Never mind the complements, where is the value?

There’s no point in having a video games console if there aren’t any video games to play on it. Nor is a printer cartridge much use without a printer. These are examples of highly complementary goods, where the value is derived from using the products together. Despite the fact that they are used together, however, the degree of specialist expertise required often means that different organisations are involved in producing the goods.

The production of complementary goods raises a number of interesting issues concerning firm strategy and value capture. Take pricing and quality, for example. Usually one firm leads, and the other follows. The video console comes first, then the video games. But once the first company has set its quality standards and invested accordingly, what incentive is there for the second company to maintain that quality standard?

Then there is pricing. If one firm increases prices in an attempt to capture more of the total value, that pricing decision may raise the total price beyond what consumers are prepared to pay. Demand falls, as does the total value available. Equally, one complementary product producer might face price pressure from competition in its market, while the other is relatively unconstrained.

Royalties are common in situations involving highly complementary goods. Firms use royalties to try and capture as much value as possible. Video console producers charge for the right to publish games for their consoles. Smartphone companies charge apps programmers’ royalties. Yet, depending on how the royalty arrangement impacts the behaviour of the firm paying the royalty fee, no additional value may actually be captured.

These are issues that Oded Koenigsberg, Taylan Yalcin, Elie Ofek and Eyal Biyalogorsky address. The authors investigate the strategic interaction between firms producing strictly complementary products. They use a stylised model, in which two firms develop complementary products, and one firm, let’s call it HardwareCo, designs its product before the second company, SoftwareCo, can design the complementary product.

The results are instructive. They illustrate the challenges faced by producers of highly complementary products wanting to maximise value. As it turns out, firms that produce both of the complementary goods are more effective at capturing value in this situation. When different firms are involved they tend to price selfishly, leading to sub-optimal value capture. They also free-ride on each other’s investments in quality, leading to value creation problems. SoftwareCo tends to under invest in quality, creating a substantial quality gap between the two products. Quality levels can be so low, that it becomes cheaper to buy the products from the separate firms, rather than the integrated producer.

Royalty fees exacerbate the quality gap. HardwareCo may extract more value. But SoftwareCo stints on quality even more. Overall quality is reduced. So this only works for both if HardwareCo cuts its price enough to make the combined product attractive. Perhaps the most interesting finding, however, is that the most value is obtained if HardwareCo has competition. To obtain this benefit HardwareCo increases quality differentiating itself from its competitor, lowers prices and raises its royalty rate. SoftwareCo introduces a lower quality product for Hardware’s competitor and has a larger market as result, and so it tolerates the raised royalty. Consumers get greater choice and better value.

Everyone wins. Who would have thought competition worked so well?

This is an executive summary of the latest academic research from Oded Koenigsberg, Eyal Biyalogorsky, Elie Ofek and Taylan Yalcin. 'Complementary Goods: Creating, Capturing and Competing for Value."