Embrace extend and extinguish ChunHui Miao University of

Embrace, extend and extinguish Chun-Hui Miao University of South Carolina

Introduction • A two-sided market • Platform composed of components – Consumers buy clients – Content providers buy servers – Purchases are uncoordinated – Components can be from different producers

Embrace, extend and extinguish • Kerberos - an encryption technology to connect users to servers 1. Early versions of Microsoft Windows use standard Kerberos; 2. Kerberos on Windows 2000 is not fully interoperable with non-Windows Servers; 3. Users can only log on if both PCs and servers run Windows 2000. • Other examples involve Netscape, Java

Overview • Questions – Why use tying to “extinguish” complementors? – Why a phased response? • Results – Because price squeeze is impossible if customers on two sides make uncoordinated purchases – When technology gap narrows, embrace, extend, extinguish – not necessarily lower welfare

Literature review • Price squeeze – Chicago school, Ordover, Sykes and Willig (1985), Whinston (1990) • Tying in two-sided markets – Rochet and Tirole (2003), Choi (2006), Amelio and Jullien (2007) • Competition in two-sided markets – Armstrong (2006), Doganoglu and Wright (2006), Carrillo and Tan (2006)

A static model • A monopolist (MS) in client - A • Two servers available - B and B’ • A consumer and a content provider trade and share the surplus – d if B’ » 0 ≤ d ≤ 1 (compatibility) – γ if B » γ < 1 (technology gap) – A consumer (content provider) gets 1 -s (or s) share

Preferences • Identical consumers • Content providers uniformly distributed on [0, 1] – server producers at the opposite ends » Same marginal cost, normalized to 0 » Fixed cost F • The more interaction with the other side, the more to gain

The game t γ Compatibility (A, B’) Price of B’ Price of A Markets clear

The monopolist’s problem • x₁: market share of B – Decreases with d client server • Profit = x₁(1 -s)γ + (1 -x₁)(1 -s)d + x₁Ps = (1 -s)d + x₁[(1 -s)(γ-d) + Ps] ↑d ↓d + only if γ large

Optimal degree of compatibility • F d 0

The result

Shortcomings • A static model, but the strategy is inherently dynamic – Cannot use the same A to embrace and extinguish – If use A 1 to embrace, A 2 to extinguish, why anyone wants A 2? • Also, what about multi-homing by content providers?

Extension to a dynamic setting • Period 1 – A 1, first generation of client – B 1’, open standard, competitively supplied • Period 2 – An improved A 2 – B 2 by MS, the same quality as B 1’

Timeline T=1 Compatibility (A 1, B 1’) T=2 Compatibility (A 2, B 1’) Prices of A 2 and B 2 Content providers buy B 2? Consumers buy A 2?

Preferences • Content providers – When connected, s – Can multi-home, use B 2 while keeping B 1’ • Consumers – not upgrade, (1 -s) – upgrade, u + (1 -s) » The second term only available when connected – u uniformly distributed on [0, a] » Some consumers will upgrade even if they lose the ability to connect

Mechanism • Sell an upgrade A 2 incompatible with B 1 – A negative externality on content providers when consumers upgrade • Offer a low price to consumers – guarantee that enough consumers will upgrade – force content providers to upgrade

Results • Iff s > 4/7 and a > 4/7, the monopolist sells both A 2 and B 2, of which A 2 is incompatible with B 1 • A large s – consumers have little incentive to keep the old version – a big loss for content providers if they do not upgrade • A large a – More valuable upgrade – Great heterogeneity among consumers so it is easy to get a sufficient number to upgrade

Welfare • Content providers are worse off • But more consumers upgrade - mitigates monopoly undersupply

Conclusion • In two-sided markets, tying of complementary goods can be profitable • but welfare implication is ambiguous

The monopolist’s problem client server • Profit = x₁(1 -s)γ + (1 -x₁)(1 -s)d + x₁Ps = (1 -s)d + x₁[(1 -s)(γ-d) + Ps] • If s=0 (and t→ 0) – Only γ if both goods are monopolized – Let d = 1, Pclient = 1 (price squeeze) » Profit = 1 > γ (one monopoly theorem)