Experiment 8 Competing standards

8.5 Student instructions

Introduction

In this experiment, there will be three sellers of operating systems (OSs). At the beginning of each round, they simultaneously have to announce a price and, if they want, a number of units offered at a discount price. Buyers are all identical. In the first round, they will have to decide which OS to buy for their computer. Future rounds represent new versions of the OS and buyers must decide to buy the updated version of their OS or switch to another OS. They can also opt not to buy any OS and suffer social exclusion. The OSs are all equally good, but they are not fully compatible with each other. Users with different OSs cannot easily share files and other information. Therefore, the value of an OS for a buyer will be determined by the number of users with the same OS at the end of the round. Your instructor will display a table showing the way buyer values are related to the number of people who purchase the product. (See Figure A for an example of such a table.)

Buyers’ information

As a buyer, you want to maximize your profits in each round. Note that profits do not accumulate from one round to the next. You need to buy the latest version of one of the available OS in each round at the announced price, or suffer social exclusion (at a cost of €100).

At the beginning of each round, you will see the table of buyer values and the prices announced by each seller. Prices do not change during a round. You will also see if there are any units at a discount price (Figure A). During the round, the instructor’s screen displays in real time the current sales number for each OS.

Buyer values and announced prices. The number of units sold of each OS are updated live during the round.

Figure A Buyer values and announced prices. The number of units sold of each OS are updated live during the round.

At the end of the round, you will receive the buyer value for your OS, which is determined by the number of users of that OS (Figure A).

Learning an OS is costly. The first time you buy an OS, and every time you switch to a different OS, you will have a learning cost of €15. For example, if you buy in Round 1, your profits will be

where the buyer value will be determined by the number of users of at the end of the round and the last €15 represents the learning costs.

In Round 2, if you buy the new version of , then your profits will be

On the other hand, if you switch to in Round 2, then your profits will be

since you need to learn the new OS.

Remember, every time you change your OS from one round to the next, you need to pay the learning cost, even if you used that OS in earlier rounds.

Finally, if you decide not to buy an OS, you will receive a loss of €100 (representing social exclusion), plus you will have to pay the learning cost if you buy an OS in the following round.

Sellers’ information

As a seller, you want to maximize your profits at the end of the experiment. Notice that sellers’ profits, unlike buyers’, accumulate from one round to another in order to allow for long-term strategies. At the beginning of each round, sellers must set the following simultaneously, and without talking to each other: the price of their OS, the number of units they want to sell at a discount price, if any, and the discount price (Figure B). Dumping is forbidden, so sellers cannot price below the cost of production of €5.

Price setting screen for Round 1. Sellers must set a regular price  for their OS, the number of units they want to sell at a discount price (), and the discount price (). Sellers cannot sell below the marginal cost of €5.

Figure B Price setting screen for Round 1. Sellers must set a regular price for their OS, the number of units they want to sell at a discount price (), and the discount price (). Sellers cannot sell below the marginal cost of €5.

At the end of each round, you receive the revenue of your sales (the prices paid by the buyers of your OS) and you have to pay the costs of production. Each unit sold costs €5 (the marginal cost). Developing an OS has a fixed cost of €75 that you must pay in the first round. After the first round, for each round you remain in the market, you have to pay a €50 fixed cost in R&D for the new version of your OS. The fixed costs are independent of the number of units sold. For example, the profits of seller in Round 1 will be

where the last two components are the variable and fixed costs, respectively. For later rounds, profits are calculated as

At the end of each round, firms will be evaluated by their shareholders (represented by the instructor). Those whose market share falls below 16% are considered not viable and will have to abandon the market. Shareholders may force bankruptcy on firms with excessive losses. Bankrupt firms will have to leave the market. Each seller can also decide whether to drop out or continue into the next round.

There will be at least two rounds and no more than ten, but sellers do not know the exact number of rounds. At the end of the last round of play, those firms who are still in business will receive an additional €15 per current customer. (This payment represents the value to the seller of an installed customer base.) Hence, the final profits for a seller still in the market are

Warm-up questions

You can use the following questions to test your understanding of the rules.

Consider the buyer values table shown in Figure C. Suppose that in Round 1, sells 25 units at €7, sells 10 units at €15, and sells 15 units at €10.

Number of users of OS Buyer value
1 and 8 10
9 and 16 20
17 and 24 30
25 and 32 40
33 and 40 50
41 or more 60

Figure C Example of buyer values of an OS.

  1. What is the buyer value of each OS to one of its buyers?
  2. In Round 1, if you bought , what are your profits?
  3. You bought in Round 1. In Round 2, the price of increases to €30 while the price of drops to 5, and the final number of buyers is the same as in Round 1. What are your profits from buying ? And from buying ? (Do not forget the learning costs.)
  4. What are the costs of the seller of in Round 1?
  1. The buyer values are 40, 20, and 20 for users of , , and , respectively.
  2. Your buyer value = 40, you paid €7, and the learning costs are €15. Therefore your profits are 40 – 7 – 15 = 18 euros.
  3. If you buy , your buyer value = 40 and you pay €30, therefore your profits are 40 – 30 = 10 euros. If you buy , your buyer value = 20 and you pay €5, but you also need to incur into the learning costs because you changed the OS. Therefore your profits are 20 – 5 – 15 = 0 euros.
  4. Seller A has a fixed cost of €75 in Round 1 plus a variable cost 280 euros (40 units at cost of €5 each). Therefore, total cost are 75 + 280 = 355 euros.

8.8 Homework questions

Your instructor shared with you the following information regarding each firm in the experiment: price policies, units sold, and total profits for the first and last rounds.

  1. In the last round, what percentage of all sales was made by the largest firm?
  2. Did the firm with the largest share in the first round have the largest share in the final round?
  3. Did the firm with the largest share make the greatest total profits?
  4. If there was only one firm in the market during the last round, what would be its profit-maximizing price policy? (Assume that all buyers are already users of its OS, and therefore do not need to pay the learning cost.) What would be the profits for buyers?
  5. Describe the price and marketing strategy you would have used to try to win the whole market for your product. How would you expect the other firms to react to your strategy?

8.9 Further reading

  • Section 21.4 in The Economy 1.0 discusses many examples of price wars among competing standards.
  • Why VHS was better than Betamax’ (Jack Schofield for The Guardian, 25 January 2003) explains how Sony Betamax made a strategic error and by the time they tried to fix it, there were so many more VHS users that the Betamax format all but disappeared.
  • Why Facebook is a better bet than Google was’ (Robert Wright for The Atlantic, 17 May 2012) uses network economies of scale to explain why Google+ failed against Facebook.
  • MySpace was born of ignorance’ (Planet Money #84, NPR, 25 August 2009) describes the flaws in MySpace that made the site fail to become the leading network, despite being created before Facebook.