Lecture 6

• Contestable markets


  Imply that industries which are not perfectly competitive can yield perfectly competitive price outcomes, subject to 'hit-and-run' entry and exit
• Conditions for perfectly contestable markets

  • All potential entrants have access to the same technology as the incumbent
  • There are no sunk costs
  • Consumers respond instantaneously to prices
  • Incumbents cannot instantaneously change prices in response to entry
  • If conditions satisfied = market is perfectly contestable, incumbent does not have monopoly power
• If P > 20


  • An entrant could capture the entire market and costlessly leave before the incumbent has time to react
  • Entry is common, and higher than market penetration
  • Large cross-sectional variation in entry - but these differences do not persist in the long-run
  • Entry and exit rates are highly positively correlated
• Strategic barriers to entry

  Actions taken by incumbents to limit entry

  Limit price:

  • What is the max price (limit price) that an incumbent can charge which prevents entry;
  • Assume homogenous products…
  • Entrant believes incumbent will not alter price or quantity;

  Diagram:

  • Pl < Pm; Q1 > Qm
  • No level of residual demand which entry would be profitable
  • Criticisms: Threat by incumbent to maintain Pl, Q1 credible? (I.e. does it benefit the incumbent?)

  
• Structural barriers to entry

  Basic industry conditions such as economies of scale, natural monopolies and network effects
• If limit pricing is not credible post-entry


  Potential entrant (PE) would not be deterred
• If products are homogenous, what happens if entry occurs?

  Both incumbent and entrant make losses
• Crucial importance of uncertain’t about actual cost differences between incumbent and PE

  • Means limit pricing might be rational
  • Incumbent wants PE to believe post-entry prices will be low
  • PE knows incumbent’s payoffs from all possible post-entry pricing scenarios, then PE knows exactly what strategy incumbent will choose
  • But if PE is uncertain about post-entry price, incumbent’s strategy will affect PE’s expectations
  • High-cost incumbent could lower price to disguise its cost
  • Low-cost incumbent tried to signal PE that it has cost advantage - PE thinks only low-cost producer can price that low
• PE learns of incumbent’s true cost

  • PE would know a high-cost incumbent has a strong incentive to represent true costs pre-entry
  • Seperating equilibrium: high and low-cost firms charge different prices in period 1 and his reveals incumbents true costs
  • Pooling equilibrium: high and low-cost firms charge same price in period 1, PE learns nothing about incumbent’s true costs until after entry
• What makes limit pricing effective

  • PE must be uncertain about post-entry competition
• Predatory pricing aim


  Aimed at firms already in industry; intended to force them to exit

  Typed:

  • Raising rival’s costs (marginal and fixed)
  • Investements to lower production costs
  • Utilising excess capacity

  Often illegal (anti-competitive)
• ’The chain store paradox’ - Reinhard Selten


  Multiple potential entrants

  • Each entrant makes decision independent of other entrants

  Pay offs:

  • Incumbent can accommodate (cooperate) entry, payoffs are 2 or 5
  • If aggressive (fight) strategy is chosen payoffs are 0 and 5

  
• The paradox


  • Selten assumed game played 20 times
  • In game 20, entrant knows that if he enters the incumbent’s rational policy is to accommodate entry so payoffs are 2,2
  • But this payoff must also hold in all previous stages of game
  • If game was played 20 times, total payoffs are 40 and 40
  • But policy does not maximise payoff to incumbent
  • Agressive strategy played in early stages of game miight deter current and future entrants
  • If incumbent was aggressive in first 10 games payoff would be 10 x 0 = 0 - future potential entrants would not enter as incumbent payoff would be (10x0 + 10x5)=50
• Price discrimination


  Charging different consumers different prices;

  • Profound welfare implications
• First degree price discrimination


  First degree price discrimination: complete transfer of consumer surplus to monopolist (no deadweight loss)

  
• Second degree price discrimination

  Price paid per unit declines with the quantity purcahsed

  • Monopolist extracts some, but not all consumer surplus
  • In diagram, equilibrium indicates a competitive outcome, only applies to last unit (eighth) purchased
  • This type of discrimination is most common in utilities

  
• Third degree price discrimination

  Price elasticity varies between groups of consumers;

  • Arbitrage is not permitted
  • This type of pricing is very common: student discounts; OAP discounts…
  • Group 1 has demand curve P = 200 - Q
  • Group 2 has demand curve P = 100 - Q
  • Group 1 has lower price elasticity than group 2
  • Price charged to group 1 > group 2

  
• More general mathematical treatment

  $\pi max: MCa+$$b =$$MRa +$$MRb$

  • MC is marginal cost of producing total output, MRA and MRB are the marginal revenue functions in both market
  • $MR =$$P(1- (1/ \in B))$
  • $Pa (1-(1/ \in a) =$$Pb(1 - (1/ \in b)$
  • Where Pa and Pb are prices in market a and b
  • $\in A and \in B$
  • Are price elasticity in each market if 3a < 3b then 1/3a > 1/3b
  • therefore: (1-(1/3a)) < (1-(1/3b))
• Perfect (first degree) price discrimination

  • Efficient
  • Same quantity is sold as would be sold by a competitive industry
  • Consumer surplus transferred to monopolist (but society is no worse off)
• Second degree price discrimination


  • May generate results that are comparable to first degree price discrimination (no deadweight loss) compared to uniform pricing policy
  • Is not Pareto efficient
• Third degree price discrimination

  • More difficult to assess
  • Need to consider total value of surplus with price discrimination compared to surplus without discrimination
• Broader welfare issues of price discrimination
• Other types of pricing to extract surplus

  Two part pricing:

  • Firm with market power changes a fixed fee and per unit charge for each unit purchased
  • This strategy yields comparable results to 1st degree price discrimination (all consumer surplus transferred to monopolist)
  • Assume; P = 10-Q, C(Q)=2Q
  • see next flash card
• Two part pricing


  Top diagram shows standard monopoly situation

  • Triangle of consumer surplus = 0.5(10-6) x 4 = $8
  • Producer surplus = (6-2) x 4 = $16
  • Fixed fee of £32 and per unit charge $, is sufficient to transfer all consumer surplus to monopolist
  • With two part pricing there is no deadweight loss
  • All profits derived from the fixed fee

  
• Block pricing 


  • Packaging units of a product and selling them as one package
  • Not the same as second degree price discrimination - the consumer is not free to decide how many units to purchase - all or nothing decision
  • Only one price charged
  • See previous diagram
  • total value to consumer (8 x 2) + 0.5(10 - 2) x 8 = $48
  • Therefore, max price the monopolist can charge is $48, which yields a producer surplus of $32