ECONOMICS 3200M Lecture 14 March 10, 2005

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ECONOMICS 3200MLecture 14March 10, 2005
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Price Discrimination

• Second degree price discrimination
• Nonlinear pricing
• Different bundles peak-load pricing
• Two-part tariffs
• T(Q) A PQ, where A CS/N CS is aggregate
  consumer surplus, N is the total number of
  consumers with each one buying only one unit
• Examples membership for clubs electricity,
  water/sewer rates photocopier leases (fixed
  amount per month plus usage fee)
• With large numbers of consumers trade-off
  between entry fee and usage fees
• Large entry fee locks in consumers, reduces
  potential market but corresponding low usage fee
  makes entry less attractive ? consider what has
  happened to pricing for cell phones
• Multiple entry/usage fee combinations ? self
  selection by consumers

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Price Discrimination

• Second degree price discrimination
• Different bundles
• Inter-temporal pricing peak/off-peak pricing
• Product and time comprise bundle
• MC may differ between peak and off-peak periods
  thus not the same as 3rd degree price
  discrimination which assumes same MC for product
• Inter-temporal pricing fashion/technology
• Price decreases over time consumers who are
  impatient or fashion/status conscious willing to
  pay higher price than consumers who are patient
  or less fashion/status conscious
• If learning curve for producer MC declines over
  time so dissimilar from 3rd price discrimiantion

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Price Discrimination

• Second degree price discrimination
• Mixed bundling
• Examples
• Tour packages vs. buying travel, accommodation,
  ground travel, food, entertainment separately
• Subscriptions vs. single purchase theaters,
  magazines
• CATV tiering of services

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Price Discrimination

• Mixed bundling strategy 4 consumers, 2 goods
• Reservation prices
• Consumer A 90 for good 1, 10 for good 2
• Consumer B 50 for good 1, 50 for good 2
• Consumer C 40 for good 1, 60 for good 2
• Consumer D 10 for good 1, 90 for good 2
• MC1 20, MC2 30
• Pricing strategies
• Bundling Price for 1 unit of both good 1 and 2
  100
• Profit All 4 consumers buy bundle profit 200
  4(100-20-30)
• Mixed bundling P1 P2 89.95 or price for 1
  unit of both 100
• Profit A buys good 1, D buys good 2, C D buy
  bundle profit 229.50 (89.95-20)
  (89.95-30) 2(100-20-30)

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Price Discrimination

• Tying generalized form of bundling
• Consumer buys one product only if another product
  also purchased
• Products bought/sold in combination
• Apple hardware,peripherals and operating systems
• Mercedes Benz warranty and services at MB
  dealers
• Funeral homes caskets and burial services
• Reasons
• Economies of scope
• 2 separate, but consecutive monopolies in value
  chain
• Assure quality
• Interrelated demands (independent costs)
  complements/substitutes

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Price Discrimination

• Another example of bundling
• Quality discrimination segment market on basis
  of preferences for quality/brand names
• Offer different combinations of prices/qualities
  (different brand names)
• Broader product line
• Automobile companies
• Beer companies
• Clothing labels
• Disney studios
• Airlines United/Ted Delta/Song
• Economies of scope production,marketing,
  distribution
• Spatial pre-emption block entry

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Networks

• Bandwagon effects
• Aggregate demand effects of price changes and
  bandwagon effects see diagram

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P
P0
P1
AD
D20
D10
Q
10
20
30
QN
Price effect
Bandwagon effect
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Networks

• Networks externalities
• PCs and software, CD players and CDs, fax
  machines, telephones
• Economies of scope and scale
• Demand per period depends on price and cumulative
  sales (total number of customers/users)
• Expectations regarding future size of network
  influences demand today for longer-lived products
• Direct network effects
• Benefit to network user depends on how may other
  users are connected via the network
• Indirect effects
• Benefit to users because size of network affects
  price and availability of complementary products

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Networks

• Direct network effects
• Size of network depends on economies of scale,
  externalities of additional connections
• Indirect effects
• Economies of scale in production of complementary
  products
• Similar in non-network industries demand for
  complementary products depends on total number of
  consumers

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Networks

• Strategic use of tie-in sales and product design
• Product compatibility reduces price competition
• Tipping point for networks if one network
  overtakes another in terms of size, the other may
  become insignificant
• VHS and Beta formats for video recording
• Apple and DOS operating systems
• Plasma vs. LCD for flat screen TVs
• Sony (Play Station), Microsoft (X-box), Nintendo
• Use standard setting process to gain advantage
  for one technology/network
• Announcements of future product availabilities
  (software) compatible with a technology
• Switching costs incentive to develop new
  products/services which appeal to new customers
  because existing customers locked in
• Upgrades software

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Pricing

• Market power short-term, longer-term
• Product characteristics commodity vs.
  differentiated network
• Basis for competition
• Cooperative behavior
• Market segments ability to price discriminate
• Uncertainty re. demand curve (position, shape)
  competitors responses costs
• Complementary goods vertical integration
• Consumer information re. quality, reliability
  (lemons model)
• Economies of scale, scope experience curves
• Signaling effects of price
• Competition law

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Vertical Controls

• Vertical controls vertical integration and
  vertical restrictions
• Relationships between upstream and downstream
  firms
• Vertical integration firm participates in more
  than one successive stage of value chain
  (production/distribution chain)
• Advantages of vertical integration
• Internalization
• Lower transactions costs avoid opportunistic
  behavior
• Quality control
• Coordination feeder networks in transportation,
  JIT delivery
• Uncertainty re. prices, availability
• Assure steady supply of key input
• Avoid government restrictions, regulations, taxes
• Regulated utilities and unregulated service
  companies
• Transfer pricing and allocation of profits

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Vertical Controls

• Vertical integration
• Eliminate externalities
• Quantity demanded depends upon P and other
  services provided
• Distribution free riding among distributors
  sub-optimal provision of services (information,
  sales staff and waiting times, promotional
  activities, after sales service (credit, free
  delivery), shelf space
• Maintain reputation for quality by controlling
  distribution
• Downstream retailer provides services
• Q D(P, S)
• S level of services
• Costs to retailer ?(S) per unit of output
• Total service costs Q?(S)
• Vertically integrated solution Max ? P C -
  ?(S) D(P, S)
• Optimal price and service level

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Vertical Controls

• Vertical integration
• Double monopoly
• M has unit costs of C and sells product to R at
  P PM (C) gt C
• R incurs no other costs and sells at PM (P) gt PM
  (C)
• QPM (P) lt QPM (C), so aggregate profits of R
  and M lower than if single monopoly
• If R operates in competitive environment, no
  negative externality for M since PC PM (C)

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P
PM (P)
P
C
D
MR
Q
Q2
Q1
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P
P2
P1
MC(PM, C)
MC(C, C)
D
MR
Q
Q1
Q2