Clicks and Mortar

1
Clicks and Mortar

• Efficiency and the Internet

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Price Discrimination

• Uniform versus non-uniform pricing
• Possibility of arbitrage ? Uniform pricing
• Uniform pricing is linear pricing
• Tariff T(q)pq
• Distribution of surplus and efficiency
• Types of price discrimination
• First degree
• Seller extracts full surplus
• Second degree
• Partial discrimination based on buyer
  self-selection into pricing category
• Third degree
• Discrimination based on signal correlated with
  preference

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Price Discrimination

• First degree discrimination
• Charge each customer her maximum willingness to
  pay
• Extracts total social surplus from the market
• Resulting allocation is efficient
• Let p(q) be the inverse demand function. Then
  the monopolist receives p(q) for the qth unit
  sold. This the monopolists marginal revenue.
  Profit maximization requires that the monopolist
  produce and sell to the point where MRMC. But
  this is the same condition that determines the
  competitive equilibrium allocation which is
  efficient.
• Implementation in monopoly market by two-part
  tariff
• Let Sc be the competitive consumer surplus

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Price Discrimination

• Graphically

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Price Discrimination

• Suppose there are n buyers each of whom has the
  same demand schedule.
• The monopolist offers a two-part tariff of the
  form
• The profit per unit sold is thenwhere C(q)
  is the monopolists marginal cost

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Price Discrimination

• Total profit is obtained by integrating the
  marginal profit with respect to qBut this is
  just the total surplus in the market.
• It is straightforward to show that the profit the
  monopolist obtains exceed what she would have
  gotten at the uniform monopoly price.
• Difficulties with implementing first-degree
  discrimination
• Lack of knowledge about demand
• Heterogeneity of demand

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Price Discrimination

• Second-degree price discrimination
• Applicable when buyers are heterogeneous and
  seller has limited information about preferences
• Uses a menu of non-linear tariffs to allow buyers
  to self-select into a pricing scheme
  (personalized pricing)
• Two-part tariff is a simple example of non-linear
  pricing scheme
• Digital goods implementation in the form of
  versioning

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Price Discrimination

• Tie-in Sales
• Bundling of complementary goods or services leads
  naturally to a two-tier pricing system
• Cameras and film
• Amusement parks and rides
• Online news subscriptions and access to archived
  material
• Information tracking and analysis capabilities of
  the web
• Flip side of targeted advertising
• Track buyer preferences
• Conduct price sensitivity experiments
• Structure pricing tariffs according to data
  collected
• Dark Side Privacy Issues

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Price Discrimination

• Third-degree price discrimination
• Monopolist is able to segment the market using
  external signals about buyer types
• Signals
• Age
• Sex
• Occupation
• Location (or referring site)
• New vs. repeat purchases
• The monopolist then sets a uniform price in each
  market segment to maximize profits from each
  segment.

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Price Discrimination

• Model
• N market segments
• pi price in segment i, qi quantity sold in
  segment i
• Di(pi) segmented demand function
• q ?i Di(pi)
• Assuming a uniform cost function across segments,
  the monopolists profit maximization is then to
  choose prices for each market segment to solve
  the problem

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Price Discrimination

• The first-order conditions for this problem can
  be manipulated into the formThe optimal
  pricing rule then is for the monopolist to set
  the markup over marginal cost (as a percentage of
  the price) equal to the inverse of the elasticity
  of demand.

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Price Discrimination

• Some implications of the markup rule
• Market segments with higher demand elasticity
  will receive a lower price? Greater price
  sensitivity market segments get lower prices
• Conversely, segments which are less price
  sensitive will pay higher prices
• Welfare analysis for simple cases shows that the
  overall effects of market segmentation are
  ambiguous. Depending on how price sensitive
  different segments are relative to each other,
  overall consumer surplus may be larger or smaller
  with discrimination than without

13
Price Discrimination

• Privacy Issues
• Sensitivity of personal information
• Medical information and insurance
• Access to credit
• Protection from job actions
• Exposure to spam
• Exposure to price discrimination
• Information value-added
• Customization of products
• Targeting of useful information about products
• Simplification of transactions

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Price Discrimination

• The myth of anonymity

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Price Discrimination

• Internet communications
• Complexity of communication protocols requires
  tracking information
• Packet switching
• Message fragmented into uniform size packets
• Headers encode information about packet
  destination using the internet protocol (IP)
  address of the recipient
• Packets routed through network under control of
  network transmission control protocol (TCP)
• TCP checks for errors in packets and will request
  retransmission of bad packets ?packets can be
  traced
• Message reconstructed as packets reach
  destination
• Cookies
• Internet communication is anything but anonymous

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Price Discrimination

• Protecting content while revealing identity
• Encryption
• Secure communications
• Online payment systems
• Digital signatures
• Trust relationships
• Legal protections
• Privacy guarantees and the First Amendment
  (freedom of speech) and Fourth Amendment (freedom
  from unlawful searches)
• Legal restrictions on distribution of personal
  information disclosed in transactions
• Truth in advertising enforcement of pledges to
  protect customer privacy by firms

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Price Discrimination

• Market mechanisms for privacy protection
• Service for information arrangements
• Email
• Search
• Online file storage
• Data analysis engines
• Trust relationships
• Trusted independent intermediary verifies content
  and claims
• Provision for legal intervention by violators
• Better business bureau model

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Intermediation

• Economic role of intermediaries
• Transactional efficiencies
• Lower costs in inventory holding, product
  delivery, insurance, financing, accounting
• Inventory and demand issues
• The internet as an information aggregator and
  transactional role for intermediaries in markets
  for digital goods
• Intermediaries as Experts
• Repeat purchases
• Incentive to acquire knowledge about product
• Intermediary as Long-term Player
• Ongoing benefit to credibility

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Intermediation

• Intermediaries as information sources
• Long-term, multi-product intermediaries and
  reputational spillovers
• Intermediary has incentive to ensure high quality
  in any given product to avoid lost sales in
  other, unrelated products
• Intermediary role provides a punishment
  mechanism in the form of exclusion of a sellers
  product if quality lags
• Intermediate production activities
• Combining of separate products in retail
  bundles
• Particularly germane in the information industry
• News and entertainment content providers combine,
  package and distribute work of individual authors
• CNN, Napster

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Auctions and Contracts

• Market Efficiency and Competition
• Contracts versus Auctions
• Auctions are competitive but costly to hold when
  all parties to the transaction must be present in
  the same place and time to participate
• Contracts are negotiated bilaterally
• Less information about costs
• Less competitive pricing (Ford-Autolite example)
• Less flexibility if terms change
• Lower cost since contract governs relationship
  for an extended period of time

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Auctions and Contracts

• Auction Types
• Direct vs. Reverse
• English vs. Dutch
• Sealed bid vs. open outcry
• Vickerys Theorem
• If buyers have the same information about an
  object being sold, are risk-neutral, and have
  independent valuations of the object, then any of
  the above auction formats will achieve maximum
  revenue for the seller.
• Key points
• Uncertainty about value
• Independence of valuations

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Auctions and Contracts

• Common value auctions
• Most common type of auction
• Valuations are unknown but closely (or perfectly)
  correlated
• Example Offshore oil tracts
• Example Procurement contracts for manufactured
  intermediate products
• The Winners Curse
• Experiment Auctioning off a jar of money
• Format
• Sealed Bid
• First price (i.e. highest price wins)

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Auctions and Contracts

• Information and the Winners Curse
• Distribution of guesses
• Mean guess as best estimate of actual value

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Auctions and Contracts

• Since the winning bid must be higher than the
  mean (unless all bids are at the mean), if the
  mean is an accurate estimate of the true value,
  then the winning bid necessarily overstates the
  value of the object at auction, and the winner
  ends up paying too much for the object.
• Optimal bid when faced with the winners curse?
• Shave bids below what you believe the true value
  to be
• Reduces revenue to the seller

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Auctions and Contracts

• Reducing the risk of the Winners curse
• Second-price auction
• Highest bid wins, but pays second highest price
• Eliminates incentive to shave bids
• Open outcry auctions
• Allows sharing of information among bidders as to
  the best guess of the true value of the object
• Multi-object auctions
• Discriminatory vs. Uniform
• Potential inefficiencies in sequential auctions

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Auctions and Contracts

• Example 2 units to be auctioned
• Buyer 1 values one unit at 10 and 2 at 20
• Buyer 2 values one unit at 9 and 2 at 10
• Simultaneous auction of both units
• Buyer 1 wins with a bid of 10
• Sequential auction Backward induction
• Suppose Buyer 1 wins in round 1
• To win round 2, Buyer 1 must bid at least 9
• Moving back to round 1, since Buyer 2 values one
  unit at 9, for Buyer 1 to win round 1, she must
  bid at least 9.
• Buyer 1s profit from this is 20-9-92.

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Auctions and Contracts

• Now, suppose Buyer 1 loses in first round.
• Buyer 1 can win in round 2 with a bid of 1,
  yielding a profit of 10-19. Hence, Buyer 1 is
  better of losing in round 1.
• Knowing this, Buyer 2 can win round 1 with a bid
  of 2. To see why, we note the following
• Buyer 1 can get a profit of 9 by losing round1
  and winning round 2. Hence, her maximum round 1
  bid, if she wins, must yield profit at least
  equal to what she gets if she loses, i.e. 9.
• Letting this bid be x, we need 20-9-x9 or x2
  and buyer 2 can win in round 1 with a bid of 2
• Revenue from the sequential auction is then 213
  so the sequential auction is clearly inefficient.