ECONOMICS 3200M Lecture 12 February 27, 2006

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ECONOMICS 3200MLecture 12February 27, 2006
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Strategic Behaviour

• Commitment and entry
• Assumptions
• Duopoly firm 1 (incumbent), firm 2 (potential
  entrant)
• Firm 1 (leader) chooses level of K (capital
  investment, capacity) K1
• Firm 2 (follower) observes K1 and selects its
  level of K K2
• ?i Ki (1 Ki Kj), K levels are strategic
  substitutes
• No fixed cost of entry
• 2-period Stackelberg game
• Types of K
• Physical capital
• Learning-by-doing (experience)
• Developing clientele advertising, switching
  costs decrease demand for entrant
• Setting up network of exclusive franchises
  increase entrants distribution costs
• Product development choosing strategic
  locations in geographic/product space

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Strategic Behaviour

• Commitment and entry
• If there are fixed/sunk costs for entry f ,
  profit function for firm 2
• ?2 K2 (1 K1 K2) f if K2 gt 0
• ?2 0 if K2 0
• Truncated reaction function for firm 2 more
  likely that entry can be deterred
• 3 possible solutions 2 deter entry (S1 and S2),
  one accommodates entry (S3)
• The larger the fixed cost, the less likely that
  entry will be accommodated (case S3)

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K2
R2 fixed costs
N
S3
S2
S1
K1
K1
K1
M2
M1
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Bayesian Analysis

• Incomplete information regarding state of demand,
  cost functions of rivals, strategic decisions of
  rivals
• Market interaction a game of asymmetric and
  incomplete information
• Firms history matters
• Conveys information to rivals
• Affects expectations of rivals
• Multi-period oligopolistic interactions
• Firms behaviour reveals information
• Rational for firm to manipulate rivals
  information and expectations

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Bayesian Analysis

• Bi , i 1 N (all possible events)
• A particular outcome
• P(Bi) a priori probabilities (expectations)
• Revise a priori probabilities after observing
  particular outcome
• P(BR?A) P(BR)P(A? BR)/?i1N P(Bi)P(A?
  Bi)
• Example
• N 2
• P(B1) 0.67 P(A? B1) 0.75 P(A? B2) 0.50
• A occurs
• P(B1?A) P(B1)P(A? B1)/?i1,2 P(Bi)P(A?
  Bi) 0.670.75/(0.670.75) (0.330.5)
  0.75

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Price Discrimination

• Sale of identical good/service at different
  prices to different buyers or at different prices
  to same buyer
• Alternative form of price discrimination
• Different bundles of features/characteristics and
  different prices
• Hotels suites, singles, doubles, floor level,
  other amenities (access to lounge, health clubs
  breakfast included priority check-in)
• First degree price discrimination perfect price
  discrimination
• Each unit sold at a different price extract all
  consumer surplus
• Difference between maximum price consumer willing
  to pay for product and actual price paid at each
  price for a particular product, each person that
  purchases the product gains a different value of
  consumer surplus different willingness to pay
  for a product
• Potential for market segmentation and price
  discrimination ? companies can exploit
  differences among consumers to increase their
  revenues and profits
• Auctions

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P
P1
P2
P3
Q
1
2
3
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P
Consumer surplus
P100
Total expenditures
Q
Q100
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Price Discrimination

• Third degree price discrimination
• Different prices to different groups of buyers
  (independent demands, interdependent cost model
  for monopolist)
• Prices differ on basis of signals related to
  perceived consumers preferences (age, location,
  occupation, income, ethnicity,etc.)
• Consumers on different demand curves as compared
  to first degree where consumers are at different
  positions on the same demand curve
• Movie theaters special rates for seniors,
  children
• Frequent user programs
• Wealth management
• Second degree
• Two-part tariffs fixed price (entry/membership
  fee) usage fee
• Preceding graph fixed price consumer surplus,
  and usage fee P100
• Membership in golf clubs
• Taxis
• Utilities

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Price Discrimination

• Conditions for price discrimination
• Firm must have some degree of market power
• Firm must be able to infer each consumers
  willingness to pay
• Firm must be able to prevent arbitrage

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Price Discrimination

• Arbitrage
• If transactions costs between consumers small
  relative to price of product, consumers who are
  able to pay low price buy extra quantities and
  re-sell to consumers who are willing to pay and
  are charged higher prices
• Scalping opportunity cost of time
• International price discrimination (dumping) and
  possibility for arbitrage transactions costs
  include transportation costs, tariffs, reputation
• Limit arbitrage
• Services cannot be resold entertainment
  services, telecom services exceptions
• Warranties valid only for original buyers
• Different bundles/prices
• Signals
• Vertical integration

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Price Discrimination

• Vertical integration example to prevent arbitrage
• Monopolist produces good used as input by two
  separate industries
• Elasticities of demand for input in 2 industries
  ?1 gt ?2
• P1 lt P2
• To prevent arbitrage
• Monopolist buys firm in industry 1 and sells only
  to this firm in this industry and sells to all
  firms in industry 2 at P2
• Other firms in industry 1 will be driven out of
  business

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Price Discrimination

• Third degree price discrimination
• Aggregate demand can be divided into N distinct
  segments on basis of exogenous information
  (signals reflecting consumer preferences, market
  research) different preferences reflected in
  different elasticities of demand
• Arbitrage not possible
• Example movie theaters different prices for
  children, youths, adults and seniors
• Pi MC/Pi 1/?i ? higher prices in markets
  with lower elasticities of demand
• Rule of thumb pricing P1/P2 (1 1/ ?2)/(1
  1/ ?1)
• Price discrimination may enable monopolist to
  survive example (MR1 MR2 MRN MC

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Price Discrimination

• Third degree price discrimination
• Same delivered price for customers
• Freight absorption by producer
• Customers located farther from production/distribu
  tion (warehouse) facility may have alternative
  suppliers thus more elastic demand
• Other examples
• Monthly vs. hourly parking rates
• Metro Pass vs. single fare
• Frequent flyer/use programs
• Each consumer has downward sloping demand curve,
  thus willing to purchase more units per period of
  time only at lower per unit price
• Consumers have different demand curves

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Price Discrimination

• Price discrimination in intermediate products
  when large customer has bargaining advantage
• Large customer may be able to integrate upstream
  (internalize) implications for competition in
  downstream market
• Price discrimination (pi.e. price concessions)
  depends upon credibility of backward integration
• Bank loans large firms charged lower interest
  rates because they have direct access to
  commercial paper and bond markets