One-Way Essential Complements

40 Pages Posted: 15 Oct 2006

See all articles by M. Keith Chen

M. Keith Chen

University of California, Los Angeles (UCLA) - Anderson School of Management

Barry J. Nalebuff

Yale University - Yale School of Management; Yale University - Cowles Foundation

Date Written: November 2006

Abstract

While competition between firms producing substitutes is well understood, less is known about rivalry between complementors. We study the interaction between firms in markets with one-way essential complements. One good is essential to the use of the other but not vice versa, as arises with an operating system and applications. Our interest is in the division of surplus between the two goods and the related incentive for firms to create complements to an essential good.

Formally, we study a two-good model where consumers value A alone, but can only enjoy B if they also purchase A. When one firm sells A and another sells B, the firm that sells B earns a majority of the value it creates. However, if the A firm were to buy the B firm, it would optimally charge zero for B, provided marginal costs are zero and the average value of B is small relative to A. Hence, absent strong antitrust or intellectual property protections, the A firm can leverage its monopoly into B costlessly by producing a competing version of B and giving it away. For example, Microsoft provided Internet Explorer as a free substitute for Netscape; in our model, this maximizes Microsoft's joint monopoly profits. Furthermore, Microsoft has no incentive to raise prices, even if all browser competition exits. This may seem surprising since it runs counter to the traditional gains from price discrimination and versioning. We also show that a essential monopolist has no incentive to degrade rival complementary products, which suggests that a monopoly internet service provider will offer net neutrality.

There are other means for the essential A monopolist to capture surplus from B. We consider the incentive to add a surcharge (or subsidy) to the price of B, or to act as a Stackelberg leader. We find a small gain from pricing first, but much greater profits from adding a surcharge to the price of B. The potential for A to capture B's surplus highlights the challenges facing a firm whose product depends on an essential good.

Keywords: bundling, complements, monopoly leverage, net neutrality, price discrimination, tying, versioning

JEL Classification: C7, D42, D43, K21, L11, L12, L13, L41, M21

Suggested Citation

Chen, Keith and Nalebuff, Barry, One-Way Essential Complements (November 2006). Cowles Foundation Discussion Paper No. 1588; Yale Economic Applications and Policy Discussion Paper No. 22. Available at SSRN: https://ssrn.com/abstract=937384 or http://dx.doi.org/10.2139/ssrn.937384

Keith Chen (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

HOME PAGE: http://www.anderson.ucla.edu/faculty/keith.chen/index.html

Barry Nalebuff

Yale University - Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5968 (Phone)
203-432-6974 (Fax)

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States
203-432-5968 (Phone)

HOME PAGE: http://barrynalebuff.com

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