Academic journal article Economic Inquiry

Efficient Durable Good Pricing and Aftermarket Tie-In Sales

Academic journal article Economic Inquiry

Efficient Durable Good Pricing and Aftermarket Tie-In Sales

Article excerpt

I. INTRODUCTION

A number of alternative theories currently exist to explain the use of tying arrangements in general. Incentives involving price discrimination, foreclosure, variable proportions, protection of franchise system goodwill, and so on have all been shown to motivate tying under various market conditions. (1) Interestingly, however, most of these theories do not appear to apply directly to the tying of aftermarket sales to the purchase of a durable good in a competitive environment. Such tying (or, equivalently, aftermarket monopolization) was a central issue in the widely debated Kodak case and continues to be a highly controversial aspect of a series of subsequent antitrust cases. (2)

The two predominant theories employed by opposing parties at trial in the Kodak case were the so-called installed-based opportunism theory and the systems theory. (3) The former posits conditions under which a durable good producer may find it profitable to raise aftermarket prices for maintenance and repair services above the competitive level to its locked-in customers, regardless of the intensity of competition in the equipment (or fore-) market. The latter, in turn, demonstrates the conditions under which such opportunistic behavior is either (a) not profitable or (b) profitable but very limited in its competitive effects. (4) While both these theories provide some useful guidance regarding the question of post-sale exploitation of purchasers of durable goods, neither provides an explicit theory of aftermarket tie-in sales that is driven by any sort of efficiency considerations.

In the wake of the controversy sparked by the Kodak decision, two important developments have emerged. First, the courts have demonstrated a strong reluctance to embrace the economic logic embodied in that decision. Despite a large number of similar claims that have subsequently been filed, there have not yet been any decisions that clearly adopt the customer lock-in argument that prevailed in Kodak. (5)

Second, in response to some dissatisfaction with the state of the economic theory relevant to aftermarket tying or monopolization at the time the case was decided, a series of articles has emerged that present newer (and, perhaps, more relevant) theories of Kodak-type behavior. (6) These include, inter alia, aftermarket monopolization incentives that derive from (a) variable proportions production as in Elzinga and Mills (2001), (b) the time inconsistency problem of durable good pricing as in Morita and Waldman (2004), (c) price discrimination as in Klein (1995) and Chen and Ross (1993, 1999), (d) socially excessive maintenance as in Carlton and Waldman (2001), and (e) economies of scope in remanufacturing of used parts as in Carlton and Waldman (2001). The common thread that connects these theories is that most contain some sort of efficiency-based motivation for aftermarket monopolization, which results in an unambiguous improvement in social welfare. (7) As a consequence, considerable doubt has been cast on the legitimacy of Kodak's broad condemnation of aftermarket monopolization.

This article attempts to contribute to this general line of research. Like the above-mentioned articles, it offers an efficiency-driven motivation for aftermarket tie-in sales or monopolization. Unlike these articles, however, the incentive arises directly from the contracting problem faced by buyers and sellers of durable goods. Specifically, like the systems theory, the model presented here assumes that buyers make their purchase decisions rationally on the basis of the expected life cycle (or total ownership) costs of the competing durable goods available at the time of purchase. Similarly, sellers make offers that incorporate the life cycle profits anticipated from the sale, including both the price received for the initial durable good purchase and the future stream of revenues from any subsequent aftermarket services provided by the seller. …

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