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Industrial Organization or Imperfect Competition

Univ. Prof. dr. Maarten JanssenUniversity of ViennaSummer semester 2011Week 2 (March 10-11)

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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

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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

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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?

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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).

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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?

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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

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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.

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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

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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

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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

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Double Marginalisation

P

QD

MC

MR

pM

qM

pR

qR

M

R

Consumer surplus

MCR= Additional welfare loss

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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?

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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

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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

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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

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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.

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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

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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

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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

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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

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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

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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

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Two problems with marginal cost price regulation Appearance of immediate losses Eventual losses: sustainability

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Problems with marginal cost regulation 1:Immediate losses

D(p)

MES

ATC

PriceCost

Output

MC

p=MC

q

Losses

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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).

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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

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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!

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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

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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!

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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!

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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!

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(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.