ECON 115. Industrial Organization

ECON 115 Industrial Organization

1. The Take-home Final (Final Essay) 2. What have we learned in Industrial Organization? What are the major takeaways?

The Final: write a short essay about a firm s or group of firms behavior... behavior that was prosecuted by the government... But behavior which can also be explained as the product of rational activity by the firm, its suppliers and customers.

This is, in the end, what our course in Industrial Organization is about: finding rational (theoretically-sound) explanations for why firms behave in the myriad ways they do.

Firms sell products for different prices, giving discounts... to some customers and bundling up products for others. Firms offer lots of different products Firms offer different quality products 2 competitors may sell a level of output with prices > cost Or 2 other competitors may set prices = to their costs In some circumstances a firm has an advantage moving first In other circumstances it is better to be a follower Sometimes firms accommodate new market entrants Or they may fight entry by adding capacity Other times firms buy or merge with competitors... or by pricing < cost appear more efficient than they really are

This is the stuff of industrial organization. To study all these variations... and seek rational explanations for them. This diversity is representative of what we call imperfect competition. Unlike perfect competition which exists primarily in textbooks imperfect competition exists in the real world.

It the goal of this course was to use economic theory to examine imperfect competition; i.e., the diversity we see in the real economy.

In this course, we concentrated on certain parts of the imperfectly competitive markets: monopolies and oligopolies. Monopolies provide the sharpest insights into how price discrimination and anticompetitive strategies work. Oligopolies are useful in understanding strategic interactions between firms.

PRICE DISCRIMINATION

Price discrimination means charging different prices to different consumers for the same good. Recall that a monopolist facing a downward sloping demand curve and employing nondiscriminatory pricing must reduce its price to all consumers in order to sell more product.

If price discrimination allows a monopolist to sell more product, it may be seen as increasing total surplus, thus improving efficiency. Of course to price discriminate, the monopolist must address two problems: 1. Identification: can the firm identify demands of different types of consumers or in separate markets 2. Arbitrage: can the firm prevent consumers charged a low price from reselling to consumers charged a higher price

The firm then must choose the type of price discrimination first-degree or personalized pricing second-degree or menu pricing third-degree or group pricing

There are three types of price discrimination: Type Name Example First Degree Personalized Pricing Maximum price charged to each consumer Second Degree Menu Pricing Quantity discounts Third Degree Group Pricing Group discounts ( early bird special senior discount )

Third-degree price discrimination: Group pricing. Consumers differ by some observable characteristic(s). A uniform price is charged to everyone in the group. This is linear pricing. Different uniform prices are charged to different groups: student discounts (Characteristic: student ID) senior discounts (Characteristic: appearance) early-bird specials (Characteristic: time) 14

Pricing Rule (Elasticity of Demand) consumers with low elasticity of demand should be charged a high price. consumers with high elasticity of demand should be charged a low price. 15

Pricing Rule (Marginal Revenue and Marginal Cost) marginal revenue must be equalized in each market. marginal revenue must equal aggregate marginal cost. 16

RULE #3: If demands are linear price discrimination results in the same aggregate output as no price discrimination. price discrimination increases profit because allocated more profitably across two markets. 17

From Last Week s Assignment Aggregate Demand: P = 14 ½ Q MC = 4. Under Perfect Competition, P = MC. P = 4, and Q = 20 Under Monopoly, MR = MC PQ (total revenue) = Q*(14 ½ Q) = 14Q - ½Q 2 MR = d(tr)/dq = 14 Q = MC = 4. Q = 10 and P = 14 ½ *10 = 9 Profit = 9 4 10 = 50 18

Now let s solve Part 3, Group Pricing Aggregate Demand: P = 14 ½ Q High Demand Group: P = 16 Q Low Demand Group: P = 12 Q Please note: if you write the HD and LD demands in terms of Q, then Q = 16 - P + Q = 12 P = Q total = 28 2P. Therefore P = 14 ½ Q 19

Find the individual Marginal Revenue Curves for the HD and LD consumers: HD Demand: P = 16 Q LD Demand: P = 12 Q HD MR = 16 2Q LD MR = 12 2Q MR HD = MR LD = MC HD 16 2Q = 4 Therefore Q = 6 and P = 10 LD 12 2Q = 4 Therefore Q = 4 and P = 8 Profits = (10 4)*6 + (8 4)*4 = 36 + 16 = 52>50 20

We now move to pricing strategies designed by monopolies to capture the consumer surplus. The primary example of this form of price discrimination is the quantity discount. Annual subscriptions often cost less in than one-off purchases. Buying in bulk usually offers a price discount. Prices are nonlinear, with the unit price dependent upon the quantity bought. Pricing is nearer to willingness to pay. 21

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. 22

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 Quantity Discounts 23

Second-degree price discrimination & Quantity Discounts: 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. 24

100 wealthy consumers, who value the 1 st unit of a good at $15 and a 2 nd unit at $10 100 moderate income consumers, who value only the 1 st unit at $12. For the producer, MC = 6. Solution: $12 for 1, $20 for 2. 1. Extract all consumer surplus from the lowest-demand group (Price for 1 unit = 12) 2. Leave some consumer surplus for other groups... to satisfy the incentive compatibility constraint. (CS w = $500) 3. Offer less than the socially efficient quantity to all groups other than the highest-demand group. 4. Offer quantity-discounting ($2.00 discount per unit if you buy two) 25

PRODUCT DIFFERENTION 26

Most firms sell more than one product. We classify product differences as either horizontal or vertical. Horizontal Differentiation: Products differ by their appeal to different types of consumers. Vertical Differentiation: Products differ by the consumers willingness to pay for quality. 27

Suppose consumers differ in their tastes; A firm may decide it best serves these different types of consumers by offering products with different characteristics but similar qualities. This is horizontal product differentiation. The firm designs products to appeal to different types of consumers. Questions: how many different types of products? how do we model this problem? 28

A useful way to formulate answers is to use a spatial model (Hotelling [1929]) to consider: Product pricing Design characteristics Product variety This model provides insights into product differentiation because location can stand-in for: space (geography) time (departure times of planes, buses, trains) product characteristics (design and variety) Consumers want products close to their preferences in space, time or characteristics. 29

Here is an example. Assume F = $50,000, N = 5 million and t = $1. Then tn/2f = 50. For an additional shop to be profitable, we need n(n + 1) < 50. This is true for n < 6. Therefore, if n = 6, then adding one more shop is profitable. But if n = 7 then adding another shop is unprofitable. 30

What does the condition on n [n(n + 1) < tn/2f] tell us? Simply, we should expect to find greater product variety when: there are many consumers (N/). set-up costs of increasing product variety are low (/F). consumers have strong preferences over product characteristics and are unwilling to buy a product if it is not very close to their most preferred product (t in the numerator). 31

BUNDLING AND TIE-IN SALES 32

Firms often bundle the goods that they offer. Microsoft bundles Windows and Explorer Office bundles Word, Excel, PowerPoint, Access Bundled package is usually offered at a discount. Tie-in sales ties the sale of one product to the purchase of another: Tying may be contractual or technological IBM computer card machines and computer cards Kodak tie service to sales of large-scale photocopiers Tie computer printers and printer cartridges Why? To make money! 33

There are two types of bundling (1) Pure bundling, which is when the products are only offered in a bundle. (2) Mixed bundling, when you offer the products both individually and in a bundle. 34

Two television stations offered two old Hollywood films Casablanca and Son of Godzilla Arbitrage is possible between the stations Willingness to pay is: $7,000 Willingness to pay for Casablanca Willingness to pay for Godzilla $2,500 Station A $8,000 $2,500 Station B $7,000 $3,000 35

Now suppose that the two films are bundled and sold as a package Industrial Organization Willingness to pay for Casablanca Willingness to pay for Godzilla How much can be charged for the package? Total Willingness to pay Station A Station B If the $8,000 films are sold $2,500 $10,500 as a package total revenue is $20,000 $7,000 $3,000 $10,000 Bundling is profitable because it exploits $10,000 aggregate willingness pay 36

If we extend our examples to include costs, should a firm offer products individually, in a bundle only or both individually and bundled? There is no simple answers: mixed bundling is generally better than pure bundling; but bundling is not always the best strategy Each case needs to be worked out on its merits. 37

Here are some basic observations: Bundling is a form of price discrimination Bundling does not always work. Pure bundling is not necessarily better than no bundling. It requires there are reasonably large differences in consumer valuations of the goods However, mixed bundling is always more profitable than either no bundling or pure bundling. 38

What about tie-in sales? Like bundling but proportions vary. It allows the monopolist to make supernormal profits on the tied good. Different users charged different effective prices depending upon usage. Facilitates price discrimination by making buyers reveal their demands. 39

2 nd Degree Price Discrimination 3 rd Degree Price Discrimination Product differentiation Bundling and Tie-sales Example: Quantity Discounts Example: Group Pricing Example: A new product. Example: Combo Products Consumers can t be identified; must force them to reveal their true selves. (Selfselect). Consumers can be identified by some observable characteristic. Consumers want products close to their preferences in space, time or characteristics Consumers willing to pay more in the aggregate. Rule: leave some consumer surplus on the table to induce high-demand groups to buy large quantities. Rule: charge consumers with low elasticity of demand a high price; equate MR for all groups. Rule: add a new product (n + 1) if: n(n + 1) < tn/2f N = size of market F = setup $ t = preference for a new product Rule: must examine profits on a case by case basis. 40

2 nd Degree Price Discrimination Industrial Organization FROM THE REAL ECONOMY 3 rd Degree Price Discrimination Horizontal Product differentiation Bundling Starbucks Latte: Tall: $2.85 (24 ) Venti: $3.95 (20 ) Oreos (Walmart) 15oz: $2.98 (20 ) 20oz: $3.50 (18 ) Theaters: Adult: $10.00 Senior: $7.00 Matinee: $6.00 Insurance: Student Discount Good Driver Fit Civic Accord Pilot Odyssey McDonalds Burgers & Fries Big Mac ( 68) Egg McMf ( 71) Drive Thru ( 75) Microsoft Office Word, Excel and Power Point. McDonald s Extra Value Meal. Computer Bundle: Laptop, Flash Drive, Case, Printer (Costco) 41

Question: in the real world, how do firms identify different groups demand functions, individuals desire for different products or consumers willingness to pay? Entrepreneurship = alertness to market opportunities. Competition is an ongoing process of discovery. Entrepreneur means acting man in regards to changes occurring in the data of the market. Ludwig von Mises The entrepreneur brings into mutual adjustment those discordant elements which resulted from prior market ignorance. Israel Kirzner I wish to consider competition... as a procedure for discovering facts. Freidrich Hayek 42

OLIGOPOLIES AND GAME THEORY 43

We now turn to a common type of market, where firms interact with a few competitors oligopoly market. Each firm has to consider its rival s actions with regards to prices, outputs, advertising, etc. This kind of strategic interaction is analyzed using game theory. To understand games, we assume players are rational distinguish between cooperative and noncooperative games distinguish between simultaneous versus sequential games 44

Need a concept of equilibrium Players (firms) choose a strategy. The strategy combination determines outcome. The outcome determines pay-offs (profits?). Equilibrium first formalized by Nash: No firm wants to change its current strategy given that no other firm changes its current strategy. 45

There are three dominant oligopoly models Cournot Bertrand Stackelberg They are distinguished by: The decision variable that firms choose The timing of the underlying game 46

The Cournot model begins with a duopoly. Two firms making an identical product Demand for this product is: P = A - BQ = A - B(q 1 + q 2 ) where q 1 is output of firm 1 and q 2 is output of firm 2 Marginal cost for each firm is constant at c per unit To get the demand curve for one of the firms we treat the output of the other firm as constant, so for firm 2, demand is P = (A - Bq 1 ) - Bq 2 You then find q 2 by finding the second firm s marginal revenue function and setting it to c. 47

For our problem, P = 14 ½ q 1 ½ q 2 Firm 2 s demand function is: P = (14 ½ q 1 ) ½ q 2 TR = Pq 2 = (14 ½ q 1 )q 2 ½ q 2 2 MR = (TR) = (14 ½ q 1 ) q 2 = MC = 4 q 2 = 10 ½ q 1 This is Firm 2 s Reaction Function. For Firm 1 it s q 1 = 10 ½ q 2 Their intersection is the Nash Equilibrium q 1 = 10 ½ q 2 = 10 ½ (10 ½ q 1 ) = 5 + ¼ q1 q 1 = 20/3 By symmetry, q 2 = 20/3. Q total = 40/3 Price = 14 ½ (40/3) = 14 6.67 = 7.33 Q perfectcompetition = 20 > 40/3 (13.33) > Q monopoly = 10 48

q* 1 = (A - c)/2b - Q -1 /2 Q* -1 = (N - 1)q* 1 How do we solve this The firms for q* are 1? identical. q* 1 = (A - c)/2b - (N - 1)q* 1 /2 So in equilibrium they (1 + (N - 1)/2)q* 1 = (A - c)/2b will have identical As the number of q* outputs 1 (N + 1)/2 = (A - c)/2b firms increases price q* 1 = (A - c)/(n + 1)B tends to marginal cost Q* = N(A - c)/(n + 1)B P* = A - BQ* = (A + Nc)/(N + 1) KEEP49

In Cournot prices are set by market mechanisms. An alternative approach is to assume that firms compete in prices. This is the approach taken by Bertrand. This leads to dramatically different results. Take a simple example: Two firms producing an identical product... choose the prices at which they sell their products. Each firm has constant marginal cost of c Demand is P = A BQ In terms of Q = a bp with a = A/B and b= 1/B 50

These best response function for functions look like this: p 2 The best response firm 1 R 1 R 2 The best response function for firm 2 (a + c)/2b c The Bertrand The equilibrium equilibrium has is both with firms both charging firms pricing marginal at cost c c (a + c)/2b p 1 51

The Bertrand model makes clear that competing on price is different from competition in quantities. Under standard Bertrand Competition, P = MC P = 4 and Q = 20, equal to Perfect Competition. COURNOT: P monopoly > P cournot > P competitive BERTRAND: P monopoly > P bertrand = P competitive Since many firms compete on price rather than quantity, this is a challenge to the Cournot approach. 52

Bertrand also says competing on price doesn t result in P = MC if certain conditions are present such as differentiated products or capacity constraints. RE: capacity constraints, at P = MC there will be more customers than both firms can satisfy. If Firm 1 sets its price at cost, Firm 2 will raise its price because it can get all the customers it can handle at a higher price. Therefore, P = MC is not a Nash Equilibrium. 53

In the Problem, each firm s capacity constraint = 5 customers. If the firms set the highest price where they each can be assured of 5 customers this would be a Nash Equilibrium. An even higher price may not assure them of all the customers they can handle; A lower price leaves money on the table. P = 14 ½ Q. Using the capacity constraints, Q total = 5 + 5 = 10 Price = 14 ½*10 = 14 5 = 9. 54

Both the Cournot and Bertrand models are examples of simultaneous games. We assume both firms move simultaneously and the market interaction is once-and-for-all. In a wide variety of markets firms compete sequentially. One firm makes a move. For example it may introduce a new product or ad campaign and The second firms sees this move and responds. 55

Sequential games are also called dynamic games. These games may create a first-mover advantage; or create a second-mover advantage; or may allow an early mover to preempt the market. Therefore, sequential move games can generate very different equilibria from simultaneous move games. 56

The most common model of a sequential game is the Stackelberg Model. The standard Stackelberg duopoly model is similar to the Cournot model in that it is output (quantity) based. However, firms choose quantities sequentially rather than simultaneously. 57

Choosing output sequentially means the leader sets its output first, and visibly, and the follower then sets its output. The firm moving first has a leadership advantage. It can anticipate the follower s actions and can therefore manipulate the follower. However, for this to work the leader must be able to commit to its choice of output. 58

In the problem, we assume there are two firms with identical products. Marginal cost for each firm = 4. Firm 1 is the market leader and chooses q 1 Firms 1 also knows how Firm 2 will react because Firm 2 will maximize profits by equating its marginal revenue [MR = (A Bq 1 ) 2Bq 2 ] to MC. This is the same reaction function we calculated in the Cournot problem, q 2 = 10 ½ q 1 59

Firm 1 knows Firm 2 s reaction function. Since Firm 1 moves first and can set quantity at whatever level it wishes, Firm 1 puts Firm 2 s reaction function into its Demand Curve, then calculates its Marginal Revenue, sets it to MC and determines it s profit-maximizing Quantity. Firm 1 s Demand Function: P = 14 ½ q 1 ½ q 2 Plugging in #2 s reaction function: P = 14 ½ q 1 ½ (10 ½ q 1 ) = 9 ¼ q 1 Therefore TR = 9q 1 ¼ q 12 MR = 9 ½ q 1 60

If MR = 9 ½ q 1 = MC = 4 q 1 = 10. This is the same quantity produced by the profitmaximizing monopolist. Plugging q 1 = 10 into Firm 2 s reaction function, you get q 2 = 5. Q total = 15. Price = 6.50 Under Stackelberg, when two firms and compete on quantity, there is a definite 1 st mover advantage. The overall market is better off under Stackelberg then under Cournot because Q total is larger (15 > 13.33) and price is lower (6.5 < 7.33). 61

It is crucial that the leader can commit to its output choice. Without such commitment Firm 2 would ignore any stated intent by Firm 1 at the monopolist profit maximizing point (here 10 units) and the only equilibrium would be the Cournot equilibrium. So how does Firm 1 commit? (1) Prior reputation (2) Investment in additional capacity (3) Place the stated output on the market 62

Clearly, in this example, being the first mover is advantageous. But is moving first always better than following? This example was based on output. What happens if we are looking at price competition? 63

With price competition matters are different: the first move does NOT have an advantage. Suppose, again, products are identical but the first-mover commits to a price greater than marginal cost. The second-mover will undercut this price and take the market. Therefore the first-mover will set price at P = MC. This is identical to simultaneous game played under Bertrand competition. 64

ANTI-COMPETITVE BEHAVIOR: Limit pricing and quantities

A firm that can restrict output to raise market price has market power. Why can t rivals compete away those positions? Why aren t new rivals lured in by high profits? Answer: firms with monopoly power may eliminate existing rivals prevent entry of new firms

Predatory actions come in two broad forms: Limit pricing: prices so low that entry is deterred. Predatory pricing: prices so low that existing firms are driven out. Outcome of either action is the same: the monopolist retains control of the market. Legal action focuses on predatory pricing because there exists an identifiable victim: a firm that was in the market but has left.

We are going to consider a model of limit pricing using what was developed previously, specifically the Stackelberg Model. Recall that the Stackelberg leader chooses output first. We also assume that: The entrant believes that the leader is committed to this output choice.

$/unit P d P e Industrial Organization Then the entrant s marginal revenue is MR e R 1 q e MR e At price P e entry is unprofitable Q d MC e R e AC e Q d The entrant equates marginal revenue with marginal cost D(P) = Market Demand Q 1 By committing to output Q d the incumbent deters entry. Market price P d is the limit price Assume instead that the incumbent commits to output Q d Quantity The entrant s residual demand is R e = D(P) - Q d 69

In our problem, the overall demand curve is P = 14 Q i q e The entrant s residual demand function is P = (14 Q i ) q e MR = (14 Q i ) 2 q e Equate it to MC = 4. Therefore the entrant s reaction function is q e = 5 Q i /2 For a limit price to be effective it must eliminate the entrant s profits at its profit maximizing level. π = TR TC = Pq e 9 4q e Set it equal to 0 By setting the profit function to 0, we can determine the quantity the incumbent must produce to forestall entry and to establish the limit price. 10

π = TR TC = Pq e 9 4q e Set it equal to 0 (P 4)q e = 9 = (14 Q i q e 4) = 9/q e = (14 Q i 5 + Q i /2 4) = 9/(5 Q i /2) = (5 Q i /2) = 9/(5 Q i /2) = (5 Q i /2) 2 = 9 take the square root of both sides = 5 Q i /2 = 3. Q i = 4, plugging this back into the reaction function q e = 5 Q i /2, q e = 3. Price = 14 Q i q e = 14 4 3 = 7. That s the limit price. At P = 7, TR for the entrant = 7*3 = 21. TC = 9 + 4* q e = 21. Profit is 0. Entry is deterred. 10

There are issues with limit pricing and predation: How does the incumbent make it credible? Are there more profitable alternatives to limit pricing? (Merging?) Are there circumstances that encourage limit pricing? (Asymmetrical information? Pretending to be a low cost competitor?) Is there any empirical evidence of predatory behavior? (Perhaps) 10

This brings us to the end of our course. The primary takeaway is this: in the hurly-burly of the marketplace, when firms appear to be behaving in peculiar and somewhat inexplicable ways, there is often a rational, logically-compelling explanation for that behavior. 73

This is empowering, because nothing strengthens one s faith in economic activity and therefore in human existence than the belief in rationality. There does remain one challenge, which is what economics is all about... 74

To be able to RATIONALLY figure it all out. 75

Good luck on your final paper... And thanks so much for taking ECON 115! 76