July 12, 2007

Does Technological Tying Spark Innovation?

Technological tying may allow a market leader to maintain an edge, but innovation is another question.


Does technological tying spark or stifle innovation?

About 10 years ago, Microsoft made headlines for a series of landmark cases stemming from the integration of its ubiquitous operating system, Windows, with its Internet Explorer browser. Microsoft’s key browser rival, Netscape — which then was said to have the better browser — later sued, alleging unfair competition. The rest is history.

The lively debate triggered by those antitrust cases about the economic merits and ills of market dominance inspired professor Michael Riordan and Richard Gilbert of the University of California, Berkeley, to examine technological tying in a monopolistic market. Their conclusion: Once a company has locked up a market for a key component, it can maintain its edge through a technological tie. As a result, innovation doesn’t necessarily follow intense and open competition. In fact, innovation often lies fallow, or falls off, after the winner takes all. 

Technological tying is basically the electronic bundling of products so that a key component works better with a complementary part from the same supplier than that of a rival. (Bundling is the packaging of products or services into a single offering, often at a discounted price.) This approach often weakens the competitor’s chance at eroding the monopolistic company’s market share.

With similar cable and content situations unfolding in the broadband market, reminiscent of the 1980s’ “last mile” phone wars between incumbent AT&T and then-upstart MCI, the researchers surmised that rampant product commoditization and price wars might make companies cautious about investing in improving products without a lead.

“When innovation is intense, the stakes are high, and the strategic uncertainty is important,” Riordan explains. “Severe price competition can prevent a company from recovering its investment. Technological tying may help foreclose competition with rival products.” 

The researchers began by modeling scenarios in which one company controlled the market for a key component, while competitors made superior complementary products. Assumptions included consumers with similar wants and needs who would purchase products of the best quality at their lowest possible price.

The professors next found that when a company holds a monopoly on a key component (in Microsoft’s case, the operating system) and rivals have an edge with a complementary offering (Netscape’s Navigator browser, for example), the dominant player’s release of a competing product (here, Explorer) would squelch its rivals’ or new arrivals’ will to innovate.

In fact, the monopolist need not even technologically tie. The possibility that it could do so may push the competing maker of a complementary component to curb planned investment and even exit a market.  

As a result, the monopolist can keep innovating, or it can stop. Either way, the monopolist will maintain its edge over rivals for complements after the competition walks away. “The monopolist knows it can earn a return from an investment in product improvement,” Riordan adds. “And rivals will be discouraged from investing in innovation.”

Of course, this analysis is based on a simulation and excludes unseen legal, political and cultural forces that could —  as in Microsoft’s case — erode market dominance or the freedom to technologically tie over time. “It’s a stark model of an extreme business environment,” Riordan says. “Most markets are not winner take all.”

Still, with many products meeting key characteristics of nearly monopolistic markets — such as filling an unmet niche (YouTube), interdependency (Napster) and interoperability (GSM phones) — “technological tying reduces the strategic uncertainty,” he says.

Which leads to a last point, about tradeoffs. Some monopolists may reap more profit by charging a premium price for key components and complementary products than they would by technologically tying them, or by enabling their dominant product to work seamlessly with other companies’ complementary products.

Similarly, if a rival for complementary components is ahead, the monopolist may want to avoid that market or collaborate so that the two offerings work in concert.

“Sometimes the tradeoff involves a choice between profits in the core or in the complements businesses,” Riordan says. “It may be best to leave complementary product innovation to others with an edge in that area.” Expected profits from stand-alone sales versus the same for packaged products should steer monopolistic sellers toward the best choice.

The key takeaway? Though technological tying may not spur innovation, for companies with market dominance over a key component, tying could be a smart strategy to help them keep or gain an edge in the complementary product market, provided antitrust laws aren’t infringed.

Conversely, companies with superior offerings should question follow-on investment if a monopolistic maker of a key component has or is mulling a competing complementary product that could be linked to its key component. “Investment decisions,” says Riordan, “should be based on where a company sits on the spectrum of conflict versus cooperation.”

Michael Riordan is the Laurans A. and Arlene Mendelson Professor of Economics and Business at Columbia Business School.

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