TCOM 546

1
TCOM 546

• Session 3

2
Overview

• Complete Shy Chapter 2 analyses
• Shy Chapter 5 - Telecommunications

3
Recap Session 2

• Looked at value of compatibility of computers
  under monopoly and duopoly conditions
• Introduced simple consumer utility models
• Used these to determine consumer purchase
  decisions
• Examined profit-maximizing prices under monopoly
  and duopoly conditions
• Examined technology choice (compatibility)
  decisions

4
Welfare Results Summary
Structure Consumer Type Market Failure?
Monopoly Identical No
Monopoly H - Compat Yes
Duopoly H - Brands No
Duopoly H - Compat Not analyzed (Yes)
5
Recap Introductory Example Description

• Taken from Shy, Chapter 2
• Deals with computer hardware
• Two approaches
• Network externalities
• Components
• Investigate how compatibility affects prices,
  profits, consumer utility, social welfare

6
Components Approach

• Do not assume that consumers preferences do not
  exhibit consumption externality
• This example has less relevance to telecom, so
  well skip over rather quickly
• Assume computer requires two components, X and Y
• E.g., computer and monitor

7
Components Approach (Continued)

• Assume two firms, A and B, produce XA, YA, XB, YB
• Assume production is costless (!)
• Systems are compatible if components can be
  mixed and matched, incompatible otherwise
• Assume three customers AA, AB, BB with
  heterogeneous preferences

8
Method

• Assign utility functions to consumers with
  respect to homogeneous/mixed systems based on
  preferences
• Utility b if both components from preferred firm
• Utility b d if only one component from
  preferred firm
• Utility b 2d if neither from preferred firm
• Assume b gt 4d

9
Incompatible Systems

• Only two systems sold
• (XA, YA) and (XB, YB)
• Consumers AB must compromise
• Use UPE
• Mild price undercutting by A attracts AB users
• Strong price undercutting by A attracts BB
  users also
• Mild undercutting yields more profit than strong
  undercutting

10
Incompatible Systems (Continued)

• Then firm with larger market share has a lower
  price but higher profit
• Lower price protects against being undercut by
  smaller firm (which could thereby significantly
  increase its market share)

11
Compatible Systems

• In this case, each consumer can buy preferred
  system
• Market for X is independent of market for Y

12
Summary of Component Model

• Consumers are better off when firms produce
  incompatible components
• Because firms can charge higher prices for
  compatible components
• Aggregate industry profit is higher under
  compatibility
• Firm with larger market share under
  incompatibility earns higher profits under
  incompatibility
• Vice versa for firm with smaller market share
• Social welfare is higher under compatibility

13
Comparison of Results

• Both the externalities and the components models
  yield similar results regarding consumer welfare,
  profits and social welfare
• Social welfare maximized with compatibility

14
Demand for Telecom Services

• High degree of network externalities
• Two types of demand
• Establishing a connection (wiring)
• Ongoing telecom services
• We look at type 1

15
Preliminary Characterization of Demand

• Shy uses a 2-class approach, similar to the
  computer examples described last week
• Assume two types of customers
• h of type H who place a high value on connection
• h of type L who place a lower value
• Let p denote connection fee (non-recurring charge
  NRC)
• Let q denote the number who actually connect

16
Utility Functions

• Type H customers
• aq p if connected
• 0 if not connected
• Type L customers
• q p if connected
• 0 if not connected
• Assume a gt 4
• Assume no coordination failure

17
Demand Function
p
ah
4h
3h
2h
h
Slope a
q
h
2h
18
Critical Mass

• The critical mass for a given price p0 is the
  minimum number of customers needed to ensure that
  at least this number of customers will benefit
  from subscribing
• In telecom, critical mass is always a function of
  price
• qcm(p0) p0/a

19
Monopoly Provider

• Demand looks like previous figure
• 2h if 0 lt p lt 2h
• h if 2h lt p lt ah
• 0 if p gt ah
• Assume monopoly spends m to connect each customer
  ( m lt ah). Also assume monopoly bears a fixed
  cost of f, where
• f lt minh(ah-m), 2h(2h-m)

20
Monopoly (Continued)

• The restrictions on m and f mean that the
  monopoly will not make a loss even if it connects
  only the type L customers
• Monopoly profit p(p) is
• 2h(p m) f if 0 lt p lt 2h
• h(p m) f if 2h lt p lt ah
• 0 if p gt ah

21
Monopoly (Continued)

• Note that agt4 implies
• h(ah-m) gt 2h(2h-m)
• Then the profit-maximizing price and profit are
• p ah
• p h(ah-m) - f

22
Social Optimality

• Welfare hUH hUL p
• h(ah-p) h0 h(p-m) f if H connect
• h(a2h-p) h(2h-p) 2h(p-m) f if all
  connect
• Simplify to
• ah2 hm f if H connect
• 2h2(a1) 2hm f if all connect
• Social welfare is maximized when all are connected

23
Entry of New Firms

• When monopoly is broken up
• Can social welfare be improved by allowing a
  second operator to connect those consumers who
  were not connected during the monopoly era?
• Can a new entrant make a profit?
• How can the monopoly be prevented from predatory
  pricing?
• Prohibit connection charges (NRCs) from being
  reduced reduced after competing provider enters
  market

24
Entry of New Firms (Continued)

• Then the incumbent serves only the h type H
  consumers
• Entrant may serve all type L consumers if its NRC
  is low enough
• Entrant has only residual demand qe
• qe h if p lt 2h
• qe 0 if p gt 2h

25
Entry of New Firms (Continued)

• Entrants profit-maximizing NRC and profit are
• pe 2h
• pe h(2h-m) f gt 0 by previous assumption

26
Homework

• Read Shy, Chapters 6 and 7
• Shy, Chapter 5, exercise 1