Competition with Aftermarket Power When Consumers Are Heterogeneous

• Author: Tobias Kretschmer,Dainis Zēgners
• DOI: http://doi.org/10.1111/jems.12179
• Published date: 01 February 2017
• Date: 01 February 2017

Competition with Aftermarket Power When

Consumers Are Heterogeneous

DAINIS Z¯

EGNERS

Institute for Strategy

Technology and Organization(ISTO) and

Organizations Research Group (ORG)

Ludwig-Maximilians-University Munich

Kaulbachstr. 45/II D-80539 Munich, Germany

d.zegners@lmu.de

TOBIAS KRETSCHMER

Institute for Strategy

Technology and Organization(ISTO) and

Organizations Research Group (ORG)

Ludwig-Maximilians-University Munich

Kaulbachstr. 45/II D-80539 Munich, Germany

t.kretschmer@lmu.de

We study a model of competitive foremarkets and partly monopolized aftermarkets. We show that

high aftermarket power prompts firms to engage in inefficiently aggressive below-cost pricing in

the foremarket. This inefficiency is driven by the presence of consumers with valuations below

marginal cost. While for intermediate aftermarket power their presence leads to a competition-

softening effect, for high aftermarket power firms attract increasing numbers of unprofitable

consumers by aggressively pricing below cost. For high aftermarket power, firms’ equilibrium

profits can therefore be decreasing in aftermarket power but are always higher than for low

aftermarket power. If firms engage in price discrimination by bundling the foremarket and

aftermarket goods or by reducing their aftermarket power, they avoid selling to unprofitable

consumers but also reduce the competition-softening effect. This decreases firms’ equilibrium

profits but increases consumer and social welfare.

1. Introduction

In many industries, firms compete fiercely in a market for a base good in a foremarket,but

then enjoy substantial aftermarket power in a complementary goods market. For products

like video game consoles and video games, printers and cartridges, tablet computers and

digital content, or mobile phones and mobile calls, firms often employ the “razor blade”

pricing model by selling their base good at a discount but earning substantial profits in

the aftermarket. For example, Nintendo, Sony, and Microsoftcompete in the market f or

video consoles, which they often sell at or below cost, but each earns substantial profits

either by selling their own video games or by earning royalties from third party video

We thank Justin Tumlinson, Steffen Hoernig, Pedro Pereira, Johannes Koenen, Joana Resende, Pascal Kober,

Marc Bourreau, Florian Englmaier, Matthias Fahn, Pooyan Khashabi, audiences at the TIME Colloquium in

Munich, the 4th Workshop on the Economics of ICT in Evora, the EARIE Conference 2013 in Evora, the 3rd ICT

Conference in Munich, and in particular our colleagues at ISTO for many helpful suggestions and discussions.

An earlier version of this article circulated under the title “Why Aftermarket Power Can Be Bad for Firms.”

C2016 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume26, Number 1, Spring 2017, 96–122

Competition with Aftermarket Power 97

game publishers.1Because in many digital goods and consumer electronics markets

firms can easily exclude competitors from the aftermarket through chip or software

technology,it has been argued that “the digital incarnation of ... [the razor blade] pricing

strategy opens up a vast array of unprecedented upselling opportunities ... [such that]

the modest approach of selling a low-cost printer to reap profits in ink cartridges seems

quaint and antiquated.”2

But does aftermarket power and the possibility of earning substantial profits with

complementary goods really lead to higher total profits if firms compete aggressively in

the foremarket? We show that this depends on the interplay of three effects: the degree

of aftermarket power, the degree of consumer heterogeneity in aftermarket usage, and

whether firms can discriminate ex ante between consumer types. For example, in the

video game industry there are hardcore gamers, who buy a large number of games,

but also casual gamers, who only buy a few games.3If firms have high aftermarket

power, hardcore gamers will be more profitable and firms will lower the price of their

console to attract more hardcore gamers. However, if firms cannot discriminate ex ante

between consumer groups, lowering the price of the console will increasingly attract

casual gamers. This problem becomes especially severe once a console is sold below

cost, as then some consumers buy the console but not a sufficient amount of video

games such that firms can break even on them.

So will higher aftermarket power lead to higher or lower overall profits and un-

der which conditions? We propose a model of a competitive foremarket and a partly

monopolized aftermarket. In the first period, two firms compete `

a la Hotelling. In the

second period, each firm splits an aftermarket surplus with those consumers who bought

its base good in the first period. If a firm has high (low) aftermarket power, it gets a

large (small) share of the aftermarket surplus. We introduce two types of consumers:

high-value consumers with a high valuation for the aftermarket that results in an over-

all valuation above marginal cost, and low-value consumers with a low valuation for

the aftermarket that results in an overall valuation below marginal cost. This implies

that firms would always prefer to sell only to high-value consumers, because low-value

consumers will never be profitable to firms. We show, however, that if firms cannot dis-

criminate between low- and high-value consumers ex ante, competition for high-value

consumers can lead to firms selling to low-value consumers. As aftermarket power in-

creases, competition gets fiercer and firms set lower foremarket prices, which attracts

more low-value consumers.

In our model, beyond a minimum threshold of aftermarket power, low-value con-

sumers can have two effects: For intermediate levels of aftermarket power,their presence

1. The market research company IHS has published several cost-break down analyses of recent video

consoles that suggest “for both Microsoft and Sony, their latest-generation video game console hardware is

unprofitable at the time of release,” but both companies “can largely compensate for their losses though sales

of highly lucrative game titles.” (IHS, 2013, “Microsoft Xbox One Hardware Cost Comes in Below Retail

Price, IHS Teardown Reveals,” ihs.com, November 26, accessed on July 28, 2015, http://press.ihs.com/press-

release/design-supply-chain/microsoft-xbox-one-hardware-cost-comes-below-retail-price-ihs-tear).

2. Source: Zawada, C., 2012, “Razor-And-Blades Pricing Strategies In The Digital Age,” Forbes.com,De-

cember 19, accessed on October 10, 2013. http://www.forbes.com/sites/ciocentral/2012/12/19/razor-and-

blades-pricing-strategies-in-the-digital-age.

3. Lee (2012) cites a study by Media Awareness Network (2005) that finds thaton average there were 6–9

games sold per console between 2000 and 2005, but “heavy users” reported owning collections of over 50+

games. Moreover, when Sony introduced the Playstation 2 console in 2000, it could also play DVDs and was

priced similarly to standalone DVD-players. So there could have been consumers who bought the console

only to watch DVDs but not for gaming. Similarly,when Sony introduced the Playstation 3, it was one of the

first Blu-Ray players.