Transcript ECONOMICS 3150B

ECONOMICS 3200M
Lecture 8
Ch. 9, 10, 11
March 20, 2013
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Strategic Behavior
Commitment and entry
• Assumptions
• Duopoly: firm 1 (incumbent), firm 2 (potential entrant)
• Firm 1 (leader) chooses level of K (capital investment, capacity) – K1
• Firm 2 (follower) observes K1 and selects its level of K – K2
• i = Ki (1 – Ki – Kj), K levels are strategic substitutes
• No fixed cost of entry
• 2-period Stackelberg game
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Types of K:
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Physical capital
Learning-by-doing (experience)
Developing clientele – advertising, switching costs – decrease demand for entrant
Setting up network of exclusive franchises – increase entrant’s distribution costs
Product development – choosing strategic locations in geographic/product space
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Strategic Behavior
Commitment and entry
• Firm 2’s reaction function: K2 = R2(K1) = [1- K1]/2
• Firm 1:
– Max 1 = 0.5K1 (1 – K1)
• Solution:
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K1 = 0.5
K2 = 0.25
1 = 0.125
2 = 0.062
Entry accommodated by firm1, but firm 1 influences firm 2’s post-entry
behavior by committing to larger capacity
• Nash game solution for simultaneous moves
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K1 = 0.33
K2 = 0.33
1 = 0.111
2 = 0.111
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K2
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R1
0.5
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S
R2 – no fixed costs
M
0.5
K1
1
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Strategic Behavior
Commitment and entry
• If there are fixed/sunk costs for entry – f , profit function for firm 2:
– 2 = K2 (1 – K1 – K2) – f
– 2 = 0 if K2 = 0
if K2 > 0
• Truncated reaction function for firm 2 – more likely that entry can be
deterred
• 3 possible solutions – 2 deter entry (S1 and S2), one accommodates
entry (S3)
• The larger the fixed cost, the less likely that entry will be
accommodated (case S3)
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K2
R2 – fixed costs
N
S3
S2
K1 ** M1 K1 *
S1
M2
K1
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Multi-market Oligopoly
• Firm 1 competes with firm 2 in market A and firm 1 has monopoly in
market B
• Compete in price in market A
• Economies of scale/scope for firm 1
• Firm 1:
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Reduce price in market B  increase demand, production in market B
Economies of scale/scope  decreases unit costs for firm 1 in market A
May be able to drive out firm 2 in market A
Trade-off: lower profits in market B vs. higher profits in market A
Also can compete more aggressively on price in market A because less
than 100% of revenues and profits for firm 1 in market A; whereas, 100%
for firm 2
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Bayesian Analysis
• Incomplete information regarding state of demand, cost
functions of rivals, strategic decisions of rivals
• Market interaction a game of asymmetric and incomplete
information
• Firm’s history matters
– Conveys information to rivals
– Affects expectations of rivals
• Multi-period oligopolistic interactions
– Firm’s behavior reveals information
– Rational for firm to manipulate rivals’ information and
expectations
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Bayesian Analysis
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Bi , i = 1 …… N (all possible events)
A – particular outcome
P(Bi) – a priori probabilities (expectations)
Revise a priori probabilities after observing particular outcome:
– P(BRA) = {P(BR)*P(A BR)}/{i=1…N P(Bi)*P(A Bi)}
• Example:
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N=2
P(B1) = 0.67; P(A B1) = 0.75; P(A B2) = 0.50
A occurs
P(B1A) = {P(B1)*P(A B1)}/{i=1,2 P(Bi)*P(A Bi)} =
{0.67*0.75}/{(0.67*0.75) + (0.33*0.5)} = 0.75
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Market Segmentation
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Example of price discrimination with straight
line demand curve
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Extract consumer surplus – value of product to
consumer less price paid; value to consumer
represents maximum price consumer willing to pay
Increase revenues, for given level of output, by
segmenting market
Market segments must have different price elasticities
of demand (different tastes)
Arbitrage not possible – one group of consumers
unable to buy product at low price and re-sell at
higher price to consumers willing to pay higher price
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Market Segmentation
Consumer surplus:
– Difference between maximum price consumer willing to pay for
product and actual price paid; at each price for a particular product,
each person that purchases the product gains a different value of
consumer surplus – different willingness to pay for a product
– Potential for market segmentation and price discrimination 
companies can exploit differences among consumers to increase
their revenues and profits
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P
P1
P2
P3
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Q
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P
Consumer surplus
P100
Total expenditures
Q100
Q
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Price Discrimination
• Sale of identical good/service at different prices to
different buyers or at different prices to same
buyer
• Alternative form of price discrimination
– Different bundles of features/characteristics and
different prices
– Hotels: suites, singles, doubles, floor level, other
amenities (access to lounge, health clubs; breakfast
included; priority check-in)
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Price Discrimination
• Conditions for price discrimination
– Firm must have some degree of market power
– Firm must be able to infer each consumer’s willingness to pay
– Firm must be able to prevent arbitrage – services
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Price Discrimination
Arbitrage
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If transaction costs between consumers small relative to price of product,
consumers who are able to pay low price buy extra quantities and re-sell to
consumers who are willing to pay and are charged higher prices
Scalping – opportunity cost of time
International price discrimination (dumping) and possibility for arbitrage –
transactions costs include transportation costs, tariffs, reputation
Limit arbitrage
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Services cannot be resold – entertainment services, telecom services exceptions
Warranties valid only for original buyers
Different bundles/prices
Signals
Vertical integration
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Price Discrimination
• First degree price discrimination – perfect price
discrimination
– Each unit sold at a different price – extract all consumer surplus
– Difference between maximum price consumer willing to pay for
product and actual price paid; at each price for a particular product,
each person that purchases the product gains a different value of
consumer surplus – different willingness to pay for a product
– Potential for market segmentation and price discrimination 
companies can exploit differences among consumers to increase
their revenues and profits
– Auctions – eBay
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Price Discrimination
• Second degree
– Nonlinear pricing
– Two-part tariffs – fixed price (entry/membership fee) + usage fee
– T(Q) = A + PQ, where A = CS/N [CS is aggregate consumer
surplus, N is the total number of consumers with each one buying
only one unit]
• Preceding graph: fixed price = consumer surplus, and usage fee
= P100
– With large numbers of consumers – trade-off between entry fee
and usage fees
• Large entry fee locks in consumers, reduces potential market; but
corresponding low usage fee makes entry less attractive  consider
what has happened to pricing for cell phones
• Multiple entry/usage fee combinations  self selection by consumers
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Price Discrimination
Second degree
• Examples:
– Membership in golf clubs
– Taxis
– Utilities: electricity, water/sewer rates
– Cell phone plans
– Personal seat licenses for hockey, football
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Price Discrimination
• Third degree price discrimination
• Aggregate demand can be divided into N distinct segments
on basis of exogenous information (signals reflecting
consumer preferences, market research) – different
preferences reflected in different elasticities of demand
• Different prices to different groups of buyers (independent
demands, interdependent cost model for monopolist)
• Prices differ on basis of signals related to perceived
consumers’ preferences (age, location, occupation, income,
ethnicity, etc.)
• Consumers on different demand curves as compared to
first degree where consumers are at different positions on
the same demand curve
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Price Discrimination
Third degree price discrimination
• [Pi – MC]/Pi = 1/i  higher prices in markets with lower
elasticities of demand
• Rule of thumb pricing: P1/P2 = (1 + 1/ 2)/(1 + 1/ 1)
• Price discrimination may enable monopolist to survive –
example (MR1 = MR2 = … MRN = MC
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Price Discrimination
Third degree price discrimination
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Movie theaters – special rates for seniors, children
Frequent user programs
Wealth management
Fashion, technology products – higher prices for first
consumers
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Price Discrimination
Third degree price discrimination
• Same delivered price for customers
– Freight absorption by producer
– Customers located farther from production/distribution
(warehouse) facility may have alternative suppliers
thus more elastic demand
• Other examples
– Monthly vs. hourly parking rates
– Metro Pass vs. single fare
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Price Discrimination
Third degree plus
• Different bundles
– Inter-temporal pricing – peak/off-peak pricing
– Product and time comprise bundle
– MC may differ between peak and off-peak periods thus not the
same as 3rd degree price discrimination which assumes same MC
for product
– Inter-temporal pricing – fashion/technology
– Price decreases over time – consumers who are impatient or
fashion/status conscious willing to pay higher price than
consumers who are patient or less fashion/status conscious
• If learning curve for producer: MC declines over time so dissimilar
from 3rd price discrimination
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Price Discrimination
• Tying – generalized form of bundling
• Consumer buys one product only if another product also purchased
• Products bought/sold in combination
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Apple: hardware, peripherals and operating systems
Apple and iTunes
Mercedes Benz: warranty and services at MB dealers
Funeral homes: caskets and burial services
Reasons:
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Economies of scope
2 separate, but consecutive monopolies in value chain
Assure quality
Interrelated demands (independent costs) – complements/substitutes
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Price Discrimination
Tie-in sales
• Mixed bundling
• Examples:
– Tour packages vs. buying travel, accommodation, ground travel,
food, entertainment separately
– Subscriptions vs. single purchase – theaters, magazines
– CATV – tiering of services
– Dell, Air Canada
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Price Discrimination
• Mixed bundling strategy: 4 consumers, 2 goods
– Reservation prices
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Consumer A: $90 for good 1, $10 for good 2
Consumer B: $50 for good 1, $50 for good 2
Consumer C: $40 for good 1, $60 for good 2
Consumer D: $10 for good 1, $90 for good 2
– MC1 = $20, MC2 = $30
– Pricing strategies:
• Bundling: Price for 1 unit of both good 1 and 2 = $100
• Profit: All 4 consumers buy bundle; profit = $200 = 4(100-2030)
• Mixed bundling: P1 = P2 = $89.95 or price for 1 unit of both =
$100
• Profit: A buys good 1, D buys good 2, C & D buy bundle;
profit = $229.50 = (89.95-20) + (89.95-30) + 2(100-20-30)
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Price Discrimination
• Price discrimination in intermediate products when large
customer has bargaining advantage
– Large customer may be able to integrate upstream (internalize) –
implications for competition in downstream market
– Price discrimination (i.e. price concessions) depends upon
credibility of backward integration
– Bank loans: large firms charged lower interest rates because they
have direct access to commercial paper and bond markets
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Price Discrimination
• Vertical integration example to prevent arbitrage
• Monopolist produces good used as input by two separate industries
• Elasticities of demand for input in 2 industries: 1 > 2
– P1 < P2
• To prevent arbitrage
– Monopolist buys firm in industry 1 and sells only to this firm in this
industry and sells to all firms in industry 2 at P2
– Other firms in industry 1 will be driven out of business
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Price Discrimination
Another example of bundling
• Quality discrimination – segment market on basis of preferences for
quality/brand names
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Offer different combinations of prices/qualities (different brand names)
Broader product line
Automobile companies
Beer companies
Clothing labels
Disney studios
Airlines – United/Ted; Qantas/Jetstar; Cathay Pacific/Dragonair; Air
Canada/Rouge
– Economies of scope – production, marketing, distribution
– Spatial pre-emption – block entry
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Market Segmentation
Market segmentation – price discrimination (telephone
companies, airlines, hotels); multiple branding – auto
companies; Rogers and Fido; Disney movie studios; retail
(Banana Republic, GAP, Old Navy, Piperlime); hotels
(Hilton – Waldorf-Astoria Collection, Conrad Hotels &
Resorts, Hilton, Hilton Garden Inn, Doubletree, Embassy
Suites, Hampton Inn, Homewood Suites); beer companies
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Networks
• Bandwagon effects
– Aggregate demand: effects of price changes and bandwagon
effects [see diagram]
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P
P0
P1
AD
D20
D10
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Price effect
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QN
Q
Bandwagon effect
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