Product Upgrades and Product Bundling: How high-tech firms seek to leverage their market power

Many high-tech industries have products that are frequently upgraded. Research by Professors Dennis Carlton and Michael Waldman explains how a dominant firm can leverage its market power in one product into increased profits by selling its key product together with such other related products as a bundle.

The study, published in the June 2012 issue of the Economic Journal, notes that many high-tech offerings, such as Microsoft’s Windows operating system, are actually a bundle of related products tied together for sale. For example, Windows 7 includes not just the Windows operating system but also other complementary products, such as Internet Explorer, Windows Media Player and Wordpad.

An important economic question is whether this type of tying is employed for efficiency reasons, as occurs when tying products together reduces costs, or because the seller has a ‘monopoly product’, such as the Windows operating system, and is trying to leverage this monopoly position into the markets for the tied goods.

The main point of this study is that if upgrades or new versions of these tied goods are introduced over time – which is a frequent occurrence in high-tech industries – then tying can be used as a way of leveraging market power.

Previous work on this topic has argued that tying can be used for leverage only under a restricted set of circumstances. The argument is easily illustrated by thinking about the sale of shoes. If a firm had a monopoly on right shoes but there were many rivals in the sale of left shoes, the right shoe monopolist would have no incentive to bundle its right shoes with left shoes to leverage its right shoe monopoly into the market for left shoes.

Rather, since almost everyone will buy both right and left shoes, the monopolist can capture all the potential monopoly profits by charging a high price for right shoes and letting left shoes be supplied by the market. This argument put forth many years ago by economists associated with the Chicago School view of antitrust analysis is still thought to remove the incentive to tie for leverage reasons in many high-tech markets.

The new study shows that this argument breaks down when complementary products are upgraded as is common in high-tech industries. In a market with upgrades, the monopolist of a product like Windows cannot use high prices of Windows today to capture all the potential profits of future upgrades of the various complementary goods that consumers employ with Windows.

So to capture those future profits, Microsoft has an incentive to tie the complementary goods with Windows, forcing consumers to buy the complementary goods from Microsoft and in this way leverage its Windows monopoly into these complementary markets.

The researchers show that the incentive to use tying in this way is especially strong when the monopolist sells inferior complementary goods – so this type of tying used for leverage can be detrimental to society.

Tying is a common practice observed in many markets and in the typical case it is driven by efficiency concerns such as reducing costs or satisfying consumer preferences. But in markets characterised by frequent product upgrades, as is the case in many high-tech industries, there is the distinct possibility that tying is being used for leverage rather than efficiency.

 ‘Upgrades, Switching Costs, and the Leverage Theory of Tying’ by Dennis Carlton and Michael Waldman is published in the June 2012 issue of the Economic Journal.