Applications Barrier to Entry and Exclusive Vertical Contracts in Platform Markets

Article excerpt

I. INTRODUCTION

Exclusive contracts in vertical relationships feature prominently in antitrust cases in network industries. At issue are contracts a firm with market power signs with its suppliers or buyers that may limit access to the market by its rivals. We focus on the case in which the firm signs exclusive contracts with upstream suppliers. For example, in the 1980s developers of games for Nintendo's video game console agreed not to provide any titles for other platforms (Atari v. Nintendo). (1) In U.S. v. Microsoft, the dominant software provider was charged with abusing its monopoly power in its contracts with Internet content providers and independent software developers, with the goal of excluding competitors to Microsoft's Internet Explorer browser. (2) Exclusive contracts such as these are an example of vertical restraints, an area in law and economics that has generated as much controversy as any.

We examine the impacts of exclusionary contracts between hardware manufacturers and software providers in the home video game market. An important feature of the market for video game consoles is indirect network effects (Katz and Shapiro 1985), whereby the consumer valuation of the primary product (the console, or "platform") increases with the number of complementary goods available (gaming software). If platform providers enjoy indirect network effects, then each may want to prevent suppliers of its complementary good from also supplying competing platforms (Evans 2003; Regibeau 2004). When a dominant platform provider and the producers of the complementary goods sign such exclusionary contracts, they burden competing platforms and potential challengers with producing the complementary goods themselves or finding alternative suppliers, which may raise rivals' costs and can diminish competition (Brennan 2007). This is the "applications barrier to entry" at issue in the Microsoft case. Foreclosure of competitors can result (Armstrong and Wright 2007). Whether survival of a single dominant platform is inefficient or to the detriment of consumers depends on the size of duplicated costs among platforms, the heterogeneity of consumers' preferences among platforms and among the complementary goods, and other factors.

We focus on estimating, determining the causes of, and exploring the implications of indirect network effects for exclusively and nonexclusively provided games. Exclusive titles are those games that can only be played on one system, because the console producer either created the game itself or negotiated an exclusive contract with a video game maker. We examine the sixth-generation videogame console market, which comprises Nintendo's GameCube, Sony's PlayStation2, and Microsoft's Xbox, and uncover an interesting finding: although we find strong indirect network effects, and a large impact of exclusivity on rivals' console demand when most games are nonexclusive, the marginal exclusive game contributes virtually nothing to console demand. Exclusivity helps a firm establish market share at first, but beyond a certain point additional locking up of software supply no longer hurts rivals. Consequently, there is no ability to capture ever more console consumers through locking in an increasing supply of exclusive games. Such capture of the whole market is often assumed in discussion or derived in theoretical models of the video game industry in specific or platform markets in general.

By itself, a finding that exclusivity does not affect console demand on the margin does not necessarily imply that there is no consumer harm, for with heterogeneous game quality it may be that a console maker need only lock in the best games to harm the rivals' ability to compete. However, our investigation suggests that exclusionary contracts did not hurt consumers, because of two important features of the videogame market. The bargaining power enjoyed by the best software providers, coupled with the existence of "blockbuster" games that enable competitors to establish market share, prevents the foreclosure of rivals through exclusive contracting suggested by some models (Armstrong and Wright 2007). …