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Article Excerpt
1. Introduction
The Bertrand paradox may provide a plausible explanation of why the majority of the content commodities on the Internet are offered for free (marginal costs). The rival is just "one click away," and competing content providers have strong incentives to undercut each other as long as there are positive profit margins.
In recent years, mobile phone operators have allowed content providers to sell content commodities like ringtones, football goal alerts, and jokes to the mobile subscribers. Similar to the Internet, the entry barriers for providers of content commodities are low, and the rival is just "one click away" also for mobile content commodities. However, in contrast to what we have observed on the Internet, mobile content commodities are not offered for free. End-user prices are well above marginal costs.
The vertical channel structure for mobile content differs from what is observed in the Internet. In contrast to the Internet, the (upstream) mobile access provider may use vertical restraints to reduce or eliminate competing content providers' undercutting incentives. One potential explanation why the Bertrand paradox is not observed for such mobile content commodities, is the price-dependent profit-sharing rule used as a vertical restraint by some upstream mobile providers. With this rule, each content provider decides the end-user price for the good he sells, but he has to pay a share of the end-user price to the upstream firms to get access to the customers on the mobile networks. The crucial feature of the rule is that it is progressive, in the sense that the share maintained by the content provider is increasing in the end-user price. Table 1 shows the profit-sharing rule used by the dominant Norwegian mobile operator Telenor. If a content provider sells his good for NOK 3, say, he receives 62% of the revenue, whereas he only receives 45% of the revenue if he reduces the price to NOK 1.
Table 1 Price-Dependent Profit-Sharing Rule Used for Content Messages
Downloaded by Mobile Phones
End-user price (NOK) 1.0 1.5 3 5 10 20 70
Share to the content provider (%) 45 54 62 66 68 70 80
A progressive profit-sharing rule implies that the opportunity cost of setting a low end-user price is relatively high, and this reduces the incentives to engage in fierce price competition. More specifically, in the formal model we show how an upstream firm can use such a rule to reduce the content providers' undercutting incentives by lowering their perceived elasticity of demand, thereby preventing destructive price competition. Even more interestingly, we show that a progressive profit-sharing rule achieves higher aggregate channel profit than alternatives where the upstream firm partly or fully dictates the end-user prices (e.g., through resale price maintenance (RPM)). This is true if we make the realistic assumption that the content providers are better informed about the demand for their goods than is the upstream firm (asymmetric information).
The labeling of the mobile provider as an upstream firm and the content providers as downstream firms is not clear-cut in the present channel structure. The mobile access provider offers market access for multiple content providers. We choose to label the content providers as downstream firms because they decide retail pricing and have more accurate information about retail demand conditions than the upstream mobile provider. (1)
The question of how vertical restraints can help solve channel coordination problems has received much attention in the literature. Under different assumptions on the channel structure, McGuire and Staelin (1983), Shaffer (1991), Ingene and Parry (1995), Desai (2000), and Kuksov and Pazgal (2007), among others, show that a two-part tariff may be used to prevent destructive downstream price competition. However, our proposed profit-sharing rule achieves higher aggregate channel profit compared to a two-part tariff if the downstream firms have more accurate information about demand than the upstream firm.
In an extension of the basic model, we allow the downstream firms to make market-expanding investments that cannot be directly and perfectly controlled by the upstream firm (for instance, because the latter has insufficient information about the market potential). The investment levels might then be too high or too low compared to the levels that maximize channel profit (e.g., Telser 1960). Such lack of control may give rise to horizontal and vertical externalities, and there exists a sizeable literature on how vertical restraints can help solve channel coordination problems. One strand of the literature focuses on how to find the minimum number of vertical restraints sufficient to maximize total channel profit. Mathewson and Winter (1984) show how a combination of a two-part tariff and RPM may be used to achieve the integrated channel outcome where retailers undertake market-expanding sales effort with potential spillovers. Lal (1990) shows that revenue-sharing may be used as an additional instrument to a two-part tariff in a context where upstream and downstream firms undertake noncontractible sales efforts (see also Rao and Srinivasan 1995).
Another strand of the literature, pioneered by Rey and Tirole (1986), emphasizes that both the private and social desirability of a given vertical restraint depend on the underlying delegation problem. They compare RPM and exclusive territories under uncertainty about demand or cost. Our starting point, too, is the underlying delegation problem; the retailers have more accurate demand information than the manufacturer. We also follow Rey and Tirole (1986) in that we do not search for the minimum sufficient number of vertical restraints inducing the same profit outcome as under channel integration. Rather, we show how the price-dependent profit-sharing rule may be used to suppress the competing retailers' undercutting incentives, and, furthermore, that this restraint may be superior to alternatives such as RPM.
In contrast to our approach, Lal (1990), Cachon and Lariviere (2005), Dana and Spier (2001), and Mortimer (2008) consider a revenue-sharing scheme that specifies fixed rather than price-dependent shares to the manufacturer and the retailer (e.g., 60% to the manufacturer and 40% to the retailer). Like our paper, Cachon and Lariviere (2005), Dana and Spier (2001), and Mortimer (2008) are motivated by observed contracts. These papers focus on revenue-sharing contracts implemented in the video rental industry, and show how revenue-sharing schemes may be used to solve channel coordinating problems related to inventory choices.
In the next section, we present a case study of how the price-dependent profit-sharing rule has been used in practice, and in [section]3 we set up a formal model to show how an optimal profit-sharing rule may induce competing content providers to choose end-user prices that maximize aggregate channel profit. In [section]4 we extend the model to allow each downstream firm to undertake noncontractible market-expanding investments (e.g., marketing) with potential spillovers, and [section]5 concludes.
2. Price-Dependent Profit-Sharing Rule--Used in Practice
Despite an awkward user interface, text messaging has been an overwhelming success in Europe and Asia. (2) The average usage per month by customers in several European countries exceeded 60 messages in 2004. (3) In several markets, person-to-person messaging has been followed by a successful deployment of content messaging, which enables the mobile users to buy different types of content such as ringtones, music, logos, alerts (e.g., goal alerts), jokes, quizzes and games, directory enquiries, and so forth.
In 1997, in the infancy of the market, the two Norwegian mobile providers, Telenor and NetCom, introduced content messaging services like news, stock quotes, and weather forecasts. The mobile access providers themselves decided which types of services should be offered, and they also took care of end-user pricing. However, this model of vertical integration did not seem to work very well; the services generated limited revenues and profit.
In 2000, the two mobile providers voluntarily shifted strategy from in-house development and production of content to one of vertical separation. With this business model, independent content providers behave as downstream firms ("retailers") responsible for sales effort, marketing, and end-user pricing, whereas the mobile providers act as upstream firms providing access to the customers (the mobile subscribers) as an input. The mobile providers offer take-it-or-leave-it wholesale contracts, specifying a menu of end-user prices among which the content providers may choose (ranging from NOK 1 to NOK 60). Moreover, the wholesale contract specifies the revenue split between the mobile provider and the content provider, where the share to the content provider increases with the end-user price (cf. Table 1).
Note that there is no competition between the mobile providers in the upstream market for content messaging. To gain access to Telenor's customers, a provider of content message services needs an agreement with Telenor, and, similarly, the content provider needs an agreement with NetCom to reach NetCom's customers. We have observed a high degree of cooperation between NetCom and Telenor. (4) In April 2000, the two mobile network providers launched a mechanism that, to a large extent, was a common wholesale concept toward content message providers. The outcome was that every mobile phone subscriber may access the same content messaging services at the same price, independent of which provider they subscribe to. In the formal model below, we consequently assume that there is an upstream monopoly selling access to a large number of independent retailers.
Content messaging became a success, and in 2004 mobile customers, on average,...
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