TYING, UPGRADES, AND SWITCHING COSTS by Dennis W. Carlton Booth School of Business University of Chicago 5807 South WoodLawn Chicago, IL 60637 and NBER (773) 702-6694, [email protected] and Michael Waldman Johnson Graduate School of Management Cornell University Sage Hall Ithaca, NY 14853 (607) 255-8631, [email protected] April 2009 * We thank the editor, Mark Armstrong, two anonymous referees, and seminar and conference participants at Cornell University, the University of Melbourne, the 2005 Joint Duke/Northwestern/Texas Industrial Organization Theory Conference, the 2006 UBC Summer Industrial Organization Conference, and the 2006 International Industrial Organization Conference for helpful comments. We also thank Justin Johnson for discussions helpful for the initial formulation of the ideas in the paper. ABSTRACT This paper investigates the role of product upgrades and consumer switching costs in the tying of complementary products. Previous analyses of the leverage theory of tying have found that a monopolist of one product cannot increase its profits and reduce social welfare by tying and monopolizing a complementary product if the initial monopolized product is essential, where essential means that all uses of the complementary good require the initial monopolized product. We show that this is not true in settings characterized by product upgrades and that tying is especially important when the upgrades are accompanied by consumer switching costs. In addition to our results concerning tying our analysis also provides a new rationale for leasing. We also discuss various extensions including the role of the reversibility of tying. Overall, our paper provides explanations for various business practices in software markets that are difficult to understand based on previous theory. I. INTRODUCTION Despite the increased interest in tie-in sales stimulated in part by the Microsoft case, little research has examined tying when product upgrades are important.1 This is quite odd because many tie- ins such as Microsoft’s tie-in of applications software with its operating system involves goods that are periodically upgraded. This paper shows that upgrades create an incentive to tie in a broader set of circumstances than is suggested by previous literature. Whinston’s (1990) classic paper on tying derived conditions under which tying used to extend market power is not profitable. This paper shows that when upgrading is important tying used to extend market power can be profitable even when those conditions are satisfied. Moreover, this paper provides an explanation for some of Microsoft’s behavior that previous theory has trouble explaining. Finally, this paper provides a new rationale for leasing. In the leverage theory of tying a monopolist in one market ties a complementary good in which there are rival producers in order to extend its market power to the tied-good market.2 Starting in the 1950s, authors typically associated with the Chicago School argued that in the common case of fixed proportions in consumption between the tied and tying goods the leverage theory of tying is never valid because a monopolist can always extract all potential profits from its original monopoly position without tying (see, e.g., Director and Levi (1956), Bowman (1957), Posner (1976), and Bork (1978)). To see their logic, consider the profitability of a monopolist of shoes versus the profitability of a right-shoe monopolist when left shoes are competitively supplied. If P* is the optimal monopoly price for a pair of shoes and PL the competitive price for left shoes, then a right-shoe monopolist can sell right shoes for P*- PL and earn the profitability associated with tying and selling a pair of shoes at P*. In an important paper, Whinston (1990) formally considers the Chicago School argument in a one-period setting and shows it holds under some conditions but not all (see also Ordover, Sykes, and 1 Carlton has served as an expert both for and against Microsoft in different cases. 2 A tie-in sale occurs when the seller of product A refuses to sell A to a consumer unless the consumer also purchases B. Product A is referred to as the tying product and B as the tied product. In the academic legal literature in antitrust the words “leverage” and “extend monopoly” have a negative connotation and are often used synonymously to mean illegal activity. In that literature, one can often usefully distinguish between the extraction of surplus (as for example occurs with price discrimination) and the creation of new deadweight loss from the creation or maintenance of market power (see Carlton and Heyer (2008) for a discussion). In this paper we use the words “leverage” and “extend monopoly” in the manner they are often used in the economics literature, not to ask whether the conduct should be illegal but rather to ask under what circumstances the conduct is profit maximizing and what the welfare effect of the practices are. We only briefly touch on antitrust implications. For a discussion of our views of the relevant antitrust issues see Carlton and Waldman (2005), Carlton and Heyer (2008), and Carlton, Greenlee, and Waldman (2008). For those who have followed the legal academic literature on this topic, we think the word “extraction” better describes the behavior in this paper than the words “leverage” or “extend monopoly.” 2 Willig (1985)). In particular, Whinston shows the argument is correct when the monopolist’s primary product is essential, i.e., all uses of the complementary good require the monopolist’s primary good. In contrast, when the primary product is not essential and where constant returns to scale and competition are lacking in the tied-good market, tying can sometimes increase monopoly profits by extending its market power to the tied-good market. From the standpoint of applying the leverage theory of tying to Microsoft’s actions, these results are problematic. For the type of applications program that Microsoft bundles with Windows an operating system is frequently essential, and thus Whinston’s results suggest that the leverage theory of tying cannot provide a rationale for why Microsoft has chosen to bundle applications programs with Windows if Windows is or is close to being a monopoly product. So the question remains, what drives Microsoft’s bundling of applications programs with Windows? One approach to answering this question is to relax the assumption that the primary good is essential by introducing the possibility of entry into the primary-good market. Then it is possible that tying can be used to preserve or extend a monopoly position in the tying market. We analyzed this possibility in Carlton and Waldman (2002). There we considered a series of models, characterized by either entry costs or network externalities, that show how a monopolist can use tying to both preserve and extend monopoly positions in the tying good.3 Our previous analysis formally shows how protecting its Windows monopoly can explain why Microsoft integrated Internet Explorer into Windows, but this reasoning is not a plausible explanation for all of Microsoft’s tying decisions involving applications programs. That is, technological conditions in the browser case are such that a successful rival browser has the potential to evolve into a substitute for Windows so our explanation of tying used to protect the primary-market monopoly is plausible. But such conditions do not hold generally for applications programs, so protecting the primary-market monopoly is not a general explanation for Microsoft’s tying decisions regarding applications programs.4 3 Other related papers based on entry deterrence include Choi and Stefanadis (2001) and Nalebuff (2004). The former shows how tying by an incumbent producer in two complementary markets can preserve a monopoly by reducing the probability of entry in each market, while the latter shows how tying can deter entry in a model where goods are independent (see also Whinston (1990)). Neither of these papers shows why a monopolist of an essential good would tie. Also, another possibility is that Microsoft is responding to efficiency considerations. See Carlton and Perloff (2005) and Evans and Salinger (2005,2008) for recent discussions of efficientcy rationales for tying. 4 Gandal, Markovitch, and Riordan (2004) build on the classic analysis of Stigler (1963) concerning the negative correlation of values to provide an explanation for Microsoft’s bundling strategy in the PC office software market. But their argument would seem not to apply to the bundling of Windows and applications programs. 3 Given the difficulty of current theory to explain Microsoft’s tying decisions regarding applications programs, we re-examine the question initially considered by Whinston which is, under what circumstances will a firm that produces a monopolized primary product tie a complementary product in order to leverage or extend its monopoly into the tied-good market? We show that because of the sequential nature of trade, if upgrades are important for the complementary product, then a primary-good monopolist may indeed tie in order to monopolize a complementary market even when the monopolist’s primary product is essential. We further show that the incentive to tie becomes even stronger when the complementary product is also characterized by switching costs (note that upgrades and switching costs are clearly associated with many of Microsoft’s applications programs).5 Thus, Whinston’s results concerning when tying is not profitable do not apply in our multi-period setting involving upgrades. Our analysis reveals that an implicit assumption in Whinston’s analysis is that all relevant sales take place simultaneously. This is a reasonable assumption for many products, but not when upgrades are important. When all goods are sold simultaneously and assuming the monopolist’s primary good is essential, the monopolist need not tie to capture all the potential monopoly profits because, as Whinston shows, appropriately choosing prices for individual products ensures the firm does at least as well as with tying.