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1a)
The key idea behind the model is that it will only be effective after several rounds, once the
competitor learns the strategy.
©
Real life example -> Uber (dynamic pricing)
During peak hours -> high price (low PED)
Off peak -> low price (high PED)
d)
f)
Or can also be when the economy is doing very badly
3a)
1. Define imperfect info
Issues that will happen without measures to tackle
1. Adverse selection
In the insurance market, it will eventually lead to only poor insured buying insurance and prices
will become too high.
** can also use game theory (numerical example) to explain adverse selection
2. Moral Hazard
Banks will take unnecessary risks because they are TBTF (too big to fail)
3b)
Can use numerical example for screening (see slide 329)
c)
https://www.mckinsey.com/industries/financial-services/our-insights/insurance-2030-the-impactof-ai-on-the-future-of-insurance
https://www.mckinsey.com/industries/financial-services/our-insights/how-top-tech-trends-willtransform-insurance
-> main gist is that imperfect information will be reduced due to increased availability of data
and faster processing (due to data sharing etc)
-> please ensure yr answer answers how does increased data reduce imperfect information.
-> cost will be lower and agents will facilitate the process
-> with better data, premiums will generally be lower for most consumers, but will be higher for
high risk consumers due to the availability of data (pricing will be more flexible)
6a)
Initial Profit is -280 if they compete based on prices. (bertrand)
Both will sell at mc where p = 40
If they compete based on quantity, (cournot)
P = 216 – 0.4q1 – 0.4q2
MR1 = 216 – 0.8q1 – 0.4q2
216 – 0.8q1 – 0.4q2 = 40
2160 – 8q1 – 4q2 = 400
Q1 = 220 – 0.5q2
By symmetry
Q2 = 220 – 0.5q1
Q1 = 220 – 0.5(220 – 0.5q1)
Q1 = 220 – 110 + 0.25Q1
0.75Q1 = 110
Q1 = Q2 = 146.67
Price = 216 – 0.4(146.67 x 2) = 98.664
Total Profit for each firm = 98.664 x 146.67 – (140 + 40 x 146.67) = 8464.25 (cournot profits)
Total Profit for market = 16928.50
-> Conditions needed for collusion
If they act like a monopoly
MR = 216 – 0.8Q
216 – 0.8Q = 40
Q = 220
P = 216 – 0.4(220) = 128
Total profits = 220 x 128 – (140 + 40 x 220) = 19220
Each firm would earn 19220/2 = 9610
Total profits and prices are higher if firms can collude.
b)
Firm 1 will charge 40 – e to capture the whole market
New quantity will become
40 = 216 – 0.4Q
Q = 440
New C(q1) = 140 + 20q1
New profits will become (440 x 40) – (140 + 20 x 440) = 8660
But this will be capture entirely by firm 1
-> non sustainable in the long run unless innovation is unique because firm 2 will also copy.
c)
Reduce Initial Costs -> barriers to entry will be lower
Market will move from oligopoly to monopolistic competition
Monopolistic competition has less ability to practice non-uniform pricing because it has less
pricing power.
(use definition of market power)
Demand for an individual firms product will become more elastic, so it will reduce market power
according to lerner index.
https://www.britannica.com/topic/Lerner-index
-> use above example to elaborate specifically on why a firm may have decreased ability to
practice bundling when there are more new entrants.
Economic Analysis I
Lecture 3
Advanced Pricing Strategies
Dr Reza Salehnejad
Objectives
Learn the major strategies for pricing imitative and new
products.
Understand how companies find a set of prices that
maximizes the profits from the total product mix.
Learn how companies adjust their prices to take into
account different types of customers and situations.
Know the key issues related to initiating and responding to
price changes.
Understand how price serves as a strategic tool to shape the
market.
Overview
I. Basic Pricing Strategies
Monopoly & Monopolistic Competition
Cournot Oligopoly
II. Extracting Consumer Surplus
Price Discrimination
Block Pricing
Two-part Pricing
Commodity Bundling
III. Pricing for Special Cost and Demand Structures
Peak-Load Pricing
Cross Subsidies
Transfer Pricing
IV. Pricing in Markets with Intense Price Competition
Price Matching
Brand Loyalty
Randomized Pricing
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3
Standard / Uniform Pricing
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4
Mark-up Pricing
Mark-up Pricing:
Selling Price = Costs of Goods Sold + (Mark-up × Cost of
Goods Sold)
Example:
Costs of Goods Sold = £2.39
Desired Mark-up = 40% (0.4)
Selling Price = £2.39 + (0.4 × £2.39) = £3.35
In competitive market, the firm may follow other firms in
setting the mark-up.
Gross Margin Pricing
Gross Margin (GM) Pricing
Selling Price =
Costs
of Goods Sold
———————–1 – GM
Example:
Costs of Goods Sold = £2.39
Desired Gross Margin = 40% (0.4)
Selling Price = £2.39 / (1 0.4) = £3.98
In competitive market, the firm may follow other firms in
setting the gross margin.
Setting & Getting the Right Prices(New Products)
Market-Skimming Pricing
Setting a high price for a new product to skim
maximum revenues layer by layer from segments
willing to pay the high price.
Premium pricing
high price for a unique product (Apple watch).
Market-Penetration Pricing
Setting a low price for a new product in order to attract
a large number of buyers and a large market share.
Standard Pricing and Profits
Price
Profits from standard pricing
= $8
10
8
6
4
MC
2
P = 10 – 2Q
1
2
3
4
MR = 10 – 4Q
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5
Quantity
8
An Example
Elasticity of demand for Kodak film is -2.
?
P = [EF/(1+ EF)] ? MC
?
P = [-2/(1 – 2)] ? MC
?
P = 2 ? MC
Price is twice marginal cost.
Fifty percent of Kodaks price is margin above
manufacturing costs.
9
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Markup Rule for Cournot Oligopoly
Homogeneous product Cournot oligopoly.
N = total number of firms in the industry.
Market elasticity of demand EM .
Elasticity of individual firms demand is given by
EF = N ? EM.
Since P = [EF / (1+ EF)] ? MC,
Then, P = [NEM / (1+ NEM)] ? MC.
The greater the number of firms, the lower the profitmaximizing markup factor.
10
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An Example
Homogeneous product Cournot industry, 3 firms.
MC = $10.
Elasticity of market demand = – ½.
Determine the profit-maximizing price?
? EF = N EM = 3 ? (-1/2) = -1.5.
? P = [EF/(1+ EF)] ? MC.
? P = [-1.5/(1- 1.5] ? $10.
? P = 3 ? $10 = $30.
11
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Non-Standard / non-Uniform
Pricing
12
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Price Discrimination: Extracting Consumer Surplus
Most models examined to this point involve a single
equilibrium price.
In reality, there are many different prices being charged in the
market.
Price discrimination is the practice of charging different prices
to consumer for the same good to achieve higher prices.
The three basic forms of price discrimination are:
First-degree (or perfect) price discrimination.
Second-degree price discrimination.
Third-degree price discrimination.
13
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First-Degree or Perfect Price Discrimination
Practice of charging each consumer the maximum
amount he or she will pay for each incremental
unit.
Permits a firm to extract all surplus from
consumers.
14
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Perfect Price Discrimination
Price
Profits*:
.5(4-0)(10 – 2)
= $16
10
8
6
4
Total Cost* = $8
2
MC
D
1
* Assuming no fixed costs
2
3
4
5
Quantity
15
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Caveats
In practice, transactions costs and information
constraints make this difficult to implement perfectly
(but car dealers and some professionals come close).
Digital technologies have lowered the costs of gathering
information and customer tracking essentially paving the
way for first degree price discrimination.
Price discrimination wont work if consumers can
resell the good.
16
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Second-Degree Price Discrimination
Price
The practice of posting a
discrete schedule of
declining prices for different
quantities.
MC
$10
$8
$5
Eliminates the information
constraint present in firstdegree price discrimination.
Example: Electric utilities
D
2
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4
Quantity
17
Third-Degree Price Discrimination
The practice of charging different groups of consumers
different prices for the same product.
Group must have observable characteristics for thirddegree price discrimination to work.
Examples include student discounts, senior citizens
discounts, regional & international pricing.
18
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Implementing Third-Degree Price Discrimination
Suppose the total demand for a product is comprised of
two groups with different elasticities, E1 < E2.
Notice that group 1 is more price sensitive than group
2.
Profit-maximizing prices?
? P1 = [E1/(1+ E1)] ? MC
? P2 = [E2/(1+ E2)] ? MC
19
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An Example
Suppose the elasticity of demand for Kodak film in the
US is EU = -1.5, and the elasticity of demand in Japan is
EJ = -2.5.
Marginal cost of manufacturing film is $3.
?
PU = [EU/(1+ EU)] ? MC = [-1.5/(1 - 1.5)] ? $3 = $9
?
PJ = [EJ/(1+ EJ)] ? MC = [-2.5/(1 - 2.5)] ? $3 = $5
Kodaks optimal third-degree pricing strategy is to charge
a higher price in the US, where demand is less elastic.
20
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Two-Part Pricing
When it isnt feasible to charge different prices for
different units sold, but demand information is known,
two-part pricing may permit you to extract all surplus from
consumers.
Two-part pricing consists of a fixed fee and a per unit
charge.
? Example: Athletic club memberships.
21
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How Two-Part Pricing Works
Price
1. Set price at marginal cost.
2. Compute consumer surplus.
3. Charge a fixed-fee equal to
consumer surplus.
10
8
6
Per Unit
Charge
Fixed Fee = Profits* = $16
4
MC
2
D
1
* Assuming no fixed costs
2
3
4
5
Quantity
22
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Block Pricing
The practice of packaging multiple units of an identical
product together and selling them as one package.
Examples
? Paper.
? Six-packs of soda.
? Different sized of cans of green beans.
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23
An Algebraic Example
Typical consumers demand is
? P = 10 - 2Q
? C(Q) = 2Q
Optimal number of units in a package?
Optimal package price?
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Optimal Price for the Package: $24
Consumers valuation of 4
units = .5(8)(4) + (2)(4) = $24
Therefore, set P = $24!
Price
10
8
6
4
MC = AC
2
D
1
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2
3
4
5
Quantity
25
Costs and Profits with Block Pricing
Price
10
Profits* = [.5(8)(4) + (2)(4)] (2)(4)
= $16
8
6
Costs = (2)(4) = $8
4
2
D
1
* Assuming no fixed costs
2
3
4
5
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MC = AC
Quantity
26
Commodity Bundling
The practice of bundling two or more products together and
charging one price for the bundle.
Examples
Vacation packages.
Computers and software.
Film and developing.
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27
An Example that Illustrates Kodaks Moment
Total market size for film and developing is 4 million
consumers.
Four types of consumers
?
?
?
?
25% will use only Kodak film (F).
25% will use only Kodak developing (D).
25% will use only Kodak film and use only Kodak developing
(FD).
25% have no preference (N).
Zero costs (for simplicity).
Maximum price each type of consumer will pay is as
follows:
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28
Total Profits by Pricing Each Item Separately?
Type
F
FD
D
N
Film Developing
$8
$3
$8
$4
$4
$6
$3
$2
Total Profit = Film Profits + Development Profits
= $16 Million + $9 Million = $25 Million
Surprisingly, the firm can earn even greater profits by bundling!
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29
Whats the Optimal Price for a Bundle?
Type
F
FD
D
N
Film
$8
$8
$4
$3
Developing Value of Bundle
$3
$11
$4
$12
$6
$10
$2
$5
Optimal Bundle Price = $10 (for profits of $30 million)
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30
Class Question
Does any of these pricing techniques capture Spotifys
pricing strategy?
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31
Peak-Load Pricing
When demand during peak Price
times is higher than the
capacity of the firm, the
firm should engage in peakload pricing.
MC
PH
Charge a higher price (PH)
during peak times (DH).
DH
PL
MRH
Charge a lower price (PL)
during off-peak times (DL).
MRL
QL
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DL
QH Quantity
32
Cross-Subsidies
Prices charged for one product are subsidized by the
sale of another product.
May be profitable when there are significant demand
complementarities effects.
Examples
?Browser and server software.
?Drinks and meals at restaurants.
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33
Double Marginalization
Consider a large firm with two divisions:
?
?
the upstream division is the sole provider of a key input.
the downstream division uses the input produced by the
upstream division to produce the final output.
Incentives to maximize divisional profits leads the
upstream manager to produce where MRU = MCU.
?
Implication: PU > MCU.
Similarly, when the downstream division has market power
and has an incentive to maximize divisional profits, the
manager will produce where MRD = MCD.
?
Implication: PD > MCD.
Thus, both divisions mark price up over marginal cost
resulting in in a phenomenon called double
marginalization.
?
Result: less than optimal overall profits for the firm.
34
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Transfer Pricing
To overcome double marginalization, the internal
price at which an upstream division sells inputs to
a downstream division should be set in order to
maximize the overall firm profits.
To achieve this goal, the upstream division
produces such that its marginal cost, MCu, equals
the net marginal revenue to the downstream
division (NMRd):
NMRd = MRd – MCd = MCu
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35
Upstream Divisions Problem
Demand for the final product P = 10 – 2Q.
C(Q) = 2Q.
Suppose the upstream manager sets MR = MC to
maximize profits.
10 – 4Q = 2, so Q* = 2.
P* = 10 – 2(2) = $6, so upstream manager charges
the downstream division $6 per unit.
36
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Downstream Divisions Problem
Demand for the final product P = 10 – 2Q.
Downstream divisions marginal cost is the $6
charged by the upstream division.
Downstream division sets MR = MC to maximize
profits.
10 – 4Q = 6, so Q* = 1.
P* = 10 – 2(1) = $8, so downstream division
charges $8 per unit.
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37
Analysis
This pricing strategy by the upstream division results in less
than optimal profits!
The upstream division needs the price to be $6 and the
quantity sold to be 2 units in order to maximize profits.
Unfortunately,
The downstream division sets price at $8, which is too high;
only 1 unit is sold at that price.
? Downstream division profits are $8 ? 1 6(1) = $2.
The upstream divisions profits are $6 ? 1 – 2(1) = $4 instead
of the monopoly profits of $6 ? 2 – 2(2) = $8.
38
Overall firm profit is $4 + $2 = $6.
Reza Salehnejad
Upstream Divisions Monopoly Profits
Price
Profit = $8
10
8
6
MR = 10 – 4Q
4
2
MC = AC
P = 10 – 2Q
1
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2
3
4
5
Quantity
39
Upstreams Profits when Downstream Marks Price Up to $8
Price
Downstream
Price
Profit = $4
10
8
6
MR = 10 – 4Q
4
2
MC = AC
P = 10 – 2Q
1
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2
3
4
5
Quantity
40
Solutions for the Overall Firm?
Provide upstream manager with an incentive to set
the optimal transfer price of $2 (upstream divisions
marginal cost).
Overall profit with optimal transfer price:
? ? $6 ? 2 ? $2 ? 2 ? $8
41
Reza Salehnejad
Pricing in Markets with Intense Price Competition
Price Matching
? Advertising a price and a promise to match any lower price offered
by a competitor.
? No firm has an incentive to lower their prices.
? Each firm charges the monopoly price and shares the market.
Induce brand loyalty
? Some consumers will remain loyal to a firm; even in the face of
price cuts.
? Advertising campaigns and frequent-user style programs can
help firms induce loyal among consumers.
Randomized Pricing
? A strategy of constantly changing prices.
? Decreases consumers incentive to shop around as they cannot
learn from experience which firm charges the lowest price.
? Reduces the ability of rival firms to undercut a firms prices. 42
Reza Salehnejad
Conclusion
First degree price discrimination, block pricing, and two part
pricing permit a firm to extract all consumer surplus.
Commodity bundling, second-degree and third degree price
discrimination permit a firm to extract some (but not all)
consumer surplus.
Simple markup rules are the easiest to implement, but leave
consumers with the most surplus and may result in doublemarginalization.
Different strategies require different information.
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43
Apples Staircase Pricing Model
Every year the firm launches a new iPhone at a premium
price, which replaces the one launched the year before.
The firm continues to offer the older product / iPhone at a
reduced price.
Price brackets are very firm and set at fixed intervals about
$100 apart.
The floor of the range has consistently remained at around
$400 while the ceiling has expanded over time.
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44
Apples Staircase Pricing Model
As the product matures the user base grows (to nearly 1
billion today).
Later buyers will opt for the lower price points, but the
availability of higher, more aspirational models (sustained
by the brand) means that a minority will gravitate
upward, mainly because they can.
This ensures that although the median and mode of the
price trend downward, the average price stays the same.
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The Staircase Price Model
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Revenue per Unit Shipped
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Readings
Main Readings
Baye, M.R., (2008) Managerial Economics & Business
Strategy, 6th Edition, Irwin McGraw-Hill, 2008, ch. 11
(Sections using calculus are optional).
Further Readings
Varian, H. Intermediate Microeconomics (2003), 6th ed., W.
W. Norton, ch. 25, pp. 439-53
For staircase pricing model see
http://www.asymco.com/2017/07/31/how-much-will-the-new-iphone-cost/
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48
Case Studies
Economic Analysis I
Case 1:
The ready-to-eat breakfast cereal industry may be characterized by relatively low economies of
scale and relatively low levels of technology. Consequently, from a technological point of view,
entry into this market is easy. Between the 1950s and the 1970s, there was virtually no entry of
new firms into this industry in the U.S, even though all the incumbent firms (Kellogg, General
Mills, General Foods, and Quaker Oats) made significant profits. Further, although the number of
firms in the industry did not change, the number of brands introduced by the incumbent firms
increased from 25 to about 80, and kept increasing. Finally, the incumbents heavily expended on
advertising. Use the monopolistic competition model to explain:
i) Why were profits so high and no entry occurred, even though entry seemed relatively
easy?
ii) Why did the number of brands increase so rapidly, while the number of firms remained
constant?
Case 2:
Retail in Switzerland is mostly dominated by highly profitable cartels. The Swiss authorities
anticipate the gradual collapse of these cartels as the country becomes better integrated with
the rest of Europe. OECD, by contrast, hold a more sceptical view, claiming that the collapse
of cartels does not necessarily lead to more competitive markets; rather, they add, cartel
breakdowns are frequently associated with an increase in concentration. Which prediction
seems more reasonable? Are the two views inconsistent?
Case 3:
A sugar-refining monopoly has three main markets: the catering industry, the confectionary
industry, and the soft-drink industry. Of these, the soft-drink industry can most easily switch
to alternative sweeteners. Why might it be profitable for the monopoly to vertically integrate
into the soft-drink industry?
Case 4:
Visa and MasterCard are the two largest providers in the market for general purpose credit
card network products and services. Together, Visa and MasterCard account for 75% of the
dollar volume of transactions, and account for 86% of the number of general purpose cards
issued. American Express, Discover/Novus, and Diners Club are the significant competitors
in the general purpose card market. Both Visa and MasterCard are joint ventures
(associations) that are owned and operated by the member banks that issue cards and provide
card acceptance services. The member banks have an interest in both Visa and MasterCard
(known as duality) and have representatives serving on the board of directors or important
committees of both Visa and MasterCard.
Since the member banks of Visa and MasterCard have a significant interest in both Visa and
MasterCard, they have little incentive or desire to compete directly against one another. The
member banks have refused efforts by MasterCard management to develop its brand through
marketing campaigns. The banks felt that this action would hurt the Visa brand, which the
banks have a stake in. They have also not supported new product development, unless the
new development was available to both Visa and MasterCard. In addition to avoiding
competition between brands, the member banks have prohibited its banks from issuing
competing credit cards, such as American Express and Discover/Novus. They have also
worked jointly to discourage merchant acceptance of competing cards and access to ATMs
for cash advances.
a) How does the dual ownership of Visa and MasterCard lessen competition between the two?
b) How have Visa and MasterCard worked to restrain its competitors from competing in the
market?
Economic Analysis I
Lecture 4
Advanced Topics in Business Strategies
Reza Salehnejad
Strategic Behaviour
Strategies to affect market structure, or rivals behaviour
versus setting optimal price / output / capacity /
given
rivals behaviour, prices, etc.
Actions taken by firms to reduce competition by actual and
potential rivals.
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2
Market
Strategic actions aim at manipulating the market environment,
which include:
Other existing firms or possible entrants;
Beliefs of consumers and existing and potential rivals;
Technology and costs of firms and entry costs.
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3
Strategic Behavior
Non-cooperative strategic behavior: encompasses actions of
one firm that wants to increase its profits by improving its
position relative to its rivals
To harm its rivals
To benefit itself
Cooperative strategic behavior: are actions that increase the
profits of all firms by reducing competition and by reducing
uncertainty about each other.
These can take the form of explicit agreements as well as
non-explicit
e.g. Practices that facilitate collusion
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4
Key Questions
Under what conditions does a firm benefit using
non-cooperative strategic behaviour?
When do oligopolists benefit from using cooperative
strategic behaviour?
Should antitrust laws forbid all actions that appear to
be non-cooperative or cooperative strategic
behaviour.
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Non- Cooperative Strategic
Behaviour
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Non-cooperative Strategic Behaviour
Must meet two conditions to be successful:
Asymmetry: The incumbent firm must have advantage over its
rivals (like acting before them, or greater market power).
Commitment: It must be credible that the firm will follow its
strategy regardless of the actions of its rivals credible threat.
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7
Non-cooperative Strategic Behaviour
Why there cant be any credible commitment?
In
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Overview
I.
Predatory Pricing to Lessen Competition
II.
Limit Pricing to Prevent Entry
III.
Raising Rivals Costs to Lessen Competition
IV.
Price Discrimination as a Strategic Tool
V.
Changing the Timing of Decisions
VI.
Penetration Pricing to Overcome Network Effects
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9
Predatory Pricing
Strategy of pricing below marginal cost to drive
competitors out of business, then raising price
to enjoy the higher profits resulting from
lessened competition.
Goal is to lessen competition by eliminating
existing competitors.
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10
Predatory Pricing
Two firms
Incumbent &
Rival
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Rival
Exits
Incumbent
Pricing
Pattern
11
Predatory Pricing
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12
Potential Problems with Predatory Pricing
Counter strategies:
?
?
Stop production.
Purchase from the predator at the reduced price and
stockpile until predatory pricing is over.
Rivals can sue under the Sherman Act
?
But it is often difficult for rivals to prove their case.
Upfront losses incurred to drive out rivals may
exceed the present value of future monopoly profits.
Predator must have deeper pockets than prey.
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13
Predation & Antitrust Law
It is illegal to charge p < MC to drive out
competition.
In practice, it is hard to evaluate and hard to prove.
Antitrust authorities dont want to mistake predation
for intense competition.
Easterbrook (1981): only consider a suit if a firm
had been driven out of business and predator has
again raised market price.
14
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Limit Pricing
Strategy where an incumbent (existing firm) prices below
the monopoly price in order to keep potential entrants out
of the market.
Goal is to lessen competition by eliminating potential
competitors incentives to enter the market.
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15
Monopoly Profits
This monopolist is
earning positive
economic profits.
These profits may
induce other firms to
enter the market.
Questions:
? Can the monopolist
prevent entry?
? If so, is it profitable to
do so?
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Limit Pricing
Limit
Pricing
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Limit Pricing
Incumbent produces QL
instead of monopoly output
(QM).
$
Resulting price, PL, is lower
than monopoly price (PM).
Residual demand curve is
the market demand (DM)
minus QL .
Entry is not profitable
because entrants residual
demand lies below AC.
Optimal limit pricing results
in a residual demand such
that, if the entrant entered
and produced Q units, its
profits would be zero.
Reza Salehnejad
Entrant's residual
demand curve
P
M
PL
AC
DM
P = AC
Q
QM
Q
L
Quantity
18
Potential Problems with Limit Pricing
It isnt generally profitable for the incumbent to
maintain an output of QL once entry occurs.
Rational entrants will realize this and enter.
Solution: Incumbent must link its pre-entry price
to the post-entry profits of the potential entrant.
Possible links:
?
?
?
?
Commitments by incumbents.
Learning curve effects.
Incomplete information.
Reputation effects.
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Potential Problems with Limit Pricing (Continued)
Even if a link can be forged, it may not be
profitable to limit price! Limit pricing is
profitable only if the present value of the
benefits of limit pricing exceed the up front
costs:
L
D
?
?
?
?
?
i
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? ? M ? ? L.
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Raising Rivals Costs
Strategy where a firm increases the marginal or fixed
costs of rivals to distort their incentives.
Not always profitable, but may be profitable as the
following example shows.
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Raising a Rivals Marginal Cost
Cournot duopoly.
Initial equilibrium at
point A.
Firm 1 raises the
marginal cost of Firm
2, moving equilibrium
to point B.
Firm 1 gains market
share and profits.
22
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Other Strategies to Raise Rivals Costs
Raise fixed costs in the industry.
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Other Strategies to Raise Rivals Costs
If vertically integrated, increase input prices in the
upstream market.
? Vertical Foreclosure: Strategy where in a vertically
integrated firm charges rivals a prohibitive price for an
essential input, thus forcing rivals to use more costly
substitutes or go out of business.
? The Price-Cost Squeeze: Integrated firm raises input price
and holds the final product price constant.
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Price Discrimination as a Strategic Tool
Price discrimination permits a firm to target price cuts to
those consumers or markets that will inflict the most damage
to the rival (in the case of predatory pricing) or potential
entrants (in the case of limit pricing).
Meanwhile, it can continue to charge the monopoly price to
its other customers.
Thus, price discrimination may enhance the value of other
pricing strategies.
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Changing the Timing of Decisions or the Order of Moves
Sometimes profits can be enhanced by changing
the timing of decisions or the order of moves.
? When there is a first-mover advantage, it pays to
commit to a decision first.
? When there is a second-mover advantage, it pays to let
the other player move first.
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Examples of Games with First and Second-Mover Advantages
Example 1: Player naming the smaller natural number gets
$10, the other players get nothing.
?
First-mover always earns $10.
Example 2: Player naming the larger natural number gets
$10, the other players get nothing.
?
Last-mover always earns $10
Practical Examples?
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If Firms A and B Make Production Decisions Simultaneously
Firm B
Firm A
Strategy
Low Output
High Output
Low Output
$30, $10
$10, $15
High Output
$20, $5
$1, $2
Firm A earns $10 by playing its dominant strategy,
which is Low Output.
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But if A Moves First:
Firm A can earn $20
by producing a high
output!
Requires
?
?
Commitment to a
high output.
Player B observes
As commitment
prior to making its
own production
decision.
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Low Output
Low Output
($30, $10)
High Output
($10, $15)
Low Output
($20, $5)
High Output
($1, $2)
B
A
High Output
B
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Networks
A network consists of links that connect different
points in geographic or economic space.
One-way Network Services flow in only one
direction.
?
Examples: water, electricity.
Two-way Network Value to each user depends
directly on how many other people use the network.
? Examples: telephone, e-mail.
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Example: A Two-Way Star Network Linking 7 Users
Point H is the hub.
Points C1 through C7 are
nodes representing
users.
Total number of
connection services is
n(n - 1) = 7(7-1) = 42.
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C6
C7
C5
C1
H
C2
C4
C3
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Network Externalities
Direct Network Externality The direct value enjoyed
by the user of a network because other people also use the
network.
Indirect Network Externality The indirect value
enjoyed by the user of a network because of
complementarities between the size of the network and
the availability of complementary products or services.
Negative Externalities such as congestion and
bottlenecks can also arise as a network grows.
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Penetration Pricing to Overcome Network
Effects
Problem: Network externalities typically make it
difficult for a new network to replace or compete with
an existing network.
Solution: Penetration Pricing
? The new network can charge an initial price that is very low,
give the product away, or even pay consumers to try the new
product to gain users.
? Once a critical mass of users switch to the new network,
prices can be increased.
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The New Network Game Without Penetration Pricing
Table 13-2 A Network Game
User 2
Network Provider
H1
H2
H1
$10, $10
$0, $0
H2
$0, $0
$20, $20
User 1
Coordination Problem
?
?
?
Neither user has an incentive to unilaterally switch to H2, even though both users
would benefit if they simultaneously switched.
With many users, it is difficult to coordinate a move to the better equilibrium.
Users may stay locked in at the red equilibrium instead of moving to green one.
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The New Network Game With Penetration Pricing
Table 13-3 The Network Game with Penetration Pricing
User 2
User 1
Network Provider
H1
H1 & H2
H1
$10, $10
$10, $11
H1 & H2
$11, $10
$21, $21
Network provider H2 pays consumers $1 to try its network; consumers have nothing
to lose in trying both networks. The green cell is the equilibrium.
Users will eventually realize that H2 is better than H1 and that other users have
access to this new network.
Users will eventually quit using H1, at which point provider H2 can eliminate $1
payment and start charging for network access.
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Conclusion
A number of strategies may enhance profits:
?
?
?
?
?
Limit pricing.
Predatory pricing.
Raising rivals costs.
Exercising first- or second-mover advantages.
Penetration pricing.
These strategies are not always the best
ones, though, and care must be taken when
using any of the above strategies.
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Readings
Main Readings
Baye, M.R., (2017) Managerial Economics & Business
Strategy, 9th Edition, Irwin McGraw-Hill, 2008, ch. 13
(Sections using calculus are optional).
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Economic Analysis I
Economics of Information
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Overview
Imperfect Information
?
Uncertainty
I.
II.
III.
IV.
?
Asymmetric Information
I.
II.
?
The Mean and the Variance
Uncertainty and Consumer Behavior
Uncertainty and the Firm
Uncertainty and the Market
Adverse Selection
Moral Hazard
Auctions
2
E