Buying Decision Coordination and Monopoly Pricing of Network Goods

• Date: 01 April 2016
• Author: Pekka Sääskilahti
• Published date: 01 April 2016
• DOI: http://doi.org/10.1111/jems.12138

Buying Decision Coordination and Monopoly Pricing

of Network Goods

PEKKA S¨

A¨

ASKILAHTI

Nokia

Karaportti 3, 02610 Espoo, Finland

saaskilahti@yahoo.com

We analyze how uncertainty about consumers’ preferences affects the pricing of a network device

and the interaction usage it enables. A premium device price may give high hardware profits,

but adoption will be low reducing the profits from interaction services. The firm internalizing

this adjusts its hardware price downward, and prices as if it was getting the maximal interaction

usage profits from the full network. Profits decrease in uncertainty, whereas consumer surplus

increases in uncertainty, but only if the level of uncertainty is high. Bundling the device and

services is profitable if uncertainty relates mostly to consumers’ private information.

1. Introduction

A product has a network dimension when it is used in interaction among consumers.

Because the consumer’s utility from a network good depends on how many other

consumers buy it, his expectations on other consumers’ actions determine whether he

actually buys the good or not. When an innovative new product is launched, much

of the uncertainty stems from consumers’ subjective preferences about the quality of

the product. We analyze how this kind of uncertainty affects the consumers’ buying

decisions of a network good in this paper. Our particular interest is in understanding

situations where a firm launching a new network productis expecting revenues from two

complementary revenue streams: device sales and interaction services enabled by the

device. In such a situation, the firm is concerned about the risk that, if initial product sales

fall short of planned, also the services revenues will be lower than anticipated. As the

firm controls both the device and services prices, it can internalize the complementarity

in an optimal way. However, price setting is made more complex by the existence of

uncertainty.Second, we look at how bundle pricing can improve the monopolist’s profits

by dispelling some uncertainty about the consumers’ future usage possibilities.

Our leading example is the smart phone, which actually is a bundle of different

services: it can be used stand-alone, for example, as a camera or as an access device to

general Internet content, but it enables of course also communication between people

by telephony, e-mail, and through the use of applications that have social network

elements.1Characteristic to the industry, new technologies and services are introduced

It hank the Editors, two anonymous referees,Jean-Charles Rochet, Juuso V ¨

alim¨

aki,Juuso Toikka,Robin Mason,

TuomasTakalo, TopiMiettinen, Pekka Ilmakunnas, Mikko Mustonen, and the seminar participants at HECER,

FDPE, and Annual Meeting of the Finnish Society for Economic Research in 2005 for helpful comments. I also

thank Universit´

e de Toulouse 1 for hospitality during my stay in 2003–2004, and the European Commission,

ENTER network, FDPE, and Yrj¨

o Jahnsson Foundation for financial support.

1. For example, a navigation service does not only tell the user where he is and how to get where he

wants to go, but also about the popularity of nearby attractions and services, and even where his friends are

and possibly also what his friends are doing. Google Latitude and Foursquare are examples of such services.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 2, Summer 2016, 313–333

314 Journal of Economics & Management Strategy

through major product launches, in so called flagship products. Although the degree of

competition of the industry varies depending on the price segment, a flagship product

enjoys a monopoly position on the new innovation until competition catches up with

subsequent launches.2It is typical that the flagship product is available only from one

mobile operator during the first stages of the product life cycle, so that the mobile

operator’s role at the launch is decisive. It is also the mobile operator who decides on

the consumer pricing of the device and many of the services (e.g., the downpayment

for the device and usage tariffs for data and calls). Our focus is on the pricing of a new

innovative device such as a flagship smart phone, but the problem of setting the launch

price right is more general to consumer electronics goods as well as to digital goods such

as games.

We model a market wherea monopoly firm sells a novel device that constitutes an

efficient medium for social interaction. The device contains innovations drastic enough

to yield a (local) monopoly position against the existing alternatives. The total utility from

the good has three components. The consumer gets stand-alone utility from ownership

and services used independently of other consumers such as general Internet content. He

also gets utility from services which value depends on the overall number of buyers, but

which are used independently of other consumers. For example, the more people there

are on the network, the more and better applications there are available for the device.

Finally, the consumer gets utility fromservices that are used in interaction directly with

other consumers who have bought the good too. Currently, the importance of social

interaction services that are used only with people the consumer knows is increasing.

Traditional phone calls and text messages are not enough anymore. As an example,

Instagram became available on Windows Phone platform only after a significant time

lag and its absence was claimed to be a competitive disadvantage against iOS and

Android platforms.3Because interaction can take place only after people have acquired

the devices, we separate the interaction stage from the acquisition stage. A key aspect

of the model is that the stand-alone values are horizontally differentiated and they

are consumers’ private information, which causes uncertainty about buying decisions.

Hence, the consumers have incomplete information about future interaction services

usage possibilities at the time they have to make their device purchase decisions. This

is a typical situation with the launch of a novel consumer electronics device.

The monopoly’s objective is to maximize total profits by finding the optimal bal-

ance between profits made on the initial device sales and subsequent services sales.

Under network externalities, there is an incentive to reduce the price, as that induces

a direct increase in demand, which in turn reinforces the value of the product, further

increasing the demand. In our setup, the firm sets the device price so that it is lower

than if there were no interaction services in order to increase the demand for services in

Music services can have playlist sharing and popularity ranking functionalities or have a “discussion space”

for over the Internet chatting, as in Spotify. Some mobile banking services enable consumer-to-consumer

money transfers. Many popular games played on smart phones have social features.

2. Recently,the two most significant smart phone manufacturers, Apple and Samsung, have avoided head

to head competition by launching flagships at different times of the year. Apple has introduced new smart

phones in the Fall, whereas Samsung does so in the Spring. The half year gap is material as disproportionate

share of smart p hone profits are made on new pro ducts.

3. The lack of applications available for Windows Phone and the bad quality of the applications were

reported to be the primary reasonsfor product returns of Windows Phone smart phones, according to industry

analysts. The reason behind the applications problem was that the Windows Phone ecosystem did not offer

large enough consumer base for the developers to be interested in it compared to rival ecosystems of iOS and

Android (Windsor,2013).