Platform Envelopment and Predatory Bundling in Digital Markets

In free market competition, some behavior by businesses is considered anticompetitive and unfair.  If authorities can prove that a business is intentionally engaging in certain behaviors to undermine and drive out competitors, such as start-ups in the same industry, that business can be punished.  Regulatory agencies like the Federal Trade Commission (FTC) and the Department of Justice (DOJ) Anticompetitive Task Force are tasked with investigating firms for anticompetitive behaviors

Platform Envelopment as a Strategy

Platform envelopment occurs when a larger firm envelopes, or absorbs, the functions of a rival within its own platform.  Even if the standalone product of the smaller rival firm is superior, consumers will tend to use the “enveloped” substitute of the larger firm out of convenience - it is already built into a larger platform.  An example would be Microsoft enveloping rival tech firm’s products into its own operating systems in the late 1990s.  Although Microsoft’s software was not better, the fact that it already existed within Windows kept most consumers from looking to higher-quality, standalone products from smaller companies.

Predatory Bundling as a Strategy

One such anticompetitive behavior is predatory bundling, which occurs when a firm intentionally offers a bundle at such a discount that other firms in the market cannot compete.  For example, a large tech firm can offer a suite of software, with multiple programs, as a bundle that costs roughly the same as a single piece of software created by a smaller rival.  Most consumers will pick the bundle, which offers greater total functionality, over the standalone software.  Once the smaller rival goes out of business, the larger firm will raise its prices and leave consumers “stuck”.  Thus, consumers have an incentive to purchase low-cost bundles quickly, knowing that prices will likely rise in the future.

Using the Two Strategies to Absorb Adjacent Markets

Digital markets allow for the easy creation of bundles.  Some products, such as operating systems and suites of software, are de facto bundles under a single name.  It is easy for producers of operating systems to add additional programs, from games to graphic design programs to communication apps, to their core product (platform envelopment).  Then, to draw rapid consumer attention, these large firms can set their product price lower than competing firms, especially start-ups, can match (predatory bundling).  Consumers will almost always pick the better financial deal, which is the discounted bundle from one of the big tech firms.

Within months of an adjacent market emerging, tech giants have absorbed it by giving consumers a convenient and low-cost way to access those new services.  They can “steal” potential customers from start-ups by offering the new services to their own users through automatic updates.  Why pay to download a new program when your operating system just got a somewhat similar substitute, overnight, for free?

Economics of Platform Envelopment and Predatory Bundling

Economies of Scope

Becoming a conglomerate, or producer of multiple products, can result in lower per-unit costs as common resources, like labor and generalized equipment, can be shared among the production of those different products.  Employees at a large tech firm can easily make additional software to be added into bundles, allowing these new programs to be created at lower cost than if designed and built by a start-up with a singular focus.  Companies that make digital bundles, therefore, enjoy economies of scope that reduce their average costs compared to start-up rivals.

Network Effects

In a concept similar to economies of scale and scope, firms that produce digital bundles also enjoy increased revenue due to the demand-enhancing result of network effects.  The more customers a company gets, the more additional customers it attracts due to the benefits of being in a shared network with your friends, coworkers, and clients.  This is because communication and data sharing are much easier among users of the same products.  If all your friends use software X and can share files seamlessly, you have a significant incentive to also use software X, even if the price is a little higher than software Y.  

When tech conglomerates engage in platform envelopment and predatory bundling, they benefit by adding quickly to their customer base.  Even if a rival can create a superior product, many prospective customers will hesitate because they want to enjoy the convenience of remaining “in network” with more of their compatriots.

Barriers to Entry

Bundling firms tend to be larger and thus enjoy economies of scale as well as economies of scope, creating a double cost of production advantage over start-ups.  They also attract and retain more customers thanks to the convenience of network effects, with customers placing financial value on being able to link seamlessly with users of the same digital product suites.  Having to compete against such advantaged rivals creates a barrier to entry for most start-ups, which are highly innovative but face high fixed costs.  

Anticompetitive Investing

However, many investors may assist start-ups simply to profit once those start-ups are purchased by bundling tech conglomerates, which can eliminate budding competition by simply adding it to their own lineup of offerings.  Thus, many start-ups are never supported as potential market players, but rather as subcontractors to be added to a larger firm as soon as value is displayed!  Even if the leaders of a start-up do not wish to be purchased by a conglomerate rival, they may have no choice if they become publicly traded.  Hostile takeovers occur when a larger company purchases a majority stake in another firm by simply buying outstanding shares of stock on the market rather than in a negotiated deal.

Regulatory Economics 

Ultimately, an innovative tech start-up can be forcibly incorporated into a dominant firm through a hostile takeover if it “goes public” and has shares sold on the open market.  This limits competition in the long run as a handful of oligopolists in the tech market can simply buy out all competition that arises.  To prevent market stagnation as bundling conglomerates prevent the rise of new products and simply add lower-quality substitutes of those products to their own bundles, governments may decide to place regulations on hostile takeovers.  Evolutions in antitrust legislation may expand the definitions of anticompetitive behavior to protect start-ups, such as by allowing easier prosecution of large companies that appear to be violating the intellectual property of start-ups through the creation of “substitute” software.