The question was key during the trial for understanding Microsoft's competitive position. Never answered to the satisfaction of many observers, the query launched Brian Viard, assistant professor of strategic management at Stanford, and Nicholas Economides, professor of economics at New York University's Stern School of Business and executive director of the Net Institute, to look for an answer.
They examined pricing, compatibility and product quality decisions for both primary, or "base," goods and the secondary, or "complementary," goods that rely on the base product to function.
Why did Microsoft charge only about $60 for Windows--its "base" product--instead of the $1,800 that many estimate it could have demanded?
The issue is particularly important for high-tech industries where consumers create virtual networks of demand for specific products such as PC or Macintosh computers, specific types of music players, or Nintendo game consoles. As more consumers choose one line of products over another, that particular line inspires the creation of more and more complementary products and support services and can create enough support for a primary product to completely squeeze out its competition.
"The greater number of complementary goods created for a product, the more people will buy the product," explains Viard. This leads to what economists term the "network effect."
"One of the implications of our model is that if a firm produces both the base good and complementary goods, that firm has more of a profit motive for investing in improving the complementary goods than does an independent company," Viard said. "So, for example, Microsoft has more of an incentive to improve its word-processing package than another firm that produces such a package but does not produce an operating system. This is because of the feedback effect between the two kinds of goods: If I improve the complementary good, it helps sales of the base good, and vice versa."
As more consumers choose one line of products over another, that particular line inspires the creation of more and more complementary products.
So why did Microsoft price Windows so low relative to Office at the time of the trial--a practice it continues today? One possible reason, says Viard, is that "they don't want to crank up the price for Windows, the base good, because they don't want to choke off the positive feedback effect with those complementary goods that Microsoft does not produce, such as statistical packages and so forth. They control the price of Office, but they don't control the price of other companies' complementary goods. So they prefer to crank up the price of Office because people value it very highly and are willing to pay a lot for it."
Prior to Viard and Economides' study, theorists measured the network effect in two mutually exclusive ways: either by looking at the detailed, underlying microeconomics, or by taking a more global view that assesses value as a function of how many other people buy the product. The researchers' study is the first to unite these two models by using companies' profits as a baseline measurement.
The model, Viard said, has implications for future antitrust cases that may involve base and complementary goods. It also may prove useful to producers of base goods who are deciding whether or not to own complementary goods. Finally, it may provide information on how to price goods in cases in which a monopolist owns the base good but not all of the complementary goods.
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