CU The Absence of Measures to Deal with Imperfect Information Markets Question


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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)
Or can also be when the economy is doing very badly
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)
Can use numerical example for screening (see slide 329)
-> 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)
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.
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.
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 firm’s product will become more elastic, so it will reduce market power
according to 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
• Learn the major strategies for pricing imitative and new
• 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
• 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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Standard / Uniform Pricing
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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 =
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
Profits from standard pricing
= $8
P = 10 – 2Q
MR = 10 – 4Q
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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 Kodak’s price is margin above
manufacturing costs.
Reza Salehnejad
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 firm’s 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.
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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.
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Non-Standard / non-Uniform
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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
• 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.
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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
• Permits a firm to extract all surplus from
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Perfect Price Discrimination
.5(4-0)(10 – 2)
= $16
Total Cost* = $8
* Assuming no fixed costs
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• 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 won’t work if consumers can
resell the good.
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Second-Degree Price Discrimination
• The practice of posting a
discrete schedule of
declining prices for different
• Eliminates the information
constraint present in firstdegree price discrimination.
• Example: Electric utilities
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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 citizen’s
discounts, regional & international pricing.
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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 Reza Salehnejad 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 • Kodak’s optimal third-degree pricing strategy is to charge a higher price in the US, where demand is less elastic. 20 Reza Salehnejad Two-Part Pricing • When it isn’t 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 Reza Salehnejad 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 Reza Salehnejad 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. Reza Salehnejad 23 An Algebraic Example • Typical consumer’s demand is ? P = 10 - 2Q ? C(Q) = 2Q • Optimal number of units in a package? • Optimal package price? Reza Salehnejad 24 Optimal Price for the Package: $24 Consumer’s valuation of 4 units = .5(8)(4) + (2)(4) = $24 Therefore, set P = $24! Price 10 8 6 4 MC = AC 2 D 1 Reza Salehnejad 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 Reza Salehnejad 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. Reza Salehnejad 27 An Example that Illustrates Kodak’s 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: Reza Salehnejad 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! Reza Salehnejad 29 What’s 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) Reza Salehnejad 30 Class Question Does any of these pricing techniques capture Spotify’s pricing strategy? Reza Salehnejad 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 Reza Salehnejad 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. Reza Salehnejad 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
Result: less than optimal overall profits for the firm.
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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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Upstream Division’s 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.
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Downstream Division’s Problem
• Demand for the final product P = 10 – 2Q.
• Downstream division’s marginal cost is the $6
charged by the upstream division.
• Downstream division sets MR = MC to maximize
• 10 – 4Q = 6, so Q* = 1.
• P* = 10 – 2(1) = $8, so downstream division
charges $8 per unit.
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• 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.
• 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 division’s profits are $6 ? 1 – 2(1) = $4 instead
of the monopoly profits of $6 ? 2 – 2(2) = $8.
• Overall firm profit is $4 + $2 = $6.
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Upstream Division’s “Monopoly Profits”
Profit = $8
MR = 10 – 4Q
P = 10 – 2Q
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Upstream’s Profits when Downstream Marks Price Up to $8
Profit = $4
MR = 10 – 4Q
P = 10 – 2Q
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Solutions for the Overall Firm?
• Provide upstream manager with an incentive to set
the optimal transfer price of $2 (upstream division’s
marginal cost).
• Overall profit with optimal transfer price:
? ? $6 ? 2 ? $2 ? 2 ? $8
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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 firm’s prices. 42
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• 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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Apple’s 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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Apple’s 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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• 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
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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
ii) Why did the number of brands increase so rapidly, while the number of firms remained
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
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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• 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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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
• e.g. Practices that facilitate collusion
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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
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Non- Cooperative Strategic
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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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Non-cooperative Strategic Behaviour
Why there can’t be any credible commitment?
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Predatory Pricing to Lessen Competition
Limit Pricing to Prevent Entry
Raising Rivals’ Costs to Lessen Competition
Price Discrimination as a Strategic Tool
Changing the Timing of Decisions
Penetration Pricing to Overcome Network Effects
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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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Predatory Pricing
Two firms
Incumbent &
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Predatory Pricing
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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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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 don’t 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 Reza Salehnejad 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. Reza Salehnejad 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? Reza Salehnejad 16 Limit Pricing Limit Pricing Reza Salehnejad 17 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 entrant’s 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 isn’t 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. Reza Salehnejad 19 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 Reza Salehnejad ? ? M ? ? L. 20 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. Reza Salehnejad 21 Raising a Rival’s 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 Reza Salehnejad Other Strategies to Raise Rivals’ Costs • Raise fixed costs in the industry. Reza Salehnejad 23 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. Reza Salehnejad 24 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. Reza Salehnejad 25 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. Reza Salehnejad 26 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? Reza Salehnejad 27 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.” Reza Salehnejad 28 But if A Moves First: • Firm A can earn $20 by producing a high output! • Requires ? ? Commitment to a high output. Player B observes A’s commitment prior to making its own production decision. Reza Salehnejad Low Output Low Output ($30, $10) High Output ($10, $15) Low Output ($20, $5) High Output ($1, $2) B A High Output B 29 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. Reza Salehnejad 30 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. Reza Salehnejad C6 C7 C5 C1 H C2 C4 C3 31 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. Reza Salehnejad 32 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. Reza Salehnejad 33 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. Reza Salehnejad 34 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. Reza Salehnejad 35 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. Reza Salehnejad 36 Readings • Main Readings Baye, M.R., (2017) Managerial Economics & Business Strategy, 9th Edition, Irwin McGraw-Hill, 2008, ch. 13 (Sections using calculus are optional). Reza Salehnejad 37 Economic Analysis I Economics of Information Reza Salehnejad 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