Competition and Quality Choice in the CPU Market ∗ Chris Nosko Harvard University November 2010 Abstract This paper uses the CPU market to study how multiproduct firms generate returns from innovation. Using a new dataset, I estimate a discrete-choice model of CPU demand and then recover estimates of the sunk cost of product introductions. I combine these estimates with a model of firm product choice to examine how product line decisions change with asymmetric technological capabilities and with the competitive environment. I use the model to show how technological leaders can use product lines as strategic weapons, isolating competition to less desirable areas of the product spectrum. I apply this insight to a large shift in technological leadership – Intel’s introduction of the Core 2 Duo – and quantify the portion of returns that came from Intel’s ability to push its principle competitor, AMD, into lower-margin product segments. I find that competition plays a key role in determining firms’ product line decisions and that these decisions are important in generating returns from innovation. Ignoring endogenous product choices leads to underestimates of the social welfare losses from monopoly. ∗ I am grateful to Ulrich Doraszelski, Lisa Kahn, Greg Lewis, Julie Mortimer, Ariel Pakes, and Alan Sorensen for invaluable advice. Also, I thank Brett Gordon for his help in putting together the pricing data, Che-Lin Su for helpful discussions about computational methods, and especially Jeremy Davies of Contextworld for generously supplying downstream data. All errors are solely mine. 1 1 Introduction When firms innovate, they often don’t just introduce products at the top-end of the market. Instead, they tend to reset their whole product line in an effort to extract the most possible profit from their innovation. Their incentives to reshape lower market segments depend on the industry structure, especially whether it is a monopoly or an oligopoly, and the technological capabilities of rival firms. In oligopoly, one way that firms generate profit is by strategically using product choices to change the nature of competition in the industry. Our ability to understand this phenomenon requires knowledge of how firms make product choices and how these product choices change with market structure. Despite the evident importance of competition for driving decisions about product lines, and the effect that these decisions have on consumer welfare, most antitrust analyses downplay them, and models of innovation almost completely ignore them. I use the CPU market to study how imperfectly competitive firms make product decisions and how these decisions affect their ability to generate returns from innovation. In this market, firms offer a menu of quality-differentiated products that is often reset to integrate new technology and to respond to actions of competitors. In 2006, Intel introduced a new product line, called the Core 2 Duo. Hailed as “the most impressive piece of silicon the world has ever seen” 1 the market went from relative equality between Intel and its rival, AMD, to one that was firmly dominated by Intel. Interestingly, it wasn’t just Intel’s ability to produce faster chips that led to dominance. Instead, much of Intel’s increased profit came from pushing AMD out of mid-range market segments, areas where AMD still had the technological capability to compete. I use variation from the introduction of the Core 2 Duo, and the relative frequency of product line changes in general, to ask the following questions: In this industry, how do firms choose the number and quality of their products? How would these choices be different if the industry were a monopoly? And how do firms use strategic product choices to increase returns from innovation? 1 See the CNET article, “Intel’s Core 2 Duo lives up to hype” from July 16, 2006: http://tinyurl.com/cnet-core2-duo 2 My first finding relates to the role that competition plays in driving product line decisions. When marginal costs rise relatively slowly with quality level – a stylized fact in the CPU industry – a monopolist has little incentive to introduce a broad spectrum of products. Instead, a monopolist can extract almost all feasible profit with a limited number of products at the high-end of the market. In oligopoly, this strategy is no longer optimal because a competitor can steal marketshare by introducing products at lower price points. This process leads to a competitive equilibrium with more products spread throughout the product line. Thus, in markets like CPUs, quality-based product separation can be driven largely by competitive interaction rather than a desire to discriminate between consumer types. 2 This contrasts with the standard literature on price discrimination, which sees the introduction of quality-differentiated products as a mechanism for extracting more revenue from high- valued consumers. 3 This finding implies that, because product line decisions matter little for a monopolist’s profitability, when they innovate, resetting a product line will play much less of a role in extracting profit from that innovation than for firms in an oligopoly. I next find that, in oligopoly, returns from innovation come not only from the ability to produce a better product at the top end, but also from an innovator’s ability to steal business from rivals throughout the product line. Using a simple model, I construct an example showing how a technological leader can isolate competition to lower margin portions of the market, thereby increasing market power over a larger product space. I combine my model with data from the introduction of the Core 2 Duo to quantify that role that these business stealing effects played in generating profit for Intel. I break apart the portion of returns that came from Intel’s introduction of new top products from the returns that came from strategic quality choices throughout the product spectrum. This comparison gives an estimate of how much we would underestimate the effect of competition on innovation incentives if we held product lines fixed. Next, I compare the profits that Intel generated in 2 In a series of theory papers, Johnson and Myatt (2003, 2006) discuss the role of competition in driving quality choices in a Cournot setting with differentiated products. 3 There is a long literature on using quality as a price discrimination mechanism going back at least to Jules Dupuit in the 19th century. The foundational modern work is Mussa and Rosen (1978), with generalizations to multi-dimensional consumer types and/or multiple firms by Rochet and Stole (2002), Armstrong (1996), Rochet and Chone (1998), and Armstrong and Vickers (2001). 3 the duopoly structure with profits that a counterfactual monopolist would have made with the same innovation. I show that, while these returns are substantially lower than that of an oligopolist in percentage terms, in absolute dollars, the returns are very similar. My empirical strategy relies on a combination of institutional details, a rich dataset containing some “exogenous” shifts, and a structural model. This industry has two firms, and these firms compete over products that differ in relatively straightforward ways, allowing me to write down a model that is simple enough to take to the data, but that still captures key aspects of the industry. By using this model to estimate primitives that we don’t generally observe in datasets – consumer preferences, marginal and sunk costs – I attempt to untangle some of the key drivers of product line decisions. I then use these estimates to shed light on Intel’s introduction of the Core 2 Duo, an event that I treat as the result of an exogenous innovative process. 4 Using the structural model, I compute how a counterfactual monopolist would choose products and compare these and the competitive outcomes to a social planner. My dataset contains CPU list prices (when purchased in 1,000 lot units) combined with European country and time specific data on desktop sales. Because the sales data contain information on the CPU that shipped with the computer, I am able to construct a monthly dataset of CPU prices and quantities sold across 8 European countries from 2003-2008. I exploit the cross country variation to generate estimates of a horizontal taste for Intel’s vs. AMD’s products and the near constant flow of new chips provides variation in quality levels. As mentioned, I use the introduction of the Core 2 Duo to consider how innovative activity interacts with quality choice to generate returns. The basis of the structural model is an underlying utility framework that allows for consumer heterogeneity in willingness to pay for quality (vertical differentiation) and het- erogeneity in brand preference across CPU companies (horizontal heterogeneity). Demand 4 In this paper I treat innovation outcomes as exogenous events, focusing on how firms generate returns from them. With respect to the Core 2 Duo in particular, this is probably not a bad assumption: The project that led to the Core 2 Duo, codenamed Banias, began at least as early as 2001 to develop a CPU for laptops (which later became the Pentium M). It was only later that this technology was thought appropriate for the desktop market. See the Seattle Times, “How Israel saved Intel”, http://tinyurl.com/core2-banias. More generally, the results in this paper can be seen as an input to a dynamic game that endogenizes innovation decisions. 4 estimation proceeds following the Pure Characteristic Model of Berry and Pakes (2007) with some modifications tailoring the problem to my setting. I recover sunk costs of product introductions from observing decisions on whether and when firms introduced new products into the market. Moment inequalities (Pakes, Porter, Ho, and Ishii (2006) ) allow me to recover bounds on the sunk cost parameter. I find that a counterfactual monopolist has little incentive to introduce a whole product line: With a single product he can capture 98% of the profit that he earns with a full, optimally-placed product line. Given the sunk cost estimates, a monopolist would introduce between 1 and 3 products compared to the 8 to 10 products that exist in the competitive market. Consumer surplus from a monopolist is found to go down by 65% compared to the competitive outcome. Much of that comes from the increased monopolist prices, but a non- trivial 13% comes from the reduction of products and their inefficiently high quality levels. I further find that the returns to innovation are higher in percentage terms in an oligopoly than in a monopoly. My estimates indicate that Intel’s profits increased by 96% with the introduction of the Core 2 Duo (from 95 to 180 million dollars monthly). 49% of that came from the introduction of new products (holding old products fixed), and the rest came from the realignment of products throughout the spectrum. Finally, a monopolist with the same innovation would have increased profits by 17% (from 488 to 573 million). Even though a monopolist has lower percentage returns, in dollar values, the amount is very similar to the oligopoly outcome. These results speak to recent antitrust enforcement in this industry. The market leader, Intel, has been widely accused of actively working to exclude AMD from the market. A number of regulatory agencies including the European Union Competition Commission, the U.S. Federal Trade Commission, and the Fair Trade Commission of Japan have either fined or investigated Intel’s behavior. Naturally, in analyzing the possible effects of a market dominated more strongly by Intel, we would like to know how the product landscape would change. My results indicate that the current market is quite competitive. An Intel monopoly would result in substantial lost consumer welfare, mostly because of higher monopoly prices, 5 but also because of a decrease in the number of products on the market. There are a number of recent empirical IO papers that examine topics related to mine. Eizenberg (2008) estimates a game where downstream OEMs choose a discrete portfolio of CPU options to offer with their PC products in a first stage, and then set prices in a second stage. 5 In contrast, I focus on competition between the upstream firms, Intel and AMD, and on how product line decisions affect their ability to generate returns from innovation. Fan (2009), Crawford and Shum (2006), Mazzeo (2002), and Draganska, Mazzeo, and Seim (2009), consider endogenous product choice in newspapers, cable television, hotels, and ice cream, respectively. Berry and Waldfogel (1999, 2001) explore firm choice of radio station formats using merger activity brought on by the Telecommunications Act of 1996, and Sweeting (2007) models single-product firms and estimates sunk cost of format switching. Two papers use the CPU market to study different topics. Song (2007) estimates a demand system closely related to the one I use below in order to compare consumer welfare measures to more widely used models. Goettler and Gordon (2009) model firm innovation incentives in the face of dynamic consumers. Because of the complexity of the dynamic model, they are forced to limit firm heterogeneity, modeling Intel and AMD as single-product firms, which doesn’t allow for the segmentation incentives that I focus on. This paper is organized as follows. Section 2 describes the industry, introduces the data that will be used, and discusses changes in the CPU market that make it a suitable environment to study nonlinear pricing and competition. Section 3 details utility primitives and goes through their estimation. Section 4 lays out the quality choice model which includes the second-stage pricing game and estimation of marginal and sunk costs. Section 5 lays out and solves counterfactuals using the estimates from earlier sections. The counterfactuals simulate what the market would look like if it were a monopoly, run by a social planner, or had different innovation outcomes. 5 Eizenberg shows how to account for issues of self-selection and partial identification in these sorts of games, an estimation problem closely related to the one in this paper. 6 2 The CPU Market The market for desktop, laptop, and server CPUs is dominated by two companies: Intel and AMD, with (respectively) approximately 80% and 18% market share as of January 2009. This paper concentrates on the market for desktop CPUs. These are CPUs that go into home and business machines that are used for everyday tasks. I concentrate on this market rather than the market for laptop chips because it is more competitive (Intel dominates the market for laptop chips) and more stable (laptop growth has been explosive over the last few years). More data are also available for this market because enthusiasts tend to buy desktop chips and chart their performance extensively. Within the desktop market, each firm typically offers between 10 and 15 chip varieties at any given time. By far the largest difference between these chips is performance. Higher performing chips tend to have higher clockspeed (operate at a higher frequency), more high- speed cache memory available, include multiple cores, and use more advanced process tech- nology. Firms can and do use all of these levers to manipulate performance, but at the end of the day a consumer need only look at how the chip performs based on some benchmark to determine it’s product quality. 6 The CPU market has long been known for offering quality-differentiated product lines. The Intel 80486 was a popular example in both the economics literature (Deneckere and McAfee (1996) ) and the popular press. Introduced in 1989, Intel created low-quality and high-quality versions of this chip. Strikingly, in order to create the low-quality chip, they went to some cost to destroy a perfectly good high-quality chip. 7 Recent examples include 6 This is, of course, a simplification. E.g., chips that have differing number of cores appeal to consumers who do different sorts of tasks with their computer (making it not perfectly collapsible to a one dimensional metric). Nevertheless, this is a product that comes about as close as possible to differing on a single vertical dimension. 7 More specifically, Intel released a “DX” version that included a math co-processing chip, and an “SX” version that did not. The co-processing chip gave a performance boost to power users but was ignored by the mainstream software of most users. The DX version sold at a substantial premium. The story goes that in order to create an SX chip, Intel manufactured a DX version and then incurred some cost to destroy the connection between the CPU and the co-processor. This manufacturing process is somewhat apocryphal. At first Intel used DX chips with properly functioning CPUs but with manufacturing defects in the co-processing unit. Later, they created a separate mask to exclude the co-processing unit completely, which decreased the die size and hence the cost. 7 Intel’s selling of a code that “unlocks” features of their G6951 processor. Consumers purchase the chip at a stock level, and should they wish to access additional performance increases, they can buy the magic code (which costs Intel nothing) that makes the chip perform better. 8 While these anecdotes illustrate isolated incidents, the industry has eluded systematic study on the quality-choice dimension. I believe this is because up until the end of 2003, Intel and AMD used a rather crude segmentation mechanism: chip manufacturers concentrated on their top chips and left their older chips to serve more price sensitive segments of the market (at reduced prices). While segmentation was occurring, the quality choice itself was not being made every period – instead, firms were constrained by their top performing chips from the last period, a strategy known as waterfalling. This changed toward the end of 2003 when firms began adjusting price and quality on a regular basis to hit different segments of the market. Appendix 1 documents this shift in the industry. The competitive nature of the industry has fluctuated markedly over the 2000’s. The mid 2000’s were the height of AMDs competitiveness, peaking with 30% marketshare at the beginning of 2006. This is up from around 10% at the beginning of 2003 and 20% at the beginning of 2009. Figure 1 plots Intel and AMD marketshare from the end of 2003 through the beginning of 2009. [Figure 1 about here.] Changing technical leadership is partially responsible for the marketshare fluctuations. From 2002-2006, AMD consistently released products whose price/performance characteristics were similar to or beat Intel’s products. However, with the release of the Core 2 prod- uct line at the end of 2006, Intel regained technical leadership, a position which they’ve held every since. Figures 2 and 3 tell the story of a rapidly and significantly changing market. In June 2006, Intel and AMD both offered products throughout the quality spectrum. In many parts of the spectrum, AMD offered products that were better and cheaper than comparable Intel products (the top panel of 2). In July 2006, Intel released a number of Core 2 Duo 8 See: http://tinyurl.com/intel-g6951. I thank Kelly Shue for pointing this out to me. 8 products. The bottom panel of figure 2 shows that these products completely dominated AMD’s offerings, substantially altering the price/quality landscape. AMD responded by slashing prices and removing products that were no longer competitive (figure 3). By January of 2008, the competitive nature of the market had changed so significantly that AMD was relegated to the bottom portion of the quality spectrum, offering almost no chips at the medium to high end. Interestingly, while AMD’s overall marketshare did not drop all the much. Its share of more expensive chips dropped almost to 0 (figure 4). [Figure 2 about here.] [Figure 3 about here.] [Figure 4 about here.] I exploit this shift in technological leadership in two ways: First, it provides natural variation in product characteristics that helps identify the demand system. Second, I explore firms’ reaction to this technological change, focusing on ways that this affected quality choices and the strategic interactions between firms. The section on counterfactuals discusses this in more detail. In addition to variation in marketshare across time, there is also substantial variation across country. Figure 5 shows that AMD’s marketshare in France is consistently higher than in other countries, especially when contrasted with their Southern neighbors, Spain. This is a useful source of variation that will play a key role in identifying the horizontal aspect of consumer heterogeneity. [Figure 5 about here.] 2.1 Data Data for this paper come from a variety of sources. Prices were gathered from websites devoted to tracking the wholesale prices of Intel and AMD chips. These are prices paid by 9 distributors and system builders when purchased in lots of 1,000. 9 Quantities come from Contextworld, a European firm that tracks computer sales. Con- textworld contracts with major retailers and distributors across the region to receive point of sales data. They then extrapolate to include retailers that they do not have contracts with. To check the accuracy of these extrapolations, I compared aggregate Contextworld data to other consulting firms that report their versions of these numbers, such as IDC, and the numbers were quite similar. The Contextworld data contain characteristics such as hard drive size, ram, screen, and important for my purposes, the exact CPU that went into the computer. These data can be broken down across country, distribution channel, and computer type (laptop or desktop). One downside to using downstream sales data is that there is a lag between when a CPU is purchased from the upstream supplier and when it is sold to the end user (making it into the quantities data). Performance data were collected from various enthusiast websites. These sites and forums take CPUs and run them through a series of benchmarks and performance tests. The end result is a number of metrics that allows chips to be compared to each other. It is important for this paper to use actual benchmark numbers instead of CPU speed (or some combina- tion of CPU speed and cache) because I am explicitly comparing performance across CPU manufacturers with substantially different architectures. Simple clockspeed doesn’t reflect actual performance in this case because the chip architecture interacts with numerous char- acteristics of the chip in complex ways to actually move information through the pipeline. 9 There is plenty of evidence that the large OEMs do not pay these list prices. Instead, at a minimum, they get percentage discounts off of them depending on their size. As long as these are the same across the OEMs in my data, then my substantive empirical conclusions will not be affected. It would be more problematic if specific OEMs got specific discounts off of certain chips and not on others. I have not heard of instances of this occurring, but given the bilateral nature of these deals, I certainly cannot rule it out. 10 [...]... not have quality choices staying at the same level as in the pre-innovation equilibrium Indeed, firms have incentives to change quality levels to increase market power over as much of the product spectrum as they possibly can In order to investigate how the returns to innovation change with market structure, I use the introduction of the Core 2 Duo As discussed earlier, Intel’s introduction of the Core... observe the per-period shocks when they make their product decisions 21 introduce a new product If they introduce it, then it must have been the case that it was more profitable than not introducing it and not paying the sunk cost Similarly, if they decide not to introduce a product, then it must have been the case that the firm would have been worse off introducing the product and paying a sunk cost These... asks the question, what if Intel and AMD fixed their product characteristics and Intel simply introduced products at the top end without re-aligning throughout the spectrum This is complicated here by the fact that marginal costs also change in between the pre and post innovation periods To adjust for this, I take the quality of products that AMD and Intel produced in the pre-innovation period and predict... done in examining the theoretical underpinnings of these results In particular, the extent to which the estimated slope of the marginal cost curve (with respect to quality) and the consumer valuation distribution are driving these results would indicate how much we might think of generalizing to other industries A second area for future work comes from the vertical supply chain in this industry My model... It is also informative to consider the quality choices that a potential monopolist would make Table 4 shows the product quality levels in the data compared to the optimal choices by a monopolist and social planner The top panel lists the product levels that would be chosen conditional on the monopolist and social planner introducing the optimal number of products into the market taking into account... given quality level along the whole quality spectrum In order to understand how innovation changes marginal costs, it is necessary to discuss a bit of detail on the CPU manufacturing process CPU s are produced in batches by etching transistors on a large wafer surface The wafer is then chopped up into little pieces, with each piece representing an individual CPU When firms innovate, they increase their... transistors (the number of transistors fixes the size of the individual chip on the die) With this increased ability, they can keep the size of the chips constant and increase performance for each chip (producing better top-end chips) They can also shrink the size of the chip on the wafer, producing more chips on each wafer (lowering marginal costs) In practice, firms both produce higher quality chips at the. .. constraints (Su and Judd 2008) using the optimization routine KNITRO where marketshares are computed with quadrature Appendix 2 details this process 3.2 Instruments Instruments other than the X’s themselves are necessary both because I estimate the standard deviations of the random coefficients (requiring at least two extra instruments) and because firms choose prices knowing the demand shocks, leading to... because Intel was already capturing a large share of potential market surplus in the pre-innovation period Postinnovation, Intel is able to produce better products, which they can then have higher markups on, but these gains are small, and for the most part they end up selling the new chips to the same people they sold the old chips to at a slightly higher price The second row of table 5 gives Intel... profits using the quality levels from the data (as estimated by the demand system) Here Intel benefits from the innovation both because they now can produce products that AMD can’t compete with at the high end (and are therefore able to charge higher markups on them) and because they restructured their product line 31 in such a way that AMD was relegated to lower portions of the quality spectrum In this . 10% at the beginning of 2003 and 20% at the beginning of 2009. Figure 1 plots Intel and AMD marketshare from the end of 2003 through the beginning of 2009. [Figure. ask the following questions: In this industry, how do firms choose the number and quality of their products? How would these choices be different if the industry