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Standards and Market Entry Reiko Aoki Kyushu University Yasuhiro Arai Kochi University 1 Introduction • Standards become beneficial when there are network effects • Consumer Value • Price of inputs Standards are pro-innovation • However, strategic use of standards is possible • Switching cost • Rival cost Standards may be antiinnovation What is the relationship between standards and innovation? 2 Standards and Innovation • Relationship between standards and innovation Patent pools and innovation Lampe and Moser (2012) Standards and innovation Farrell & Saloner (1985), Cabral & Salant (2013) • Entry Deterrence Entry Deterrence by Increasing standard inertia Farrel and Saloner (1987) Entry Deterrence by Increasing switching cost Klemperer (1987), Chen (1997) 3 Focus of this Paper • There is a standard in place. Incumbent Investment Standard Inertia Improve the Technology Entrant Investment Improve the Technology • • Incumbent in two things • Entrant Incumbentcan caninvest improve his technology to deteronly the invests entry. to improve 1. Increase standard inertia technology Investcan in installed baseto improve his technology to counter the • Entrant also invest Improve complementary technology deterrence. Increase switching cost 2. Improve the standard (technology) 4 Framework: Timing • Player Firm 0 :incumbent Firm 1 :new entrant Consumers • Timing of this game 1. Invest in technology (sequential) I. Firm 0 invests in technology II. Firm 1 invests in technology 2. Market competition (Bertrand competition) • We examine how investments relate to second stage subgame equilibria. 5 Framework: Consumer • Consumers are located over unit interval ( Hotelling ) The surplus of a consumer ∈ 0,1 is given by 0 − 0 − :when he purchases from firm 0 1 − 1 − − 1 − :when he purchases from firm 1 : the value of products : price of the product : cost of changing to different standard (switching cost). : the per unit transportation cost • We define the bench marks �0 0 , �1 1 and � 0 , 1 by 0 − 0 − �0 0 = 0 1 − 1 − − 1 − �1 1 =0 0 − 0 − � 0 , 1 = 1 − 1 − − 1 − � 0 , 1 • We assume ≥ 2. 6 Hotelling Model • Then 0 − 0 1 − 1 , 1 − �1 1 = , 0 − 1 − 0 + 1 + + � 0 , 1 = 2 �0 0 = • By definition, it must be that either or 7 Framework : Optimization in Market • Firm 0 chooses 0 to maximize his profit 0 = 0 = 0 �0 = 0 = 0 � = 0 = 0 0 0 − 0 0 0 − 1 − 0 + 1 + + for for for 0 − 0 ≤ − 1 + + 1 − 1 + + 1 < 0 − 0 ≤ + 1 − − 1 + 1 − − 1 < 0 − 0 • Firm 1 chooses 1 to maximize his profit 1 = 1 = 1 1 − �1 = 1 = 1 1 − � = 1 = 1 1 1 − − 1 1 − 0 + 0 + 1 − − 1 for for for 1 − − 1 ≤ − 0 + 0 − 0 + 0 < 1 − − 1 ≤ + 0 − 0 + 0 − 0 < 1 − − 1 8 Framework : Optimization in Market • Firm 0’s best response correspondence 0 = 0 1 i. If 3 < 0 , 0 1 = ii. 0 − 1 + + 1 − for 1 − − 1 ≤ 0 − 3 0 − 1 + + 1 + 2 for 1 − − 1 ≥ 0 − 3 0 + 1 − − 1 − for 1 − − 1 ≤ − 0 − 1 + + 1 + 2 for 1 − − 1 ≥ − If 3 > 0 , 0 1 = iii. If 3 = 0 , 0 1 = 0 − 1 + + 1 + 2 for all 0 3 0 3 9 1 − − 1 ≥ 0 Framework : Optimization in Market • Firm 1’s best response correspondence 1 = 1 0 i. If 3 < 1 − , 1 0 = ii. − 0 − − 0 + 1 − for − 0 + 0 + 1 − 2 for 0 − − 0 + 1 − If 3 > 1 − , − 1 0 = 1 − − + 0 − 0 − 0 + 0 + 1 − 2 for for for for 0 − 0 ≤ − − 1 − 2 1 − < 0 − 0 ≤ 1 − − 3 2 1 − − 3 < 0 − 0 0 − 0 ≤ − − − 1 − 2 1 − 1 − < 0 − 0 ≤ − 2 3 1 − < 0 − 0 3 10 Framework : Optimization in Market • Firm 1’s best response correspondence 1 = 1 0 iii. If 3 = 0 , 0 1 = − 0 + 0 + 1 − 2 for all 0 − 0 ≥ 0 11 Market Equilibrium I. Only Firm 0 (Deter Entry): All consumers purchase from firm 0 II. Only Firm 1 (Standard Replaced): All consumers purchase from firm 1 12 III. Two firms co-exist in the market (unique equilibrium): and 0 − 1 + + 3 ∗ 1 − 0 − + 3 , 1 = 3 3 2 1 0 − 1 + + 3 1 1 − 0 − + 3 0∗ = , 1∗ = 2 2 3 3 0∗ = p1 p0 = v0 − v1 + S + p1 + t 2 R0 2 p0 = v0 − v1 + S + p1 − t R1 p1 = t − v0 + p0 + v1 − S 2 v1 − S + t − v0 13 p1 = p0 + v1 − S − t − v0 v1 − S − t − v0 0 p0 IV. Two firms co-exist in the market (multiple equilibria): 0∗ 0 + 1 − < 3 3 − 0 = − 1− 3 p1 1 − − 3 p0 = , 1∗ = v0 − v1 + S + p1 + t 2 v1 − S + t + v0 R0 p1 = 0 2 + 1 − − − 3 3 where ∈ [0,1] t − v0 + p0 + v1 − S 2 t − v0 + v1 − S 2 R1 0 p0 If we also assume that the entrant is sufficiently efficient 1 − ≥ 2 , then this regime never occurs. Market Equilibrium ν1 − S Standard Replaced Regime II Only Firm 1 Co-existence (Unique equilibrium) 3t Regime III Regime I Only Firm 0 Regime IV Standard Upgraded Co-existence 0 3t ν0 15 Iso-consumer surplus curve ν1 − S ν1 − S CS increases Regime II 3t Iso-social surplus curve SW increases Regime II 3t Regime III Regime III Regime I Regime I 0 Regime IV 3t ν0 0 Regime IV 3t ν0 Investment • We examine how investments relate to second stage subgame equilibria. Firm 0 (Incumbent) can invest in technology, Δ0 0 = ̅ + Δ0 (Upgrade) max 0 Δ0 , Δ1 , − 0 Δ0 Δ0 Firm 1 (Entrant) can invest in technology,Δ1 0 = ̅ + Δ1 (Replace) max 1 Δ0 , Δ1 , − 1 Δ0 Δ1 Costs of investment are 0 Δ0 Δ20 Δ21 = , 1 Δ1 = 2 2 17 Subgame • For simplicity, we assume that ̅ > 3 • If there is no investment Δ0 = Δ1 = 0 , 0 = 1 = ̅ and regime (III) will transpire • There are two possible regimes after Firm 0 has its investment choice. 0 + > 3 ν1 − S ν1 − S Replacement Regime II 3t Regime III Regime IV 0 ̅ , ̅ − 3t 0 + < 3 Replacement Regime II 0 3t Regime I Upgrade ν0 Regime III Regime IV 0 0 ̅ , ̅ − 3t Regime I Upgrade ν0 18 Subgame • The final outcome depends on firm 1’s investment choice. Next Proposition shows the equilibrium outcome of this game. Proposition 2 In equilibrium, if ≤ 1/3 or 9 3 − 1 / 9 − 1 < , Δ∗0 + > 3 and Δ∗1 = 0 Final outcome is regime I (Upgrade) if > 1/3 and 9 3 − 1 / 9 − 1 > , Δ∗0 + < 3 and Δ∗1 > 0 Final outcome is regime III (Co-existence) 19 Conclusion • Policy (competition, standardization ) should be technology life cycle dependent • Incumbent improving technology (upgrade) always makes consumer better-off • Investment in installed base can reduce consumer surplus • When technology is in infancy, entry deterrence (upgrade, switching cost) and persistence of single standard • When technology matures, co-existence of new and old standards • There will never be replacement in equilibrium (entrant never dominates) 20 Appendix:Dual Investment • There is a standard in place. Incumbent Entrant Investment Investment Increasing Standard Inertia Improve the Technology Improve the Technology • Incumbent can invest in two things • Entrant only invests to improve 1. Increase standard inertia technology Invest in installed base Improve complementary technology Increase switching cost 2. Improve the standard (technology) 21 Appendix:Dual Investment • We examine how investments relate to second stage subgame equilibria. Firm 0 (Incumbent) can invest in 1. Technology improvement, (Upgrade) 2. Installed base = increase switching cost Firm 1 (Entrant) invests in technology, (Replace) Costs of investment are 22 Subgame • For simplicity, we assume that ̅ > 3 • If there is no investment Δ0 = Δ1 = = 0 , 0 = 1 = ̅ and regime (III) will transpire • There are two possible regimes after Firm 0 has its investment choice. 0 + > 3 ν1 − S ν1 − S Replacement Regime II 3t 0 Replacement Regime II Regime III 3t Regime I Upgrade Regime IV 3t 0 + < 3 ν0 Regime III Regime I Upgrade Regime IV 0 3t ν0 23 Subgame • The final outcome depends on firm 1’s investment choice. Next Proposition shows the equilibrium outcome of this game. Proposition 2 In equilibrium, if ≤ 1/3, if > 1/3, Δ∗0 + ∗ ≡ Δ∗ > 3 and Δ∗1 = 0 Final outcome is regime I (Upgrade) Δ∗0 + ∗ ≡ Δ∗ < 3 and Δ∗1 > 0 Final outcome is regime III (Co-existence) 24