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ECONOMICS 3200MLecture 8

Ch. 9, 10, 11

March 16, 2016

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Strategic BehaviorCommitment 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

• Types of K:– 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 BehaviorCommitment and entry • Firm 2’s reaction function: K2 = R2(K1) = [1- K1]/2• Firm 1:

– Max 1 = 0.5K1 (1 – K1)• Solution:

– 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

– K1 = 0.33– K2 = 0.33 1 = 0.111 2 = 0.111

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K2

K1

R1

R2 – no fixed costs

1

0.5

0.5 1

N

S

M

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Strategic BehaviorCommitment and entry • If there are fixed/sunk costs for entry – f , profit function for firm 2:

2 = K2 (1 – K1 – K2) – f if K2 > 0 2 = 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

K1

R2 – fixed costs

NS3

S2S1

K1 ** K1 * M2M1

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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:

– 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, reputation of CEO matter

– 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• 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(BRA) = {P(BR)*P(A BR)}/{i=1…N P(Bi)*P(A Bi)}

• Example:– N = 2– P(B1) = 0.67; P(A B1) = 0.75; P(A B2) = 0.50– A occurs– P(B1A) = {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

• Example of price discrimination with straight line demand curve

– 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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P

Q

P1P2P3

1 2 3

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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

Q

P100

Q100

Consumer surplus

Total expenditures

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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 at

low cost– Firm must be able to prevent arbitrage – services

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Price DiscriminationArbitrage• 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– Services cannot be resold – entertainment services, telecom services exceptions– Warranties valid only for original buyers– Different bundles/prices– Signals – Vertical integration– Squeeze out scalpers -- Ticketmaster

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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, Sothebys

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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• Movie theaters – special rates for seniors, children• Frequent user programs • Wealth management• Big data – credit card information, opt in, GPS tracking via

phone

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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

– Apple: hardware, peripherals and operating systems– Apple and iTunes– Mercedes Benz: warranty and services at MB dealers– Funeral homes: caskets and burial services– Reasons:

• 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, automobiles

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Price Discrimination• Mixed bundling strategy: 4 consumers, 2 goods

– Reservation prices• 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(100-20-

30)• 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 DiscriminationAnother example of bundling• Quality discrimination – segment market on basis of preferences for

quality/brand names– Offer different combinations of prices/qualities (different brand names)– Broader product line– Automobile companies– Beer companies– Clothing labels– Disney studios – Hotels – Airlines – 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

Q

P0

P1

10 20

D10

30

D20

AD

QN

Price effect Bandwagon effect