Theory of Industrial Organization

Theory of Industrial Organization Inhoud Les 1: Introduction – what is industrial organization ..........................................................
Author: Walter Hall
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Theory of Industrial Organization Inhoud Les 1: Introduction – what is industrial organization ...........................................................................4 1.

Central Questions....................................................................................................................4 1.1.

Is there market power?....................................................................................................4

1.2.

How do firms acquire and maintain market power? .........................................................4

1.3.

What are the implications of market power? ...................................................................4

1.4.

Is there a role for public policy regarding market power?.................................................4

Les 1: Game Theory ............................................................................................................................5 1.

Game Theory...........................................................................................................................5

2.

Solving the game .....................................................................................................................5

3.

4.

2.1.

Nash Equilibrium .............................................................................................................5

2.2.

How do we find a NE? ......................................................................................................5

Normal and extensive form games ..........................................................................................6 3.1.

Normal form games .........................................................................................................6

3.2.

Extensive form games ......................................................................................................6

Sub-game perfect equilibrium .................................................................................................6

Les 2: Price Discrimination ..................................................................................................................7 Introduction ....................................................................................................................................7 1.

Types of price discrimination ...................................................................................................7

2.

Third-degree price discrimination ............................................................................................8

3.

Nonlinear pricing .....................................................................................................................8

4.

Versioning, bundling, and other forms of consumer sorting .....................................................9

5.

4.1.

Versioning .......................................................................................................................9

4.2.

Bundling ........................................................................................................................ 10

4.3.

Durable good pricing...................................................................................................... 10

Is price discrimination legal? Should it be? ............................................................................ 10

Les 3: Durable Goods ........................................................................................................................ 11 1.

Intertemporal price discrimination ........................................................................................ 11 1.1.

2.

Monopoly without commitment .................................................................................... 11

Is inter-temporal price discrimination profitable? .................................................................. 11 2.1.

Limited consumers: continuous demand  profitable ................................................... 11 2013-2014

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2.2.

Big number of consumers: discrete demand  not profitable ....................................... 12

3.

Renting or leasing .................................................................................................................. 12

4.

What can firms do to circumvent lack of commitment? ......................................................... 12

Les 4: Static Oligopoly Competition ................................................................................................... 13 Introduction .................................................................................................................................. 13 1.

The Bertrand model – price competition ............................................................................... 13

2.

Pricing with capacity constraints ........................................................................................... 14

3.

The Cournot model – quantity competition ........................................................................... 14 3.1.

Monopoly, duopoly and perfect competition ................................................................. 15

4.

Bertrand versus Cournot ....................................................................................................... 15

5.

The models at work: comparative statics ............................................................................... 15 5.1.

Input costs and output prices ......................................................................................... 15

5.2.

Exchange rate fluctuations and market shares ............................................................... 16

5.3.

New technology and profits ........................................................................................... 16

Les 5: Product Differentiation ........................................................................................................... 17 Introduction .................................................................................................................................. 17 1.

Horizontal differentiation, vertical differentiation, and the characteristics approach ............. 17

2.

Product differentiation and market power ............................................................................ 17

3.

Product positioning ............................................................................................................... 18

4.

Imperfect information and switching costs ............................................................................ 19 4.1.

Switching costs .............................................................................................................. 19

4.2.

Price dispersion ............................................................................................................. 19

Les 6: Sequential Moves.................................................................................................................... 20 1.

Sequential moves .................................................................................................................. 25

Les 6: Entry Deterrence ..................................................................................................................... 26 Introduction .................................................................................................................................. 26 1.

2.

Entry Deterrence ................................................................................................................... 26 1.1.

Entry accomodation and blockaded entry ...................................................................... 26

1.2.

Commitment, ex-ante optimality, and ex-post optimality .............................................. 26

1.3.

Alternative preemption strategies ................................................................................. 27

1.4.

Product proliferation ..................................................................................................... 27

1.5.

Contracts as a barrier to entry ....................................................................................... 27

Predation .............................................................................................................................. 27 2.1.

What is predatory pricing? ............................................................................................. 28 2013-2014

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2.2.

The Chicago school and the long-purse theories of predatory pricing............................. 28

2.3.

The Chain store paradox ................................................................................................ 29

2.4.

Other explanations of predatory pricing ........................................................................ 29

2.5.

Nonpricing predatory strategies..................................................................................... 30

2.6.

Public policy toward predation ...................................................................................... 30

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Les 1: Introduction – what is industrial organization    

Gebaseerd op hoofdstuk 1 ‘an introduction to industrial organization’ Subject: the workings of markets and industries, in particular the way firms compete with each other. Emphasis on the study of the firm strategies that are characteristic of market interaction Focus on olipology  TIO = economics of imperfect competition

1. Central Questions  

Market power: the ability to set prices above cost, specifically above incremental or marginal cost. One could say that the goal of industrial organization is to address the following four questions:

1.1. Is there market power?  Chicago school: extent of market power is very low, because new firms will enter a market when there are profits made.  extent of market power may be significant 1.2. How do firms acquire and maintain market power?  Creating market power: legal protection from competition, firm strategies,…  Maintain market power: reputation for toughness,… 1.3. What are the implications of market power?  Market power is bad for society o Makes firms richer at the expense of consumers o Decreases economic efficiency o Induces firms to waste resources to achieve and maintain market power  market power can be a precondition for technical progress 1.4. Is there a role for public policy regarding market power?  Primary role public policy: avoid negative consequences of market power o Regulation: actions of a firm which detains monopoly or near-monopoly power are directly under a regulator’s oversight o Antitrust: prevent firms from taking actions that increase market power in a detrimental way  Chicago school: few situations where market power exist result from government intervention  Industrial policy: strengthening the market position of a firm or industry, particularly with respect to foreign firms.  not in favor of economists

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Les 1: Game Theory Structuur van de slides is gevolgd, aangevuld met info uit het boek

1. Game Theory   

Oligopoly: situation with a small number of firms in a market Interdependent decision making: your/your competitor's payoff depends not only on its own decision but also on the decision of another player. Game: stylized model that depicts situations of strategic behavior, where the payoff for one agent depends on its own actions as well as on the actions of other agents. o a set of players o a set of rules  who moves when  what do they know when the move  what can they do (strategic sets) o The payoffs: the utility each player gets as a result of each possible set of actions.

2. Solving the game 

We look for the equilibrium: strategy combination where no players had an incentive to change her strategy given the strategies of the other players.

2.1. Nash Equilibrium  A pair of strategies constitutes a Nash Equilibrium if no player can unilaterally change its strategy in a way that improves its payoff.  Formally: a set of strategies forms a NE if, for every player i:



 Gegeven de keuzes van de andere spelers (S-i) zal speller I altijd Si verkiezen boven Si* Note that the equilibrium is defined in terms of strategies, not payoffs.

2.2. How do we find a NE?  Dominant strategy: whenever a player has a strategy that is strictly better than any other strategy regardless of the other players’ strategy choices.  Dominated strategy: strategy whose payoff is inferior to that of another strategy, regardless of what the other player does.  Prisoner’s dilemma  conflict between individual incentives and joint incentives  How do we find a NE? o Elimination of dominated strategies  Only works if the strategies are strictly dominated o Check for NE cell by cell o Sometimes there aren’t any  Important: we assume that players are rational and that players believe the other players are rational.

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3. Normal and extensive form games 3.1. Normal form games  Normal form of the game: matrix where each cell corresponds to a combination of strategic choices.  We can use the normal form if: o There are a limited amount of players (2/3) o There are a finite number of strategies o Actions approximately simultaneous  not literally 3.2. Extensive form games  Use for games that are sequential o Only feasible for 2/3 players o Finite number of strategies o NOT simultaneous actions  Game tree: a decision tree except that there is more than one decision maker involved  Circle  decision node  Solve this game by applying principle of backward induction

4. Sub-game perfect equilibrium  

Sub game: part of larger game that can stand alone as a game itself Voorbeeld:



For a strategy to be a subgame perfect equilibrium (SPE) strategy, it can only contain actions that are optimal for their respective subgames.  SPE: equilibria that are derived by solving first the Nash equilibrium for the subgame, and then, given the solution, solving for the entire game backward. A credible commitment may have significant value in sequential games



KUNNEN: oefeningen seminarie 1

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Les 2: Price Discrimination Structuur vh boek (Cabral) is gevolgd, aangevuld met info uit de slides en uit ander boek (Shy)

Introduction 

  



  

Price discrimination: the practice of setting different prices for the same good, whereby the relevant price in each case depends on the quantity purchased, on the buyer’s characteristics, or on various sale clauses. o objective: maximize earnings by taking as much of the consumer surplus as possible Based on difference in price sensitivity of consumers Perfectly competitive market  law of one price: there cannot be two different prices for the same product  this would introduce arbitration opportunities For more than one price to prevail in equilibrium: o Agents are imperfectly informed about the different prices o Transaction costs of buying and selling are so high that resale is not profitable  price discrimination requires the absence of resale  How to make resale difficult: individual warranties, contractual prohibitions, services, o Seller must have market power, otherwise p = mc  law of one price Preconditions for discrimination for seller: o Possession of information  discrimination based on characteristics o Instruments to design prices  versioning, bundling, Resale can be illegal or physically impossible  discrimination more common in services Test to determine whether there is price discrimination or not: the ratio of prices across markets is different from the ratio of marginal cost Uniform pricing:

1. Types of Price Discrimination  

Selection by indicators / third-degree price discrimination: buyer characteristics are observable  the seller can establish different prices as a function of the buyer’s characteristics Self-selection / second-degree price discrimination / screening : the seller has some information about the heterogeneity of the buyers’ preferences but cannot observe the characteristics of each buyer in particular o Alternative definition: unit price depends on quantity purchased, but not on the identity of the consumer 2013-2014

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o Little or no MC are favorable for doing discrimination Perfect discrimination / First-degree price discrimination: situation in which the seller sets different prices for each buyer and for each unit purchased by each buyer, extracting all the consumer’s surplus. o price is based on willingness to pay: each consumer with willingness to pay > MC will be served o profits = total surplus, CS = 0 o maximizes society welfare: there is no deadweight loss

2. Third-degree price discrimination    

Market segmentation: seller divides buyers into groups, setting a different price for each group o Spatial price discrimination: based on geographical location A seller should charge a lower price in those market segments with greater price elasticity. Some people gain, some lose Math:

3. Non-lineair pricing    

Nonlinear pricing: charge different prices according to the quantity consumed  a form of second-degree price discrimination Two-part tariffs: charge a fixed part f and a variable part p, proportional to the quantity purchased.  P(q) = f + pq The seller should set f at the maximum value such that consumers are still willing to buy If the seller can set a two-part tariff and all consumers have identical demands, then the variable price that maximizes total profits is the same that maximizes total surplus: the efficient price. o F = CS o P = MC 2013-2014

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 

Nonlinear pricing  total efficiency ↑, but consumer welfare ↓ Multiple consumers o Seller offers consumer the choice of different tariffs o Seller must meet two conditions:  Incentive-compatibility constraint: make sure that type 2 consumers have no incentive to adopt type 1 tariffs and vice versa  Participation constraint: make sure that each type of consumer prefers to pay the fixed fee and consume its optimal quantity rather than not consuming at all o Optimal menu: f1 = CS1(p1), p1>c, f1 < f2 < CS2(p1), p2=c o Solution is not efficient: seller’s profit is lower than it would be where it able to differentiate consumers directly

4. Versioning, bundling, and other forms of consumer sorting 

Manners to indirectly sort consumers by group  offer different deals such that consumers selfselect

4.1. Versioning  Seller is able to sort consumers according to their willingness to pay (vb. Eerste klas, tweede klasse trein)  Damaged goods: firms reduce the quality of some of their existing products o Sometimes the firm even has to incur an extra cost for this reduction of quality o It can’t be argued that price differences are the result of cost differences in this case o Price discrimination may be good for everyone  Low-valuation consumers can buy the damaged good, while they wouldn’t before  High-valuation consumers are better off because the firm may have to reduce the price for the high-quality version

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4.2. Bundling  Bundling = tie-in-sales  Pure bundling: buyers must purchase the bundle or nothing  Mixed bundling: buyers are offered the choice between purchasing the bundle or one of the separate parts  By offering different versions of the same product, or different packages of related products, a seller may be able to indirectly discriminate between different types of buyers. 4.3. Durable good pricing  Timing is essential when buying a durable good  Sellers may set different prices now and in the future sell both to high-valuation buyers at a high price and low-valuation buyers at a low-price  Rational buyer may wait until the price drops  possibility of setting different prices in each period, at first sight an advantage to the seller, turns out to be its curse  Solutions o Commit to not lower price in the future o Not sell the durable good, but lease it

5. Is price discrimination legal? Should it be?       



Total welfare is greater under price discrimination Consumer welfare is lower  TRADE-OFF: Efficiency consumer welfare Different consumers pay different prices More consumers are served  TRADE-OFF: Fairness objective of making the good accessible to as many consumers as possible Cases in reality o It may happen that total efficiency decreases as a result of price discrimination o There are cases when price discrimination implies a strict Pareto-improvement Public policy is also driven by the aim to prevent price discrimination from injuring competition  how to balance anti-competitive effects and pro-competitive effects

KUNNEN: oefeningen seminarie 2

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Les 3: Durable Goods Dit is voornamelijk wat in de slides staat, een heel klein beetje aangevuld met info uit hoofdstuk 5 Shy en artikel ‘the Durapolist Puzzle: Monopoly Power in Durable-Goods Markets’.

1. Intertemporal price discrimination   



Durable good/durable: a long-lasting good that can be used repeatedly. Perishable good: a non-durable good that cannot be used more than once even if it has a long shelf life. Main features o Firms offer the same product in different periods o Consumers buy only 1 item over the whole horizon  Benefits are derived over a number of periods  Consumers can decide on the timing of their purchase Consequence: possibility of inter-temporal price discrimination

1.1. Monopoly without commitment  Monopoly is unable to commit to prices in the future  monopolist decides over prices in every period.  Coase (1972) pointed out that a durable goods monopolist has substantially less market power o First period sets monopoly price and sells to part of potential consumers o Next period faces “residual demand” and optimally lowers price to sell to remaining consumers o Consumers in first period foresee this and wait, and thus demand in first period falls.  the company competes with itself over time o Monopolist thus optimally lowers price in first period. o Firm loses all price-setting power  this is known as the coase conjecture o Monopoly setting leads to outcome that converges to the perfectly competitive outcome

2. Is inter-temporal price discrimination profitable? 



Conditions in both situations: o Durable product can be sold over 2 periods o Consumers derive utility from a unit of this product only in these 2 periods. o Monopolist sets price of product in period 1 (p1) and in period 2 (p2) o Consumers who purchase the product in period 1 (2) benefit from its services for 2 (1) periods. o Firm and consumers have the same discount factor. Onderstaande situaties hebben wij afgeleid in de les met een oefening: ook zeker kennen! (Zie bijgevoegd notitie blad)

2.1. Limited consumers: continuous demand  profitable  Explained by Pac man model or price skimming  Consumers are able to foresee that a selling durable goods monopolist would be hurt too much by lowering prices now.  These consumers then buy the good as soon as it is equal to their reservation utility as they realize that prices will not fall further, unless they purchase it.  Monopolist lowers prices according to which consumers have already bought.  A monopolist can exercise full market power and perfectly price discriminate. 2013-2014

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2.2. Big number of consumers: discrete demand  not profitable  Explained by the coase conjecture  Rational consumers are able to calculate that a selling durable goods monopolist would lower future prices due to future fall in the demand.  This reduces willingness to pay high prices in first period.  Monopolist must lower prices in first period.  Since the monopoly cannot commit not to lower its future prices, it is induced to lower its firstperiod price.

In reality, the large number-model is most applicable, although there are exceptions.

3. Renting or leasing   

Renting: The renter (firm) maintains ownership of the product, but contracts with the consumer to allow the consumer to derive services from the product for a given period specified in the renting contract. Selling: The firm transfers all rights of ownership for using the product and getting the product back from the consumer, from the time of purchase extended indefinitely. Intuition: by renting each period, the demand stays each period the same.

4. What can firms do to circumvent lack of commitment?  



     o o

Main goal: make sure you can commit to prices Most-favored-customer guarantees  Vb. In the market for electric-turbine generators General Electric offered a discount to a customer, obligated it to give the same discount retroactively to all other customers who had bought the same product within the previous six months. Buy-back guarantees: buy back a good that will be offered to the firm in the future at a price just under the monopoly price, thus making it against interest to release into the market quantities that would lower the price of its durables below the monopoly price. Contrived durability: manufacturing a product less durable than could have been manufactured, or producing me with a specific technology rather than with a better one that is available. Planned obsolence: strategy of shortening the lifetime of a product after it is released onto the market. Tying to expensive perishable good Leasing/renting Crippling secondhand market and after-market Second-hand market: used goods are durables that outlast the consumer’s needs and return to the market to be traded as cheap substitutes for new durables, the second hand market. After market: market on which complementary goods and services are sold

KUNNEN: oefeningen hoofdstuk 5 - Shy

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Les 4: Static Oligopoly Competition Structuur vh boek, hoofdstuk 7, is gevolgd (Cabral), aangevuld met info uit de slides en info uit hoofdstuk 6 (Shy) p. 97-103, 107-112, 126-127

Introduction   

Oligopoly: situation in which there are a few competitors Duopoly: situation in which there are 2 competitors In oligopolies, there is strategic interdependence between competitors

1. The Bertrand model – price competition 



   

 







Demand received by a firm depends on: o Price it sets o Prices set by rival firms Betrand model o Two firms o Homogeneous products o Simultaneous price setting o Same production technology o Same available information o Both have same, constant marginal cost o Demand is linear o Firms compete in one period only, prices are chosen once and for all o Firms have no capacity constraints o Each firm assumes that when he maximizes his profits, the other firm does not change its price Whichever firm sets the lowest price gets all of the demand Undercutting: the action of a firm to slightly reduce the price below that of its competitor. If both firm set the same price, then each firm receives ½ of market demand Best response/reaction – function: a function pi(pj) that gives, for each price by firm j, firm I’s optimal price o Downward sloping: for each firm, if the rival’s output level increases, the firm would lower its output level Reaction curves of both firms are identical, symmetrical with respect to the 45° line Nash equilibrium is given by the intersection of the reaction curves o P1 = p1(p2) o P2 = p2(p1) Under price competition with homogeneous product and constant, symmetric marginal cost, firms price at the level of marginal cost.  As the number of competitors goes from one to two, equilibrium price goes from monopoly price to perfect competition price. Bertrand paradox o Equilibrium price = MC o Same level as under perfect competition o No efficiency loss o Two competing firms are sufficient to reach this equilibrium (!) oefening: indien de producenten verschillende MC hebben: 2013-2014

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o o o

Eerst p = MC van de minst efficiënte producent Checken of de efficiëntere producent geen lagere prijs kan zetten met een hoger bijhorende winst Checken of deze producent de monopolieprijs niet kan zetten (!!!!)  Pc = pmon if pmon < MC andere producent

2. Pricing with capacity constraints 





Bertrand model not realistic: o If firms sell differentiated products, duopoly price competition does not necessarily drive prices down to MC homogeneous products o Possibility of retaliation firms compete in one period only o Capacity constraints in the short run Assumption: each firm is constrained by capacity o If total industry capacity is low in relation to market demand, then equilibrium prices are greater than marginal cost Other ways to generate above-marginal-cost equilibrium prices: o Differentiate products o Demand randomly fluctuates o Infinitely pricing repeated game

3. The Cournot model – quantity competition  

 



Cournot model: output decisions are made simultaneously before prices are chosen Assumptions of the model o Homogeneous product o Same production technology o Same available information o Simultaneous output-decision which maximizes profits o Each firm assumes that when he maximizes profits, the other firm does not change its output level Market price is then set at the level such that demand equals the total quantity produced by both firms. Solution of cournot model o Derive each firm’s optimal choice given its conjecture of what the rival does  reaction curve  If P(A) = a-bQ, C(q) = cq and Q = q1 + q2  Then Q1(q2) = (a-c)/2b - q2/2  reaction curve o Put the reaction curves together and find a mutually consistent combination of actions and conjectures  residual demand: all possible combinations of firm 1’s quantity and price for a given value of q2 o Determine the point at which marginal revenue equals marginal cost o Deriving the equilibrium: pair of values such that q1 is firm 1’s optimal response given q2 and vice versa.  Intersection of reaction curves.  Qn = (a-c )/ 3b Extension to N firms o Assumption: all firms have same cost structure 2013-2014

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o o

 Calculate best-response function of representative firm  Q1 = q2 = … = qn  Q = (a-c/b) * (n/n+1) Where firms have different cost functions, we would have to derive the best-response function for each of the N firms. As the number of firms grow indefinitely, output level approaches the competitive output

3.1. Monopoly, duopoly and perfect competition  Total output under Cournot is greater than that under monopoly and lower than that under perfect competition  Price perfect competition < cournot equilibrium price < price monopoly  Deadweight loss perfect competition < deadweight loss cournot < deadweight loss monopoly  In an oligopoly with n firms, equilibrium price is closer to perfect competition the greater n is.

4. Bertrand versus Cournot  

  

Some industries are more realistically described by the Cournot model, some by the Bertrand model Games with two strategic decisions are best modeled as two-stage games o Long run decision taken in first stage o Short – run decision taken in second stage, given the values of the long-run decision If it is more difficult to adjust capacity/output than it is to adjust prices  Cournot If it is easier to adjust output levels than it is to adjust prices  Bertrand Most real-world industries seem closer to the case where capacity is difficult to adjust

5. The models at work: comparative statics  



We can use the model to predict how the market will change as a function of changes in various exogenous conditions Comparative statics: we compare two equilibria, with two sets of exogenous conditions, and predict how a shift in one variable will influence the other variables. o No prediction of a dynamic path o Static: back in equilibrium, what will things look like Justification of this method o Dynamic processes converge to the Cournot equilibrium, no matter what the initial situation, we always converge to the Nash equilibrium o Static models useful for comparative statics only o Static models give an idea of where the system will converge after all of the interim adjustments have taken place o Comparative statics take into account all of the effects that follow from an exogenous change taking the initial equilibrium values as constant may lead to gross misestimating of the impact of an exogenous change

5.1. Input costs and output prices  Effect of an increase in marginal cost  We need to compute a new reaction curve based on the higher value of MC  downward shift of the reaction curve 2013-2014

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 

Each firm’s output as well as total output are lower in the new equilibrium; price is greater Wanneer we de vraagfunctie afleiden naar de kost, kunnen we zien hoeveel verschil in prijs een procentuele stijging van de kost zal veroorzaken.

5.2. Exchange rate fluctuations and market shares  Decrease in MC  reaction curve shifts upward  Calibration: the process of obtaining values for the model parameters based on information about the equilibrium 5.3. New technology and profits  Amount that firm 1 should be willing to pay for the technology is the difference between its profits with lower MC and its current profits.

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Les 5: Product Differentiation Structuur gebaseerd op Cabral H 12, aangevuld met info uit slides, nota’s en uit Shy chapter 7 (p. 149-152)

Introduction 



In reality, perfect competition often does not appear, due to: o Firms’ conduct  Price strategies  Product differentiation o Market environment  Switching costs consumers  Lack of information consumers Cases in which the assumptions of homogeneous product and perfect information fail to hold  implications for market performance

1. Horizontal differentiation, vertical differentiation, and the characteristics approach     

Consumers evaluate their relative merits differently, their preferences may even be negatively correlated Horizontal differentiation: Consumer A prefers 1 over 2, consumer B prefers 2 over 1 o Appears whenever products are defined by more than one characteristic Vertical differentiation: all consumers prefer one product over another o Consumers have the same ordinal, but not the same cardinal preferences Real world examples combine both sorts Characteristic approach: approach which assumes that consumer demand is directed not toward products per se but rather toward product characteristics. o Consumers are interested in the characteristics goods posses o The demand for each good is derived from the demand for characteristics o net utility: Uik = Bi1Ck1 + … + Bi4Ck4 – Pk  Bij is consumer i’s valuation of characteristic j  Ckj is how much product/service k has of characteristic j  Assumption of rational consumer behavior: each consumer chooses the product/service that proves the highest net utility o Advantages  General treatment of product differentiation that encompasses both horizontal and vertical differentiation.  Significant improvements in the use of available data n x m parameters ipv n²  Useful framework for business strategy

2. Product differentiation and market power 



Ice cream example o Difference in physical location of consumers o OR difference between consumers as to how they value characteristics Transportation cost: measures the consumer’s aversion to buying something different from his or her optimal degree of sweetness. 2013-2014

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Hotelling model: explains how firms compete in prices when their products are differentiated.

o o







Buyers choose which seller to buy from (not whether to buy or not) Total cost of buying = p + tx  should be minimized  T: travelling cost  X: location  P: price o Each firm faces a downward-sloping demand o Because products are no longer identical, a firm still receives positive demand although it prices higher. o Equilibrium price strictly greater than MC How to solve for the equilibrium o Find consumer X who is indifferent between buying from A or B  derive demand functions and profit functions o Derive best response functions o Use the best response functions to find NE The greater the degree of product differentiation, the greater the market power  if transportation costs are low, equilibrium price is close to MC and seller’s face a more horizontal demand. Solution to the Bertrand paradox

3. Product positioning   

Product positioning: firms can choose where to locate their products Element of strategic behavior: distance with respect to competitors must be defined with respect to the rivals’ choices of product characteristics Firms first simultaneously choose where to locate their product and then simultaneously choose prices, given their product locations: o Direct effect: for given prices, the closer firm 1 is located to firm 2, the greater its demand is, and the greater its profits are o Strategic effect: since prices are set equal to MC when firms have the exact same location, firms tend to differentiate more in order to get prices above MC.  Balance of the two effects depends on:  Value of transportation costs  Timing of entry and location 2013-2014

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 

 Amount of product differentiation  Heterogeneity of consumers  Relocation costs  Number of product dimensions If price competition is intense  high degree of differentiation Not intense  low degree of differentiation

4. Imperfect information and switching costs    



There are cases, where differences are to a great extent subjective  same framework applies Case: consumers are imperfectly informed about prices or have to pay a cost to switch between sellers. Search cost: cost the consumer must pay to visit each store and find out its prices Every firm can price at monopoly-level: p = u o Lowering the price is not going to attract any new customers, because consumers expect every store to price at the same level and the search cost is positive Search costs may lead to monopoly pricing even though firms compete in price and the product is homogeneous

4.1. Switching costs  Sometimes, switching costs are artificially create by the seller  Effect switching costs = effect search costs  If s is large enough, then there exists an equilibrium at the monopoly level  Firm can set a slightly higher price  if the price difference with respect to rival firms is less than the switching cost, no consumer would switch (!)  The greater the value of search or switching costs, the greater the sellers’ market power tends to be. 4.2. Price dispersion  Why don’t consumers shop around more often? o The expected gain form searching for a lower price does not compensate the search cost  Stores charging a high price make sales only to consumers with positive search costs  Stores charging a low price sell both to consumers with positive search cost who happened to visit that store first and to consumers with zero search cost o While selling at a lower margin, low-price stores sell a greater quantity  = tourist-locals model

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Les 5: Collusion Introduction     

It is natural that firms attempt to establish agreements between themselves with a view toward increasing their market power. Solutions can be found so all firms can be better off  collusion Cartel agreements, secret agreements, tacit agreements (=attained for historical reasons or because they are natural),… Tacit collusion: firms make independent decisions that have the same effect as if they had cooperated Explicit/overt collusion: firms communicate

1. Repeated interaction and the stability of collusive agreements   

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Bertrand: p = MC in equilibrium Problem with collusion: prisoner’s dilemma Circumvent prisoner’s dilemma by Grim strategies: o First period: set price at monopoly level o Second period  Set price at monopoly level, when other firm hasn’t cheated  Set price at MC when other firm has cheated  cheaters future payoff = 0 o If firm 1 deviates by setting p1 =/= pm, then its future payoff is zero, the best firm 1 can do is maximize short-run profits: pm – heel klein getal o Condition that proposed strategies form an equilibrium: PV cooperating > PVdeviating

 πc = profit cartel = (1/2)* πm = (1/2)* profit monopoly  πd = profit deviating  π0 = profit cournot competition Only works with infinite number of interactions The discount factor must be bigger than a certain number, for u cartel to succeed 0 q1  firm 2 will not enter; firm 1 will still make profit, but of course less than in the monopoly situation. o Firm 1 loses π1m(q1m) - π1m(q1D) o But when it wouldn’t have deterred entry, the firm would have lost even more: π1m(q1m) – π1s(q1s)

1.1. Entry accommodation and blockaded entry  When entry costs are very low, it could be optimal for firm 1 to allow entry: entry accommodation o The profit from entry deterrence is now lower than the profit from letting firm 2 enter  If entry cost is very large, then firm 1 should ignore the threat of entry and choose monopoly output: blockaded entry 1.2. Commitment, ex-ante optimality, and ex-post optimality  Suppose first that capacity costs are zero and that a firm may add capacity at any time, firm 1 will be able to revise its output decision even after firm 2 enters the market 2013-2014

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  

Firm 1 will announce its intention of producing a particular output  credible? For the announcement to be credible, it must be optimal for firm 1 to implement what it announces when the time comes for making the relevant decision Alternative interpretation: firm 1 must choose production capacity, capacity costs are very high and every investment in capacity is sunk o Once capacity costs are paid, it is equally costless for firm 1 to set any output level up to capacity  Capacity preemption is a credible strategy only if capacity costs are high and sunk

1.3. Alternative preemption strategies  Important qualifications of the theoretical model of deterrence by capacity expansion o It is not only a matter of deterring versus accommodating entry  Firms can also influence the time at which entry will occur, because most of the time you can’t avoid rivals to ever entry o Incumbents have various available strategies other than capacity expansion  Investing in service quality, cost reduction, brand recognition,… 1.4. Product proliferation  Launching new varieties of a product  Only optimal insofar as it deters entry 1.5. Contracts as a barrier to entry  Signing long-term contracts (vb. because of anticipated patent expiry)  By signing a contract, incumbent and his buyer act, as it were, a “monopolist” with respect to the potential entrant.  buyer + incumbent = monopolist potential entrant  The “monopolist” know the potential entrant receives an entry surplus, positive expected profits from entering.  The “monopolist” sets an entry price, a fee that must be paid to the buyer for breach of the longterm contract signed with the supplier  When the entrant is very efficient, entry takes place in spite of the fee

2. Predation   



Predation: practices that have rivals’ exit as the main goal Predatory pricing: pricing below cost to injure rival firms and thus induce their exit  important form of predation Must be credible o Incumbent must convince the entrants that its threat to lower the price below cost level is credible o And must convince them that price levels will stay this way until others leave the market Low chances to be successful – symmetric firms o The firm engaging in predatory pricing must supply the entire market against the low price o This price is also below own marginal cost; o The prey can always decide to supply (much) less o The predator loses more than the prey o Thus: when firms are symmetric, it is unlikely that one firm could drive the o Other firm out of the market. 2013-2014

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Higher chances to be successful – asymmetric firms o If the incumbent firm has lower costs than the entrant, the profit maximizing strategy in case of Bertrand competition is to set a price just below the average costs of the entrant o In this way the incumbent acquires a reputation for toughness o Perhaps banks lend more money to incumbents o Imperfect information & signaling Possible ways out for the prey o Merge with the incumbent firm o Long-term contracts with buyers o Restrict output in periods of predatory pricing (if possible to zero) and increase output again when prices have returned to a normal level

2.1. What is predatory pricing?  How can you be sure that a price drip is not simply a shift from one equilibrium (monopoly) to equilibrium (Cournot), with exit not being intended?  Very difficult to distinguish pro-competitive behavior from anti-competitive  If the incumbent makes losses  can only be justified by the intention of driving competition out of the market 2.2. The Chicago school and the long-purse theories of predatory pricing  Chicago school: no predatory pricing should be observed in practice o Rational players should never exit when preyed upon o Rational predators should never engage in predation  Reasoning: o Period 1  Incumbent prices aggressively  negative profits  Or incumbent doesn’t price aggressively  duopoly profits o Period 2  Incumbent has priced aggressively, the entrant decides to stay  Monopolist will no longer behave aggressively, since the entrant will stay it chooses duopoly profits over negative profits  the monopolist threat of pricing low is not credible when the entrant stays  entrant should stay, and if necessary borrow money from a bank  As a consequence, monopolist shouldn’t price aggressively in the first place, since it can foresee this situation  Critique: long-purse / deep-pocket theory o Chicago school relies too much on rationality and perfect information  Vb. Bank will not always lend money  there is a chance that the entrant should leave o Predation is observed in practice o It can be rational for the incumbent to be a predator and for the prey to resist aggressive behavior o P percent of the times, predation is successful in driving competition out of the market  What is important is that one firm is financially constrained whereas the other is not

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2.3.

The Chain store paradox

2.4. Other explanations of predatory pricing  Low-cost signaling o Pricing low may signal that there is no room for an additional firm to make money in the same market  Reputation for toughness o By pricing aggressively, the incumbent may acquire a reputation for being though so that in the future no more entry will take place  Growing markets o Markets where long-term success requires a significant market share from early on o Need for a base of early adopters  snowball effect, critical mass (bv. Facebook werkt niet zonder een voldoende aantal gebruikers)  Predatory pricing may be a successful strategy when o The prey is financially constrained o Low prices signal low costs or the predator’s toughness o Capturing a minimum market share early on is crucial for long-term survival

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2.5. Nonpricing predatory strategies  Impose contractual terms  Bundling or tying 2.6. Public policy toward predation  Very difficult area of antitrust and competition policy  Great disagreements among economists o Does predation exist?  tendency to believe it does o How do we identify predatory behavior?  USA: Areeda-turner test: prices should be regarded as predatory if they fall below marginal cost + look for post-exit prices: do they go up again?  Problems with Areeda-turner  Low prices can be part of advertising campaign  Low prices can signal future production, in case of demand externalities  Cost structures may change throughout time o Should predatory pricing be illegal? What are the welfare effects?  Balance possible higher future prices against lower short-run prices  There is a chance that the entrant stays anyway  good for consumer  Ambiguous effects on welfare

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