The Economics of Networks: Quality Coordination in Mix-and-Match The Economics of Networks

3.3.3 Quality Coordination in Mix-and-Match

The framework of mix and match models applies to both variety and quality features that are combinable additively in the utility function. That is, in the standard mix-and-match model, the utility accruing to a consumer from component Ai is added to the utility from component Bj. However, in some networks, including telecommunications,24 the utility of the composite good AiBj is not the sum of the respective qualities. In particular, the quality of voice in a long distance call is the minimum of the qualities of the component parts of the network, i.e., the local and the long distance transmission. Thus, significant quality coordination problems arise in a network with fragmented ownership. Economides (1994b) and Economides and Lehr (1995) examine this coordination problem.

Let A and B be components that are combinable in a 1:1 ratio. Suppose that the quality levels of the components are qA and qB, while the quality level of the composite good is qAB = min (qA, qB). Consumers have varying willingness to pay for quality improvements as in Gabszewicz and Thisse (1979) and Shaked and Sutton (1982), and firms play a two-stage game of quality choice in the first stage, followed by price choice in the second stage. As mentioned earlier, Cournot (1838) has shown that an integrated monopolist producing both A and B will charge less than two vertically-related monopolists, each producing one component only. This is because of the elimination of double marginalization by the integrated monopolist. Economides (1994b) and Economides and Lehr (1995) show that an integrated monopolist also provides a higher quality than the two independent monopolists. In bilateral monopoly, marginal increases in quality have a bigger impact on price. Being able to sell the same quality at a higher price than under integrated monopoly, the bilateral monopolists choose lower quality levels, which are less costly. Despite that, because of double marginalization, prices are higher than in integrated monopoly, a lower portion of the market is served, and firms realize lower profits.25 Thus, lack of vertical integration leads to a reduction in quality. Note that this is not because of lack of coordination between the bilateral monopolists in the choice of quality, since they both choose the same quality level.26

In this setting, Economides and Lehr (1995) examine various ownership structures where, for at least one of the types of components there is more than one quality level available. Clearly, a situation where all components have the same quality is not viable, since competition would then drive prices to marginal cost. Further, for a "high" quality composite good to be available, both an A- and a B-type goods must be of "high" quality. They find that a third (and fourth) "low" quality goods have a hard time surviving if they are produced by independent firms. In contrast, in parallel vertical integration (with firm i, i = 1, 2, producing Ai and Bi), firms prefer not to interconnect --i.e., to produce components that are incompatible with those of the opponent.

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