturers exclusively pre-install Google applications on their devicesPrevented the success of rival apps by bundling its own apps and services on Android devices with other Google applicationsPrevented manufacturers who want to use Google apps from developing and marketing modified and potentially competing versions of Android on other devices

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Week 12: Bank Networks Formation and Systemic Risk

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Network Structure and Collapse

The network gets formed in anticipation of “good” and “bad” times

Bad times eliminate nodes with prob. Pb

As Pb increases, banks form ex ante more dense networks expecting more widespread collapses in bad times

Pb increase is more costly to the each bank because it has to create a more dense network ex ante

If Pb is underestimated, the prob. of collapse of any node of the formed network increases

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Possibilities of Collapse (= Node Leaving the Network)

Individual nodes can collapse both in good and bad timesCollapse of Bi increases the probability of collapse of a connected node BjThere can be cascading collapsesFor the same network structure, cascading collapses increase as the probability of shocks increases

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Network Structure

It pays to have more connections because more connections make it more likely to find a trading partner (to diversify risk (Allen and Gale)) and therefore less likely for any node to collapse

In “bad” times, there are fewer nodes to connect to, so less diversification of risk

But fewer connections could restrict a cascading collapse to only a cluster of nodes by limiting the propagation of the financial distress (Battiston et at.)

Higher connectedness could also degrade credit worthiness and increase financial distress

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Public Policy to Reduce Impact of Collapses in “Bad” Times

Network-specific recommendations

Collect data on interconnected banks (and other institutions that have similar functions) and identify the network structure

Analyze the banking sector as a network structure

Assess the risk to a bank from further-away neighbors in the network

Identify central nodes whose collapse can have very significant impact on the network

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Systemic Risk as a Network IssueOur Model

First, banks B1, B2, …, Bn form a network by checking the credit worthiness of each other at a cost and in anticipation of subsequent trading

Second, the state of the world is revealed, Good = “g” or Bad = “b”

Let Pg < Pb be the prob. of unacceptably high credit risk

A bank (node) with unacceptably high credit risk collapses (or, equivalently, no one trades with it)

Third, in each of M periods, each bank receives a positive or negative shock with prob. q

If, in the same period, directly connected banks Bi and Bj receive opposite shocks they trade at low cost

If banks Bi and Bj are not connected directly but only through other nodes they trade at a higher cost, and the intermediate nodes benefit too

If bank Bi receives a positive or negative shock and cannot find anyone to trade with, it trades with the Fed at a high cost