Economics of Management StrategyBEE3027

Lecture 5

Reminder!!!

• Essay deadline: 27th April.– Should you wish to pick your own topic, please come and

see me BEFORE the Easter break.

• Essays will be evaluated on the following criteria:• Good knowledge of the material;• Ability to construct a solid, coherent argument;• Evidence of outside reading.

• Readings and assignment for this week:– *Oz Shy, Industrial Organization, chapter 13

Peak-Load pricing

• The peak-load pricing problem was first studied in the context of public utility pricing, such as transportation or electricity.

• However it is a widely utilised pricing tool in industries such as:– Hotels;– Airlines;– cinemas.

Peak-Load pricing

• There are three factors that characterise the peak-load pricing problem:– Demand must vary across different periods;

– Capital must be leased or rented for long periods;• Firm’s production capacity must be fixed in the medium

term;

– There is no possibility to store excess output.

Peak-Load pricing

• Consider the case of an airline which must set output in high and low seasons.

• The monopolist faces two costs:– Capacity cost, r, which refers to the rental cost of airplanes;– Variable cost, c, which refers to the cost per passenger.

• Hence, for each plane carrying K passengers, the total capacity cost is rK

hhh QAp lll QAp 0 lh AA

Peak-Load pricing

• So, the airline’s total cost equals:

• We know that the monopolist will set Q such that MR=MC.

• The question facing the monopolist is that MC is now a function of passenger cost as well as capacity!

rKQQcTC lh )( KQQ hl ,0

Peak-Load pricing

• They key to answering this problem is to realise that in low season, it is unlikely that the airline will be flying at full capacity.

• Therefore, by selling one more seat, costs will only increase by c.

• Hence:

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l

h

pcArcA

p

cMR

rcMR

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Peak-Load pricing

• So in essence the high-season customers “carry” the capacity and operational costs, while the low-season customers only pay the latter.

• What is the welfare impact (profits + consumer surplus) of this type of pricing?

• In other words, what would happen if firms would be forbidden to charge different prices along the year?

Peak-Load pricing

• The answer depends on the difference between high-season and low-season demands.

• If it is too big, then the firm may not serve low-season customers at all.– In this case, this type of price discrimination is

efficient.

Tying

• Requirements tying is a practise whereby a monopoly manufacturer of good A requires customers to also purchase a another good B from itself.

• In other words, the monopolist leverages its market power from one market to the other.

• The two goods may or may not be complements.

• E.g. Cameras and film, copiers and toner, operating systems and software applications.

Tying

• So far we’ve worked under the assumption that firms sell only one product.

• In reality, firms often sell a variety of products– Proctor & Gamble (household goods)– HP (PCs and printers).

• If consumers have different reservation values for different products, how can firms exploit this?

Tying

• Consider a monopolist who sells goods X and Y

• There are two consumers, 1 and 2.

• Each consumer demands at most one unit of each good.

• Each consumer has a different valuation of each good.

Tying

X Y

Consumer 1 H L

Consumer 2 L H

Consumer valuations of X and Y are either H or L

H > L > 0

Tying

• If the monopolist is not allowed to use tying, it has two options:

• Sell both goods at a low price such that both consumers purchase;– Px = Py = L; – Profit = 2L + 2L = 4L– Consumer Surplus = (H-L)+(H-L) = 2(H-L)– Welfare = 4L+2(H-L) = 2H + 2L

Tying

• Sell both goods at a high price such that each consumer only buys one unit.– Px = Py = H– Profit = H + H = 2H– Consumer Surplus = 0– Welfare = 2H

Tying

• Monopolist will choose pricing policy which gives it highest profit.

• It will set Px=Py = H if:2H > 4L => H > 2L

• Conversely it will set Px=Py = L if:H < 2L

Tying

• Now suppose that the monopolist is able to sell both goods as a package.

• The optimal price for the package is H + L.

• This yields the monopoly profit = 2(H+L)

• Consumer surplus = 0!

Tying

• As long as consumer preferences are negatively correlated, tying will increase monopoly profits.

• A further possibility arises if we allow for consumer preferences to be more diverse.

• Suppose we add a third type of consumer who gains equal utility from consuming either good.

Tying

X Y

Consumer 1 4 0

Consumer 2 3 3

Consumer 3 0 4

Tying

• If tying is not possible, monopolist can:Set Px = Py = 3

Profit = 4 x 3 = 12

CS = 2x(4 – 3) = 2

Set Px = Py = 4

Profit = 2 x 4 = 8

CS = 0

Tying

• If tying is permitted:Set Pp = 6Profit = 6CS = 0

Set Pp = 4Profit = 3 x 4 = 12CS = 6 – 2 = 4.

• Monopolist would pick a package price of 4.

Tying

• If monopolist can charge a separate price for package AND each item in isolation (mixed tying):

Px = 4, Py = 4, Pp = 6.

Profit = 2 x 4 + 6 = 14

CS = 0

Tying

• Monopolist sets Px & Py such that:– Consumer 2 is not willing to buy goods separately;– But Consumers 1 and 3 are not willing to do so.

• Monopolist sets Pp such that:– Consumers 1 and 3 are willing to buy package– But Consumer 2 is not.

• By employing mixed tying, monopolist is able to extract entire consumer surplus.– This only works as long as valuations are negatively

correlated

Microsoft vs. EU Commission

• In 2000, the commission expanded the investigation to include the effects of tying Windows Media Player (WMP) with Windows 2000.

• The investigation found that this tying practise significantly reduced the incentives of media content companies to offer their products to competing firms on the media player market.

• See also discussion in Church & Ware concerning US vs. Microsoft regarding tying practises in the web browser market.