Tying and Bundling in Two-Sided Markets -WhyTyingWMPandtheWindowsOSIncreasesTotalWelfare- Tilburg University Master Thesis Author: Pauline Luise Affeldt ANR: 285505 Supervisor: Prof. Lapo Filistrucchi Program: MSc Economics Department: Department of Economics Date of Completion: November 28, 2011 Date of Defense: December 13, 2011 Abstract Recently, the European Commission seems to closely scrutinize the high-tech and software sector as the investigations into Intel, IBM, Qualcomm, Rambus, Apple, SAP and Google over the last years show. In these cases, the Commission is mainly concerned about exclusionary behavior by dominant firms. Tying and bundling practices are part of these behaviors and have traditionally been seen as anti-competitive and adopted to foreclose competition. Nevertheless, especially software markets are not only highly dynamic, they are also in many instances characterized by two-sidedness. The literature on two-sided markets has shown that the traditional models and procedures used in antitrust analysis often deliver incorrect results if applied unaltered to two-sided markets. Given the recent focus of the European Commission on the high-tech sector, this thesis inves- tigates whether tying and bundling practices in two-sided markets can be judged in the same way as these practices in one-sided markets or whether the economics of two-sided markets imply that tying and bundling can be profit-maximizing strategies that potentially increase both total welfare and consumer surplus. The literature on tying and bundling in two-sided markets is therefore reviewed and factors determining the likely welfare implications of tying and bundling in two-sided markets are identi- fied. The concepts emerging from the literature are then applied to the decision by the European Commission against Microsoft. In this case, the European Commission found Microsoft guilty of abusing its dominant position in the operating system market by tying its Windows Media Player to the Windows Operating System. Since streaming media players are two-sided platforms, the Microsoft EU case allows applying the findings from the literature to a high profile abuse of dominance decision. Lastly, since one of the crucial factors determining the likely welfare implications of tying in two-sided markets is multi-homing, a game theoretic model of tying in a two-sided market with horizontally differentiated products in which both groups of consumers multi-home is developed based on Choi (2010). In order to make the model fit closer to the Microsoft EU case, two groups of users are distinguished, who differ in their transportation costs. While mainstream users have relatively high transportation costs, tech-savvy users have low transportation costs. The model further investigates whether tying will lead to foreclosure of the rival in the media player market if absent tying the market is covered and content providers as well as high and low transportation cost users multi-home. i Acknowledgements There are several people who played an important role in the completion of this thesis. Firstly, I would like to thank my supervisor, Prof. Lapo Filistrucchi, not only for valuable comments on my thesis and his time, but also for making the last year at Tilburg University a unique, challenging and rewarding experience. Secondly, I thank the second reader, Prof. Jan Boone, for useful comments on the model. Thirdly, I thank Christoph Schottmüller for his precious help. Without him I would not have been able to complete the model. Fourthly, I would like to thank my boyfriend, Falk, for his love, patience and support not only over the period of writing this thesis but during my whole time at Tilburg University. Lastly, I thank my parents for always supporting me in every possible way over the entire course of my studies. ii Contents 1 Introduction 1 2 Literature Review 3 2.1 Tying and Bundling . 3 2.1.1 Definitions of Tying and Bundling . 3 2.1.2 Traditional One-Sided Explanations . 6 2.2 Two-Sided Markets . 11 2.2.1 Definition of Two-Sided Markets . 11 2.2.2 Types of Two-Sided Markets . 12 2.2.3 Pricing in Two-Sided Markets . 13 2.2.4 Single- versus Multi-Homing . 14 2.2.5 Platform Size . 14 2.2.6 Implications for Competition Policy . 15 2.3 Tying and Bundling in Two-Sided Markets . 15 2.3.1 Review of the Literature . 16 2.3.2 Factors Determining Likely Effects . 26 2.3.3 Implications for Tying and Bundling Antitrust Cases in Two-Sided Markets . 29 3 Microsoft EU Case Discussion 31 3.1 Summary of the Facts . 32 3.1.1 Investigation ...................................... 32 3.1.2 ConsideredAbuses ................................... 32 3.1.3 StructureoftheCase ................................. 32 3.2 EconomicAnalysisoftheMicrosoftEUCase . 34 3.2.1 Are the Tying Good and the Tied Good Two Separate Products? . 35 3.2.2 Does Microsoft’s Tie Foreclose Competition? . 36 3.2.3 Are There Arguments Justifying Microsoft’s Tie? . 38 3.2.4 Dynamic Aspect of Microsoft’s Tying . 42 3.3 ConclusiononMicrosoftEUCase. 44 iii 4 A Model of Tying in a Two-Sided Market with Multi-Homing on Both Sides 46 4.1 Model Set-Up . 46 4.1.1 Users . 47 4.1.2 ContentProviders ................................... 48 4.2 Market Equilibrium in Two-Sided Market with Multi-Homing and No Tying . 49 4.3 Market Equilibrium in Two-Sided Market with Multi-Homing and Tying . 52 4.3.1 No Tying . 53 4.3.2 Tying . 54 4.3.3 IncentivestoTie .................................... 56 4.4 Welfare Analysis . 57 4.5 Potential Other Tying Equilibrium: Tying with No Multi-Homing by Users . 60 4.6 SignificanceforMicrosoftEUCaseandLimitations. 63 5 Conclusion 67 References 69 AAppendix 72 A.1 Profit Maximization on User Side with Multi-Homing and No Tying . 72 A.2 Derivation of Assumption A1 . 72 A.3 Derivation of Assumption A2 . 73 A.4 AssumptiononvinChoi(2010) ............................... 74 A.4.1 No Tying with Covered Market and Multi-Homing . 75 A.4.2 No Tying with Not Fully Covered Market and No Multi-Homing . 75 A.4.3 Tying with Covered Market and Multi-Homing . 81 A.4.4 TyingwithNoMulti-Homing . 81 A.5 Derivation of Covered Market Condition under No Tying . 84 A.6 Derivation of Covered Market Condition under Tying . 90 A.7 Profit Maximization of Platform B under Tying . 91 A.8 Profit Comparison of Platform A under Tying and No Tying . 92 A.9 Profit Comparison of Platform B under Tying and No Tying . 93 A.10 Change in Number of Multi-Homing Users due to Tying . 94 A.11ChangeinTotalWelfareduetoTying . 95 A.12ChangeinUserSurplusduetoTying. 96 A.13ChangeinContentProviderSurplusduetoTying . 98 A.14 Profit Maximization of Platform A under Tying with No Multi-Homing . 100 iv List of Figures 1Two-SidedMarketWithMulti-HomingonBothSides...................48 2 User Choices for Type θ .................................... 50 3 Two-Sided Market with Tying by A and Multi-Homing . 55 4 Two-Sided Market with Tying by A and No Multi-Homing . 61 v 1 Introduction Tying and bundling have traditionally been seen as anti-competitive by competition authorities. Ac- cording to standard economic theory, tying and bundling have welfare enhancing as well as welfare decreasing effects. On one hand, tying and bundling can often lead to efficiencies, which are welfare enhancing. On the other hand, these strategies can be used as a tool to price discriminate and hence extract consumer surplus more efficiently. Lastly, tying and bundling can be used strategically to foreclose competitors and entrants both in the tied and the tying good’s market. This thesis’ goal is to investigate whether these results of standard economic theory also hold in a two- sided market context. Over the last ten years, an extensive literature about the economics of two-sided markets has developed. This literature shows that many of the economic results that hold in traditional one-sided markets do not hold in two-sided markets. Hence, a thorough assessment of antitrust cases in two-sided markets requires taking into account the specifics of two-sided markets. While the issues of for example defining a relevant market, establishing dominance or evaluating the effects of mergers in two-sided markets have been discussed in the literature, there exists no comprehensive review of the literature about tying and bundling in two-sided markets. In my thesis I hence address the question of whether the effects of tying and bundling in two-sided markets can be assessed in the same way as in a one-sided market context or whether in a two-sided market tying and bundling can be profit-maximizing strategies rather than instruments to foreclose competitors and entrants. I furthermore try to answer the question under which circumstances tying and bundling in two-sided markets can increase total welfare and potentially also consumer surplus. In order to answer these questions, I first review the existing literature on tying and bundling in one- sided markets as well as in two-sided markets and draw conclusions about which factors determine the likely economic effects of tying and bundling in two-sided markets. After having defined these factors, I apply them to the Microsoft EU case in which Microsoft was found guilty of abusing its dominant position in the Operating System (OS) market by tying its Windows Media Player (WMP) to its Windows OS. Even though the case was already decided in 2004, the case is still relevant today. Especially software markets are characterized by two-sidedness in many cases, where the two sides of the market are typically content or software providers on one side and users on the other side. Furthermore, in recent years, the European Commission seems to have looked especially closely at the high-tech sector as the recent investigations into Intel, IBM, Qualcomm, Rambus, Apple, SAP and Google show.1 Since the high-tech sector is seen as an important driver of economic growth, the European Commission is especially concerned with exclusionary conduct by incumbents and keeping the sector competitive.