The Economics of Bundling Practices in Antitrust An Introduction

1. The Economics of Bundling Practices in AntitrustAn Introduction • Adrian Majumdar • Adrian.Majumdar@rbbecon.com 17 January 2010

2. Today’s topics • Background (abuse of a dominant position) • Definitions and overview of reasons for bundling • Chicago school arguments for pro-competitive bundling • Theories of anti-competitive bundling • Microsoft case studies • Concluding Remarks

3. Background (1) • Bundling practices usually considered under Article 102 (TFEU): do they amount to an abuse of a dominant position? • Dominance = substantial market power • Competitive constraints on alleged dominant firm not strong enough: • Existing competition (Domco has high market share, rivals face high barriers to growth) • Potential competition (Domco protected by high entry barriers) • Buyer power (e.g. buyers unable to sponsor entry or growth by rivals)

4. Background (2) • Competition policy: • Protects the process of competition • Harm to competition matters, not harm to competitors • Effective competition presumed to benefit end consumers • Consumer policy, inter alia, seeks to complement competition policy by developing engaged consumers able to: • Assess • Access • Act on available information. • This talk focuses on the impact of bundling on the process of competition.

5. Definitions • Where the price of a good, or the ability to purchase that good, is conditional on the quantity purchased of another good

6. Economics definitions* • Pure bundle: A and B available together but not separately (sold in fixed proportions) • Mixed bundle:A and B available separately and together at a discount to the sum of their individual prices • Tying: A available only if you buy B. B available with or without A. • static tie= half a mixed bundle (Sky basic with or without Sky Sports, no Sky Sports without Sky basic) • dynamic tie= AB, A2B, A3B, etc (no printer without cartridge, but cartridge without printer) * See Nalebuff (2003), DTI Economics paper no. 1.

7. Why bundle? (1) • Price discrimination:e.g. where consumers’ valuations for each product differ but for the bundle as a whole they are similar. Note also ‘metering’ • Quality/reputation:firm wants its machines serviced by own staff, otherwise faulty repairs undermine reputation of its machine • Technology:steering wheel, engine bundled with body of car... standardisation allows more efficient runs than bespoke production • Distribution efficiencies:cheaper to distribute some products together than to deliver each separately • Business secrets:unbundling may release IP • All products bundled to some degree:Bundling not per se a concern, even by dominant firms.

8. Why bundle? (2) • Reduce double marginalisation (‘Cournot Effect’) • Suppose buyer needs both component A and component B before it can produce • If A and B sold independently by firms with market power, both products are marked up (reduces demand for these components) • If producers of A and B merge, new entity realises that higher price for B reduces demand for A and vice versa • Merged firm lowers price(cf. GE Honeywell debate)

9. Why bundle? (3) • Anti-competitive motives: • Deter new entry to a market • Protect market power of Domco • NB – note link to margin squeeze and refusal to supply, and vertical agreements • Other motives (not discussed today) • Dampen competition • Generate ‘after market’ profit (incompatible systems, add on products at POS) • Obfuscation device

10. Chicago school versus anti-competitive foreclosure (1) • Background to the following examples: • There is a monopolist of product A, selling A1. • The monopolist also produces a second good B (B1) where it faces (potential) competition from B2. • We also consider potential competition from a rival producer hoping to introduce A2. • Consider different relationships between the two types of product, A and B: • Product B can be used only with A (strong complementarity), e.g. bundling an essential component A with another component B (examples 1, 3 and 4) • Product B has value independently of A (example 2)

11. Chicago school versus anti-competitive foreclosure (2) • Chicago School argument: • Where B provided in a competitive market fewer problems are likely to arise with bundling (Chicago) • Especially if A and B sold according to a fixed ratio (‘fixed proportions’). • Where B provided in a market where competition is imperfect there is greater scope for anti-competitive foreclosure (post Chicago).

12. Example 1 • Monopolist can produce for two markets, A and B. • There is perfect competition in market B • Assume goods A and B are strong complements, such that B has value only when consumed with A • Monopolist could bundle (in effect refusing to supply A to all other firms) and so become a monopolist in market B. • But should it? A1 B1 Should monopolist refuse to supply product A1 to B2 by (pure) bundling A and B1? Consumers B2

13. Chicago argument • Complementarity means that as the price in market B goes down, more of A is bought... lower price of B expands the monopolist’s market. • So monopolist should allow competition in market B since this keeps the price of B products low (and may encourage efficiencies) • If monopolist bundles, this will generate extra profits only if bundling generates efficiencies • Chicago message:no incentive to bundle to exclude another firm more efficient at producing a complementary good in a competitive market (works best if goods purchased in fixed proportions – e.g. see Hilti case)

14. Example 2: Whinston's insight • Bundling can be profitable for monopolist when products A and B are independent goods(valuation of bundle is the sum of individual valuations of A and B). • Bundling can deter new entry into the B market by a more efficient firm. When bundling is irrevocable, can be a commitment to intense price competition. • Intuition: • suppose consumers choose between buying B or the AB bundle. • if consumers buy B, then monopolist does not sell its A product… but A is the product on which it makes money. • So monopolist ensures that the AB bundle is priced to win. • Rival producer of B does not expect to make any sales and so does not enter.

15. Example 2: Implications of Whinston’s model for policy? • We learn that bundling can intensify price competition (see system competition below) • But Whinston’s model is dependent on a credible commitment to bundling (i.e. cannot unbundle after entry occurs), so works better with technical bundling • Where A and B are strong complements, Whinston’s model less likely to apply, and Chicago argument is stronger – i.e. monopolist should allow low cost producer of B to enter as that generates more sales of A.

16. Example 3: Protecting market power (1) • Monopolist produces A and B. Assume monopolist has market power in both markets. (Thus not a Chicago case.) • Potential entrant can enter both markets but this requires investing in R&D and that the investment is successful. • If B is useful only when consumed with A then bundling makes entry harder – entry must occur on ‘two fronts’. • Entrant must succeed not only in inventing a B product (B2) but also an A product (A2). • Entrant may decide not to enter when would have tried to enter (one or both markets) if monopolist did not bundle (depends on ‘parameter values’).

17. Example 3: Protecting market power (2) Monopolist refuses to supply A1 by bundling A1 and B1 A1 B1 Consumers Entrant has better A2 and B2 products but must succeed with A2 and B2 to sell either product A1 B1 Consumers B2 A2 Example: probability of success with one product is 0.50. Probability of success with two products is – if independent – 0.25. Expected return from innovating falls.

18. Example 4: Defensive leverage Monopolist refuses to supply A1 by bundling A1 and B1 A1 B1 Consumers B2 Entrant has better A2 and B2 products but must obtain presence in B market first (to establish the B2 platform from which to launch A2) A1 B1 Consumers B2 A2 Why deter entry by a more efficient firm? Chicago argument suggests there is no point. Post-Chicago,B2 could have been a route to market for a new competitor’s A2 product.Raise entry barrier in the A market.

19. Component by component versus bundle competition (1) • Component by component competition = compatibility • Assume two competing ‘systems’: printers and cartridges • Compatibility: My printer can be combined with your cartridge (and vice versa) • If I price high on printers, I may lose a sale to you. But, I might generate a cartridge sale from your sale of that printer. • Less ‘costly’ for me to price high.

20. Component by component versus bundle competition (2) • Competing bundles =incompatibility • My printer-cartridge system competes with your printer-cartridge system but consumers cannot mix my printers with your cartridges (and vice versa) • If I price high on printers, I may lose the sale of the whole system. • So with system competition, we compete more aggressively on price. (Can still be a more profitable approach, e.g. where reduces double mark ups.)

21. Further issues to consider* • Moving away from the extreme assumptions of the models... • Single line buyers.Many buyers interested only in one product and not the bundle? Pure bundling may be less profitable. But mixed bundling may still occur. • Scale effects.Economies of scale and network effects – if rival needs access to incumbent’s system to obtain scale economies, bundling components may be more likely to harm competition? But need to take into account incumbent’s long term incentives to develop key components in the first place. • Counter strategies.Rival replicates the bundle. Form alliances / buy in the other product. Harder to do where Domco is the only supplier of a key component in the bundle and entry barriers prevent easy replication of that component. • * See European Commission, Enforcement Priorities Guidance

22. US Microsoft case (1) • Software that ran on Windows (operating systems) OS often incompatible with alternative OS. • A new OS supplier would find it difficult to convince programmers to develop software for its system. • Without good choice of applications for the OS, consumers would not want the OS… but if they do not want the OS… applications are not written for it • US Microsoft case identifies: the “applications barrier to entry” for rival OS • NB – this is an example of an indirect network externality or two sided market. (Consumers want OS with lots of applications but applications writers only want to write for OS that have lots of demand. Developing a rival OS ‘platform’ requires getting both sides on board.)

23. US Microsoft case (2) • Bundling issue: Netscape Navigator (NN, a rival browser to internet explorer) was de facto refused access to the Microsoft operating system because Microsoft bundled a free browser (Internet Explorer, IE) into Windows as the default browser. • DoJ also argued that Microsoft ‘polluted Java’ and used various tactics (as well as bundling IE into Windows as default browser) to reduce NN share. • Java at time was a programming language that would have allowed applications to run on alternative OS, such as Netscape Navigator • Success of Java would imply that OS become a ‘commodity’ (not differentiated by available applications) • Microsoft would then lose its market power?

24. US Microsoft case (3) – Applications barrier to entry App App App Windows JAVA + other OS User User User

25. US Microsoft case (4) • Solving the applications barrier to entry? App App App Windows JAVA + other OS User User User

26. US Microsoft case (5) • US: the Microsoft remedy in the US comprised the following (in a consent decree to which the DOJ was also a party, so applicable nationwide): • Client choice of middleware (e.g. ability to remove IE-icon from the desktop and designate a third party browser as default browser).  • Note that Microsoft was not forced to offer a version of Windows without IE. • Disclosure of the internal Windows interfaces that are called on by Microsoft middleware to third party middleware vendors. • NB: EU remedy on recent Microsoft Media Player case: • In the Windows Media Player case, Microsoft has been required to offer a version of Windows without Media Player (e.g. Windows XP N) • Intended to give OEMs an unbiased choice between offering a PC with Mediaplayer and offering a PC with a rival player • However, very few copies of the “N” versions have been sold. Users expect Media Player to be present. No price difference between the different versions.

27. EU browsers case (1) • Issue was Microsoft bundling IE (a low speed browser without offline facilities for internet based applications) as default browser. • So applications being written to the ‘lowest common denominator’ – disadvantaging browsers (although they had gained share against IE) and, in theory, rival OS that relied more on online applications. Slower innovation? App App App Windows Rival browsers + other OS Slower switching? User User User

28. EU browsers case (2) • Choice screen: • Will be shown to users with IE as default browser • Allows users to easily install additional browsers • Browsers will still need to be downloaded • Browsers shown selected on the basis of usage shares • Updated twice a year • Enabling users and OEMs to turn the user-interface of Internet Explorer on and off: • The underlying IE code continues to be present, but can only be invoked through explicit user action

29. EU Microsoft browsers (3): The choice screen

30. Concluding remarks • In antitrust, bundling usually considered in relation to abuse of a dominant position. Main concern recently has been anti-competitive foreclosure from denying access to a critical complementary good (e.g. access to Windows as default browser). • But bundling is not per-se abusive and has many pro-competitive motivations. • Remedies are also difficult – e.g. where bundling amounts to ‘refusal to supply’, authorities need to determine access terms and monitor compliance. • Intervention must also take into account the risk of harming incentives to innovate.

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32. Back up slides – selective issues in behavioural economics • When might firms bundle to take advantage of consumers with bounded rationality or ‘myopic’ behaviour? • Suppose consumers systematically make mistakes due to: • a limited capacity to process information - hence the use of ‘heuristics’ or rules of thumb • specific biases such as overconfidence, or problems of self-commitment

33. Examples and causes of bounded rationality or myopia • Consumers weigh losses higher than they weigh equally sized gains (‘loss aversion’) • The way a decision problem (e.g. a purchase decision) is formulated influences the decision of a consumer. This is also known as a framing effect (NB important in consumer surveys). • Consumers have separate mental accounts for decisions that are interrelated (e.g. a sweater is too expensive to purchase yourself but fine to receive as a present from your partner... And you have joint bank accounts!) • More generally, people often cannot calculate the optimal choice for a given decision problem under complexity (only a limited number of iterations can be processed).

34. Bundling in the face of consumer myopia (1) • Example 1: Bundling of the product with other products to take advantage of myopia • Consumers may overvalue their future usage of a product. Firms may take advantage of this bias. • Consider the health club market. Sellers in this market can either offer a per-visit fee or a yearly subscription which amounts to an inter-temporal bundle. • Consumers who overvalue their future use of the health club will subscribe to the yearly scheme even if a per-visit fee would be more advantageous for them. • If there is a systematic bias of consumers to overvalue their use of health clubs firms may adjust their marketing scheme by trying to persuade customers to purchase the yearly subscription or by only offering yearly subscriptions (i.e. the inter-temporal bundle) .

35. Bundling in the face of consumer myopia (2) • Example 2: Obfuscation of prices by bundling different product attributes and/or by offering more complex pricing schemes • Recent economic research shows that in a market for retail financial products prices may stay above competitive levels and rise even more as more firms enter the market. • Possible explanations include information overload or that firms deliberately add complexity (in terms of pricing schemes) to the products they offer in a market in which consumers are bounded in their financial literacy.

36. Examples of possible solutions • Increasing transparency (e.g. obligation of seller to inform customer, about certain attributes) • Are the products understood or do consumers focus on just one thing (APRs)? • Increase the risk of coordination? • Market provides own solutions – comparison services, specialist advisers? • Restriction of products – harms innovation? • Unbundling – ‘waterbed effects’ (sophisticates pay more), lowers return from informing oneself? • Regulated benchmarks – need regular revision?