When Does Aftermarket Monopolization Soften Foremarket Competition?

• DOI: http://doi.org/10.1111/jems.12167
• Published date: 01 December 2016
• Author: Yuk‐fai Fong,Ke Liu,Jin Li
• Date: 01 December 2016

When Does Aftermarket Monopolization Soften

Foremarket Competition?

YUK-FAI FONG

Economics Department

Hong Kong University of Science & TechnologyBusiness School

Kownloon, Hong Kong

yfong@ust.hk

JIN LI

Kellogg School of Management

Northwestern University

Evanston IL 60208

jin-li@kellogg.northwestern.edu

KELIU

Economics Department

Hong Kong University of Science & TechnologyBusiness School

Kownloon, Hong Kong

kliuaa@ust.hk

This paper investigates firms’ abilities to tacitly collude when they each monopolize a proprietary

aftermarket. When firms’ aftermarkets are completely isolated from foremarket competition, they

cannot tacitly collude more easily than single-product firms. However, when their aftermarket

power is contested by foremarket competition as equipment owners view new equipment as a

substitute for their incumbent firm’s aftermarket product, profitable tacit collusion is sustainable

among a larger number of firms. Conditions under which introduction of aftermarket competition

hinders firms’ ability to tacitly collude are characterized.

1. INTRODUCTION

In 1992, the U.S. Supreme Court ruled in favor of 18 independent service organizations

(ISOs), which sued Kodak for its refusal to sell them replacement parts for servicing

Kodak’s photocopiers and micrographics equipment.1Since Kodak’s market share was

not considered substantial in the case, the questions of particular interest to economists

are: (i) whether firms that do not have substantial market power in the equipment market

are able to exercise their power in the related proprietary aftermarkets; and (ii) whether

Earlier versions of this paper were circulated under different titles. We want to thank Ricardo Alonso, Eric

Anderson, Joe Farrell, Patrick Greenlee, Igal Hendel, Qihong Liu, Albert Ma, Niko Matouschek, Marco Otta-

viani, Konstantinos Serfes, Frances Xu, Jano Zabojnik, and especially Jim Dana, Kai-Uwe K¨

uhn, and Jay Surti

for useful comments and suggestions. We wouldalso like to thank seminar participants at the Department of

Justice, DePaul University,HK University of Science & Tech., University of Hong Kong, University of Illinois

Urbana-Champaign, Peking University,and several conferences. Pak Hung Albert Au provided excellent re-

search assistance. Yuk-faiis grateful to the Department of Economics and Finance at City University of Hong

Kong for the hospitality during his visit.

1. Details of the case are available, for example, in Hay (1993). Borenstein et al. (2000) point out that at the

time their paper was published, there were over 20 antitrust cases brought against equipment manufacturers

whose customers relied on them heavily for aftermarket supplies/services.

C2016 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 4, Winter 2016, 852–879

Aftermarket Monopolization 853

these firms can earn substantial overall industry profits and cause significant consumer

injury.

Borenstein et al. (1995, 2000) show that equipment manufacturers tend to set supra-

normal prices in their proprietary aftermarkets. On the other hand, Shapiro and Teece

(1994) and Shapiro (1995) argue that installed-base opportunism is unlikely if equipment

manufacturers have reputation concern. Although these studies provide different an-

swers to question (i), they largely agree on question (ii) in that as long as the equipment

market is competitive, firms with monopolized proprietary aftermarkets cannot earn

supranormal profits because competition in the equipment market would induce them

to rebate any aftermarket profits through lower equipment prices.

To demonstrate the relevance of proprietary aftermarkets to firms’ overall prof-

its and consumer welfare, this paper investigates the effect of aftermarket power on

equipment sellers’ ability to collude. We explicitly distinguish between two types of

aftermarket power: unconstrained aftermarket power and constrained aftermarket power.A

firm’s aftermarket power is said to be unconstrained if the firm’s aftermarket product

is for adding new functionality that cannot be provided by the equipment. Therefore, a

firm’s established customers do not consider new equipment as a substitute for the

firm’s aftermarket product and firms’ aftermarkets are isolated from competition in the

equipment market. For example, hotel owners possess unconstrained aftermarket power

over room service and mini-bar items because guests in need of a late-night refreshment

for practical purposes do not consider renting another hotel room as a substitute. Other

products characterized by unconstrained aftermarket power include insurance for car

rental, memory and hard drive upgrades for laptops, and business class upgrades for

air travel. On the other hand, a firm’s aftermarket power is said to be constrained if the

firm’s aftermarket product is for restoring the lost functionality of the equipment and its

established customers consider new equipment of a different brand as a substitute for the

firm’s aftermarket product. For example, printer manufacturers only enjoy constrained

aftermarket power because existing owners of their printer consider its proprietary

compatible replacement cartridge and a new printer of another brand as substitutes.

Other aftermarket products characterized by constrained aftermarket power include

razor blades, refills of fine writing ballpoint pens, maintenance and repair services for

electronic products, luxury watches, vehicles, and expensive medical devices.

This paper shows that when firms’ aftermarket power is unconstrained, their

ability to sustain supranormal profits is no different from that of single-product firms.

Ironically, when their aftermarket power is constrained, collusion is sustainable among

a larger number of firms.

We consider oligopolistic firms competing in the equipment market, each the sole

provider in the equipment’s aftermarket. New consumers arrive in the market every

period, each staying for two periods. Each consumer purchases the equipment in the

first period of her market life and the aftermarket product in the second period. Products

offered by different firms are ex ante homogeneous to consumers in the sense that if

consumers anticipate paying the same total price for different firms’ equipment and

aftermarket products, then consumers in the first period of their market life value these

firms’ products equally.

When firms enjoy unconstrained aftermarket power, there is no competition be-

tween the equipment and aftermarket products. As a result, firms can charge their

established customers up to their reservation value for the aftermarket product both in a

collusive equilibrium and on the punishment path. If any firm undercuts the equipment

price by an infinitesimal amount, it will capture the entire industry profit derived from