The Power of Complements

The Power of Complements

In this week's lecture:

• Examples and definition of complementary products
• The economic definition for complementary products
• Cross-price elasticity of complementary products
• How substitute goods can also be surprising complements
• Interesting strategies in markets with complementary products
• Supporting the supplier of a complementary product
• Produce the complements - Advantages and disadvantages
• Strategies for firms that produce the complements
• Cross subsidize complementary products
• Bundle complementary products
• Increase Lock-In
• How complementarity can help achieve cooperation among firms who might otherwise compete
• Competitors as Complementors
• How Strategic Partnerships foster coordination between firms
• Shared decision making
• Organisation Integration
• Economic Integration

Complementary Products

Examples of complementary products:

• Computers and Software
• Skis & Skiing Sticks
• Smartphones & Apps

 

Economic Definition

The utility increase when the products are used together.

• Two products A and B
• These are complements if B increases users' utility from A, and vice versa
• U(A+B) > U(A) + U(B)

Cross-Price Elasticity

• Two products A and B
• These are complements if the demand for B increases when the price of A drops, and vice versa
• This phenomenon is referred to as negative cross price elasticity
• Cross price elasticity is how the price of one product depend on the price of another products

Surprising Complements

• Substitute good can also have complementary effects
• A price cut of the substitute good decreases market share but increases the size of the market, resulting in a positive net effect
• Example: Cloth shops in the same mall
• Shop A's price cut makes the whole mall more attractive
• Shop B's sales increase due to the additional customers

Supporting the Supplier

• Enable the supplier in ways that increase sales of complement e.g.:
• Better quality of complement
• Higher sales of complement
• Example: Apple
• Gave laptops to students writing software for Mac OS
• More compatible software titles made Apple's laptops more attractive
• Example: Game console manufacturer 3DO
• Problem
• Console manufacturers sold consoles for high prices to make profits
• This attracted a limited number of customers only
• Neither optimal for console manufacturers not for game publishers
• Solution
• Publishers paid a fee of 3 dollars to 3DO for every game copy sold
• 3DO could sell consoles much cheaper and attract more customers
• This way, publishers could sell more copies and increase profits

Producing Complements

• It may make sense to produce the complement yourself
• Example
• Sony produces game console and video games
• Hewlett Packard manufactures printers and printing ink
• Contra
• Market for complements may simply be unattractive
• Complement may require competencies the firm lacks (production, R&D, management, ...)
• Prospective customers might be put off by a firm's dominant position
• Pro
• Better tailoring of complement to own product
• Quality control for complement
• Internalization of the positive effects (externalities) of the complement on own product
• Cross-Subsidies
• Bundling
• Increasing Lock-in

Cross Subsidies

• Idea
• Product A is sold at small margins (even loss) to increase sales of Product B (high margins)
• Advantage
• Increase profits through intelligent pricing
• Risks
• Consumers do not buy product B at all
• Consumers buy product B from another manufacturer
• Examples: 
• Razors and razor blades
• Printers and printer cartridges
• Mobile phones & operator contracts

Bundling

• Idea
• Firm sells product A and complement B combined as a package
• Advantage
• Little or no competition in market for A
• Decreased competition in market for B
• Risks
• Potential buyers of "A only" or "B only" are lost
• Bundling becomes standard and advantages of unbundling are overlooked
• e.g. How to differentiate and how to set prices
• Examples
• Game console and games 
• e.g. Wii bundle with console, game, steering wheel
• Operating system and web browser
• Flight and baggage handling

Increasing Lock-In

• Idea
• Users have switching costs when switching from A to a substitute
• The more complements (B, C, ...) to A they buy, the higher the switching cost
• Advantage
• Higher switching costs imply a higher value of the customer to the firm
• You can charge customers higher prices
• Examples
• Microsoft Office and MS Windows
• Games and video consoles

Competitors as Competitors

• In certain situations, firms may be
• Competitors in one part of the market
• Complementors in another part of the market
• In such a constellation, they may not compete that harshly
• Example: Music Players & Music Content
• Sony and Apple
• Competitors
• Both sell portable music players
• Complementors
• Sony Music provides music content for Apple's iPod / iPhone
• Apple's iTunes store is important sales platform for Sony's music content
• Example: Mobile Phone Calls
• Vodafone and T-Mobile
• Competitors
• Both sell mobile phone contracts
• Complementors
• Their networks are interlinked
• Customers join Vodafone because they know that they can also call T-Mobile customers , and vice versa.
• Parts of Vodafone's / T-Mobile's revenues come from these cross-network calls

Strategic Partnerships

• Drivers of Strategic Partnerships
• Producers of complementary goods depend on each other
• Helping each other and coordinating each other's behaviour maximizes the positive effects of complementarity
• In many cases, integration into one single company not feasible or not desired by involved firms
• Forming a strategic partnership is a powerful way of institutionalizing coordination and formalising interests
• Definition of Strategic Partnerships
• Relationships between firms
• Typical characteristics
• Shared decision making
• Organizational linkages & coordination mechanisms(organisational integration)
• Joint equity ownership (economic integration)
• Organisational Integration
• Teams across firms
• Established reporting and decision routines across firms
• Heavy exchange of information
• Economic Integration
• Direct cross ownership of equity
• Firm A holds X% of Firm B's assets and vice versa
• Setting up a new legal entity (joint venture)
• Benefits
• Alignment of interests
• Retention of control and exclusivity
• Feasibility of inter-organisational coordination
• Complementarity and Strategic Partnerships
• If firms produce complementary products, already high incentives to work together cooperatively
• Less need for economic integration to align interests