ECON-115 Lecture 13 - Kids in Prison Program · • Price discrimination means charging different...

ECON 115

Industrial Organization


1. The Take-home Final (Final

Essay)

2. What have we learned in

Industrial Organization?

What are the major takeaways?


• The Final: write a short essay about a firm’s

or group of firms’ behavior . . .

• behavior that was prosecuted by the

government . . .

• But behavior which can also be explained

as the product of rational activity by the

firm, its suppliers and customers.


• This is, in the end, what our course in

Industrial Organization is about: finding

rational (theoretically-sound) explanations

for why firms behave in the myriad ways

they do.

Industrial OrganizationFirms sell

products for

different

prices, giving

discounts

. . . to some

customers and

bundling up

products for

others.

Firms offer

lots of

different

products

Firms offer

different

quality

products

2 competitors

may sell a

level of

output with

prices > cost

Or 2 other

competitors

may set prices =

to their costs

In some

circumstances

a firm has an

advantage

moving first

In other

circumstances

it is better to

be a follower

Sometimes

firms

accommodate

new market

entrants

Or they may

fight entry by

adding capacity

Other times

firms buy or

merge with

competitors

. . . or by

pricing < cost

appear more

efficient than

they really are


• This is the stuff of industrial organization.

• To study all these variations . . . and seek

rational explanations for them.

• This diversity is representative of what we

call imperfect competition. Unlike perfect

competition – which exists primarily in

textbooks – imperfect competition exists in

the real world.


• It the goal of this course was to use

economic theory to examine imperfect

competition; i.e., the diversity we see in the

real economy.


• In this course, we concentrated on certain

parts of the imperfectly competitive

markets: monopolies and oligopolies.

• Monopolies provide the sharpest insights

into how price discrimination and anti-

competitive strategies work.

• Oligopolies are useful in understanding

strategic interactions between firms.


PRICE

DISCRIMINATION


• Price discrimination means charging different

prices to different consumers for the same good.

• Recall that a monopolist facing a downward

sloping demand curve and employing non-

discriminatory pricing must reduce its price to all

consumers in order to sell more product.


• If price discrimination allows a monopolist to

sell more product, it may be seen as increasing

total surplus, thus improving efficiency.

• Of course to price discriminate, the monopolist

must address two problems:

1. Identification: can the firm identify demands of

different types of consumers or in separate markets

2. Arbitrage: can the firm prevent consumers charged a

low price from reselling to consumers charged a higher

price


• The firm then must choose the type of price

discrimination

– first-degree or personalized pricing

– second-degree or menu pricing

– third-degree or group pricing


• There are three types of price discrimination:

Type Name Example

First Degree Personalized

Pricing

Maximum price charged to each

consumer

Second Degree Menu Pricing Quantity discounts

Third Degree Group Pricing Group discounts (“early bird special”

“senior discount” )


• Third-degree price discrimination: Group pricing.

• Consumers differ by some observable

characteristic(s). A uniform price is charged to

everyone in the group. This is “linear pricing.”

• Different uniform prices are charged to different

groups:

– “student discounts” (Characteristic: student ID)

– “senior discounts” (Characteristic: appearance)

– early-bird specials (Characteristic: time)

14


• Pricing Rule (Elasticity of Demand)

– consumers with low elasticity of demand

should be charged a high price.

– consumers with high elasticity of demand

should be charged a low price.

15


• Pricing Rule (Marginal Revenue and

Marginal Cost)

–marginal revenue must be equalized in

each market.

–marginal revenue must equal aggregate

marginal cost.

16


• RULE #3: If demands are linear –

–price discrimination results in the same

aggregate output as no price

discrimination.

–price discrimination increases profit

because allocated more profitably across

two markets.

17


• From Last Week’s Assignment

– Aggregate Demand: P = 14 – ½ Q

– MC = 4.

– Under Perfect Competition, P = MC.

– ∴ 𝑃 = 4, 𝑎𝑛𝑑 𝑄 = 20

• Under Monopoly, MR = MC

– PQ (total revenue) = Q*(14 – ½ Q) = 14Q - ½Q 2

– MR = d(TR)/dQ = 14 – Q = MC = 4.

– ∴ Q = 10 and P = 14 – ½ *10 = 9

– 𝑃𝑟𝑜𝑓𝑖𝑡 = 9 − 4 ∗ 10 = 5018

Industrial Organization• Now let’s solve Part 3, Group Pricing

– Aggregate Demand: P = 14 – ½ Q

– High Demand Group: P = 16 – Q

– Low Demand Group: P = 12 – Q

• Please note: if you write the HD and LD demands

in terms of Q, then

– Q = 16 - P

– + Q = 12 – P

– = Qtotal = 28 – 2P. Therefore P = 14 – ½ Q

19

Industrial Organization• Find the individual Marginal Revenue Curves for the

HD and LD consumers:

– HD Demand: P = 16 – Q LD Demand: P = 12 – Q

– HD MR = 16 – 2Q LD MR = 12 – 2Q

– MRHD = MRLD = MC

– HD 16 – 2Q = 4 Therefore Q = 6 and P = 10

– LD 12 – 2Q = 4 Therefore Q = 4 and P = 8

– Profits = (10 – 4)*6 + (8 – 4)*4 = 36 + 16 = 52>50

20


• We now move to pricing strategies designed by

monopolies to capture the consumer surplus.

• The primary example of this form of price

discrimination is the quantity discount.

– Annual subscriptions often cost less in than one-off purchases.

– Buying in bulk usually offers a price discount.

• Prices are nonlinear, with the unit price

dependent upon the quantity bought.

• Pricing is nearer to willingness to pay.

21


• A nonlinear pricing strategy depends upon the information available to the seller. That determines whether to employ first-degree (personalized) or second-degree (menu) pricing.

• Under first-degree price discrimination, the

monopolist charges the maximum price that each

consumer is willing to pay.

– Extracts all consumer surplus

– Since profit equals the total surplus, first-degree price

discrimination is efficient. 22

Industrial Organization• Can a seller achieve a similar outcome if prices

must be announced in advance?

• Yes, with non-linear prices

• Two-part pricing is an example of common

non-linear pricing strategy.

– charge a quantity-independent fee

(membership?), plus a per unit usage charge

• Block pricing is a second example.

– bundle total charge and quantity in a package

• Quantity Discounts23


• Second-degree price discrimination & Quantity Discounts:

1. Extract all consumer surplus from the lowest-demand group.

2. Leave some consumer surplus for other groups . . . to satisfy the incentive compatibility constraint.

3. Offer less than the socially efficient quantity to all groups other than the highest-demand group.

4. Offer quantity-discounting.24


• 100 wealthy consumers, who value the 1st unit of a good at $15 and a 2nd unit at $10

• 100 moderate income consumers, who value only the 1st

unit at $12. For the producer, MC = 6.

• Solution: $12 for 1, $20 for 2.1. Extract all consumer surplus from the lowest-demand

group (Price for 1 unit = 12)

2. Leave some consumer surplus for other groups . . . to satisfy the incentive compatibility constraint. (CSw

= $500)

3. Offer less than the socially efficient quantity to all groups other than the highest-demand group.

4. Offer quantity-discounting ($2.00 discount per unit if you buy two) 25


PRODUCT DIFFERENTION

26

27


• Most firms sell more than one product. We

classify product differences as either horizontal

or vertical.

• Horizontal Differentiation: Products differ by

their appeal to different types of consumers.

• Vertical Differentiation: Products differ by the

consumers’ willingness to pay for quality.

28


• Suppose consumers differ in their tastes;

• A firm may decide it best serves these different

types of consumers by offering products with

different characteristics but similar qualities.

• This is horizontal product differentiation. The

firm designs products to appeal to different

types of consumers.

• Questions:

– how many different types of products?

– how do we model this problem?

29

Industrial Organization• A useful way to formulate answers is to use a

spatial model (Hotelling [1929]) to consider:– Product pricing– Design characteristics– Product variety

• This model provides insights into product differentiation because location can stand-in for:– space (geography)– time (departure times of planes, buses, trains)– product characteristics (design and variety)

• Consumers want products “close” to their preferences in space, time or characteristics.


• Here is an example. Assume F = $50,000, N

= 5 million and t = $1.

• Then tN/2F = 50.

• For an additional shop to be profitable, we

need n(n + 1) < 50. This is true for n < 6.

• Therefore, if n = 6, then adding one more

shop is profitable.

• But if n = 7 then adding another shop is

unprofitable. 30

31


• What does the condition on n [n(n + 1) < tN/2F] tell us?

• Simply, we should expect to find greater product

variety when:

– there are many consumers (N/).

– set-up costs of increasing product variety are low

(/F).

– consumers have strong preferences over product

characteristics and are unwilling to buy a product

if it is not “very close” to their most preferred

product (t in the numerator).

32


• BUNDLING AND TIE-IN SALES

33

Industrial Organization• Firms often bundle the goods that they offer.

– Microsoft bundles Windows and Explorer

– Office bundles Word, Excel, PowerPoint, Access

• Bundled package is usually offered at a discount.

• Tie-in sales ties the sale of one product to the purchase

of another: Tying may be contractual or technological

– IBM computer card machines and computer cards

– Kodak tie service to sales of large-scale photocopiers

– Tie computer printers and printer cartridges

• Why? To make money!

34


• There are two types of “bundling”

(1) Pure bundling, which is when the products are only offered in a bundle.

(2) Mixed bundling, when you offer the products both individually and in a bundle.

35

Industrial Organization• Two television stations offered two old Hollywood

films

– Casablanca and Son of Godzilla

• Arbitrage is possible between the stations

• Willingness to pay is:

Station A

Station B

Willingness

to pay for

Casablanca

Willingness

to pay for

Godzilla

$8,000

$7,000

$2,500

$3,000

$7,000

$2,500

36


Station A

Station B

Willingness

to pay for

Casablanca

Willingness

to pay for

Godzilla

$8,000

$7,000

$2,500

$3,000

Total

Willingness

to pay

$10,500

$10,000

Now suppose

that the two films are

bundled and sold

as a package

How much can

be charged for

the package?

$10,000

If the films are sold

as a package total

revenue is $20,000

Bundling is profitable

because it exploits

aggregate willingness

pay

37

Industrial Organization• If we extend our examples to include costs,

should a firm offer products individually, in a bundle only or both individually and bundled?

• There is no simple answers:

– mixed bundling is generally better than

pure bundling;

– but bundling is not always the best strategy

• Each case needs to be worked out on its

merits.

38

Industrial Organization• Here are some basic observations:

– Bundling is a form of price discrimination

– Bundling does not always work. Pure

bundling is not necessarily better than no

bundling.

• It requires there are reasonably large differences in

consumer valuations of the goods

– However, mixed bundling is always more

profitable than either no bundling or pure

bundling.

39


• What about tie-in sales?

– “Like” bundling but proportions vary.

– It allows the monopolist to make

supernormal profits on the tied good.

– Different users charged different effective

prices depending upon usage.

– Facilitates price discrimination by

making buyers reveal their demands.

40

Industrial Organization2nd Degree Price

Discrimination

Example: Quantity

Discounts

3rd Degree Price

Discrimination

Example: Group

Pricing

Product

differentiation

Example: A new

product.

Bundling and

Tie-sales

Example:

Combo

Products

Consumers can’t be

identified; must force

them to reveal their

true selves. (Self-

select).

Consumers can be

identified by some

observable

characteristic.

Consumers want

products “close” to

their preferences in

space, time or

characteristics

Consumers

willing to pay

more in the

aggregate.

Rule: leave some

consumer surplus “on

the table” to induce

high-demand groups

to buy large quantities.

Rule: charge

consumers with

low elasticity of

demand a high

price; equate MR

for all groups.

Rule: add a new

product (n + 1) if:

n(n + 1) < tN/2F

N = size of market

F = setup $

t = preference for a

new product

Rule: must

examine profits

on a case by

case basis.

41

Industrial OrganizationFROM THE REAL ECONOMY

2nd Degree Price

Discrimination

3rd Degree Price

Discrimination

Horizontal

Product

differentiation

Bundling

Starbucks Latte:

Tall: $2.85 (24¢)

Venti: $3.95 (20¢)

Oreos (Walmart)

15oz: $2.98 (20¢)

20oz: $3.50 (18¢)

Theaters:

Adult: $10.00

Senior: $7.00

Matinee: $6.00

Insurance:

Student Discount

Good Driver

Fit

Civic

Accord

Pilot

Odyssey

McDonalds

Burgers & Fries

Big Mac (‘68)

Egg McMf (’71)

Drive Thru (‘75)

Microsoft“Office”

Word, Excel and

Power Point.

McDonald’s Extra

Value Meal.

Computer Bundle:

Laptop, Flash Drive,

Case, Printer

(Costco)

42

Industrial Organization• Question: in the real world, how do firms identify

different groups demand functions, individuals’ desire for

different products or consumers’ willingness to pay?

• Entrepreneurship = alertness to market opportunities.

• Competition is an ongoing process of discovery.

“Entrepreneur

means acting man

in regards to

changes occurring

in the data of the

market.” Ludwig

von Mises

“The entrepreneur

brings into mutual

adjustment those

discordant elements

which resulted from

prior market

ignorance.” Israel

Kirzner

“I wish to

consider

competition . . .

as a procedure for

discovering

facts.” Freidrich

Hayek

43


OLIGOPOLIES AND

GAME THEORY

44


• We now turn to a common type of market, where firms

interact with a few competitors – oligopoly market.

• Each firm has to consider its rival’s actions with

regards to prices, outputs, advertising, etc.

• This kind of strategic interaction is analyzed using

game theory. To understand games, we

– assume “players” are rational

– distinguish between cooperative and non-

cooperative games

– distinguish between simultaneous versus sequential

games

45


• Need a concept of equilibrium

– Players (firms) choose a strategy.

– The strategy combination determines

outcome.

– The outcome determines pay-offs (profits?).

• Equilibrium first formalized by Nash: No firm

wants to change its current strategy given

that no other firm changes its current

strategy.

46


• There are three dominant oligopoly models

– Cournot

– Bertrand

– Stackelberg

• They are distinguished by:

– The decision variable that firms choose

– The timing of the underlying game

47

Industrial Organization• The Cournot model begins with a duopoly.

• Two firms making an identical product

• Demand for this product is:

• P = A - BQ = A - B(q1 + q2)where q1 is output of firm 1 and q2 is output of firm 2

• Marginal cost for each firm is constant at c per unit

• To get the demand curve for one of the firms we treat

the output of the other firm as constant, so for firm 2,

demand is P = (A - Bq1) - Bq2

• You then find q2 by finding the second firm’s marginal

revenue function and setting it to c.

48

Industrial Organization• For our problem, P = 14 – ½ q1 – ½ q2

• Firm 2’s demand function is: P = (14 – ½ q1) – ½ q2

• TR = Pq2 = (14 – ½ q1 )q2 – ½ q22

• MR = (TR)’ = (14 – ½ q1) – q2 = MC = 4

• ∴ q2 = 10 – ½ q1 This is Firm 2’s Reaction Function.

For Firm 1 it’s q1 = 10 – ½ q2

• Their intersection is the Nash Equilibrium

• q1 = 10 – ½ q2 = 10 – ½ (10 – ½ q1 ) = 5 + ¼ q1

• ∴ q1 = 20/3 By symmetry, q2 = 20/3. Qtotal = 40/3

• Price = 14 – ½ (40/3) = 14 – 6.67 = 7.33

• Qperfectcompetition = 20 > 40/3 (13.33) > Qmonopoly = 10

KEEP49


q*1 = (A - c)/2B - Q-1/2

How do we solve this

for q*1?The firms are identical.

So in equilibrium they

will have identical

outputs

Q*-1 = (N - 1)q*1

q*1 = (A - c)/2B - (N - 1)q*1/2

(1 + (N - 1)/2)q*1 = (A - c)/2B

q*1(N + 1)/2 = (A - c)/2B

q*1 = (A - c)/(N + 1)B

Q* = N(A - c)/(N + 1)B

P* = A - BQ* = (A + Nc)/(N + 1)

As the number of

firms increases price

tends to marginal cost

50


• In “Cournot” prices are set by market mechanisms.

• An alternative approach is to assume that firms compete in prices. This is the approach taken by Bertrand. This leads to dramatically different results.

• Take a simple example:

– Two firms producing an identical product . . .

– choose the prices at which they sell their products.

– Each firm has constant marginal cost of c

– Demand is P = A – BQ

– In terms of Q = a – bP with a = A/B and b= 1/B

51

Industrial OrganizationThese best response functions look like this:

p2

p1c

c

R1

R2

The best response

function for

firm 1The best response

function for

firm 2

The equilibrium

is with both

firms pricing at

c

The Bertrand

equilibrium has

both firms charging

marginal cost

(a + c)/2b

(a + c)/2b

52


• The Bertrand model makes clear that competing on

price is different from competition in quantities.

• Under standard Bertrand Competition, P = MC

• ∴ P = 4 and Q = 20, equal to Perfect Competition.

COURNOT: Pmonopoly > Pcournot > Pcompetitive

BERTRAND: Pmonopoly > Pbertrand = Pcompetitive

• Since many firms compete on price rather than

quantity, this is a challenge to the Cournot

approach.

53


• Bertrand also says competing on price doesn’t

result in P = MC if certain conditions are present

such as differentiated products or capacity

constraints.

• RE: capacity constraints, at P = MC there will be

more customers than both firms can satisfy. If Firm

1 sets its price at cost, Firm 2 will raise its price

because it can get all the customers it can handle at

a higher price. Therefore, P = MC is not a Nash

Equilibrium.

54

Industrial Organization• In the Problem, each firm’s capacity

constraint = 5 customers.

• If the firms set the highest price where they

each can be assured of 5 customers this would

be a Nash Equilibrium.

– An even higher price may not assure them of all

the customers they can handle;

– A lower price “leaves money on the table.”

• P = 14 – ½ Q. Using the capacity constraints,

• Qtotal = 5 + 5 = 10

• Price = 14 – ½*10 = 14 – 5 = 9.

55


• Both the Cournot and Bertrand models are

examples of simultaneous games.

• We assume both firms move simultaneously

and the market interaction is “once-and-for-all.”

• In a wide variety of markets firms compete sequentially.

• One firm makes a move. For example it may

– introduce a new product or ad campaign –and

• The second firms sees this move and responds.

56


• Sequential games are also called dynamic games. These games –

– may create a first-mover advantage; or

– create a second-mover advantage; or

– may allow an early mover to preempt the market.

• Therefore, sequential move games can generate very different equilibria from simultaneous move games.

57


• The most common model of a sequential game is the Stackelberg Model.

• The standard Stackelberg duopoly model is similar to the Cournot model in that it is output (quantity) based.

• However, firms choose quantities sequentially rather than simultaneously.

58


• Choosing output sequentially means

– the leader sets its output first, and visibly, and

– the follower then sets its output.

• The firm moving first has a leadership advantage.

• It can anticipate the follower’s actions and can

therefore manipulate the follower.

• However, for this to work the leader must be able to commit to its choice of output.

59


• In the problem, we assume there are two firms with

identical products.

• Marginal cost for each firm = 4.

• Firm 1 is the market leader and chooses q1

• Firms 1 also knows how Firm 2 will react because

Firm 2 will maximize profits by equating its marginal

revenue [MR = (A – Bq1) – 2Bq2] to MC.

• This is the same reaction function we calculated in the

Cournot problem, q2 = 10 – ½ q1

60


• Firm 1 knows Firm 2’s reaction function.

• Since Firm 1 moves first and can set quantity at

whatever level it wishes, Firm 1 puts Firm 2’s reaction

function into its Demand Curve, then calculates its

Marginal Revenue, sets it to MC and determines it’s

profit-maximizing Quantity.

• Firm 1’s Demand Function: P = 14 – ½ q1 – ½ q2

• Plugging in #2’s reaction function:

• P = 14 – ½ q1 – ½ (10 – ½ q1) = 9 – ¼ q1

• Therefore TR = 9q1 – ¼ q12 MR = 9 – ½ q1

61


• If MR = 9 – ½ q1 = MC = 4 ∴q1 = 10.

• This is the same quantity produced by the profit-

maximizing monopolist.

• Plugging q1 = 10 into Firm 2’s reaction function, you

get q2 = 5. Qtotal = 15. Price = 6.50

• Under Stackelberg, when two firms and compete on

quantity, there is a definite 1st mover advantage.

• The overall market is better off under Stackelberg

then under Cournot because Qtotal is larger (15 >

13.33) and price is lower (6.5 < 7.33).

62


• It is crucial that the leader can commit to its output

choice.

• Without such commitment Firm 2 would ignore

any stated intent by Firm 1 at the monopolist profit

maximizing point (here 10 units) and the only

equilibrium would be the Cournot equilibrium.

• So how does Firm 1 commit?

(1) Prior reputation

(2) Investment in additional capacity

(3) Place the stated output on the market

63


• Clearly, in this example, being the first mover

is advantageous.

• But is moving first always better than

following?

• This example was based on “output.”

• What happens if we are looking at price

competition?

64


• With price competition matters are different:

the first move does NOT have an advantage.

• Suppose, again, products are identical but the

first-mover commits to a price greater than

marginal cost.

• The second-mover will undercut this price and

take the market.

• Therefore the first-mover will set price at P =

MC. This is identical to simultaneous game

played under Bertrand competition.


ANTI-COMPETITVE

BEHAVIOR:

Limit pricing and

quantities


• A firm that can restrict output to raise market

price has market power.

• Why can’t rivals compete away those

positions?

• Why aren’t new rivals lured in by high

profits?

• Answer: firms with monopoly power may

– eliminate existing rivals

– prevent entry of new firms


• Predatory actions come in two broad forms:

– Limit pricing: prices so low that entry is

deterred.

– Predatory pricing: prices so low that existing

firms are driven out.

• Outcome of either action is the same: the

monopolist retains control of the market.

• Legal action focuses on predatory pricing

because there exists an identifiable victim: a firm

that was in the market but has left.


• We are going to consider a model of limit pricing using what was developed previously, specifically the StackelbergModel.

• Recall that the Stackelberg leader chooses output first. We also assume that:

– The entrant believes that the leader is committed to this output choice.

69


ACe

MC

e

$/unit

Quantity

D(P) = Market Demand

Q1

R1

Assume instead that

the incumbent

commits to output Qd

The entrant’s residual

demand is

Re = D(P) - Qd

Qd

Re

MRe

qe

Pe

Then the entrant’s

marginal revenue is MRe

The entrant equates

marginal revenue

with marginal cost

At price Pe entry is

unprofitable

Qd

Pd

By committing to output

Qd the incumbent deters

entry. Market price Pd

is the limit price

10

Industrial Organization• In our problem, the overall demand curve is

P = 14 – Qi – qe

• The entrant’s residual demand function is P = (14 –Qi) – qe MR = (14 – Qi) – 2 qe Equate it to MC = 4. Therefore the entrant’s reaction function is

qe = 5 – Qi/2

• For a limit price to be effective it must eliminate the entrant’s profits at its profit maximizing level.

• π = TR – TC = Pqe – 9 – 4qe Set it equal to 0 By setting the profit function to 0, we can determine the quantity the incumbent must produce to forestall entry and to establish the limit price.

10

Industrial Organization• π = TR – TC = Pqe – 9 – 4qe Set it equal to 0

• (P – 4)qe = 9 = (14 – Qi – qe – 4) = 9/qe

• = (14 – Qi – 5 + Qi /2 – 4) = 9/(5 – Qi/2)

• = (5 – Qi/2) = 9/(5 – Qi/2)

• = (5 – Qi/2)2 = 9 take the square root of both sides

• = 5 – Qi/2 = 3. Qi = 4, plugging this back into the reaction function qe = 5 – Qi/2, qe = 3.

• Price = 14 – Qi – qe = 14 – 4 – 3 = 7. That’s the limit price.

• At P = 7, TR for the entrant = 7*3 = 21. TC = 9 + 4* qe = 21. Profit is 0. Entry is deterred.

10


• There are issues with limit pricing and predation:

– How does the incumbent make it credible?

– Are there more profitable alternatives to limit pricing? (Merging?)

– Are there circumstances that encourage limit pricing? (Asymmetrical information? Pretending to be a low cost competitor?)

– Is there any empirical evidence of predatory behavior? (Perhaps)

73


• This brings us to the end of our course.

• The primary takeaway is this: in the

“hurly-burly” of the marketplace, when

firms appear to be behaving in peculiar and

somewhat inexplicable ways, there is

often a rational, logically-compelling

explanation for that behavior.

74


• This is empowering, because nothing

strengthens one’s faith in economic activity

– and therefore in human existence – than

the belief in rationality.

• There does remain one challenge, which is

what economics is all about . . .

75


•To be able to

RATIONALLY

figure it all out.

76


•Good luck on your

final paper . . .

•And thanks so much

for taking ECON 115!

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ECON-115 Lecture 13 - Kids in Prison Program · • Price discrimination means charging different...

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