ECON 115. Industrial Organization

Transcription

1 ECON 115 Industrial Organization

2 1. Reprising Non-linear Pricing 2. A Second Look at Discounts 3. Welfare Implications of Price Discrimination 4. The Case of Standard Oil and Price Discrimination 5. A 2 nd Degree Price Discrimination Problem

3 First 60 Minutes Reviewing non-linear pricing Entry Fees Block Pricing How Discounts Work Second 50 Minutes Evaluating welfare effects of Third-degree price discrimination Second-degree price discrimination The Standard Oil Case A 2 nd Degree Price Discrimination Problem.

4 A nonlinear pricing strategy depends upon the information available to the seller. That determines whether to employ first-degree (personalized) or second-degree (menu) pricing. Under first-degree price discrimination, the monopolist charges the maximum price that each consumer is willing to pay. Extracts all consumer surplus Since profit equals the total surplus, first-degree price discrimination is efficient. 4

5 Suppose you inherit five antique cars. Your research shows there are 5 collectors each with different reservation prices. Each is willing to pay: Linear Pricing: Personalized pricing $10000 $6000 $10000 $8000 $6000 $8000 $6000 $6000 $6000 $4000 $6000 $4000 $2000 $6000 $2000 Revenue under standard monopoly pricing = $18,000 Revenue under personalized pricing = $30,000 5

6 First-degree price discrimination is very profitable, And it leads to the efficient choice of output, since no value-creating exchanges are missed. However, it requires: 1. detailed customer information; and 2. the ability to avoid arbitrage. The information requirements appear insurmountable. Solvable if personal information is available (accounting services; university applicants) and prices 6 can be set after the customer has agreed to the contract.

7 Can a seller achieve a similar outcome if prices must be announced in advance? Yes, with non-linear prices Two-part pricing is an example of common non-linear pricing strategy. charge a quantity-independent fee (membership?), plus a per unit usage charge Block pricing is a second example. bundle total charge and quantity in a package 7

8 Example of Two-part pricing. A jazz club serves two types of customer: Old: demand for entry + Q o drinks is P = V o Q o Young: demand for entry + Q y drinks is P = V y Q y Cost of operating the jazz club C(Q) = F + cq Assumptions: V o > V y : Old will to pay more than Young Demand and costs are all in daily units Equal numbers of each type of customer. 8

9 Suppose that the jazz club owner applies traditional linear pricing: free entry and a fixed price for drinks. Aggregate demand is Q = Q o + Q y = (V o + V y ) 2P Set the equation equal to price: P = (V o + V y )/2 Q/2 MR therefore is MR = (V o + V y )/2 Q Maximize profits be equating MR and MC, where MC = c and solve for Q: Q U = (V o + V y )/2 c Substitute into aggregate demand to give the equilibrium price: P U = (V o + V y )/4 + c/2 9

10 Under this linear pricing scheme: Each Old consumer buys: Q o = (3V o V y )/4 c/2 drinks Each Young consumer buys: Q y = (3V y V o )/4 c/2 drinks Profit from each pair of Old and Young is: U = (V o + V y 2c) 2 /8 10

11 This example can be illustrated as follows: Price (a) Old Customers (b) Young Customers (c) Old/Young Pair of Customers Price Price Vo a V o V y e d b g f Vo+V y 4 + c 2 h i c k j MC MR V o V y V o +V y 2 - c Vo + V y Linear pricing leaves each type of consumer retaining the consumer surplus. 11

12 Jazz club owner can improve on this. Remember the consumer surplus at the uniform linear price is: Old: CS o = (V o P U )*Q o /2 = (Q o ) 2 /2 Young: CS y = (V y P U )*Q y /2 = (Q y ) 2 /2 He can charge an entry fee (just less than): E o = CS o to each Old customer and E y = CS y to each Young customer; The club checks IDs to implement this policy. Each type will still be willing to frequent the club and buy the equilibrium number of drinks. This increases profit by E o for each Old and E y for each Young customer. 12

13 The jazz club can do better still! The club can 1. Reduce the price per drink; this increases consumer surplus; 2. Then extract the additional consumer surplus can through a higher entry fee. Let s consider the best the jazz club owner can do with respect to each type of consumer. 13

14 Set the unit price equal to marginal cost $/unit V i The entry charge converts consumer surplus into profit This gives consumer surplus of (V i - c) 2 /2 c MC Set the entry charge to (V i - c) 2 /2 MR V i - c V i Profit from each pair of Old and Young now d = [(V o c) 2 + (V y c) 2 ]/2 14

15 Set the unit price equal to marginal cost This gives consumer surplus of (V i - c) 2 /2 Set the entry charge to (V i - c) 2 /2 $/unit V i c The entry charge Using converts two-part consumer pricing surplus increases into profit the monopolist s profit MR V i - c V i MC Profit from each pair of Old and Young now d = [(V o c) 2 + (V y c) 2 ]/2 15

16 There s another pricing method the club owner can use called Block Pricing: offer a package Entry plus X number of drinks for $Y. Maximize profit by following these two rules: 1. Offer each consumer type an amount equal to how much that type would buy if price equaled marginal cost. 2. Set the total charge for each type equal to the total willingness to pay for the that quantity. 16

17 $ Old $ Young V o Willingness to pay of each Old customer supplied to each Old customer V y Willingness to pay of each Young customer supplied to each Young customer c MC c MC Q o V o Q y V y WTP o = (V o c) 2 /2 + (V o c)c = (V o2 c 2 )/2 WTP y = (V y c) 2 /2 + (V y c)c = (V y2 c 2 )/2 17

18 How to implement this block pricing policy? Here are the simple rules: 1. Card everyone at the door. 2. Give customers the requisite number of tokens that are exchanged for drinks. 18

19 What if the seller cannot distinguish between buyers? For example, perhaps they don t differ by age by rather by income, which is unobservable. Then the type of price discrimination just discussed is impossible. A high-income buyer will pretend to be a low-income buyer to avoid the high entry price and to pay the smaller total charge 19

20 Take a specific example: P h = 16 Q h P l = 12 Q l MC = 4 To capture the consumer surplus using first-degree price discrimination requires: High-Income: entry fee $72 and $4 per drink or entry plus 12 drinks for a total charge of $120. Low-Income: entry fee $32 and $4 per drink or entry plus 8 drinks for total charge of $64. 20

21 This will not work. High-Income types get no consumer surplus from the package designed for them, but get consumer surplus from the low-income package. Therefore, they will pretend to be lowincome even if this limits the number of drinks they can buy. To address this problem, the seller designs a menu of offerings targeted at the two types. 21

22 This alternative offer must be what economists call incentive compatible. Any offer made to high-demand consumers must provide as much consumer surplus as they would get from an offer designed for lowdemand consumers. 22

23 In designing this pricing scheme, the seller endeavors to make buyers: 1. Reveal their true types; 2. Self-select the quantity/price package designed for them. This is the essence of second-degree price discrimination. Without the ability to identify different types of buyers, a two-part tariff is ineffective because it allows deception by buyers. The best option is quantity discounting. 23

24 $ 16 High-income So will the highincome consumers: because the ($64, 8) package gives them $32 consumer surplus Low-Income The low-demand consumers will b willing to buy this ($64, 8) package $32 8 $32 $64 $40 $32 4 $24 $8 MC 4 MC $32 $16 $ $ 12 Offer the low-income consumers a package of entry plus 8 drinks for $64 $8 24

25 This is the incentive High-income compatibility constraint Low-Income So any other package offered to high-income $ $ 16 consumers must offer at least $32 consumer 12 surplus $32 8 $32 $64 $40 $32 $8 4 $24 MC 4 MC $32 $16 $32 $

26 Low income Industrial Organization So they can be offered a package consumers will not of ($88, 12) (since $ = 88) buy the ($88, 12) and they will buy this package since they High-income Low-Income are willing to pay Profit from each only $72 for 12 high-income High income consumers are drinks consumer is $ willing to pay up $ to $120 for 16$40 entry plus 12 drinks if no other And profit from ($88-12 x $4) package is 12 available each low-income consumer is $32 ($64-8x$4) $32 8 $32 $64 $40 $32 4 $24 $8 MC 4 MC $32 $16 $32 $

27 $ 16 High-income $ 12 Low-Income These packages exhibit quantity discounting: highincome pay $7.33 per unit and low-income pay $8 $32 8 $32 $64 $40 $32 4 $24 $8 MC 4 MC $32 $16 $32 $

28 High-Income $ 16 $28 Can the clubowner do even better than this? $ 12 Low-Income Yes! Reduce the number of units offered to each low-income consumer $87.50 $44$92 $59.50 $ MC 4 MC $28$48 $

29 A high-income consumer will pay up to $87.50 for entry and 7 High-Incomedrinks $ 16 $28 So buying the ($59.50, 7) package gives him $28 consumer surplus So entry plus 12 drinks can be sold for $92 ($ = $92) $ Profit from each ($92, 12) package is $44: an increase 12 of $4 per consumer Suppose each low-income consumer is offered 7 drinks Each consumer will pay up to Low-Income $59.50 for entry and 7 drinks Profit from each ($59.50, 7) package is $31.50: a reduction of $0.50 per consumer $87.50 $44$92 $59.50 $ MC 4 MC $28$48 $

30 $ 16 Industrial Organization A high-income consumer will pay High-Income up to $87.50 for entry and 7 The monopolist does better by So buying the drinks ($59.50, 7) package Suppose each low-income gives him reducing $28 consumer the surplus number of units consumer is offered 7 drinks So entry offered plus 12 drinks Can to low-income can the be clubowner do $ even sold consumers Each consumer will pay up to Low-Income Profit from for each since $92 ($120 ($92, this - 12) 28 allows = $92) him to increase $59.50 for entry and 7 drinks package is $44: an increase the better charge of $4 than to this? high-income Yes! Profit Reduce from each the ($59.50, number 7) per consumer consumers 12 of units package offered is $31.50: to a reduction each $28 of $0.50 per consumer low-income consumer $87.50 $44$92 $59.50 $ MC 4 MC $28$48 $

31 Reducing the number of units to each low-income consumer begs the question: does the monopolist always want to supply both types of consumer? There are cases where it is better to supply only high-income types: high-end restaurants golf and country clubs To return to our example, suppose there are N l low-income and N h high-income consumers. 31

32 Suppose both types of consumer are served: two packages are offered ($57.50, 7) aimed at low-income and ($92, 12) aimed at high-income profit is $31.50xN l + $44xN h Now suppose only high-income consumers are served: then a ($120, 12) package can be offered profit is $72xN h Is it profitable to serve both types? Only if $31.50xN l + $44xN h > $72xN h 31.50N l > 28N h This requires that N h < N l 28 = There should not be too high a fraction of high-demand consumers. 32

33 Summarizing second-degree price discrimination: 1. Extract all consumer surplus from the lowestdemand group. 2. Leave some consumer surplus for other groups... to satisfy the incentive compatibility constraint 3. Offer less than the socially efficient quantity to all groups other than the highest-demand group. 4. Offer quantity-discounting. Second-degree price discrimination converts consumer surplus into profit less effectively than first-degree. Some consumer surplus is left on the table in order to induce high-demand groups to buy large quantities. 33

34 How does price discrimination affect welfare? Remember, welfare for economists is not the same as being fair, relates solely to efficiency, and is merely a measurement of the total surplus First, we will examine Third Degree Price Discrimination. 34

35 Suppose that there are two markets: weak and strong Price The discriminatory price in the weak market is P 1 Price The discriminatory price in the strong market is P 2 D 1 The maximum gain in surplus in the weak market is G The uniform price in both market is P U P 2 MR 2 D 2 The minimum loss of surplus in the strong market is L P U P U P 1 G MR 1 L MC MC ΔQ 1 ΔQ 2 35

36 Price D 1 Price discrimination cannot increase surplus unless it increases aggregate output Price P 2 MR 2 D 2 P U P U P 1 MR 1 G L MC MC ΔQ 1 ΔQ 2 It follows that ΔW < G L = (P U MC)ΔQ 1 + (P U MC)ΔQ 2 = (P U MC)(ΔQ 1 + ΔQ 2 ) 36

37 Non-linear price discrimination raises profit. Does it increase social welfare? Price suppose that demand of consumer group i is P = P i (Q) Demand marginal cost is constant at MC = c suppose quantity offered to consumer group i is Q i total surplus consumer surplus plus profit is the area between the demand and marginal cost up to quantity Q i c Total Surplus Q i Q i (c) MC 37

38 Pricing policy affects distribution of surplus Price output of the firm First is welfare neutral Demand Second affects welfare Does it increase social welfare? Total Surplus Price discrimination increases social welfare of group i if it increases quantity supplied to group i. c Q i Q i Q i (c) MC 38

39 First-degree price discrimination always increases social welfare. Price It extracts all consumer surplus but generates socially optimal output. output to group i is Q i (c) Demand Total Surplus this exceeds output with uniform (nondiscriminatory) pricing c Q i Q i (c) MC 39

40 Menu pricing is less straightforward. Suppose that there are two markets: low demand high demand Uniform price is P U Menu pricing gives quantities Q 1s, Q s 2 Welfare loss is greater than L Welfare gain is less than G Price P U Price P U L Q l s Low demand offered less than the socially optimal quantity Q l U Q h U G Q h s MC MC High demand offered the socially optimal quantity 40

41 It follows that Industrial Organization Price ΔW < G L = (P U MC)ΔQ 1 + (P U MC)ΔQ 2 = (P U MC)(ΔQ 1 + ΔQ 2 ) P U L MC A necessary condition for seconddegree price discrimination to increase social welfare is that it increases total output Like third-degree price P U discrimination But second-degree price discrimination is more likely to increase output Price Q l s Q l U Q h U G Q h s MC 41

42 Bonus Lecture: STANDARD OIL AND PRICE DISCRIMINATION The role of railroad rebates in creating a monopoly

43 The most famous antitrust case in US History and one that still resonates today in political discourse is the case against Standard Oil. Did Standard Oil use its enormous size to restrain trade and monopolize the market in violation of the Sherman Antitrust Act? Or was Standard Oil just a brilliant, highly efficient competitor?

44 This much is certain: Standard Oil was enormously successful. At one point, it monopolized the business of refining petroleum products (89% market share). John D. Rockefeller is the richest man in American history (Worth in today s dollars = $ BN.) In 1911, the Standard Oil was broken up by the US Government into 34 companies, including: Standard Oil of New Jersey (today ExxonMobil) Standard Oil of New York (today ExxonMobil) Standard Oil of California (today Chevron) Standard s Atlantic (today ARCO)

45 This is a very short history of Standard Oil and the case against it. It illustrates two things that are critical to this course: 1) How difficult it is to differentiate between smart, aggressive business practices and illegal ones. 2) How 2 nd Degree Price Discrimination (in the form of rebates) played a central role in the case against Standard Oil.

46 Oil was discovered in Titusville, PA in For 30 years Pennsylvania was the center of the oil world! In the 19 th century, oil was primarily used in lamps. It was cheaper than whale oil, which had been the world s principal illuminant. In the first decade after oil s discovery, there were huge levels of exploration, well-drilling and refinery-building by thousands of entrepreneurs.

47

48 The oil industry consists of crude production, refining and transportation. Although Standard Oil would own some productive fields and pipelines, their primary holdings were refineries. Rockefeller acquired his first refinery in 1863 in Cleveland.

49 Standard Oil was chartered in Ohio in 1870; at the time it was the US s largest refiner with 10% market share. By 1880 it had nearly 90% market share. WHY? Answer 1: Did they have more efficient operations and better marketing and distribution? OR Answer 2: Did they buy-up competitors at firesale prices or drive them out of business by employing high shipping costs, thanks to special deals with railroads (rebates)?

50 There is little doubt that Standard Oil was a brilliant business operator. Even one of its harshest critics, Ida Tarbell, wrote a chapter in her book on Standard Oil entitled, The Legitimate Greatness of Standard Oil. During its most dominant period ( ) the price of kerosene fell from 26 to 8 and Standard s cost of production fell from 3 to ½.

51 In 1882 saw two important developments. Oil was discovered in Russia, and Pipelines replaced railroads as the low cost method of transporting oil. Both developments necessitated Standard Oil making its business more efficient, which meant closing some operations. This required subsuming all the different refiners in the Standard Oil group into a single legal entity: The Trust. (Ergo, antitrust legislation. )

52 Legal issues with its trust led Standard Oil to relocate to New Jersey, creating the Standard Oil holding company in Meanwhile the oil universe was changing. Starting in the 1890s, major oil discoveries in TX, LA, OK and CA brought new competitors to the market (Pure, Sun, Texaco, Gulf). New products (gasoline) became more important, while kerosene faded. Slowly, Standard s market share began to erode, dropping to 60% by the time of the breakup.

53 At the same time anti-standard Oil sentiment began building in the country, thanks to muckraking journalists such as Ida Tarbell. The Federal government brought its suit against Standard Oil in In 1909 a federal court found Standard Oil guilty of restraining competition by combining 30 separate units into one company and by controlling transportation costs. In 1911 the Supreme Court agreed with the lower court and Standard Oil was broken up.

54 Why would railroads agree to provide lower costs to Standard Oil through rebates? This is, in fact, a form of price discrimination. Standard Oil was a huge shipper of oil. Standard also provided loading facilities and tank cars to keep costs down.

55 Also, long-haul rail transport has exceedingly low marginal costs (near $0). This led railroads to constantly engage in price wars. The railroads had tried to enter into cartels to keep prices high, but had failed due to cheating. The railroads actually recruited Standard Oil and other refiners to cartelize rail rates by agreeing to ship a fixed percentage of oil in each railroad. They were called eveners because they evened out the amount of oil each railroad carried. This eliminated the reason to cheat.

56 Tarbell (and some scholars) argue the threat of rebates (and lower shipping costs) were instrumental in forcing refiners to sell out to Standard Oil at below-market prices. Others say that deflationary pressures + enormous industry overcapacity (12 million barrels/year capacity vs. 6 million barrels market demand in 1871 and 1872) led many refiners to bail out of the industry. The Supreme Court agreed with the first argument. The actual truth is????

57 Next week: Introduce Product Differentiation Horizontal Product Differentiation