Bundling vertically differentiated communications services ... - CiteSeerX

Bundling vertically differentiated communications services to leverage market power Jan Kra¨mer

Jan Kra¨mer is based at the School of Economics and Business Engineering, University of Karlsruhe, Karlsruhe, Germany.

Abstract Purpose – The purpose of this paper is to investigate whether and how bundling services may achieve leverage of market power from the telco’s home to a secondary service market (e.g. video broadcasting). Despite digital convergence, in many countries the former telco monopolist remains to hold significant market power in its home market for telecommunication services. Design/methodology/approach – To this extent the author considers a formal game-theoretic model where the telco firm holds a monopoly in the market for telecommunications services, while competing with a cable firm in the market for video broadcasting services. Services may differ in quality. For the firms, the provision of high-quality services is more costly than the provision of low-quality services. Conversely, consumers have a greater reservation price for higher service qualities. Therefore firms face a trade off between revenues and cost when selecting the optimal service quality. Findings – The model shows that the telco firm can achieve market power leverage by bundling its services, which therefore is more profitable than offering each service separately. In particular, the quality leverage mechanism is highlighted, which reveals that bundling alters the optimal service quality choice of the competitors favorably. Research limitations/implications – Like every game-theoretic model, the present model rests on formal assumptions representing stylized facts. Future research should determine these by empirical evidence. Practical implications – The paper reveals how bundling may be employed as a strategic weapon in order to increase profits in the converging communications market. Originality/value – The paper shows that bundling communications services can not only have significant ramifications for the quality of these services, but also for the competition in industry. Keywords Telecommunications, Digital communication systems, Competitive strategy, Pricing Paper type Research paper

1. Introduction

Received 18 May 2008 Accepted 25 November 2008

PAGE 64

j j info

The communications industry is one of the key drivers of economic growth (Ro¨ller and Waverman, 2001) and has recently, following the liberalization of the sector in the late twentieth century, undergone a tremendous transformation. In particular, digital convergence is at present a key factor in the developments underlying electronic communications (OECD, 2006). Digital convergence refers to the ability of different network platforms to carry essentially similar kinds of services (COM, 1997). It takes place at different levels. Damjanovic (2002), for example, differentiates between technological, regulatory and economic convergence. While there is a significant body of literature concerned with technological and regulatory convergence, Bauer (2007) points out that economic ‘‘literature fails to embed convergence in a broader economic theory of networks and service provision’’. Furthermore, he concludes that ‘‘convergence unfolds in ways that are more complicated and with effects that are more multilayered than commonly recognized’’. It is the aim of this paper to contribute into this hiatus of economic literature.

VOL. 11 NO. 3 2009, pp. 64-74, Q Emerald Group Publishing Limited, ISSN 1463-6697

DOI 10.1108/14636690910954980

In most leading OECD countries today, digital convergence enabled former telecommunication monopolists to enter the neighboring TV and video broadcasting market by offering digital IPTV over their own network (Ortiz, 2006). On the contrary, regional cable network monopolists have also invested in network digitization in order to augment their traditional TV broadcasting service by a telecommunication service themselves. Maldoom et al. (2005, p. 80) affirm that consumers view the telecommunication services delivered over different platforms as close substitutes. As such, digital convergence has created a common market for telecommunications and video services. However, in many countries (such as Australia, Finland, France Germany, Italy or Spain, just to name few) there remains are tremendous asymmetry in terms of market power between the former telecommunication monopolist and the cable network incumbent. While virtually all users have been customers of the telco’s telephone service prior to the market liberalization, in comparison only few customers simultaneously had a cable TV subscription. To capture this asymmetry in its very essence, I model the communications industry to be comprised by two distinct markets and two distinct firms: The market for telecommunications services (such as telephony and internet) is served by the telco company only (monopoly market) and the market for video broadcasting services (such as TV and video-on-demand) is jointly served by the cable and the telco company (duopoly market). Thus, the analysis in this paper is only concerned with the infrastructure competition between the two integrated cable and telephone network operators, who own their own network[1]. The peculiar feature of this market structure is that each firm originates from a home market where it is considered to have some additional market power over her competitor[2]. Moreover, it is widely believed that each firm’s home service (i.e. telephony for the telco firm and video broadcasting for the cable provider) is superior to that of the competitor’s, e.g. in terms of reliability, customer service, transfer speeds, video quality or content. Although the observed product differentiation might also be due to a rather technical nature at first, I argue that there is also a long-lasting economic intuition which will prevail even if technical difficulties should be overcome in a matured industry. More precisely, I consider this industry to be vertically differentiated, such that firms may deliberately choose different service qualities in order to distinguish themselves from their competitors. Each firm will then make use of its home market advantage by offering a service quality higher than that of its competitor, because high-quality products are generally associated with higher profits. In practice providers often employ an additional business strategy which has become known under the buzz word Multiple Play: That is, firms often sell their services in a bundle only, although it would be technically possible to offer each service separately. For example, if a customer wants to use the telco’s IPTV service, he will also have to sign up for the telephone service – the firm’s home product. I employ a formal game-theoretic model to investigate whether bundling is indeed a profitable pricing strategy and under which circumstances it might be part of an equilibrium strategy. My main result is that bundle-pricing serves as a powerful market leverage device through which one firm may carry its home market advantage over to the secondary market. This is achieved through a quality-sorting effect which emerges as firms seek to detensify price competition by specializing on providing either the high- or low-quality service in both markets, thereby leaving the high-end provider better and the low-end competitor worse off than under separate pricing.

2. Related literature This paper relates to two major strands of economic literature: vertical product differentiation and bundling. The basic structure of the game employed here, where firms in a duopoly decide first on quality levels and then on prices, owes much to Shaked and Sutton (1982, 1983). These early contributions derive the consumers’ quality choice from a direct utility function relating different preferences to differences in income. Instead, Tirole (1988, Section 2.1.1) considers an indirect utility function, which introduces a heterogeneous taste parameter that can be interpreted as the marginal rate of substitution between income and quality. Thus, higher income corresponds to higher taste for quality and in this vein Tirole was able to capture the notion of the earlier papers by the same simple (indirect) utility function which I will employ here[3]. These classical contributions have all affirmed that in equilibrium

j j

VOL. 11 NO. 3 2009 info PAGE 65

firms will differentiate their products and that the firm producing the higher quality will earn greater profits than the low-quality provider[4]. As Lehmann-Grube (1997) points out, this high-quality advantage is hardly surprising, since all authors have assumed either zero or small and decreasing costs of quality improvement. Although, subsequently some authors (Aoki and Prusa, 1996; Boom, 1995; Motta, 1993; Ronnen, 1991) have confirmed the high quality advantage for specific cost functions, Lehmann-Grube is able to generalize this result to all cost functions which are increasing and convex in the quality chosen, but independent of the output[5]. This seems to be a natural assumption in the context of communication network industries, where scale economics are rather prominent since each additional customer induces near zero marginal costs, whereas (fixed) costs of, e.g. network maintenance are very high[6]. Furthermore, he shows that if firms choose their quality sequentially in Stackelberg fashion, then the Stackelberg-leader will always select the product of higher quality. This result is important for the present context because it explains that the incumbent can exploit its home market advantage by establishing itself as the high-quality provider. The literature on bundling, on the other hand, has at first been primarily concerned with monopolized markets. The seminal papers of Adams and Yellen (1976), McAfee et al. (1989) and Schmalensee (1982, 1984) high-lighted bundling as a price discrimination device for multi-product monopolists. Later, Whinston (1990), in an effort to re-establish the previously discredited leverage theory[7], was the first to consider the aforementioned market structure, in which a multi-product firm holds a monopoly in one product market, but faces imperfect competition in the other. This basic market structure has subsequently been in the focus of attention by numerous scholars, who have shown various means through which bundling may facilitate market power leverage. Among these were entry deterrence (Carlton and Waldmann, 2002; Martin, 1999; Nalebuff, 2004; Whinston, 1990), economics of aggregation (Bakos and Brynjolfsson, 2000), cost savings (Bakos and Brynjolfsson, 1999; Chae, 1992; Salinger, 1995), informational leverage (Choi, 2003), reduction of rivals’ innovation incentives (Choi, 2004), (tacit) collusion (Seidmann, 1991; Spector, 2007) and competition mitigation (Carbajo et al., 1990; Chen, 1997; Whinston, 1990). In this paper, I employ the same market structure and show that bundling might also achieve market leverage through a quality sorting mechanism. The remainder of this article is structured as follows. Section 3 will introduce the formal model which serves as the basis of my analysis. In particular, I will consecutively follow the logic of backwards induction by deriving equilibrium conditions for the separate- and bundle-selling regime first and eventually deducing the equilibrium selling strategy for the telco firm. To conclude, I will interpret the results in the light of the leverage theory in Section 4.

3. The model The landline communications industry is considered to be constituted by two firms, i ¼ 1,2, and to consist of two distinct markets, denoted by m ¼ A, B, respectively. The telecommunications firm, i ¼ 1, holds a virtual monopoly in the market for fixed-line telephone services, m ¼ A. On the contrary, the market for video broadcasting, m ¼ B, is a duopoly in which the incumbent cable firm, i ¼ 2, competes with the entrant telecommunications firm, i ¼ 1[8]. Each firm offers exactly one service in each of its markets. Firms’ services are heterogeneous and can differ with respect to quality, q. Firms elicit their service offer in two steps. First, firms choose service quality and subsequently the price, p. This structure reflects that service quality is a strategic long term variable, whereas price is a short-term variable which involves no strategic commitment and can be changed at any time. In their home market, incumbents choose their service quality first. This is a strategic advantage according to Lehmann-Grube (1997), because the incumbents may establish themselves as the high-quality providers in their home market and thereby earn greater profits. The incumbents’ quality is then observed by the entrant, who may subsequently choose his optimal quality level. Finally, after all quality levels are observed by all firms, prices are chosen simultaneously.

j j

PAGE 66 info VOL. 11 NO. 3 2009

In addition, firm 1 can decide whether to sell its two services separately (denoted by s or the separate selling regime) or as a bundle (b or bundling regime). It is the aim of this paper to show that a firm 1’s selling strategy (i.e. s or b) can have significant ramifications on the quality decision of all firm’s services. Hence, the selling strategy decision must take place before the quality decisions. In summary, the timing structure of the whole game is comprised of the following four stages: 1. Firm 1 decides upon its selling strategy (s or b). 2. Firm 1 and 2 simultaneously choose the quality of their home market services (qA1, qB2). 3. Firm 1 chooses the quality of its secondary service (qB1). 4. Firms simultaneously choose the prices for their services ( p1, pB2)[9]. There is a continuum of consumers normalized to mass 100 who have a positive valuation for exactly one service from each market m¼A;B. More specifically, consumers differ in their marginal willingness-to-pay for quality,u, and value a service offer of quality q at:[10] V u ðqÞ ¼ uq Consequently, consumers with a relatively low u do not value quality enough in order to find it reasonable to purchase a rather expensive high-quality service, which consumers with a relatively high u would still find attractive. In contrast to horizontal product differentiation models, however, at equal prices all consumers prefer the service of higher quality. Moreover, u is uniformly, independently and identically distributed in the unit interval. As a limit case, I assume that tastes are perfectly correlated across service types, i.e. a consumer with a high willingness to pay for quality for service type A has an equally high willingness to pay for quality for service type B. Note that u can be interpreted as the marginal rate of substitution between income and quality. Consumers with a higher income have a lower marginal utility of income and thus a higher u (see Tirole, 1988, p.96). Of course, all consumers can be uniquely ordered according to their income and since the same consumers are present on both markets, there is good reason to believe that this ordering is identical (or at least highly positively correlated) across markets. I assume that firms’ costs of quality improvement fall on fixed costs only. Yet, notice that this assumption does not neglect the existence of marginal costs per se, but rather suggest that marginal costs are not influenced by a firm’s service quality choice. In particular, consider the following cost function for each service: CðD mi ; q mi Þ ¼ aD mi þ

1 q mi 2 2

where Dmi denotes the demand of service qmi and a is the constant marginal costs. Clearly, if marginal costs are quality independent, they have no influence on the service quality and merely result in a linear mark-up on prices. Thus, for expositional clarity, I can w.l.o.g. normalize a to zero. Obviously C’( · ).0 and C’’( · ) . 0, i.e. the cost function is convex such that services of higher qualities are more costly to provide and increasingly so at higher cost levels[11]. In order to be able to isolate the strategic effect of bundle pricing alone, I assume away any scope economies or consumption dependencies, i.e. complementarity or substitutability across services of different markets. Following an investigation by Crampes and Hollander (2007) this does not pose a limitation: ‘‘In the Triple Play case, one can discard the argument of utility super-additivity. Even if the services were complements for the consumer, there is no reason to purchase from a single supplier.’’ Moreover, they note that due to the digital nature of the services, one may assume that the transaction cost argument, by which consumers prefer a ‘‘single bill’’, is not essential. Consequently, each consumer’s total valuation is linearly separable his valuation for each service. Notwithstanding, since consumers have a positive valuation for exactly one service from each market only, on each market the competitively supplied services are demand substitutes. More precisely, given two distinct service offers (q1;p1) and (qB2;pB2), a

j j


consumer, say u~, will be indifferent between both offers if and only if V u~ðq 1 Þ 2 p 1 ¼ V u~ðq B2 Þ 2 p B2 Moreover, the consumers’ outside option is normalized to zero, i.e. the consumer indifferent between buying service offer (qi; pi) and not buying at all, say u^, is determined by: V u^ðq i Þ 2 p i ¼ 0 The set of indifferent consumers imposes a demand pattern onto the unit interval. Thus, the demand a firm receives for a specific service offer is determined by the interval in which those consumers are located for whom this offer maximizes utility. In this way, firm i’s total demand, Di (qi, pi, q-i, p-i, Q) can be represented by a vector, which depends on firm i’s own offer, the service offer of the other firm – i and the characteristics of the consumers, Q, which comprises the assumptions about the distribution and correlation of preferences. If firm 1 has chosen a separate selling strategy, the demand vector contains the demand for every distinct suboffer, D1 ¼(D sA1;D sB1). Conversely, when firm 1 employs bundling, the demand vector degenerates to a single value which represents the demand for the pure bundle, D b1. Let Ri ¼Di pi be firm i’s revenue. Then firm 1’s and 2’s profit, which they individually seek to maximize, is given by:

P1 ¼ R 1 2 Cðq A1 Þ 2 Cðq B1 Þ; P2 ¼ R 2 2 Cðq B2 Þ: The solution concept is that of subgame perfectness (Selten, 1975) and thus I solve for the equilibrium of the game by backwards induction. Therefore, it will be convenient to partition the subsequent analysis in three main steps. First, the separate selling regime (s) is considered in isolation, as it forms a special case due to the absence of cross-market effects. Second, the bundling regime (b) are analyzed and, eventually, firm 1’s equilibrium selling strategy (stage one of the game) is determined. The separate selling regime As a point of departure, let us first investigate the subgame that occurs if firm 1 chooses the separate selling strategy Under this regime, firm 1 assigns a separate price to each of its two services such that consumers can mix-and match an individual service package from the firms’ suboffers, possibly containing services of different firms. Clearly, there is no economic link between the markets which could influence firms’ or consumers’ decisions. Hence, I can investigate the equilibrium quality levels and prices for each of the two markets separately. Monopoly Market A. Under the separate selling regime (s), firm 1 faces a simple monopolistic optimization problem in market A. First it chooses the optimal quality, q sA1, and subsequently the optimal price, p sA1. Lemma 1: Under the separate selling regime, in market A firm 1 will offer a service with (q s* A1; s* p s* A1)¼(25.00; 12.50) and thereby earn a profit of p A1¼312.50. Proof: Since firm 1 is a monopolist in market A, consumers will buy as long as they receive nonnegative utility from doing so. Thus, the last consumer to buy firm 1’s service in market A satisfies: u sA1¼p sA1 / q sA1 such that D sA1¼100 (1- usA1). Consequently, the firm’s revenue and profit functions become: R s ¼ D sA1 p sA1 ;

PsA1 ¼ R sA1 2 12 q sA1 2 : s 1 Solving the first order condition of p sA1 with respect to p sA1 yields p s* A1¼ 2 q A1[12]. After s substituting this optimal price into the first order condition with respect to q A1 and solving, I obtain the optimal service quality and thus profit.B

Duopoly Market B. The analysis of the duopoly market under the separate selling regime is slightly more complicated because firms must coordinate among each other which quality

j j


levels they will each supply. Clearly, in equilibrium both firms will not offer the same service qualities, because such a lack of service differentiation will inevitably lead to a subsequent Bertrand price war and hence zero profits. Therefore, as quality is one dimensional here, one firm must evolve as the high-quality provider and the other firm as the low-quality provider. Lehmann-Grube has shown that the high-quality provider is generally better off than the low-quality provider. Thus, firm 2 will exploit its first-mover home market advantage by eliciting the higher service quality. Lemma 2 summarizes these results in the light of the current model. Lemma 2: Under the separate selling regime, in market B firm 2 will offer a high-quality s* s* service with (q s* B2; p B2)¼ (24.52; 10.37) and thereby earn a profit of p B2¼ 244.70. As the Stackelberg-follower, firm 1 provides a low-quality service in market B with (q s* B1; s* p s* B1)¼(4.78; 1.01) and thereby earns a profit of p B1¼15.15. Proof: According to Lehmann-Grube (1997), the first-mover, firm 1 will choose its quality optimally with respect to its prior that q sB2 . q sB1 holds in equilibrium. Thus, the demand functions are D sB2¼100 (1-usB12) and D sB1¼100 (usB12-usB1), where usB12¼(p sB2 - p sB1)/(q sB2q sB2) and usB1¼p sB1/q sB1. Firms’ profits amount to:

PsB2 ¼ D sB2 psB2 2 12 q sB2 2 ; PsB2 ¼ D sB2 psB2 2 12 q sB2 2 ; First, simultaneously solving for optimal prices and substituting this back into the profit functions yields (see Motta, 1993):

PsB2

¼

400

q sB2 ðq sB2 2 q sB1 Þ

PsB1

¼

100

q sB2 q sB1 ðq sB2 2 q sB1 Þ

ð4q sB2 2 q sB1 Þ2 ð4q sB2 2 q sB1 Þ2

2

1 s 2 2 q B2 ;

2

1 s 2 2 q B1 :

Next, we solve ›PsB1 =›q sB1 ¼ 0for the optimalq sB1 ðq sB2 Þand substitute this back into the profit function of firm 2. Finally, solving ›PsB2 =›q sB2 ¼ 0, yields q s* B2¼24.52. from which the other values stated in the lemma derive subsequently. *

However, thus far these values only constitute an equilibrium candidate which hinges upon s* the ex-ante assumptions that an interior solution for the prior q s* B2 . q B1 exists. In other words, in order to show that the candidate equilibrium is indeed Nash, it remains to be verified whether any of the two firms has an ex-post incentive to deviate from its designated position of being the low or high quality provider. More specifically, in Nash equilibrium it must be ensured that the low-quality firm has no incentive to high quality leapfrog and provide an even higher quality than the designated high quality firm. In this case the game would have no equilibrium. On the contrary, low quality leapfrogging is relevant only if the low-quality firm earns higher payoffs than the high-quality firm (see Lehmann-Grube, 1997). Since this is never the case here, we must consider high quality leapfrogging only. For the present case, Motta (1993) has shown that high-quality leapfrogging is not advantageous, thus the above values indeed constitute and equilibrium.B Proposition 3: Under the separate selling regime, firm 1 earns a total profit of p s* 1 =327.65 and firm 2 a profit of p s* 2 =244.70 The bundling regime In contrast to the separate pricing regime, which did not evoke any cross-market effects, bundling creates externality on the other market. In order to compare firm 1’s service bundle with firm 2’s competing service offer, consumers cannot consider each market separately anymore, but must simultaneously assess both offers on the converged markets. I can show that this externality acts as a quality-leverage device, which enables firm 1 to provide a high-quality service on both markets, although it has a strategic disadvantage by selecting its quality level subsequent to firm 2 in market B.

j j


Under bundling the consumer indifferent between the firm 1’s bundle and firm 2’s single service offer has a marginal willingness to pay of:

ub12 ¼

q bA1

p b1 2 p bB2 þ q bB1 2 q bB2

The equation directly reveals that consumers compare the aggregate quality of the bundle (q bA1þq bB1) with the quality of the individual service (q bB2). For the same reason as in the b* b* separate pricing regime, q b* A1þq B1¼q B2 cannot constitute an equilibrium as firms’ service lack differentiation. Moreover, it is obvious that being the aggregate high-quality provider remains to be beneficial. However, since q bA1 and q bB2 are chosen simultaneously by firm 1 and firm 2, neither holds a clear strategic advantage which would immediately resolve the quality leadership question. Therefore, consumers and firms can have two different ex-ante b* b* b* b* b* priors (i) q b* A1þq B1 , q B2 (ii) q A1þ q B1 . q B2, which propose different equilibrium candidates. I will investigate each in turn: q bA1* þ q bB1* , q bB2*

ðiÞ

According to this prior, firm 2 emerges as the high-quality provider, while the aggregate quality of firm 1’s bundle constitutes the low quality service. Lemma 4: There exists no Nash equilibrium in pure strategies under the bundling regime b* b* with prior q b* A1þq B1 , q B2. Proof: Given the prior firms’ profit functions are:

Pb2 ¼ 100ð1 2 ub12 Þp bB2 2 12 q bB2 2 : Pb1 ¼ 100ðub12 2 ub1 Þp b1 2 12 q bA1 2 12 q bB2 2 ; Solving for optimal prices (analogous to market B under separate selling) and substituting these back into the profit functions yields:

Pb2

¼

400

q bB2 ðq bB2 2 ðq bA1 þ q bB1 ÞÞ

Pb1

¼

100

q bB2 ðq bA1 þ q bB1 Þðq bB2 2 ðq bA1 þ q bB1 ÞÞ

ð4q bB2 2 ðq bA1 þ q bB1 ÞÞ2 ð4q bB2 2 ðq bA1 þ q bB1 ÞÞ2

2 2

1 b 2 q B2 ;

1 b 2 q A1

2 12 q bB1 :

Now, firm 1’s best quality response with respect to the quality levels which have been chosen b b simultaneously in stage 2 of the game is derived by solving ›Pb1 =›q bB1 ¼ 0 for q b* B1(q A1,q B2) Substituting this back into the firms’ profit functions and simultaneously solving the first order conditions for firm 1 and firm 2 with respect to q bA1 and q bB2, respectively, yields: b* b* q b* A1¼q B1¼3.69 and q B2¼24.21. Again, we have to check whether high-quality leapfrogging by firm 1 is possible, before the equilibrium candidate can be affirmed. Given the above quality levels, p b* 1 ¼23.96. If there exists a tupel of quality levels (q bA1, q bB1, q bB2* ) with q bA1þ q bB1. q bB2* .for which 2

*

ðq bA1 þ q bB1 Þ ðq bA1 þ q bB1 2 q bB2 Þ

1 1 2 q bA1 2 q bB1 2 . 23:96 2 2 ð4ðq bA1 þ q bB1 Þ 2 q bB2* Þ2 A simple calculation reveals that high-quality leapfrogging is indeed advantageous, e.g. for q bA1¼q bB1¼27.25 which yields a profit of p b1¼215.76. Thus, there the equilibrium candidate is not Nash and there exists no equilibrium in pure strategies. B b* p b1(q bA1,q bB1,q b* B2) . p 1 , i.e. 400

*

*

*

qbA1 þ qbB1 . qbB2

ðiiÞ

b* b* Lemma 5: Under the bundling regime with prior q b* A1þq B1 . q B2, the unique subgame b* b* q ; p )¼(25.10; 25.10; 22.98) and perfect Nash equilibrium configuration is given by (q b* A1, B1 1 b* b* b* (q b* ; p )¼(5.49; 1.26) with corresponding profits of p ¼551.41 and p B2 B2 1 2 ¼17.23.

j j


Proof: Now the profit functions are:

Pb1 ¼ 100ð1 2 ub12 Þp b1 2 12 q bA1 2 12 q bB2 2 ; Pb2 ¼ 100ðub12 2 ub2 Þp bB2 2 12 q bB2 2 : The derivation of the equilibrium candidates then runs analogously to the proof of Lemma 4 b* b* and yields q b* A1¼q B1¼25.10 and q B2¼ 5.49. This time, we must check whether firm 2 has an b* incentive to quality leapfrog by choosing an appropriate q bB2 .q b* A1þq B1¼50.20. One may easily check that: *

400

*

q bB2 2 ðq bB2 2 ðq bA1 þ q bB1 ÞÞ ð4q bB2 2 ðq A1 þ q B1 ÞÞ2 b*

b*

1 2 q bB2 2 , 0; 2

for all q bB2 .50.20, which affirms the equilibrium candidate to be Nash. B s* Finally, since p b* 1 ¼ 551.41 . p 1 ¼ 327.65, firm 1 will choose bundling in stage one of the game.

4. Interpretation The following central proposition follows immediately from the analysis in Section 3 and summarizes its main result. Proposition 6: In the unique subgame perfect equilibrium, the telco firm (firm 1) can achieve market power leverage (from its home market, A, to its secondary market, B) by bundling its services. Despite having a strategic disadvantage in the market for video broadcasting (market B), the telco firm will eventually provide the high-quality service there, while being more profitable than its incumbent. The Proposition highlights a new mechanism of leveraging market power, which I shall refer to as quality leverage. Hereby, bundling leads to increased profits because it alters the equilibrium quality choice of the firms. Indeed the mechanism is rather powerful, because leverage is achieved despite a strategic disadvantage in the secondary market. Moreover, in Kra¨mer (2007) I show that the effect is very robust and persists under a wide range of alternative assumptions. Most importantly, quality leverage does not hinge on the positive correlation of consumers’ preferences across markets, but remains viable also for uncorrelated tastes. Furthermore, it is easy to see that, e.g. the introduction of economies of scope rather strengthens the quality leverage effect as it becomes less costly to provide the secondary service. In essence, quality leverage is feasible because firms wish to shield themselves from increased price competition: By bundling the telco firm connects the previously unconnected markets for telecommunication and video broadcasting services on the demand side. In other words, bundling prevents consumers from mix-and-matching different service offers. For the firms, this results in an all-or-nothing situation, which in turn c.p. increases the intensity of the price competition. The firms may mitigate the harsh price competition by increasing the heterogeneity of their service offers. More precisely, this is achieved by increasing the vertical differentiation of the service offers, i.e. the firms concentrate on serving either the high- or low quality end of the market. This quality sorting effect is at the heart of the quality leverage mechanism: First the telco firm lures its competitor into a all-or-nothing situation by announcing a bundling strategy in stage 1. Then both firms try to alleviate the prospectively harsh price competition (in stage 4) by selecting service qualities (in stages 2 and 3), such that they provide either the high – or low quality end of the consumers in all of their markets.

5. Conclusion In this article I presented a model of competition between two communications service providers. A telco firm holds a monopoly in the market for telecommunications services, while competing with a cable firm in the market for video broadcasting services. Contrary to most of the previous literature, I do not consider communications service as a homogeneous

j j


good, but argue that these services differ in various quality measures, such as bandwidth, content, or failure rates. For the firms, the provision of high-quality services is more costly than the provision of low-quality services. Conversely, consumers have a greater reservation price for higher service qualities. Therefore firms face a trade off between revenues and cost when selecting the optimal service quality. I can show that service bundling is more profitable than separate selling to the telco firm. In particular, the quality leverage mechanism is identified, which reveals that the telco firm can exploit its home market power by choosing a bundling strategy which in turn alters the optimal service quality choice of its opponent favorably. In conclusion, it is annotated that the current framework is believed to be applicable for any digital goods industry characterized by high fixed costs and near zero marginal costs, such as the software industry, for example.

Notes 1. At this point, I deliberately neglect the possible effects of competition among service resellers, who buy capacity from the network operators. 2. I use the term market power very broadly here but will formalize its notion later in the text. 3. See also Peitz (1995) for a more elaborate argument. Therein the corresponding direct counterpart of Tirole’s indirect utility function is constructed and shown that the underlying preference relation satisfies reflexivity, transitivity, completeness and local nonsatiation. See Choi and Shin (1992) for an explicit solution to the model in Tirole (1988). 4. In all models, including the present, consumers’ willingness-to-pay is uniformly distributed on some interval. Therefore, results may differ if a skewed distribution is assumed. 5. On the contrary, if quality improvement induces an increase of marginal cost (at a higher rate than consumer’s willingness to pay) Moorthy (1988) affirms that the low-quality provider earns greater profits. Also Kuhn (2007) finds a low-quality advantage under positive marginal costs, as long as consumers’ utility depends only very little on quality. 6. A related argument justifies to focus on a two-firm economy because high sunk costs constitute an insurmountable entry barrier to firms not controlling a network of their own. 7. In a nutshell, the leverage hypothesis suggests that a firm with market power in its primary market could use bundling as a device in order to gain an advantage in a secondary market. The hypothesis has for a long time been dismissed on the grounds of the Chicago critique (see, e.g. Bowman, 1957; Director, 1956; Posner, 1976), which, however, implicitly assumed a perfectly competitive secondary market and constant returns-to-scale technology. 8. I take the telco’s entry decision as given and sunk, such that exit is prohibitively costly. Thus, I fade out any aspects related to strategic entry deterrence nor will I address the question whether entry should have occurred in the first place. 9. If firm 1 has selected s in the first stage of the game, p1 is in fact a price vector, constituted by the individual prices pA1 and pB1. 10. For firm 1, q1¼(qA1, qB1) 11. Also in reference to the communications industry, Economides and Lehr (1995) have proposed the same cost function. 12. An asterisk denotes an equilibrium value or that the variable has been optimized.

References Adams, W.J. and Yellen, J.L. (1976), ‘‘Commodity bundling and the burden of monopoly’’, The Quarterly Journal of Economics, Vol. 90 No. 3, pp. 475-98. Aoki, R. and Prusa, T.J. (1996), ‘‘Sequential versus simultaneous choice with endogenous quality’’, International Journal of Industrial Organization, Vol. 15 No. 1, pp. 103-21. Bakos, Y. and Brynjolfsson, E. (1999), ‘‘Bundling information goods: pricing, profits, and efficiency’’, Management Sciences, Vol. 45, pp. 1613-30.

j j


Bakos, Y. and Brynjolfsson, E. (2000), ‘‘Bundling and competition on the internet: aggregation strategies for information goods’’, Marketing Science, Vol. 19 No. 1, pp. 63-82. Bauer, J.M. (2007), ‘‘Bundling, differentiation, alliances and mergers: convergence strategies in US communication markets’’, Munich Personal RePec Archive. MPRA Paper No. 2515, posted 3 April 2007. Boom, A. (1995), ‘‘Asymmetric international minimum quality standards and vertical differentiation’’, The Journal of Industrial Economics, Vol. 3 No. 1, pp. 101-19. Bowman, W.S. Jr (1957), ‘‘Tying arrangements and the leverage problem’’, Yale Law Journal, Vol. 67, pp. 19-36. Carbajo, J., de Meza, D. and Seidmann, D.J. (1990), ‘‘A strategic motivation for commodity bundling’’, The Journal of Industrial Economics, Vol. 38 No. 3, pp. 283-98. Carlton, M. and Waldmann, D.W. (2002), ‘‘The strategic use of tying to preserve and create market power in evolving industries’’, RAND Journal of Economics, Vol. 33, pp. 194-220. Chae, S. (1992), ‘‘Bundling subscription tv channels: a case of natural bundling’’, International Journal of Industrial Organization, Vol. 10 No. 2, pp. 213-30. Chen, Y. (1997), ‘‘Equilibrium product bundling’’, The Journal of Business, Vol. 70 No. 1, pp. 85-103. Choi, C.J. and Shin, H.S. (1992), ‘‘A comment on a model of vertical product differentiation’’, The Journal of Industrial Economics, Vol. 40 No. 2, pp. 229-31. Choi, J.P. (2003), ‘‘Bundling new products with old to signal quality, with application to the sequencing of new products’’, International Journal of Industrial Organization, Vol. 21, pp. 1179-200. Choi, J.P. (2004), ‘‘Tying and innovation: a dynamic analysis of tying arrangements’’, The Economic Journal, Vol. 114, pp. 83-101. COM, European Commission (1997), ‘‘Green Paper on the Convergence of the Telecommunications, Media and Information Technology Sectors, and the Implications for Regulation’’, COM(97)623. Crampes, C. and Hollander, A. (2007), ‘‘Triple play time’’, Communications and Strategies. MPRA Paper No.3552, posted 13 June 2007. Damjanovic, D. (2002), Regulierung der Kommunikationsma¨rkte unter Konvergenzbedingungen, Springer, Wien. Director, E. (1956), ‘‘Aaron; Levi. Law and the future: trade regulation’’, Northwestern University Law Review, Vol. 51, pp. 281-96. Economides, N. and Lehr, W. (1995), ‘‘The quality of complex systems and industry structure’’, in Lehr, W. (Ed.), Quality and Reliability of Telecommunications Infrastructure, Lawrence Erlbaum, Hillsdale, NJ. Kra¨mer, J. (2007), ‘‘Service bundling and quality competition on converging communications markets’’, PhD Dissertation, Universita¨t Karlsruhe, Karlsruhe. Kuhn, M. (2007), ‘‘Minimum quality standards and market dominance in vertically differentiated duopoly’’, International Journal of Industrial Organization, Vol. 25 No. 2, pp. 275-90. Lehmann-Grube, U. (1997), ‘‘Strategic choice of quality when quality is costly: the persistence of the high-quality advantage’’, The RAND Journal of Economics, Vol. 28 No. 2, pp. 372-84. McAfee, R.P., McMillan, J. and Whinston, M.D. (1989), ‘‘Multiproduct monopoly, commodity bundling, and correlation of values’’, The Quarterly Journal of Economics, Vol. 104 No. 2, pp. 371-83. Maldoom, D., Marsden, R.A.D., Sidak, J.G. and Singer, H.J. (2005), Broadband in Europe: How Brussels Can Wire the Information Society, Springer, New York, NY. Martin, S. (1999), ‘‘Strategic and welfare implications of bundling’’, Economics Letters, Vol. 62 No. 3, pp. 371-6. Moorthy, K.S. (1988), ‘‘Product and price competition in a duopoly’’, Marketing Science, Vol. 7, pp. 141-68. Motta, M. (1993), ‘‘Endogenous quality choice: price vs quantity competition’’, The Journal of Industrial Economics, Vol. 41 No. 2, pp. 113-31.

j j


Nalebuff, B.J. (2004), ‘‘Bundling as an entry barrier’’, The Quarterly Journal of Economics, Vol. 119 No. 1, pp. 159-87. OECD (2006), ‘‘Policy considerations for audio-visual conent distribution in a multiplatform environment’’, STI/ICCP/TISP(2006)3/FINAL Ortiz, S. Jr (2006), ‘‘Phone companies get into the TV business’’, Computer, October, pp. 14-17. Peitz, M. (1995), ‘‘Utility maximization in models of discrete choice’’, Economic Letters, Vol. 49, pp. 91-4. Posner, R.A. (1976), Antitrust Law: An Economic Perspective, University of Chicago Press, Chicago, IL. Ro¨ller, L.H. and Waverman, L. (2001), ‘‘Telecommunications infrastructure and economic growth: a simultaneous approach’’, American Economic Review, Vol. 91 No. 4, pp. 909-23. Ronnen, U. (1991), ‘‘Minimum quality standards, fixed costs, and competition’’, The RAND Journal of Economics, Vol. 22 No. 4, pp. 490-504. Salinger, M.A. (1995), ‘‘A graphic analysis of bundling’’, Journal of Business, Vol. 68, pp. 85-98. Schmalensee, R. (1982), ‘‘Commodity bundling by a single-product monopolist’’, Journal of Law and Economics, Vol. 25, pp. 67-71. Schmalensee, R. (1984), ‘‘Gaussian demand and commodity bundling’’, Journal of Business, Vol. 57, pp. 211-30. Seidmann, D.J. (1991), ‘‘Bundling as a facilitating device: a reinterpretation of leverage theory’’, Economica, Vol. 58 No. 232, pp. 491-9. Selten, R. (1975), ‘‘Reexamination of the perfectness concept for equilibrium points in extensive games’’, International Journal of Game Theory, Vol. 4, pp. 141-201. Shaked, A. and Sutton, J. (1982), ‘‘Relaxing price competition through product differentiation’’, The Review of Economic Studies, Vol. 49 No. 1, pp. 3-13. Shaked, A. and Sutton, J. (1983), ‘‘Natural oligopolies’’, Econometrica, Vol. 51, pp. 1469-83. Spector, D. (2007), ‘‘Bundling, tying, and collusion’’, International Journal of Industrial Organization, Vol. 25 No. 3, pp. 575-81. Tirole, J. (1988), The Theory of Industrial Organization, MIT Press, Cambridge, MA. Whinston, M.D. (1990), ‘‘Tying, foreclosure, and exclusion’’, The American Economic Review, Vol. 80 No. 4, pp. 837-59.

To purchase reprints of this article please e-mail: [email protected] Or visit our web site for further details: www.emeraldinsight.com/reprints

j j
