Industry

• Pigou (1920)


  3-fold classification of price discrimination

  1. First Degree: Complete information to make take-it-or-leave-it offers
  2. Second Degree: Customer self selection (e.g., business vs economy class)
  3. Third Degree: Exogenous signals like education discounts that firms use to classify customers
• Two effects of discrimination on welfare

  1. The misallocation effect: Output inefficiently distributed because marginal utilities are not equal
  2. The output effect: total output may change
• Varian (1985)


  A necessary condition for discrimination to raise welfare

  • Total output rises
  • (P-C)*(ΔQ) >= (ΔW)
• Second-degree Price Discrimination


  Intel 586 Chip:

  • Purposefully damaged to encourage customers to sort themselves
• Dupuit (1849) Class System

  • Second-degree price discrimination hits the poor, not because it wants to hurt them, but to frighten the rich
  • Having refused the poor what is necessary, they give the rich what is superfluous
• Conventional Pricing (SDPD)


  Linear Pricing: price per unit, p, total payment is pQ
• Tariffs


  Need not be linear

  • The firm may offer a package specifying a total T to be paid for quantity Q
  • Nonlinear pricing, if there are alternative packages that do not follow a linear pattern
• Vives (1988)


  Oligopoly Discrimination
• Belleflamme and Peitz


  Price Bundling
• What is Bundling


  Selling two or more products in a single package, combined in fixed proportions

  E.G., subscriptions to TV typically packages lots of channels together
• Monopoly Bundling


  Second-degree price discrimination

  • Reduces customer heterogeneity
  • Works best when consumer valuations are negatively correlated, but also works when uncorrelated
• 3 strategies for 'bundling'

  1. Separate Selling
  2. Pure Bundling
  3. Mixed Bundling
• The Coase Conjecture


  Durable Goods Monopoly

  • A monopolist that sells a durable good to a market where resale is impossible will not want to discount the good in any future state
  • The producer of an infinitely durable good loses all his monopoly power when the period between his price adjustments converges to zero
• How may a monopolist evade the Coase Conjecture

  1. Credible commitment
  2. Leasing
  3. Planned obsolescence
• Give 2 examples of goods with two-part tariff pricing

  1. Taxis
  2. Polaroid Cameras
• Hotelling (1929)


  Linear City Model
• 3 types of product differentiation

  1. Horizontal: Preference orderings vary
  2. Vertical: For equal prices, everyone prefers the same
  3. Characteristics: Products are bundles of characteristics. A is preferred to B if A has more desirable characteristics
• Hotelling's (1929) Linear City. If t=0 in this model, what happens to the competition of the market

  It becomes Bertrand Competition, with both firms unable to exert monopoly power over their neighbouring consumers
• Why are linear cost models bad in Hotelling?

  If there are linear cost functions, small changes in firm price/place may lead to jumps in demand, which would cause discontinuous demand functions
• Salop (1979) 


  Circular City Model

  Free entry
• Salop (1979)


  2 stage game

  1. Choose to enter
  2. Compete on prices
• Salop (1979)


  Maximal differentiation is exogenously imposed

  Firms are spaced equidistant from each other once enter
• Market Power Definition


  Salop (1979)

  • Economist's: Price above marginal cost
  • Policy-maker's: Price above average cost
• The 'efficiency effect'


  A monopoly makes more profit than an oligopoly carrying the same brands facing the same technology

  • Incumbents in Salop's 1979 model have greater incentives to introduce new products than an entrant
  • The efficiency effect biases the market structure towards multibrand monopoly
• Schamelensee (1978)


  Deterrence in the ready-to-eat breakfast cereal industry
• Schamelensee (1978)

  • in 1972, the Federal Trade Commission issued a complaint charging the four largest manufacturers of read-to-eat breakfast cereal with 'Brand Proliferation'
  • The practices of proliferating brands, differentiating similar products and promoting trademarks resulted in entry deterrence
• Schamelensee (1978)

  1. The production of RTE cereal had been highly concentrated (around 85% from top 4)
  2. Between 1950-1972, the six leading producer introduced over 80 brands
• Lancaster (1966) 


  Characteristic Differentiation

  • Brands are valued because they provide certain characteristics
• Empirical issues estimating demand functions in differentiated product markets

  • Demand is hard to estimate over a set of characteristics and price
  • Random factors (noise)

  Set Utility equal to a regression on characteristics, - price + random factors
• 4 Reasons why entry may not erode supernormal profits

  1. Economies of scale (fixed costs)
  2. Absolute cost advantages
  3. Product-differentiation advantages
  4. Capital requirements
• 3 kinds of behaviour of incumbents in the face of entry threat

  1. Blockaded Entry (entrants will not enter regardless)
  2. Deterred Entry (Modified behaviour
  3. Accommodated Entry (More profitable to allow entry)
• Topsy Turvy Principle of free entry

  Bertrand

  • Market equilibrium can only sustain 1 firm
  • The free-entry equilibrium is a monopoly precisely because post-entry competition yields the perfectly competitive outcome
• Why are sunk costs important

  They signal commitment

  • The buying of equipment may have strategic effects beyond internal cost-minimisation
• The commitment effect is stronger...

  1. The more slowly capital depreciates
  2. The more specific it is to the firm
• Empirical Tests for Free Entry Predictions

  1. Bresnahan and Reiss (1991); Econometric Methods

  • Discrete choice methods estimate profits and F
  • Using these estimates, calculate Sn by using the free entry condition

  2. Campbell (2005)

  • Regress average firm size in martket i on population and other controls (e.g., retail wage, advertising costs)
• Results of empirical tests of free entry conditions

  • Market size for duopoly well above that for monopoly
  • But for n > 3, markups approximately equal to 1
  • Markups stop falling as the number of entrants reaches n=4

  Firms are, on average, larger in larger markets (Campbell, 2005)
• The effect of entry on welfare is composed of three terms

  1. If Price and Quantity were unaffected by entry, an entering firm would earn the current industry profit, 0
  2. Output per firm is depressed by an extra firm
  3. Consumer Surplus effect is 0 since the marginal consumer pays marginal price
• Dupont 1972; SED

  1. Maintain strategy that would involve investing £200million in new capacity between 1972-1985
  2. Growth strategy, investing £499 million over the same period

  In 1972, new pollution control legislation sharply increased costs

  • DuPont announced plans for a new plant for 1975, but competitors announced in 1974 that it would too
  • DuPont lied about starting a new plant, but had to follow through anyway
• Ghemawat (1984)


  'Preemption is a hazardous process in which miscalculations can depress profitability for the entire industry for years to come'
• Milgrom and RobertsSignalling model of predation

  • Incumbent has private information about its own marginalcost. By charging a low price, a low-cost incumbent maycredibly signal that it has low marginal costs.