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1
Industrial Organization or Imperfect Competition
Univ. Prof. dr. Maarten JanssenUniversity of ViennaSummer semester 2011Week 2 (March 10-11)
2
Aspects of Monopoly behaviour and its
consequences Durable goods monopoly Vertical relations between monopolists Regulation of monopoly Bundling Price Discrimination
1st degree price discrimination Personalized pricing
2nd degree price discrimination Menu of prices (everyone chooses from the menu)
3rd degree price discrimination Different groups are charged different prices
3
I. Durable goods - Limits to market power
Two issues: A monopolist who sells durable goods creates its
own competition (“second” hand markets). Consumers who are served never come back to
the market again and thus prices are expected to fall. Consumers who would otherwise buy today may decide
to wait if they expect prices to decline, which reduces demand and market power today.
Coase’s conjecture (1972): A durable goods monopolist has (almost) no monopoly power if the time between price adjustments is very small.
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Durable goods - Limits to market power (idea)
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Durable goods - Limits to market power (model set-up) t = 1,2, p(1), p(2) No cost (for simplicity) Consumers´ willingness to pay v is uniformly
distributed over [0,1]. (Creates linear demand) Discount factor δ, common to firms, consumers
0 < δ < 1 Consumers with v´s such that v-p(1) > δ(v-p(2)) or
v > [p(1)-δp(2)]/(1-δ) buy in period 1 v*(p(1),p(2)) is the consumer who is indifferent
6
Durable goods - Limits to market power (optimal pricing) I
Demand in period 1, D(1) = 1 - v*(p(1),p(2)) = 1 - [p(1)-δp(2)]/(1-δ) (1)
Demand in period 2, D(2) = v*(p(1),p(2)) – p(2) = [p(1)-δp(2)]/(1-δ) – p(2)
(2) Profits are given by
p(1)D(1) + δp(2)D(2) (3) Optimization wrt p(2) gives p(2) = p(1) No limit to market power? Did we do something wrong?
7
Durable goods - Limits to market power (optimal pricing) II This is the right solution if the firm can credibly
commit to charging p(1) and p(2) before consumers make decisions
However, this is not time consistent (not subgame perfect): when period 2 comes the firm wants to change its pricing decision!
Time consistent policy, is to maximize {[p(1)-δpe(2)]/(1-δ) – p(2)}p(2) to give p*(2) = [p(1)-δpe(2)]/2(1-δ)
If consumers rationally expect this - pe(2) = p*(2) -, then p*(2) = p(1)/(2-δ)
For any δ, p*(2) < p(1).
8
Durable goods - Limits to market power (optimal pricing) III How to get the optimal p(1)? Substitute (1) and (2) as well as the optimal value of
p(2) back into (3) and then take the first-order condition to yield p*(1) = (2- δ)2/2(4-3δ)
What is the standard monopoly price? Same price as when you commit to p(1)=p(2)=½
It is interesting to observe that ½ > p*(1) > p*(2) for any 0 < δ < 1 Indeed, durability creates limits to market power!
What happens when δ goes to 0 or 1?
9
Limits to market power: Possible solutions
Leasing (renting) rather than selling Build a reputation (or commit) not to offer the good
in the future. Destroy your mould, film, or plates
Build a reputation not to cut your prices in the future Buy-back guarantees Best-price clauses
New customers Try to increase future demand; price will not fall then
Planned obsolescence
10
What about the Coase conjecture? A durable goods monopolist has (almost) no
monopoly power if the time between price adjustments is very small, i.e., δ is close to 1. But, above it seems you go back to monopoly pricing
This is due to the two-period nature of the above model. If we consider T-period model, then for any δ < 1, the
monopolist has an incentive to set p(T) below p(T-1) as long as p(T-1) is above MC.
Coase conjecture is true in the limit, when T becomes infinitely large.
11
II. Vertical relations
Product chain: Upstream-downstream Manufacturers (producers) and retailers
Different issues, related to competition at different levels Exclusive dealing Resale price maintenance Pre-sale service provision Different pricing arrangements
12
Vertical restraints and pricing Double Marginalization Issues: Monopoly manufacturer and monopoly retailer
Manufacturer makes suits that are sold through the retailer
Consumer demand for suits: P = a - bQ
Suits cost € Cp each to make
Retailer incurs additional cost of € Cr per suit sold: space, labor etc.
The manufacturer sells the suits to the retailer at a price of r each
13
The examplePrice (P)
Quantity
Demand marginal revenue for the retailer is MR = a – 2bQ
MR
marginal cost is r + Cr
MC
MC = MR gives r = a-Cr -2bQ
Price (r)
Quantity
Manufacturer’s demand
The manufacturer’s marginal revenue is MR = a-Cr -4bQ
MR
Marginal cost is € Cp
MC
MC = MR gives Q = (a-Cr-Cp)/4
Compare to standard monopoly P = (3a+Cr+Cp)/4
14
Double Marginalisation
P
QD
MC
MR
pM
qM
pR
qR
M
R
Consumer surplus
MCR= Additional welfare loss
15
Vertical restraints merger of manufacturer and retailer improves on the foregoing outcome
Price
Quantity
marginal revenue for the merged firm is MR = = a-2bQ
Demand
marginal cost is MC = € Cr + Cp
MC
Standard monopoly problem
Lower price and higher profits
But is such a mergernecessary to achieve
these gains?
16
Double Marginalisation: a solution Non-lineair pricing (two-part tariff)
sell for a low per unit price (p = mc) plus a fixed fee (for example, almost the
monopoly profit) marginal consideration of retailer like that of a
monopolist franchise fee
17
Two-Part Pricing Manufacturer sells Q suits at a total charge of C(Q) = T + rQ
Set r equal to the manufacturer’s marginal cost
The retailer’s profit is: R = (a – bQ - Cr - Cp)Q - T
The retailer’s marginal revenue is: MR = a – 2bQ
The retailer’s marginal cost is: MC = Cr + Cp
Equating MR and MC yields monopoly result
Because the fixed charge does not affect marginal calculations, the retailer chooses the vertically integrated output and sells at the vertically integrated price
Because the fixed charge does not affect marginal calculations, the retailer chooses the vertically integrated output and sells at the vertically integrated price
The manufacturer uses the fixed charge T to claim this profit
18
Two-Part Pricing (cont) How common is a two-part pricing type of
scheme? When seen as a franchise agreement
fairly common fixed charge represents a franchise fee
giving the retailer the right to sell the manufacturer’s product
generates up-front profit for the manufacturer
so the manufacturer is willing to set a price per unit near to (at) marginal cost
19
Royalty Schemes
Royalty schemes are another way to link the interests of the manufacturer and the retailer. But these too have problems. Under one possible royalty contract the manufacturer sells at cost to the dealer and then receives a fraction of the retailer’s revenuesThe retailer’s marginal revenue is: = (1 - )(a -2bQ)
Equating marginal revenue with the marginal cost yields the retailer’s profit maximizing output of
Q* = a/2b - Cr + Cp
2b(1 – This is less than the monoply output for all positive values of , i.e., for any scheme under which the manufacturer earns a profit.
20
Royalty Schemes (cont.)
So, a royalty scheme like the one above cannot replicate the integrated outcome
There are other possible royalty contracts, though. One is to give the suits at no charge to the dealer and then again claim some of the downstream revenue
Now the retailer equates marginal revenue with a marginal cost of 40: = (1 - )(500Q - 2Q/100) = 40
Solving for Q yields : Q* = 25,000 - 20001 -
At = 1/3 or 33.33% this will equal 22,000
A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit . . . BUT
A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit . . . BUT
21
Royalty Schemes (cont.) As a final scheme we consider the case in which the manufacturer sells at cost and sets a royalty that is a fraction of the retailer’s net profits
the retailer’s profit now is: R = (1 - )(a - bQ - Cr - Cp)Q
Notice that the factor 1- now affects both revenues and costs:
So marginal revenue equals marginal cost at the monopoly output level
This type of royalty scheme always works. The royalty rate is set bynegotiation to distribute aggregate profits
This type of royalty scheme always works. The royalty rate is set bynegotiation to distribute aggregate profits
22
Royalty Schemes (cont.) Why are royalty schemes based on profits not more
widespread? profits are easy to disguise
misrepresent costs incur additional discretionary costs: travel
costs, entertainment ….. suppose that retailing incurs fixed costs of F:
marketing, space costs ... then the retailer can exaggerate F to negotiate
a lower royalty rate revenues are more easily observable
23
III. Regulation of Monopoly
Technological: when production costs are minimized concentrating output in a single firm. (sub-additivity)
Entry costs: Sunk nature of cost involved in entry
Absolute cost advantages of incumbent. Sunk expenditures by consumers
(switching costs) The beneficial effects of economies of
scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power
24
Natural monopoly An industry is a
natural monopoly if the production of a particular good or service by a single firm minimizes cost.
In such a case, regulation may be a way to overcome part of the welfare loss due to market power
25
Regulation of Natural Monopoly Price cap: Marginal cost pricing I
D(p)ATC
PriceCost
Output
Decreasing returns to scale
MES
MC
p=MC
q
Profits
ATC
26
Two problems with marginal cost price regulation Appearance of immediate losses Eventual losses: sustainability
27
Problems with marginal cost regulation 1:Immediate losses
D(p)
MES
ATC
PriceCost
Output
MC
p=MC
q
Losses
28
Possible solutions
Subsidization of losses But this may lead to regulatory capture (firms invest
resources into influencing the regulator’s decisions) Average cost pricing regulation
But, then no incentives for cost reduction Price cap regulation
Maximal incentives for cost savings, but regulator probably will adjust price cap if cost savings are realized (as regulators usually cannot commit not to do it).
29
Problems with Marginal cost regulation 2:Long run losses: Sustainability
Entrantp=MC-1cent
MES
ATC
PriceCost
Output
MC
D(p)
qq-q
Losses
p=MC
q
30
Conclusion regulation
Technological features may lead to the “desirability” of monopolies
Regulation yields mixed results: the gains from regulation must be traded-off against potential inefficiencies created by the regulation itself.
Sometimes, best regulation is no regulation at all!
31
IV. Bundling (Tying, mixed Bundling) Tying: The practice of conditioning the sale of one
good on the purchase of another good. Manufacturer of machines (e.g. photcopiers) tying service
contracts Franchises which tie the use of its brand name to the
purchase of the franchise inputs Bundling: tying in fixed proportions
Vacation packages Computers and software
Mixed Bundling: consumers have the choice of buying products separately or as a bundle at a reduced price
32
Bundling: making use of consumer heterogeneity
An Example
Others €3 €2Engineers €4 €6Managers €8 €4
Economists €8 €3
Type MS Word MS Excel
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Optimal Price for Word
Others €3 €2Engineers €4 €6Managers €8 €4
Economists €8 €3Type MS Word MS Excel
€8 2,000,000 €16,000,000€4 3,000,000 €12,000,000€3 4,000,000 €12,000,000
Price Demand π
€8 2,000,000 €16,000,000
Optimal price!
34
Optimal Price for Excel
Others €3 €2Engineers €4 €6Managers €8 €4
Economists €8 €3Type MS Word MS Excel
€4 2,000,000 €8,000,000€3 3,000,000 €9,000,000€2 4,000,000 €8,000,000
Price Demand π
€6 1,000,000 €6,000,000
€3 3,000,000 €9,000,000
Optimal price!
35
Optimal Price for the Bundle
Others €3 €2Engineers €4 €6
€11 2,000,000 €22,000,000€10 3,000,000 €30,000,000€5 4,000,000 €20,000,000
Price Demand π
€12 1,000,000 €12,000,000
€10 3,000,000 €30,000,000
€5€10
Managers €8 €4 €12Economists €8 €3 €11
Type MS Word MS Excel MS Excel+Word
Optimal price!
36
(Mixed) Bundling is not always bad for consumers
Creditproduct
PPI
Consumer group A
25 4
Consumer group B
11 9
Consumer group C
19 0
PPI is insurance product, only bought of primary product is bought
-Without bundling: company will price at 19 and 4, resp. giving profits of 42 and CS of 6, 0 and 0.
-With mixed bundling, company will price at 19 and 20 for the bundle, giving profits of 59 and CS of 9, 0 and 0.