Topic 5: Changing Added Values

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Topic 5 Changing Added Values

• Monopoly and Competition
• Paul Kerin Sam Wylie
• MBS Term 3, 2004

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Co-operation vs Competition

• Your payoff or profits depend ultimately on your
  added value
• At the time of negotiations, your added value is
  fixed
• But can you gain by taking unilateral
  (non-cooperative) actions prior to negotiations
  to improve your (relative) added value?

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Actions that Change Added Value

• Improving total value
• Reducing own costs
• Improving product quality
• Network effects

• Limiting others added values
• Creating scarcity
• Encouraging competition
• Raising rivals costs

• Caveat avoid sunk expenditures prior to
  negotiations that can harm relative added value
• Can lead to the hold-up problem
• Better to contract prior to sinking costs

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Mini-case

• Nintendo

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Some Surprising Facts ...

• 1991 Average Market Value
• Nissan 2.0 Trillion Yen
• Sony 2.2 Trillion Yen
• Nintendo 2.4 Trillion Yen
• Why is this so?
• Added value ...

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Nintendos Strategy The Good

• Increase total value
• Cheap hardware
• Great software (games)
• revitalised the video game business (which had
  died after Atari)
• created a virtuous cycle increased sales lead to
  more software house lining up to be part of
  Nintendo.
• Exclusivity clause in licensing agreement
• increased demand drives down manufacturing costs
• growing base of machines attracts more outside
  game developers
• increases demand further exploiting network
  effects

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Nintendos Strategy The Bad

• Limit added value of others
• Restricting supply
• As demand increased Nintendo was careful about
  flooding the market.
• Controlled the number of copies of games produced
  and retailed
• 1988 Christmas season saw a massive shortfall in
  supply
• paradoxically, the shortfall lead to increased
  demand. Why?
• Raising rivals costs hard to replicate platform
• software prevented by exclusivity
• hardware leapfrog Nintendo with new technology
• Other players
• Combat buying power of retailers by keeping
  cartridges in short supply.
• Software security chip allowed them to manage
  licensing restrict to 5 titles develop games
  in-house and by multiple independents.
• Suppliers Mario was a hit and reduced the power
  of Mickey Mouse.

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Nintendos Strategy The Result

• Nintendo had rebuilt home video games to a 5
  billion worldwide business
• 90 share of US and Japanese 8-bit video game
  market
• Nintendo products accounted for over 20 of the
  entire US toy industry
• Mario was more popular than Mickey Mouse with US
  children

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Monopoly

• What is a monopoly and is it bad?

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What is a monopoly?

• A monopoly is a market with a single producer
• Close substitutes (if any) are controlled by the
  same player

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Examples

• Trains
• Water service
• Australia Post?
• Large employer in a small town
• Quality monopolies Sony Trinitron, Nintendo
  Entertainment System
• Microsoft ?

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Its All in the Cards

• I have 10 red cards
• 10 students each have 1 black card
• A red card and a black card together are worth
  10 (paid by the Dean)
• Who will get what?

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Its Mostly in the Cards

• We get another chance to play the game
• But I find there are 3 red cards missing
• Pie is smaller by 30
• Is everyone worse off?

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CORE Bargaining the basis of Added Value

• Basic idea
• Individuals and Groups should never get less than
  their outside option
• That is, what the group could get if they split
  off went on their own
• Why cant you get more than your Added Value)?
• Because if you get more than your Added Value,
  the group would get more by refusing to cooperate
  with you.

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CORE Bargaining is an extreme approach

• Gives a simple prediction of what the outcome
  will be
• can be a good start
• But we need to remember that the results are a
  little too extreme
• in the second card game, students got nothing
• Bear in mind that real life may not produce such
  extreme results

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Application Several Customers

• Assume that there is a monopolist seller and
  three buyers
• Also assume that there is sufficient capacity to
  cover all three customers
• Sellers costs are 2 per unit
• Each buyer has a WTP of 8

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Surplus Created

• What is surplus created in this market?

8 - 2 8 - 2 8 - 2
Produce sell
Surplus 3 x 6 18
Seller and buyers
No trade
0
If the seller has capacity to produce 3 (or more)
units, does it capture all of the surplus?
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Added Value of a Buyer

• What is the Added Value of Buyer 1?

8 - 2 8 - 2 8 - 2
Sell to 1
AV1 18 - 12 6
Seller and buyers
Dont sell to 1
8 - 2 8 - 2
If the seller has capacity to produce 3 (or more)
units, each buyer has an added value of 6?
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Value Created

• AV of each buyer 6
• AV of monopolist 18
• ? What is the range that the price of goods can
  take, in each transaction?
• The monopolist derives no bargaining power from
  monopoly its like one buyer facing one seller,
  for each unit.
• ? If prices split the difference, the price will
  be 5 and the monopolist will earn 9 3 ? 5 -
  3 ?2

8
2
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Limited Supply

• Now suppose that the monopolist produces only two
  units. Cost per unit is still 2
• What is total value in this market?
• (8 - 2) 2 12
• What is the added value of a buyer?
• (8 - 2) x 2 (8 - 2) x 2 0!
• the Added Value of buyers has fallen drastically
• According to the core, the monopolist may earn
  12 rather than 9

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Competition Among Buyers

• Potential competition from buyer 3
• 3 is the excluded buyer (s)he would like to
  replace 1 or 2
• If either 1 or 2 leave the game, the seller can
  still sell to 3
• No buyer is needed to sell a unit each buyer
  has zero added value
• However, the presence of excluded buyer 3 is very
  valuable to the monopolist she pushes 1 and 2s
  added value to zero, and they earn less

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CORE Bargaining

• CORE bargaining players never get more than
  their added value
• ? What do the buyers get if monopolist sells 2
  units to 3 buyers, each with WTP of 8?

• Any one buyer has zero added value if he does
  not buy from the monopolist, another buyer will
• ? get nothing
• ? P ? 8

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How much capacity?

• Usual trade-off is about uncertainty or
  variability in sales
• Underbuild - lose sales
• Overbuild - pay for unused capacity
• Added-value trade-off
• Underbuild - limit customers added value
• Overbuild - every customer is powerful

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Good vs Bad Monopoly

• Bad monopoly power refers to the practice of
  firms restricting output (or otherwise destroying
  value) in order to diminish buyers added value
• Good if a monopolist can capture most of the
  value without destructive strategies, this is bad
  for its buyers, but good for society
• Can you name some good and bad monopolies?

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Water and Diamonds

• Nothing is more useful than water but it will
  purchase scarce anything scarce anything can be
  had in exchange for it. A diamond, on the
  contrary, has scarce any value in use but a very
  great quantity of other goods may frequently be
  had in exchange for it
• Adam Smith, Wealth of Nations, 1776.
• In 1776, diamonds were relatively rare

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Why are diamonds so expensive?

• Relative scarcity caused high value
• Created incentives to find new deposits. This
  was done over the next two centuries
• There is now an abundance of diamonds
• Why do they cost so much? DeBeers ...

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The DeBeers Monopoly

• Almost all of the worlds diamonds sold through
  DeBeers distribution system or Central Selling
  Organization (including Russia)
• DeBeers restricts supply invites a selected
  number of dealers. If they try and speculate they
  are not invited back
• DeBeers manages demand through marketing
• How much longer will the monopoly persist?

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Conditions for Monopoly Power

• When can a firm exercise monopoly power?
• Credibly restrict output (DeBeers)
• Reputation for output reductions (Disney)
• Insufficient plant (Nintendo)
• When cant a firm exercise monopoly power?
• Banking, unions

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Lessons for a monopoly

• A monopoly needs to consider the costs and
  benefits of limiting supply
• Benefits
• Get bigger slice of the pie
• Prestige value
• May gain free publicity
• May encourage customers to buy slower moving
  parts of range

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Lessons for a monopoly

• A monopoly needs to consider the costs and
  benefits of limiting supply
• Costs
• Reduces total pie
• May affect customer relationship and future sales
• May create general buyer ill will
• Leaves a hole in the market that may encourage
  entry