Bounded Rationality

1
Welcome

• Strategies of Network Companies
• Jonathan D. Wareham
• wareham_at_acm.org

2
Agenda

• Pricing
• Standards
• Auctions
• Bundling

3
Price Levels

• Assumption that electronic markets have less
  friction than comparable markets.
• Search costs lower
• Competition increases
• Average prices should fall, converging on market
  level
• Study of prices of books and CDs and software
  sold on internet
• Higher prices greater variance in electronic
  channel !!!!!

4
u
u
5
u
u
6
Possible Causes

• Superior disc. pricing techniques lower
  registration and menu costs
• Heterogeneity wine in store or restaurant
• Versioning
• Temporal preference consumer behavior and types
• Imperfect information bait and switch
• Neural real estate 5 sites/75 traffic
• Market immaturity eMarkets too young

7
Fixed Prices
P
1.00
1 Coke
Q
8
Fixed Prices
Consumers Surplus
Dead Weight Loss
MC
9
Get a little more revenue
10
2nd Degree Price Discrimination

• product line pricing, market segmentation,
  versioning
• Gold Club, Platinum Club, Titanium Club,
  Synthetic Polymer Club
• First Class, Business Class, World Traveler Class
• Professional Version, Home Office

11
3rd Degree Price Discrimination

• The practice of charging different groups of
  consumers different prices for the same product
• Examples include student discounts, senior
  citizens discounts, regional international
  pricing, coupons

12
Maximize the Revenue ! Perfect (1st degree) Price
Disc.
13
Perfect Price Discrimination
Price
Profits .5(4-0)(10 - 2) 16
10
8
6
4
Total Cost
2
MC
D
1 2 3 4 5
Quantity
14
Prefect Price Discrimination

• Practice of charging each consumer the maximum
  amount he or she will pay for each incremental
  unit
• Permits a firm to extract all surplus from
  consumers
• Difficult airlines, professionals and car
  dealers come closest

15
Caveats

• In practice, transactions costs and information
  constraints make this is difficult to implement
  perfectly (but car dealers and some professionals
  come close).
• Price discrimination wont work if you cannot
  control three things
• Preference profiles
• Personalized billing (anonymous transactions
  lesson sellers discriminatory power over
  consumers)
• Consumer arbitrage

16
What is different about this site?
17
Conclusions

• Internet double edged sword
• Consumers enjoy lower search costs, but
• eMarketers have superior tools to register your
  consumption patterns and price sensitivity
• The end of fixed pricing???
• Fixed pricing as an institution only 100 years
  old!!
• Developed in response to large scale
  economies/production models.with standard
  products !!!!

18
But lets mix things up a bit more..

• Product heterogeneity, Make the products
  different!!!!
• Available from different locations and time
  periods (wine served in store or restaurant)
• Levels of customer service, Mass Customization
• Search engines, product reviews, samples may
  create stickiness - charge price premium.
• Outstanding product information or compelling web
  design. Colors, wall paper, or exposure cycles
  may also influence buying behavior.

19
Customer Info and Economic Effects

• Personalized product highest price charged.
• Price comparison is impossible.
• Sellers may be in a better position to bargain.
• All consumers needs are met.
• Some configurations of industrial goods may not
  be feasible.
• All consumers may be served efficiently.

20
Market Segmentation through Quality
Differentiation

• Different classes of service (1st class, 2nd
  class)
• Basic, expanded basic and premium cable services
• Economy, family and luxury automobiles
• Standard, professional subscription plans
• Educational, professional, enterprise versions of
  software

The key consideration is how to charge
high-income group more without making them switch
to lower-class goods
21
Differentiated Products

• Homogeneous products in the industrial age
• Competition through differentiation
• Horizontal differentiation (brand proliferation)
• Vertical differentiation (quality)
• Reasons for differentiation
• Reduce substitutability
• Segment the market
• Entry into the market
• price control

Market power
22
Horizontal Differentiation

• The game of location (proximity to customers
  tastes)

Alice
Bob
1/2
Bob
Alice
23
Vertical Differentiation
High
Price
Low
Quality
24
How???

• Versions
• Timing and delays
• Ease of use
• Pathways into site
• Segregation of markets and users
• Analysis of click stream and previous purchasing
  history

25
Making Self-Selection Work

• May need to cut price of high end
• May need to cut quality at low end
• Value-subtracted versions
• May cost more to produce the low-quality version.
• In design, make sure you can turn features off!

26
How Many Versions?

• One is too few
• Ten is (probably) too many
• Two things to do
• Analyze market
• Analyze product

27
Analyze Your Market

• Does it naturally subdivide into different
  categories? AND
• Are their behaviors sufficiently different?
• Example Airlines
• Tourists v. Business travelers

28
Analyze Your Product

• Dimensions to version
• High and low end for each dimension
• Design for high end, reduce quality for low end
• Low end advertises for high end in service
  industries Cheap rates
• High end Flagship products -advertises for low
  end in many products.

29
Goldilocks Pricing

• Mass market software (word, spreadsheets)
• Network effects
• User confusion
• Default choice 3 versions
• Extremeness aversion
• Small/large v. small/large/jumbo

30
Extremes Aversion

• Bargain basement at 109, midrange at 179
• Midrange chosen 45 of time
• High-end at 199 added
• Mid-range chosen 60 of time
• Wines
• Second-lowest price
• Framing effects-example

31
Cross-Subsidies

• Prices charged for one product are subsidized by
  the sale of another product
• May be profitable when there are significant
  demand complementarities effects
• Examples
• Browser and server software
• Drinks and meals at restaurants
• Long distance and local access
• Auto spare parts
• Razor Blades
• Burger, fries, drinks
• Auto financing

32
Lessons

• Version your product
• Delay, interface, resolution, speed, etc.
• Add value to online information
• Use natural segments
• Otherwise use 3
• Control the browser, access, comparisons, etc.
• Bundling cross subsidies may reduce dispersion

33
Down Dirty

• First degree (perfect) price discrimination
• market of one
• Second degree price discrimination
• product line pricing, market segmentation,
  versioning
• Third degree price discrimination
• different prices to different groups
• Other definitions in literature

34
Standards Examples

• RR gauges
• Edison v. Westinghouse
• NBC v. CBS in color TV
• 3Com v. Rockwell/Lucent
• Qwerty
• What is going on now in wireless???

35
Examples

• Rival evolution
• Video machines
• Rival revolutions
• DVD-A v. SACD
• Evolution v. Revolution

36
Recent Standards Wars

• AM stereo
• Auto industry invested, radio didnt
• Digital wireless phones
• Europe GSM
• US GSM, TDMA (cousin of GSM), CDMA
• TDMA 5 million
• CDMA 2.5 million
• GSM 1 million

37
Standards Wars

• Ericsson (TDMA) has ATT, SBC , Bellsouth
• Qualcom (CDMA) has Bell Atlantic, US West, etc
• Performance play strategy
• How big are the network externalities?
• Geographic scope
• Investment is sunk, systems interconnect

38
Key Assets

• Control over an installed base
• Intellectual property rights
• Ability to innovate
• First-mover advantages
• Manufacturing
• Strength in complements
• Reputation and brand name

39
Network Externalities

• Direct Network Effects Xn
• The value of a product is a direct function of
  the number of others that own the product
• Telephones, Fax machines
• Indirect Network Effects
• Your DVD player is not interdependent with my DVD
  player. However, more people who demand DVD
  players will increase the number of DVDs
  available.

40
Demand Supply for a Network Good
41
Diffusion and Price
42
What is an auction ?

• A method for allocating scarce resources based on
  competition
• Bidding mechanism
• the seller (auctioneer) defines the auction
  rules
• how the winner is determined
• how much he must pay
• each buyer chooses a bidding strategy
• The auction rules define a game among buyers
• should use game-theoretic concepts to analyze
  auctions

43
Examples

• Ancient cases
• 500BC Herodotus mentions about auctions in
  Babylon
• Ancient Rome commercial trading, selling war
  booty
• 193 A.D. auction for the entire empire
• More recent cases auctions
• for rare collective items
• in wholesale markets of fish, flowers, etc.
• for public contracts
• in stock market
• Very recent cases auctions
• over Internet (E-bay, ONSALE, etc.)
• for bandwidth (Interxion, RateX, etc.) , spectrum

44
Auctions and resource allocation

• An auction is a market mechanism that
• allocates resources (goods) to buyers
• generates value for the consumers
• generates revenue for the seller
• generates revenue for the producer
• Is used where traditional market mechanisms (e.g.
  fixed price) can not be used
• can serve as an internal mechanism

value
Seller
buyers
revenue
45
Performance Measures

• When choosing an auction design, a variety of
  assessment criteria and measures may be used
• social efficiency (maximize the total value to
  buyers Vickrey)
• revenue (seller profit)
• bidder profit
• time, complexity, susceptibility to collusion
• Why is it hard to design? Due to lack of
  information!

• Auction incentive mechanism
• buyer maximizes expected profit
• seller maximizes performance measure

46
Bidder and seller characteristics

• Valuation
• private values
• common values
• correlation
• Risk assessment
• risk neutral
• risk averse
• Symmetry
• symmetric
• asymmetric

47
Auctions

• Uses
• Major types of Auction
• English
• First-price, sealed-bid
• Second-price, sealed-bid (Vickrey)
• Dutch

48
English Auction

• An ascending sequential bid auction.
• Bidders observe the bids of others and decide
  whether or not to increase the bid.
• The item is sold to the highest bidder.

49
English Auction

• ascending bid, open-outcry
• item is sold at least at the reserve price
• best strategy for bidder
• bid a small amount more than the previous high
  bid until bidders valuation is reached, then
  stop
• auctioneer has great influence
• most emotional and competitive of auctions
• much information regarding demand is revealed

50
First-Price, Sealed-bid

• An auction whereby bidders simultaneously submit
  bids on pieces of paper.
• The item goes to the highest bidder.
• Bidders do not know the bids of other players.

51
First price, sealed-bid

• first price wins
• sealed (each bidder is ignorant of other bids)
• usually each participant is allowed one bid
• two parts
• bidding period
• resolution (winner determination) phase
• bidders strategy shade bids
• to generate positive profit
• to avoid winners curse (for common value)
• little information on demand is revealed

52
Second Price, Sealed-bid

• The same bidding process as a first price
  auction.
• However, the high bidder pays the amount bid by
  the 2nd highest bidder.

53
Developed for Social Efficiency Vickrey auction

• second price wins, sealed
• the item is awarded to the highest bidder at a
  price equal to the second highest bid
• dominant strategy submit a bid equal to true
  valuation ? incentive compatibility
• less fear of winners curse (for common value)

54
Why???? Asymmetric Cases

• Different distributions for bidders valuations
• Revenue equivalence does not apply
• First price auctions not socially optimal
• Public authorities should use second price
  auctions for efficiency purposes
• otherwise, possibility for inefficiency

u
55
Intuition

• Aggressive bidders receive sure and certain
  awards but pay a price closer to market
  consensus.
• The price that winning bidder pays is determined
  by competitors' bids alone and does not depend
  upon any action the bidder undertakes
• Hence, closer to real market valuation and
  socially optimal
• Less bid shading or collusion occurs because
  people don't fear winner's curse.
• Hence, they may adjust bid upwards.
• Bidders are less inclined to compare notes before
  an auction.

56
Dutch Auction

• A descending price auction.
• The auctioneer begins with a high asking price.
• The bid decreases until one bidder is willing to
  pay the quoted price.
• Strategically equivalent to a first-price auction

57
Dutch Auction

• descending price (often by Dutch clock),
  open-outcry
• first price wins
• auctioneer usually has no influence
• little information on demand is revealed

price
58
Information Structures

• Independent private values
• Bidders know their own valuation of the item, but
  not other bidders valuations
• Bidders valuations do not depend on those of
  other bidders
• Affiliated (or correlated) value estimates
• Bidders do not know their own valuation of the
  item or the valuations of others
• Bidders use their own information to form a
  value estimate
• Value estimates are affiliated the higher a
  bidders estimate, the more likely it is that
  other bidders also have high value estimates.
• Common values is the special case in which the
  true (but unknown) value of the item is the same
  for all bidders

59
Optimal Bidding Strategy in an English Auction

• With independent private valuations, the optimal
  strategy is to remain active until the price
  exceeds your own valuation of the object.

60
Optimal Bidding Strategy in a First-Price,
Sealed-Bid Auction

• If there are n bidders who all perceive
  valuations to be evenly (or uniformly)
  distributed between a lowest possible valuation
  of L and a highest possible valuation of H, then
  the optimal bid for a risk-neutral player whose
  own valuation is v is

61
Example

• Two bidders with independent private valuations
  (n 2)
• Lowest perceived valuation is unity (L 1)
• Optimal bid for a player whose valuation is two
  (v 2) is given by

62
Optimal Bidding Strategy in a Second-Price
Sealed-Bid Auction

• The optimal strategy is to bid your own valuation
  of the item.
• This is a dominant strategy.
• You dont pay your own bid, so bidding less than
  your value only increases the chance that you
  dont win.
• If you bid more than your valuation, you risk
  buying the item for more than it is worth to you.
  

63
Optimal Bidding Strategies with Affiliated Value
Estimates

• Difficult to describe because
• Bidders do not know their own valuations of the
  item, let alone the valuations others.
• The auction process itself may reveal information
  about how much the other bidders value the
  object.
• Optimal bidding requires that players use any
  information gained during the auction to update
  their own value estimates.

64
The Winners Curse

• In a common-values auction, the winner is the
  bidder who is the most optimistic about the true
  value of the item.
• To avoid the winner's curse, a bidder should
  revise downward his or her private estimate of
  the value to account for this fact.
• The winners curse is most pronounced in
  sealed-bid auctions.

65
Common value auctions

• Value of bidder is not fixed before the auction
• True value of item is not known ex-ante, although
  defined
• Value to bidder i depends on other bidders
  values
• examples sealed box with coins, oil-lease
• Complex strategies, no general results
• Winners curse the winner discovers that he
  overestimated the value of the item
• Strategic approach shade the bid to account for
  the adverse selection bias

66
Expected Revenues in Auctions with Risk Neutral
Bidders

• Independent Private Values
• English Second Price First Price Dutch
• Affiliated Value Estimates
• English Second Price First Price Dutch
• Bids are more closely linked to other players
  information, which mitigates players concerns
  about the winners curse.

67
Collusion

• Bidders make collusive agreements to get the item
  at a lower price
• they select their designated winner (the one with
  the highest valuation)
• others promise to follow a specific strategy
  (abstain from bidding)
• Which auctions are more collusive than others ?
• Enforcement issue incentives for non-winners to
  keep their promise

68
Collusion (cont.)

• First price sealed bid and Dutch auctions not
  self-enforcing! no possibility for punishment
• In FP winner places bid
  other bidders may abstain or break the ring by
  bidding slightly higher
• In Dutch one of the others may shout mine and
  win!
• English and Second price auctions
  self-enforcing!
• In English if one of the others bids higher than
  promised, then the winner may overbid again
• In SP winners bid valuation of others bid

69
What would you pay for all this stuff?

70
Desired Revenue
3.5
3.5
3.5
3.5
3.5
35
3.5
3.5
3.5
3.5
3.5
71
Your Valuation
3
3
4
6
3
35 But If Price 3.5 Revenue 14
2
3
4
4
3
72
Solution Bundle it!!!
3
3
4
6
3
35 Revenue 35
2
3
4
4
3
Someway, somehow, you will find a combination of
products equal to 35
73
Why Bundle?

• Technological complementarities in production,
  distribution, and consumption
• Sunday newspaper
• A bundle of articles we do not read them all,
  but which ones??
• Economies of scale in production and distribution

74
Why Bundle?

• Price discrimination
• Intuition different
• Price discrimination based on ability to identify
  and segregate customers
• But we cant always do that hence 2nd degree
  price discrimination
• But when marginal costs are low bundling may be
  better!

75
Bundling

• Price discrimination
• Increases the menu of prices to better match
  heterogeneous distribution of consumers
• Bundling reduces the effective heterogeneity of
  consumers willingness to pay.
• Someway, somehow out of these 10 goods, you
  will find some combination that you will value at
  20 - we just do not know which ones.

76
Key Variables

• Production Costs cost of producing additional
  units for the bundle
• Distribution Costs Costs of distributing a
  bundle
• Transaction Costs Costs of administrating the
  transaction arranging for payment
• Binding Costs cost of binding components
  together as a bundle
• Menu Costs Costs of administering multiple
  prices of bundle

77
Production Costs

• When production costs specifically marginal
  costs are low bundle.
• The inclusion of an additional product does not
  cost much, so why not do it anyway and increase
  your chances of addressing consumers valuation
  profile.
• Software, magazines, cable packages
• Hi marginal costs un-bundle

78
Distribution Costs

• When distribution costs are high - bundle.
• Newspapers
• Low distribution costs un-bundle
• Pay per view TV
• Buying single articles on internet

79
Transaction Costs

• If cost of administering small payments is
  sufficiently low use micro-payments
• Pay per view
• Buying single articles on internet
• If cost of administering payments is high-
• use long term payment/subscriptions
• Magazines, Cable TV

80
Binding and Menu Costs

• If binding costs are high dont bundle
• High menu costs may make discriminatory pricing
  difficult and may favor bundling by default
• Neither of these are as determinative as the
  others.

81
To Bundle or to Un-Bundle?

• It depends on a combination of all factors
• Marginal cost most important
• Distribution costs secondary
• Transaction costs are micro payments feasible?
• Binding and Menu costs peripheral but an issue.