Competition in Complementary Markets

1
Competition in Complementary Markets

• Kyle D. Cattani
• H. Sebastian Heese

2
Complementary Products iPods and iTunes
3
Other participants in the markets for MP3 players
and music

• MP3 Players (Hardware)
• IRiver
• Sony
• Creative
• Rio
• Music (Software) Stores
• Real
• Napster
• MusicMatch

4
Complementary Markets and Standards
Market Hardware
Apple has 75 Mkt Share
Standard Apple
Standard Other
Apple has 83 Mkt Share
Market Software
5
Real Reaches Out

• RealNetworks announces (July, 2004) that
  customers buying music from their store can now
  play the music on an iPod
• Apples customers could benefit from this news.
  But Apple was not amused

6
Apple Press Release, 7/29/04

• We are stunned that RealNetworks has adopted the
  tactics and ethics of a hacker to break into the
  iPod...
• We strongly caution Real and their customers
  that when we update our iPod software from time
  to time it is highly likely that Reals Harmony
  technology will cease to work with current and
  future iPods.

7
Research Questions

• What might drive Apples resistance to an open
  standard?
• Under what conditions does a firm benefit from
  exclusive formats? Open formats?
• How does maintaining a proprietary standard
  affect profits, market share, and prices?

8
Two Markets, Two Standards
Market H
AH
OH
Standard A
Standard O
AS
OS
Market S
9
Literature

• Netessine and Zhang (2005)
• Parker and Van Alstyne (2005)
• Bhaskaran and Gilbert (2005)
• Armstrong (2002) Competition in Two-Sided Markets

10
Model Notation

• Two markets (Hardware and Software)
• Two providers in each market, each with a
  different format (Apple and Other)
• Strength of the externality effect to market m
• Customer Reservation price for product of
  standard f in market m
• Market share of standard f in market m
• Customer Reservation price including externality

11
Model Demand (Hotelling)
Customers ideal points vary from 0 to 1
Competing products are at extreme points
Om
Am
indifferent customer
0
1

• Disutility for product characteristic per unit
  from ideal point in market m
• Utility for customer x in market m for purchase
  of standard A at price PAm
• Utility for customer x in market m for purchase
  of standard O at price POm
• Indifferent customer is at xm

Solving for xm, this equation corresponds to
market share of format A in market m
12
Two Markets, Two Standards
Market H
AH
OH
Standard A
Standard O
AS
OS
Market S
13
Kyles Favorite Cartoon
14
Model Assumptions

• Assume that Apple sets prices to maximize profits
  across both markets (iPod and iTunes), while
  competitors in the competing markets are
  independent.
• Strategies Apple might consider
• C Closed
• O1 Open 1 (iPods can play competitors music)
• O2 Open 2 (iTunes can play on competitors
  player)
• O Open (both of Apples products are open)

15
Model Results Profit

• Under full symmetry of markets and firms

• Apple should open its product offerings!
• Why does Apple keep its standards proprietary?
• Is Apple stupid?

16
Model Results Demand

• Under full symmetry of markets and firms

• Apple leverages its ownership structure as it
  internalizes the complementarity effects.
• With proprietary standards, Apple has higher
  market share.

17
Model Results Prices

• Under full symmetry of markets and firms

• Apples employment of proprietary standards leads
  to lower prices (than under open standards, cet.
  par.)

• Though not customer centric in terms of
  functionality, proprietary standards benefit
  customers in terms of lower prices.

18
Model Results Relative Increases in Profits

• Under full symmetry of markets and firms

• Even though Apples short term profits could be
  increased by supporting open standards, its
  competitors might benefit much more (in percent).

19
Model Results Relative Increases in Profits

• Customers seem to like Apple, which has higher
  market share and charges higher prices.
• We represent customer preferences in our model
  through a difference in the ex-ante reservation
  prices. Let ? 0 represent the incremental
  utility customers associate with iPods. Then

• The stronger the consumers preferences for Apple
  are, the stronger is the per-cent profit increase
  for Apples competitors relative to Apples own
  per-cent profit increase.

20
Sebs Favorite Cartoon
21
Explaining Apples motives

• Apple might be going for market share
• We have seen that market share is higher under a
  closed strategy
• And, their customers are captive (once iPod,
  forever iPod)
• A closed market contributes to barriers to entry
• More market share for Apple implies that less
  market is available to competition, and
• Lower prices support the notion of barrier to
  entry there is less money to be made (limited
  potential ROI)
• That Apples competitors stand to benefit more
  than Apple from an open standard lends further
  support to an hypothesis that Apple might be
  trying to strengthen its dominant position and
  increase barriers to entry.

22
Anecdotal Evidence that Apple is strengthening
its dominant position

• Smaller players have not had a lot of staying
  power. Perhaps they are suffering from Apples
  maintaining closed standards

• In 2003, the pioneer and former leader in the MP3
  player market was absorbed by DM Holdings after
  filing for Chapter 11 bankruptcy protection.

Rio

Jens
?
Creative?
23
Barrier to Entry - Anecdotal Evidence

• After attacking the Sony PlayStation with the
  Xbox, insiders are waiting for Microsoft to
  unveil its XPod an iPod killer.
• Microsoft isnt particularly interested in
  increments from the digital media device business
  or online music. Its after a spot in the
  consumers living rooms. (Business Week 2/6/06)
• One key strategic aspiration of some powerhouses
  with substantial amounts cash (Microsoft, Sony,
  Dell) is to own the customer or his/her living
  room.
• Keeping Apples iEmpire (Fortune 2/6/06) closed
  makes it more difficult for these firms to enter
  the market.

24
Other settings to which our model applies (or
can be extended easily)

• HD DVD players/content (Sony)
• Standards war is reprise of VHS/Betamax
• Sony owns players and content
• Operating Systems/Office Software (Microsoft)
• Microsoft ultimately achieved dominance
• Printers/Ink Cartridges (HP)
• Refill kiosks open the standard

25
If You Remember Nothing Else

• iPod and iTunes
• It is apparently not about short-term profit it
  is about market share.