Transcript Slides - Competition Policy International

ANTITRUST ECONOMICS 2013
David S. Evans
University of Chicago, Global Economics Group
TOPIC 13:
Date
Elisa Mariscal
CIDE, Global Economics Group
PREDATORY AND OTHER PRICING STRATEGIES
Topic 13| Part 1
29 October 2013
Overview
2
Part 1
Part 2
Price
Discrimination/Com
plex Pricing
Predatory Pricing
Limit Pricing
Loyalty Rebates
Key Takeaways
3
Aggressive pricing is the essence of competition. Consumers benefit
when companies cut their margins to the bone, offer low prices, and
stimulate demand.
Aggressive pricing can also be a tool for eliminating competitors
today so that a firm can secure significant market power and then
raise its prices.
Distinguishing between pricing that is good or bad for consumers is
difficult and likely has high rates of error. Critical to balance the false
positives and false negatives in designing competition rules for
pricing abuses.
4
Price Discrimination and Other
Complex Pricing
Price Discrimination and Other Complex Pricing
5
Basic price discrimination.
Charging different groups different prices (3rd degree price
discrimination).
Charging separately for each unit (1st degree price discrimination).
Non-linear prices (2nd degree price discrimination).
What is Price Discrimination?
6
Price discrimination refers to:
Charging different prices.
For the same good
• To different people
• At different times or
• For different quantities
Even though the costs are the same (or more accurately where the
price differences aren’t accounted for by cost differences).
Price Discrimination is Common in Competitive
Markets
7
Airline seats. Few people on an airline flight are paying the same
price even if they are sitting in the same class of seats.
Sales. At the beginning of every month French shops have legal sales.
American universities. The price of going to Harvard University varies
from $0 to $50,250. Only a small portion pay the full price.
People who buy 10 cups of coffee at Caffe Nero get the next cup
free.
Restaurants make very different profit margins on different dinners
served the same night.
Harvard does it …
8
… and so does eBay
9
Several Conditions Must Hold for Price
Discrimination
10
Firm must have some market power (but as we’ve said most have
some).
Firm must have some way to identify customers who would be willing
to pay more (time, age, sex, location, other behavior).
• Sales: early versus late buyers separate fashion conscious from not.
• Universities: income proxy for willingness to pay and hard to sell
diplomas.
• Pharmaceutical companies: charge different prices for same drug in
different countries.
Firm must be able to limit arbitrage (otherwise low-paying customers
will resell to high-paying customers).
• Airlines: time of booking; resale hard.
• Parallel trade is about efforts to bypass price discrimination by
arbitrageurs.
• Fashion conscious can’t wait for the sales.
“Third-Degree Price Discrimination”
11
Price
Group 2 pays lower price
Firms charge different
customers different
prices for the same
good.
P1 > P2
P1
Consider case where
marginal cost and
average cost is the
same for every unit.
P2
MC
D2(P2)
q2
q1
Output
MR1
MR2
D1(P1)
“Third-Degree Price Discrimination”
12


1
1 
P1  1    MC  P2  1 

 E1 
 E2 
P1  MC
1

P1
E1
P2  MC
1

P2
E2
Welfare Consequences of 3rd Degree Price
Discrimination
13
Tends to expand output and therefore makes social surplus bigger.
Tends to shift surplus from consumers to producers.
Compared with charging a single price, discrimination:
• Benefits one customer group while harming another customer group.
• Tends to increase social welfare whenever, as is often the case, it
tends to increase output
• May increase or decrease consumer welfare.
“First Degree Price Discrimination”
14
What’s the best a firm could do with price discrimination? Charge
everyone as much as they would be willing to pay for each unit.
That gives the firm the entire area between the demand curve and
the cost curve: that’s the most profit it could ever get; but it
requires so much information and such complex pricing that it is
seldom possible in practice.
“First Degree Price Discrimination”
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Each point may reflect
different quantities
purchased by
individual consumers or
an additional
consumer that is willing
to buy at that price.
Price
P1
P2
P3
D(P)
Maximum profit for the firm;
maximum total surplus;
minimum consumer surplus.
MC
q1
q2
q3
Output
“Second Degree” Price Discrimination
16
A firm might be able to approximate perfect price discrimination in
several ways:
• Two-part tariffs: access fee plus usage fee.
• Non-linear pricing: complex volume discounts.
• Tie-in sales: use a consumable product to meter demand for a
durable product.
“Second Degree” Price Discrimination—Two-Part
Tariffs
17
Two-part tariff: Buyers pay a fixed fee (lump-sum fee) for the right to
consume a good and a uniform price for each unit of product
consumed.
Profit benefits of two-part tariffs include:
• Firms can charge a low usage fee to encourage increased
consumption and use the fixed charge to recuperate the consumer’s
higher surplus.
• This makes them at least as much profits as a uniform tariff (could
always make the fixed charge 0 which replicates the uniform tariff).
Examples of two-part tariffs:
• Euro Disney: Charges a fixed charge with no usage element
(probably due to convenience).
• Movie theatre: entrance fee and then pay for food.
• Credit cards: pay annual fee plus get rewards (negative price) for
each transaction.
Economics of Two-Part Tariffs
18
Two groups of consumers
Demand schedule is for member of
group
•Group 1 has high demand.
•Group 2 has low demand.
An average uniform price would
lose some of the low demand
consumers.
Fee Members
Price
of Group 1 =
Fee Members
•Could charge a single two part
tariff like before.
More profitable to charge two,
two-part tariffs targeted at
members of each group.
of Group 2 =
P1
P2
Example: Mobile phones,
•Many two part tariffs with
different fixed monthly charges
and variable call charges.
MC
D2
Q2
Q1
MR2
MR1
D1
Output
Tie-Ins and Metering for 2nd Degree Price
Discrimination
19
Consider the case where a firm sells a durable good like a fax
machine.
The customers use a non-durable product (like ink) with the durable
good over its lifetime.
The price of the durable machine is like an access charge for the
system.
The price of the “consumables” can be used to meter intensity and
then value the use.
High-use customers might get a low marginal price for
“consumables” so the average cost per use is lower than for lowuse customers.
Bundled Products and Price Discrimination: The
Case of Block Booking
20
Suppose two products and two customers and each product costs $0.
Theatre 1
Theatre 2
Optimal
Price
Profit
Consumer
Surplus
Gone with the Wind
$8000
$7000
$7000
$14000
$1000
Gertie’s Garter
$2500
$3000
$2500
$5000
$500
$10500
$10000
$10000
$20000
$500
$1000
($1000)
Bundle
Change from
Bundling
Cost per Product
0
NOTE: Total surplus is unchanged--producers get $1000 profit and consumers
lose $1000.
Source: George J. Stigler, “United States v. Loew’s Inc.: A Note on Block Booking,” Supreme Court Review 152 (1963),
pp. 152-157
Demand Aggregation and Package Sales
21
Suppose two products and two customers and each product costs $0.
Accountant
Optimal
Price
120
30
120
120
0
20
120
120
120
0
140
150
140
280
10
+40
10
Lawyer
Word processing
Spreadsheet
Bundle
Change from
Bundling
Cost per Product
Profit
Consumer
Surplus
0
NOTE: Total surplus increases by 50--producers get +40 and consumers +10 (290
total value-280 total cost).
Demand Aggregation
22
Out of 100 people 1-10 would pay $22 for component 1, 11-20 would
pay $22 for component 2, …, 91-100 $22 for component 10; each would
pay $2 for each of the other 9 components.
Costs are zero.
Profit-maximizing price is $22 (profits= $2200) and consumers only buy
one component; price for separate components is $2 (profits= $2000)
and each consumer buys all 10. No consumer surplus since complete
extraction by producer.
But consumers would pay $22 + 9 x $2 = $40 for all 10. So charge $40 for
all ten. Profits = $4000. All consumers buy all components but still no
consumer surplus.
Generally consumer surplus increases as a result of demand
aggregation because more people are able to buy and get to keep
some surplus.
Price Discrimination and Static Social Welfare
23
Compare price discrimination with linear pricing in a simple static
situation.
Price discrimination tends to increase profits as firm with market
power gets more consumer surplus.
Price discrimination also reduces dead-weight loss of monopoly
since it tends to expand output (but not always).
Price discrimination has an ambiguous effects on consumer
welfare—people who pay high prices lose while those who pay low
prices gain (and remember those who pay low prices wouldn’t get
the good at all without price discrimination).
Bottom line: price discrimination usually increases social welfare but
not necessarily consumer welfare.
Price Discrimination and Dynamic Social Welfare
24
Economists tend to view price discrimination as beneficial or
benign.
• Reduces dead-weight loss.
• Enables firms to recover fixed costs and therefore may permit firms to
enter who couldn’t otherwise.
• Additional profits can help firms recover risks and investments in
entering new businesses (see Baumol and Swanson).
• And everyone does it—price discrimination persists in competitive
markets which suggests that it is efficient (See US Supreme Court
decision in Illinois Works, 2006).
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Limit Pricing
Basic Story of Limit Pricing
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Firm A is a monopoly and faces potential entry by less efficient firm
B.
Firm A drops its monopoly price so that it is just lower than the
minimum price firm B would need to make its entry profitable.
By doing this firm A discourages firm B from coming in and
competing.
Entry of firm B could result in Bertrand competition thereby
jeopardizing all profit or Cournot competition thereby jeopardizing
some profit.
Monopoly Facing Actual or Potential Entry
27
Limit pricing strategies
Price
• Suppose monopoly is more
efficient than entrants
but…
• It is still profitable for
entrants to come in if they
can sell at less than the
monopoly price.
PI
MCE
PI ‘
MCI
• Monopoly may lower its
price enough to make it
unprofitable for entrants to
come in (from PI to PI’).
MR
Output
Monopoly Facing Actual or Potential Entry
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Post-entry strategies:
• Monopoly has the choice of accepting entrant, or fighting entrant.
• Decision depends on the ability to drive entrant out and reputational
benefits of being tough.
Entrant
Stay out
Enter
Incumbent
0
10
Fight
Accommodate
-1
4
0
5
Reasons Not to Wait…
29
In some circumstances it may in fact be better to just drop prices
after an entrant comes in. However, there are several reasons not
to wait.
Entrants may not know the monopoly is more efficient. As a result of
asymmetric information they mistakenly come in.
If they had not incurred any sunk costs monopolist could drop price
and they would leave.
If they have incurred sunk costs then after entry it is better to stay in
and drop the price.
Therefore monopolist may want to discourage “stupid” entry.
Limit Pricing and Competition Policy
30
Suppose a dominant firm has not engaged in limit pricing.
Suppose a less-efficient entrant comes in.
The dominant firm will lower price below entrant’s price.
The entrant will leave the market if it doesn’t have sunk costs.
The dominant firm will then raise price back up until it happens
again.
Should competition policy prohibit a dominant firm from dropping
its price below the entrant’s price even though the entrant is less
efficient?
End of Part 1, Next week Part 2
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Part 1
Part 2
Price Discrimination
and Other Complex
Pricing
Predatory Pricing
Limit Pricing
Loyalty Rebates