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 ©
Slide22
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
Slide3A 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
Slide44
Network industries often
provide necessities
provide infrastructure
are key to economic growth
Network industries have special features
Slide5Platforms
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
Slide6Profit 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
Slide7Network effect:
7
A user will pay more to connect to a larger networkPlatforms leverage network effects
Slide88
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
Slide9Technological change has facilitated networks and
Telecommunications became extremely cheapComputation power rose exponentially
9
Slide10Effects of cheap computational power and cheap telecom
New products, new servicesNetworks, platformsOld products/services produced differently -> disruptionBig shifts in value of companies
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Slide11Week 1: Introduction
RequirementsMidterm examClass participation; interactivityFinal group projectGroups of 4 writing an original paperPreliminary presentation of paper on week 10Subject matterAreas we will cover
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Slide12Overview: 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
Slide13Overview: 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
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Slide14Overview: 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
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Slide15Overview: Areas we will cover
Week 4: pp. 108-134Network structures and platformsTwo-sided pricing
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Slide16Overview: Areas we will cover
Week 5, pp. 135-165Network structures and platformsNetwork propertiesNetwork effectsPlatforms Pricing on networksNature of competition on networks
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Slide17Overview: Areas we will cover
Weeks 6-7, pp. 166-189Compatibility and interconnectionDesirability Divergence of private and public incentives Public policy issues
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Slide18Overview: Areas we will cover
Week 7, pp. 190-204Bottlenecks and Interconnection Pricing
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Slide19Overview: Areas we will cover
Week 8, pp. 205-214Application: Taxi cabs as a two-sided networkApplication: Electric cars as a two-sided network
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Slide20Overview: Areas we will cover
Week 9, pp. 215-263Application: Payment Systems (credit and debit cards)Application: Mobile Money in Africa
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Slide21Overview: Areas we will cover
Weeks 10, pp. 264-280Application: Digital BooksWeek 11, pp. 281-322Application: Two-sided Pricing & Network Neutrality on the Internet
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Slide22Overview: 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
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Slide23References
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.
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Slide24Weeks 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
Slide25Demand, supply, and price determination
25
Slide26Cost 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.
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Slide27Three cost technologies:(1) Constant Returns to Scale
27
Slide28Cost technologies: (2) IncreasingReturns to Scale, F > 0, MC constant
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Slide29Cost technologies: (3) Increasing and Then Decreasing Returns to Scale
29
Slide30Consumers’ 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
Slide3131
Slide32Producers’ 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)
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Slide3333
Slide34Total 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
Slide3535
Slide36Total surplus is maximized at qc
36
TS
0 qc q
Keep in mind that this will NOT be true in network industries
Slide37Price 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
Slide38Price 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
Slide39Price 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
Slide40Price 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
Slide41Price 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
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Slide42Price 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
Slide43Market 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
Slide44Market 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
Slide45Market 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
Slide46Game 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
Slide47Games in extensive form: sequential incumbent-entrant game
47
Slide48Games in extensive form: simultaneous games
48
Slide49Non-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
Slide50Prisoners’ 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
Slide51Prisoners’ 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
Slide52Simultaneous Incumbent-Entrant Game
Pl. 2 (I)high Qlow QPl. 1 (E)Enter(-3, 6)(8, 8)Stay Out(0, 18)(0, 9)
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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)
Slide53Battle 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?
Slide54Matching 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
Slide55Is cooperation needed?
To establish a network link between A and B it needs to be profitable for both A and B
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Slide56Week 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
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Slide57Networks 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
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Slide58Example: the Information Superhighway (1994)
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Slide59Network structure
59
Nodes: entities
Edges/links: relationships
Directed or not
Features/colors of nodes
Features of links
Slide60Human connections networks
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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?
Slide61Blogs in the 2008 presidential campaign
61
Slide62Spread of an epidemic
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Slide63World trade network example from Easley and Kleinberg, Figure 1.8
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Slide64Network structure:Undirected and directed graphs
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Slide65Network structure: Connected components
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Slide66Network structure:Breadth-first search
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Slide67A Simple Social NetworkWith Three Components
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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
Slide68A Star (Hub & Spoke) Network
68
JFK
ATL
LAX
ORD
SEA
Slide69A Complete Network
69
JFK
ATL
LAX
ORD
SEA
Slide70Competing Platforms
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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
Slide71Competing 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
Slide72Concepts, 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
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Slide73Concepts, 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)
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Slide74Measures 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
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Slide75Degrees of separation? 6?
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Slide76Importance 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:
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Slide7777
Slide78Densely-connected, homogeneousparts that are weakly connected to each other
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Slide79Homophily
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.
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Slide80Homophily 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.
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Slide81Week 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.
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Slide82Basics 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
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Slide83Originally 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
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Slide84DoD 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
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Slide85Explosive growth of the Internet
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Slide86Pricing 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
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Slide8787
Slide88USA has low broadband penetration and lags behind poorer countries
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Slide89BB 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
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Slide90Week 3: Cybersecutity and Privacy
Nicholas Economides et al. (2010), Toward Better Usability, Security, and Privacy of Information Technology, Committee Report, National Academies of Sciences.
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Slide91Issues
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?
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Slide92Significant 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
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Slide93The 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
Slide94Perspectives 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
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Slide95The 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
Slide96Private 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
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Slide97Private 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
Slide98From 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
Slide99In 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
Slide100What 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
Slide101From 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
Slide102Should 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
Slide103The 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
Slide104Global 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
Slide105Policy 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
Slide106Some 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
Slide107NETWORK FORMATION
Other Notes pp. 40-84 (to be added)
107
Slide108Week 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
Slide109109
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
Slide110110
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
Slide111111
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
Slide112In 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
Slide113One-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
Slide114A long distance (two-way) network or an ATM (one-way) network
114
Slide115Virtual 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
Slide116Financial and other exchanges: network effects arise because market liquidity is desirable
116
Slide117Top 5 capitalization companies over time: in 2016, all tech
117
Slide118Top 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
Slide119Examples 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
Slide120120
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)
Slide121121
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
Slide122Platforms are taking over …
122
Slide123Why 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
Slide124The more Uber cabs on the road, the more riders they will attract and vice versa
124
Uber can increase scale and reap network effects
Slide125Winner-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
Slide126Reason 2: Platforms usually have fewer employees and less fixed investment than traditional companies
126
Slide127Platforms 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
Slide128Traditionally, 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
Slide129Platforms 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
Slide130Not 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
Slide131131
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)
Slide132132
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
Slide133133
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)
Slide134134
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
Slide135Weeks 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
Slide136136
Stylized model for the Internet as a platform: money flows
Platform
(ISP)
Consumers
Content /
Applications
Providers
s
p
R
Slide137137
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
Slide138Complementarity 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
Slide139Network effects
NatureHow they ariseEffects Consequences on competition, market structure and profits
139
Slide140Sources 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
Slide141Sources 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
Slide142Sources 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
Slide143Sources 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
Slide144Networks 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
Slide145Sources 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
Slide146Network 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
Slide147Network 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
Slide148Critical 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
Slide149When 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
Slide150Economides 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
Slide151The 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
Slide152Possibility 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
Slide153Critical 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
Slide154154
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
Slide155Multiplicity 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
Slide156Efficiency (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
Slide157Gross benefit (area under the demand) is B(n, n)
Marginal benefit of network expansion
157
Slide158Efficiency (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
Slide159159
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
Slide160Mathematical 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
Slide161161
The marginal benefit of network expansion is always higher than the willingness to pay of the last participant
Slide162If 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
Slide163Fulfilled expectations
163
Slide164If 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
Slide165165
Adoption S-curves from various network industries
Slide166Platforms 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
Slide167Weeks 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
Slide168Why 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
Slide169Technical standards competition
VHS vs. BetaWindows vs. Mac vs. LinuxMP3 vs. WMA vs. RealAudioHD DVD vs. Blu-RayiPhone vs. Android vs. Windows 8
169
Slide170Technical 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
Slide171171
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)
Slide172172
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
Slide173173
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
Slide174Strategic 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
Slide175Standards 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
Slide176Standards 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
Slide177Standards 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
Slide178Standards 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
Slide179Standards 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
Slide180180
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
Slide182182
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
Slide183Profits inequality and network effects under incompatibility. k = value of the good with no network effects
183
Slide184Herfindahl-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
Slide185185
Inequality of market shares and prices under incompatibility for pure network goods (k = 0)
Slide186Profits, Consumers’ and Total Surplus under incompatibility for pure network goods (k = 0)
Ratios of profits of consecutive firms range from 15 to 20
186
Slide187Monopoly 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
Slide188No 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
Slide189Strategic Choice of Compatibility in Duopoly
Equilibria in a Two-Firm Industry
k
189
Slide190190
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
Slide191Week 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
Slide192192
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
Slide193Interconnection 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
Slide194194
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
Slide195195
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)
Slide196196
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
Slide197197
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
Slide198198
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
Slide199199
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
Slide200200
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?
Slide201201
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
Slide202202
Innovation issues
Efficiency and intensity of innovation in monopoly compared to competition and oligopoly is an open question in economics
Slide203Regulation?
203
Slide204204
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
Slide205205
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
Slide206Week 8
Applications of platforms(a) Taxicabs, Uber, Lynx(b) Electric cars
206
Slide207(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
Slide208Traditional 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
Slide209Parallel markets
Pre-arranged ridesTown cars“Black cars”Liveries (in NYC above 96th Street and outside Manhattan)Each fleet uses incompatible dispatch systems
209
Slide210Reasons 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
Slide211New 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
Slide212“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
Slide213Since rival taxicab networks are incompatible
We expect very significant inequalities in market shares, prices, and profits
213
Slide214(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
Slide215Compatibility issues
Technical standards of charging stations and batteries
215
Slide216Week 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
216
Slide217217
(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.
Slide218218
Three-parties Setup (American Express, Discover)
American Express
Merchant
Consumer
Goods worth $100
$97
$100
Slide219219
Four-parties Setup (MasterCard, Visa)
Acquiring Bank
Issuing Bank
Merchant
Consumer
Goods worth $100
$98
$98.5
$100
Interchange fee
Visa network
Slide220220
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
Slide221221
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?
Slide222222
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
Slide223223
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
Slide224224
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
Slide225225
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 ....”
Slide226226
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
Slide227227
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)
Slide228228
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?
Slide229229
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
Slide230230
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
Slide231231
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)
Slide232232
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
Slide233233
Effects of Proposed Changes
Increased inter-network and intra-network competition likely to result in lower transaction facilitation fees
Slide234234
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
Slide235235
More radical changes
Separating authentication from payment
Large merchants eliminate acquirers?
Slide236In 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
Slide237U.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
Slide238EU 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
Slide239(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
Slide240240
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
Slide241Three functions of mobile banking network
To transfer money to another person or businessTo transport money in the very short termTo save money
241
Slide242242
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:
Slide243In 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
Slide244M-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
Slide245Frequency of service by type
Service typeFrequencyCash-in23%Cell phone top up21%Cash-out19%P2P transfer17%Purchases13%Bill pay5%Other2%
245
Slide246Cash-out fees
Amount500-39994000-49995000-999910000-1999920000-2999930000-3999940000-4999950000-99999100000-199999Fee500600750120013501500175020002500
246
Slide247Transfer 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
Slide248Despite 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
Slide249Cashing 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
Slide250Cash-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
Slide251Data
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
Slide252Tanzania
252
Slide253Frequency of transfers
253
Slide254Transfer network
254
Slide255Transfers
255
Cash is a close substitute to m-transfers for short distances
Elasticity of demand for m-transfers decreases with distance.
Slide256Lifetime of money in network
256
Slide257Number of P2P transfers before leaving the network
257
Slide258Transfers
258
Cash is a close substitute to m-transfers for short distancesElasticity of demand for m-transfers decreases with distance
Slide259Probability of an m-transfer increases with distance
259
Slide260Summary 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
Slide261System 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
Slide262Price elasticity of cash-out in cash-in-cash-out transfers
262
Slide263People put money in the phone rather than keep cash
263
Slide264People store cash on the phone to ameliorate risk
264
Slide265Many 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
Slide266Sept. 15, 2015, the three smaller networks introduce compatibility through software interface
Largest network (Vodacom) remains incompatibleTransfers across networks electronically feasible but expensive
266
Slide267Impact of telecom network
on probability of using mobile banking
267
Slide268Main 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
Slide269Week 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
Slide270History 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
Slide271Book sales revenue 2012, eBooks surpass hardcover
271
Slide272Retail 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
Slide273Publishers 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
Slide274In 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
Slide275Once 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
Slide276Suit 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
Slide277Apple 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
Slide278Effects 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
Slide279Prices increased as a result of the conspiracy
279
Slide280Ebook prices before and after the conspiracy agreement
280
Slide281Strength 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
Slide282Settlement 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
Slide283Similar 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
Slide284In 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
Slide285DOJ 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
Slide286Week 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
Slide287287
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
Slide288288
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)
Slide289289
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)
Slide290290
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
Slide291291
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!”
Slide292292
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)
Slide293293
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
Slide294294
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.
Slide295FCC’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.”
295
Slide296FCC’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.”
296
Slide297FCC 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.
297
Slide298EU: 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
298
Slide299EU: 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
299
Slide300300
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
Slide301301
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
Slide302302
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
Slide303303
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
Slide304304
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”
Slide305305
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
306
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
Slide307307
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
Slide308308
Stylized model: Money flows
Platform
(ISP)
Consumers
Content /
Applications
Providers
s
p
R
Slide309Crucial 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?
309
Slide310Model 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”
310
Slide311311
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
Slide312312
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
Slide313Economides-Hermalin assumes congestion
Examines under what conditions NN is optimalWhat pricing does the ISP implement?
313
Slide314Model 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
314
Slide315Define 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
315
Slide316316
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.
Slide317317
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]
Slide318318
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.
Slide319Each 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
Slide320Welfare = 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
320
Slide321The 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
321
Slide322Crucial 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
322
Slide323Dynamic 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
323
Slide324Distinction 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
324
Slide325In 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
Slide326326
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
Slide327Conclusions 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
327
Slide328Week 12: Bottom line
328
Slide329329
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
Slide330330
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
Slide331331
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
Slide332332
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
Slide333333
Success? Very successful for Microsoft against Netscape which saw its share going from 100% to 0%
But, so-and-so in audio players
Slide334334
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
Slide335335
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
Slide336336
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)
Slide337337
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+%
Slide338338
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
Slide339339
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
Slide340340
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
Slide341341
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
Slide342342
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
Slide343343
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
Slide344344
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
Slide345345
6. Exclusive contracts
Example: Microsoft
Exclusive contracts with AOL and other ISPs on adoption of Internet Explorer
Successful but illegal for a dominant firm
Slide346346
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
Slide347347
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)
Slide348348
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 …
Slide349349
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
Slide350350
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)
Slide351351
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
Slide352352
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
Slide353Weeks 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
353
Slide354Microsoft 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
354
Slide355355
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)
Slide356356
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
Slide357357
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
Slide358The 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
Slide359359
“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
Slide360“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
360
Slide361Findings 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
361
Slide362362
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
Slide363363
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
Slide364364
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
Slide365365
Monopoly may maximize social surplus
when there are network externalities present under conditions of incompatibility; value of de facto standardization
Slide366Microsoft 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
366
Slide367Bundling 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
367
Slide368The 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
368
Slide369Settlement 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.)
369
Slide370Settlement 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.
370
Slide371Settlement 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
371
Slide372Settlement 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
372
Slide373Multi-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
373
Slide374Second 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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Slide375Choice 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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Slide376Investigations 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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Slide377US 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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Slide3784/15/2015, 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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Slide379Allegations cont.
Google demoted placement of “aggregators” such as Foundem
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Slide380EU 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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Slide381Week 12: Bank Networks Formation and Systemic Risk
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Slide382382
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
Slide383Possibilities 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