Pricing - Web.UVic.caweb.uvic.ca/~pcourty/Chap9-11.pdf · Emirates Airline, Dubai-Mumbai, Economy...
Transcript of Pricing - Web.UVic.caweb.uvic.ca/~pcourty/Chap9-11.pdf · Emirates Airline, Dubai-Mumbai, Economy...
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Pricing Pricing
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Emirates AirlinesEmirates Airlines
Source: Emirates Airline, Reproduced with permission
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Emirates Airline, Dubai-Mumbai, Economy class, May 2004
Fare Restrictions Price
Year KRTAE1 None AED 2250
(US$ 613)
Special Excursion QEE4MAE1
Min. 7 days, max. 4 mths stay
AED 1900QEE4MAE1 stay
Basic Season Special Excursion LLE4MAE1
Low season; min. 7 days, max 4 mths stay
AED 1550Excursion LLE4MAE1 max. 4 mths stay
Basic Season Special Excursion VLE4MAE1
Low season; min. 7 days, max. 4 mths stay
AED 1200
3(c) 2000-2007, I.P.L. Png & D.E. Lehman
y
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Emirates Airline, Mumbai-Dubai, Economy class, May 2004
Fare Restrictions Price
Economy unrestricted None INR 25,600LRT (US$ 557)
Economy restricted LRTIN1
None INR 22,700LRTIN1
Regular Excursion LEE3M1
Min. 7 days, max. 3 mths stay
INR 20,100LEE3M1 mths stay
Special Excursion VEE3MIN1
Max. 3 mths stay. INR 17,000
4(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Emirates AirlineEmirates Airline
Why does Emirates charge lower fare for passengers originating from Mumbai?
How is this discrimination possible?
5(c) 2000-2007, I.P.L. Png & D.E. Lehman
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VW Passat
Audi A6
What’s wrong ith d twith product
design?
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OutlineOutlineOutlineOutline
if i i uniform pricing complete price
discriminationdiscrimination direct segment
discriminationdiscrimination indirect segment
discrimination bundling selecting the pricing
7(c) 2000-2007, I.P.L. Png & D.E. Lehman
policy
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Uniform PricingUniform Pricing
8(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Uniform Pricing: Profit MaximumProfit Maximum
MR = MC
Equivalently, set the incremental margin percentage equal to the inverse of absolutepercentage equal to the inverse of absolute value of price elasticity of demand,
(price - MC) / price = -1/e(price MC) / price = 1/e
9(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Uniform Pricing:Price ElasticityPrice Elasticity
always set price so that demand is elastic
if demand more elastic, then lower incremental margin percentage (IM%) g p g ( )
e = -2 IM% = 1/2e = -1.5 IM% = 2/3/
10(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Uniform Pricing:PrivatePrivate--Label ColaLabel Cola
Suppose that WalMart learns that demand for private-label cola is less elastic than theprivate label cola is less elastic than the demand for Coca Cola. Should WalMart set a higher price for private-label
cola? Elasticity IM% Price = cost + margin Price = cost + margin
11(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Contribution MarginContribution Margin
contribution margin % = (price - average variable cost) / price
if constant returns to scale: MC = AVC and IM% = CM%
12(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Against Cost-PlusAgainst Cost-Plus
Impractical: How to determine mark-up?pWhat if production cost is almost zero?
Doesn’t maximize profit.p
13(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Uniform Pricing: ShortcomingsShortcomings
leaves buyers with a lot of surplus
does not sell to everyb
$
does not sell to every potential buyer
buyer surplus
potential buyers
price
potential buyers
marginal cost
14(c) 2000-2007, I.P.L. Png & D.E. Lehman
0 quantity
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O tlineO tlineOutlineOutline
uniform pricing complete price discriminationp p direct segment discrimination indirect segment discrimination indirect segment discrimination bundling selecting the pricing policy selecting the pricing policy
15(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Complete Price DiscriminationComplete Price Discrimination
Price each unit at buyer’s benefit and sell quantity where MB MCquantity where MB = MC
maximum profit - theoretical idealdifferent from MR = MC
I l t ti k l Implementation: must know entire marginal benefit and marginal cost curves
16(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Complete Price Discrimination:PracticePractice
bargaining auctions
17(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Complete Price Discrimination:Hong Kong Jockey ClubHong Kong Jockey Club
Club has monopoly over horse racing and betting in Hong Kongbetting in Hong Kong.
Rents 60 race-track boxes on seasonal basis to institutional clientsto institutional clients Box locations vary – clients prefer boxes
closer to finish line. “Rental” is minimum monthly F&B charge
based on seating capacity.
18(c) 2000-2007, I.P.L. Png & D.E. Lehman
How to increase profit?
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O tlineO tlineOutlineOutline
uniform pricing complete price discriminationp p direct segment discrimination indirect segment discrimination indirect segment discrimination bundling selecting the pricing policy selecting the pricing policy
19(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Direct Segment Discrimination IDirect Segment Discrimination, I
Price by segment
Implementationfixed identifiable characteristic - basic for
segmentationAge, gender, nationality, location
lno re-sale
20(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Direct Segment Discrimination IIDirect Segment Discrimination, II
simple case: uniform price within each segment
within each segment IM% = -1/efor segment with more elastic demand,
then lower incremental margin percentage (IM%)
21(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Direct Segment Discrimination IIIDirect Segment Discrimination, III
22(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Direct Segment Discrimination:“Not for Retail Sale”“Not for Retail Sale”
Heinz serves
• institutional customers (food service, restaurants) directly
• retail customers indirectly through supermarkets and g pgrocery stores
23(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Internet ServicesInternet Services
residential -- $30-50/month business – over $100/month
How is discrimination possible?
24(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Direct Segment Discrimination:LocationLocation
Free on board (FOB) price - does not include deliveryinclude delivery
Cost including freight (CF) price - includes d lidelivery
conventional productsdigital productsdigital products
25(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Direct price discrimination: Gray MarketsGray Markets
Price differential parallel imports Retailers: Hong Kong music stores source music CDs g g
through parallel imports Consumers: 2 million U.S. consumers buy drugs from
Canadian pharmacies (on-line)
Managing the gray market packaging packaging warranty service technical differentiation
26(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Asian Wall Street JournalAsian Wall Street Journal
Price for annual subscription, May 2006
Print: Hong Kong (HK$ 2 700) US$ 348Print: Hong Kong (HK$ 2,700) US$ 348
Print: Singapore (S$ 525) US$ 331
k ( ) $Print: Tokyo (Yen 94,500) US$ 845
Interactive: Worldwide US$ 99
Why different prices for print edition but not interactive
27(c) 2000-2007, I.P.L. Png & D.E. Lehman
y p pedition?
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O tlineO tlineOutlineOutline
uniform pricing complete price discriminationp p direct segment discrimination indirect segment discrimination indirect segment discrimination bundling selecting the pricing policy selecting the pricing policy
28(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Indirect Segment DiscriminationIndirect Segment Discrimination
Structure choice to earn different incremental margins from each segmentmargins from each segment
Implementationp seller controls some variable to which segments
are differentially sensitive buyers cannot circumvent the variable
29(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Air Travel: Air Travel: BenefitsBenefits
Unrestricted Restricted Traveler Segment
UnrestrictedTravel ($)
RestrictedTravel ($)
Maria Business 1000 200Tom Business 900 180 R bi V ti 500 400Robin Vacation 500 400Leslie Vacation 280 224
30(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Air Travel: Air Travel: Indirect Segment DiscriminationIndirect Segment Discrimination
P d t
F S lTotal R
Total C t
P fitProduct Fare
($) Sales Rev.
($) Cost($)
Profit($)
U t i t d 900 2 1 800 400 1 400Unrestricted 900 2 1,800 400 1,400
Restricted 399 1 399 200 199
*MC=200
31(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Chinese Embassy: Visa FeesChinese Embassy: Visa Fees
Application periodpp p
1 day 3 days 7 days
Single entry $75 $60 $25
Double entry $85 $70 $35Double entry $85 $70 $35
32(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Pricing Policies: RankingRanking
Profitability Policy Information Requirementq
Highest Complete price discrimination
Highest
Di t t Direct segment discrimination
Indirect segment Indirect segment discrimination
Lowest Uniform pricing Lowest
33(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutline
uniform pricing complete price discriminationp p direct segment discrimination indirect segment discrimination indirect segment discrimination bundling selecting the pricing policy selecting the pricing policy
34(c) 2000-2007, I.P.L. Png & D.E. Lehman
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BundlingBundling
strategy pure bundlingmixed bundling
implementationd d ff b f f segments derive different benefits from
separate products negatively correlated preferences negatively correlated preferences low marginal cost
35(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Cable Television: Cable Television: BenefitsBenefits
“if every segment … was wild about one thing and hated the rest, they have done thei job” (Economist)their job” (Economist) Segment Education MusicSegment Education
channel Musicchannel
Conservatives $20 $ 2
Middle of road $11 $11
36(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Pure or Mixed BundlingPure or Mixed Bundling
What is the profit-maximizing pricing policy if marginal cost per channel = 0g p marginal cost per channel = $5
37(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Ace RentAce Rent--aa--Car of Perth,Car of Perth,,,Western Australia (2004)Western Australia (2004)
Toyota Camry rental
unlimited mileage – A$ 288 for four days
time and mileage rate – A$ 216 for four days including 400 free kilometers plus additional mileage g p gcharge 25c per kilometer
38(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Microsoft Office 2007Microsoft Office, 2007
Home and student Standard Profession
al Ultimate
Regular price $149.99 $399.99 $499.99 $699.99
Academic price $139.85 $134.85 $169.85 $249.85
39(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutline
uniform pricing complete price discriminationp p direct segment discrimination indirect segment discrimination indirect segment discrimination bundling selecting the pricing policy selecting the pricing policy
40(c) 2000-2007, I.P.L. Png & D.E. Lehman
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CannibalizationCannibalization
“business travelers were contorting their schedules to .. qualify for fares with leisure travel restrictions”
Northwest VP Tom Bach
degrade low-end item upgrade high-end item
41(c) 2000-2007, I.P.L. Png & D.E. Lehman
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CannibalizationCannibalization
d Low-margin item draws customers away from higher-margin product.P ibl l ti Possible solutions: Limit availability of low-end item
S d b h l Separate distribution channels Product design
D d l d itDegrade low-end itemUpgrade high-end item
42(c) 2000-2007, I.P.L. Png & D.E. Lehman
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VW Passat
Audi A6
What’s wrong ith d twith product
design?
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Information technologyInformation technology
More discrimination more data on
More price competition (less
more data on buyers
easier to
discrimination) easier to
icustomize products
online auctions
compare prices
online auctions
44(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Information ProductsInformation Products
music, computer software, novel: once content is created, marginal cost is almost zero
offer multiple versions on-line stock prices: real-time/delayed computer software: Pro/Regular novels: hard cover/paperback
45(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Strategic Thinking
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Coke vs Pepsi 1999Coke vs. Pepsi, 1999
Nov. 16: Coca-Cola raised price 7%
Nov. 22: Pepsi raised price 6.9%
“Coke and Pepsi will move now from price-based competition to marketing-based
i i ”competition”,Andrew Conway, Morgan Stanley
47(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Strategic SituationsStrategic Situations
parties actively consider the interactions with one another in making decisions
game theory -- set of ideas and principles to guide strategic thinking simultaneous actions: strategic form sequential actions: extensive form
48(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutlineOutlineOutline
Nash equilibrium randomized strategiesg coordination / competition sequencing sequencing strategic moves
49(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Radio FormatsRadio Formats
Merkur
Lite AC no change
JupiterHot AC J: 60,
M: 40J: 60,
M: 40p
no change J: 70,M: 30
J: 50,M: 50
50(c) 2000-2007, I.P.L. Png & D.E. Lehman
M: 30 M: 50
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Nash EquilibriumNash Equilibrium
Given that the other players choose their Nash p yequilibrium strategies, each party prefers its own Nash equilibrium strategy
No one is willing to deviate unilaterally from a h l bNash equilibrium
51(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Nash Equilibrium:Dominated StrategyDominated Strategy
Generates worse consequences than another strategy, regardless of the choices of the otherstrategy, regardless of the choices of the other parties
d i t d t t never use dominated strategy
52(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Nash Equilibrium:SolutionSolution
eliminate dominated strategies, then check remaining cells
“arrow” technique
53(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Nash equilibrium:Radio formatsRadio formats
Merkur
Lite AC no change
J: 60 J: 60
Jupiter
Hot ACJ: 60,
M: 40J: 60,
M: 40
J: 70 J: 50Jupiterno change
J: 70,M: 30
J: 50,M: 50
54(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Nash equilibrium:Prisoners’ dilemmaPrisoners’ dilemma
Samsung
Do not confess ConfessDo not confess Confess
Do not I: 0, I: -10,Infine
on
Do not confess S: 0 S: 0
I: 0 I: -5Confess
I: 0,S: -10
I: 5,S: -5
55(c) 2000-2007, I.P.L. Png & D.E. Lehman
What should Samsung do?
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Nash equilibrium:Competitive dilemmaCompetitive dilemma
Pepsi
Raise price DiscountRaise price Discount
Raise priceC: 3,
P: 3C: 0,
P: 5
Coke
Raise price P: 3 P: 5
DiscountC: 5, C: 1,
Discount P: 0 P: 1
What should Coke do?
56(c) 2000-2007, I.P.L. Png & D.E. Lehman
What should Coke do?
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OPEC: Oil CartelOPEC: Oil Cartel
June 1998: Saudi Oil Minister Naimi, “I don’t think anybody expects 100% y y pcompliance… Once the price goes up, there will be cheating”gMarch 1999: Algerian Oil Minister Youcef Yousfi “OPEC is still able to actYoucef Yousfi, OPEC is still able to act collectively and restore market stability”
57(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Resolving Competitive DilemmaResolving Competitive Dilemma
repetition -- using punishment strategy Saudi Arabia is low-cost producerp
commitment to raise price / not to cut price Pepsi separated franchisor / bottlep p / price-matching
58(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Out of Nash EquilibriumOut of Nash Equilibrium
What if another player doesn’t play Nash equilibrium strategy? Nash equilibrium strategy may not be best still don’t use dominated strategygy
59(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutline
Nash equilibrium Randomized strategiesg Coordination / competition Sequencing Sequencing Strategic move
60(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Randomized StrategiesRandomized Strategies
choose among pure strategies according to probabilities
must be unpredictable
61(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Randomized strategies:Retail price competitionRetail price competition
Two competing retailers – Jaya and Ming Three segments Three segments
captive (loyal) to Ming captive (loyal) to Jaya captive (loyal) to Jaya switchers
62(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Randomized strategies:Retail price competitionRetail price competition
Ming
Hi h i L iHigh price Low price
High price J: 60, J: 40,Jaya M: 40 M: 50
Low price J: 50, J: 50,Low price J: 50,M: 40
J: 50,M: 30
63(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Randomized strategies:Retail price competitionRetail price competition
Pricing trade-off:hi h i t t t b l f l l high price to extract buyer surplus of loyal customers
low price to get store switchers low price to get store switchers Solution: randomized discounts
64(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutline
Nash equilibrium Randomized strategiesg Coordination / competition Sequencing Sequencing Strategic move
65(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Coordination/competition:Evening newsEvening news
Delta
7.30pm 8.00pm
7 30A: 1, A: 3,
Zeta
7.30pmB: 1 B: 4
8 00pmA: 4, A: 2.5,
8.00pmB: 3 B: 2.5
66(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Coordination/Competition:Zero/Positive SumZero/Positive Sum
zero-sum games: pure competition -- one party better off only if other is worse off
positive-sum games: coordination -- both can be better off or both worse off
co-opetition: competition and coordination
67(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Coordination/Competition: Instant Messaging TechnologiesInstant Messaging Technologies
Venus Inc.
Orange Green
Sol Corp.Orange S: 1.5
V: 1.5S: 1
V: 1p
Green S: 1V: 1
S: 1.5V: 1.5
68(c) 2000-2007, I.P.L. Png & D.E. Lehman
V: 1 V: 1.5
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Coordination/competition:Future DVD standard
Consumers
Blu-ray HD-DVD
M: 1 M: -1
DVD player manuf-
Blu-rayM: 1,
C: 1M: 1,
C: -1
M: -1 M: 1manufacturers HD-DVD
M: 1,C: -1
M: 1,C: 1
69(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Coordination/Competition: Focal PointFocal Point
Single Nash equilibrium - clear focal point
Multiple Nash equilibria - look for focal point to see which one to play
70(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutline
Nash equilibrium Randomized strategiesg Coordination / competition Sequencing Sequencing Strategic move
71(c) 2000-2007, I.P.L. Png & D.E. Lehman
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SequencingSequencing
Game in extensive form – sequence of moves:
nodes odesbranchesoutcomesoutcomes
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Sequencing:Extensive FormExtensive Form
backward induction final nodes intermediate nodes initial
node
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Sequencing:Extensive FormExtensive Form -- TV NewsTV News
74(c) 2000-2007, I.P.L. Png & D.E. Lehman
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OutlineOutlineOutlineOutline
Nash equilibrium randomized strategiesg coordination / competition sequencing sequencing strategic moves
75(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Strategic MoveStrategic Move
Action to influence beliefs or actions of other parties in a favorable way
• Credibility- irreversible commitment
• First mover advantage• Second mover advantage• Second mover advantage
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Strategic Move:LithographerLithographer
(1) serial number (2) destroying the plate
77(c) 2000-2007, I.P.L. Png & D.E. Lehman
(2) destroying the plate(3) other solution?
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Strategic Move:LockLock--InIn
sunk costs – learning, complementary hardware – become switching costs
lock-in strategy initially, price low/free to lock in buyer exploit later
counter lock-in competitive upgrade
78(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Strategic Move:LockLock--Out Verizon WirelessOut Verizon Wireless
Los Angeles wireless market dominant: Verizon and Cingular dominant: Verizon and Cingular entrants: AT&T and Sprint
Verizon Digital Plus 200: 1000 free minutes of Verizon Digital Plus 200: 1000 free minutes of calls to/from another Verizon customer
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Pepsi’s Strategic MovePepsi s Strategic Move
1995-99: intense price war Nov. 99:
Nov. 16: Coca-Cola raised price 7% Nov. 22: Pepsi raised price 6.9% “C k d P i ill f i b d “Coke and Pepsi will move now from price-based
competition to marketing-based competition” (Andrew Conway, Morgan Stanley)
How did they get out of price war? Mar. 99: Pepsi spun off Pepsi Bottling Group (PBG)
80(c) 2000-2007, I.P.L. Png & D.E. Lehman
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C di i l S i MConditional Strategic Moves
Threats – if it succeeds, then it needn’t be carried outcarried out
Promises – if it succeeds, then it needn’t be carried out
Ideal strategic move doesn’t impose costs
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Morgan Stanley:“Shareholder rights plan”“Shareholder rights plan”
If any party acquires 15% or more of company’s shares other shareholders getcompany’s shares, other shareholders get right to buy additional shares at 50% discount.discount. Impact on hostile bidder?Good or bad for shareholders?Good or bad for shareholders?
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Conditional Strategic Move:Poison PillPoison Pill
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Conditional Strategic Move:TwoTwo--Tier Takeover BidTier Takeover Bid
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Conditional Strategic Move:StrikeStrike
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Why are strikes rarer in American professional football than in baseball?
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Conditional strategic move: Without deposit insurance
b k idepositor
maintains
bank remains solvent
principal + interest
depositor
deposit bank insolvent zero
depositor
withdraws d it
principalbank remains solvent
deposit
principalbank insolvent
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Conditional strategic move: With deposit insurance
b k idepositor
maintains
bank remains solvent
principal + interest
depositor
deposit bank insolvent principal
depositor
withdraws d it
principalbank remains solvent
deposit
principalbank insolvent
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RepetitionRepetition
expanded strategies: condition actions on actions of other partiesp external events
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Repeated CartelRepeated Cartel
tit-for-tat Axelrod’s rules
do not strike first reciprocate both good and badp g act simply and clearly do not be envious
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Oli lOligopoly
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U.S. Wireless Telecommunications Industry: does the Sprint/NEXTEL merger y p / g
increase or decrease competition?
• 62.0 million subscribers
illi b ib• 60.7 million subscribers
•• 53.6 million subscribers53.6 million subscribers
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OligopolyOligopoly
Oligopoly is a market with a small number of sellers whose actions are interdependent
A duopoly is a market with two sellers
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OutlineOutlineOutlineOutline
pricing capacity capacity price/capacity leadership t i i titi restraining competition antitrust (competition) policy
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Pricing: MonopolyPricing: Monopoly
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Homogenous ProductHomogenous Product
Bertrand model: sellers who produce at constant marginal cost with unlimited capacity compete on price
Suppose one of the two firms charges price p, above marginal pp g p p, gcost
The other firm has three choices: price > p: lose all customersprice p: lose all customersprice = p: split the market in halfprice < p: gain the whole market, even marginally below p P i i j t b l i t fit bl Th l i ld Pricing just below p is most profitable. The same logic would
apply to the other firm. So, the Nash equilibrium is for both firms to charge price = p.
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Differentiated ProductsDifferentiated Products
Sellers compete partially on price, partially on product design/placement
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Pricing: Differentiated ProductsDifferentiated Products
the Hotelling model of duopoly
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Pricing: Differentiated ProductsDifferentiated Products
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Differentiated sellers: best response price functions
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Pricing:Product DesignProduct Design
Desire for market share leads firms to locate “close” to their customers
Desire to avoid direct competition leads firms to locate away from their competitor (less differentiation leads to more direct price competition)O ti l l ti i l t d ff Optimal solution is a complex tradeoff
99(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Pricing:Strategic ComplementsStrategic Complements
Actions are strategic complements if an adjustment by one party leads other parties to adjust in the same direction
Example: if Ajax lowers price and Bacchus responds by lowering price, then prices are strategic complements
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OutlineOutlineOutlineOutline
pricing capacity capacity price/capacity leadership t i i titi restraining competition antitrust (competition) policy
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Capacity CompetitionCapacity Competition
Cournot model: sellers produce at constant marginal cost and compete on production capacity (homogeneous product)
Residual demand curve: market demand less the quantities supplied by other sellers
Best response functions show the best it h i f h ll f ticapacity choice for each seller as a function
of the other seller’s capacity choices
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ExampleExample
Mars Cellular and Pluto Wireless compete on capacity
Market demand = 300 – 3p Marginal cost = $30/subscriber/monthg $ / /
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Capacity CompetitionCapacity Competition
Residual Demand Curves
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CapacityCapacity
Best Response Capacity Functions
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Capacity:Cost DifferencesCost Differences
A decrease in marginal cost for one firm will lead to an increased market share for that firm and a decreased market share for thefirm and a decreased market share for the other firm
This is seen by shifting outward the best This is seen by shifting outward the best response function of the firm with the lower marginal cost
Changes in fixed costs do not shift the best response functions
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Capacity:Multiple SellersMultiple Sellers
With multiple sellers with differing marginal cost, the incremental margin percentage in the industrypercentage in the industry can be represented by
HHI
pcp
)(
where HHI is the Herfindahl –Hirschman Index is the
p
cHirschman Index, is the industry weighted average cost, and is the elasticity of demand.
c
107(c) 2000-2007, I.P.L. Png & D.E. Lehman
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Capacity:Strategic SubstitutesStrategic Substitutes
Actions by various parties are strategic substitutes if an adjustment by one party leads other parties to adjust in the opposite direction
Capacity levels in the Cournot model are strategic substitutes
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Las Vegas StripLas Vegas Strip
Group No. of hotels (1995)
Hotels added (1996-
Hotels added (1999-
Average occupancy
June 30, 200
Average occupancy
June 30, 200
Average daily room
1 –June 30,
Average daily roo m
1 –June 30, -97)
-2000)
Jan. 1 –04 Jan. 1 –05
m rate Jan. 2004
m rate Jan. 2005
MGM Mirage 1 (MGM Grand) 1 (New York, New York)
3 (Mirage, TI, Bellagio)
96.3% 97.6% $159 $173
Mandalay Resort Group
3 (Luxor, Circus-Circus, Excalibur)
1 (Monte Carlo ) 1 (Mandalay Bay) 92% 93% $121 $131
Other notables Caesar’s Palace, Aladdin
Stratosphere Venetian, Paris
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OutlineOutlineOutlineOutline
pricing capacity capacity price/capacity leadership t i i titi restraining competition antitrust (competition) policy
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Price LeadershipPrice Leadership
Consider and industry with fixed costs and a market leader
The leader can use a first mover advantage by choosing output and price to create a residual demand curve for a potential entrant that leaves no room for profitThi i k “li it i i ” This is known as “limit pricing”
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Price/Capacity Leadership:PricePrice
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Price/Capacity Leadership:CapacityCapacity
The Stackelberg Model: the leader commits to capacity before the followerh l d k h f ll ’ The leader takes into account the follower’s
subsequent choice of capacity The result is an industry production capacity greater The result is an industry production capacity greater
than in Cournot competition (with a lower price) The leader has a larger market share than the
follower (first mover advantage, even though the follower gets to observe the leader’s capacity before choosing its capacity)
113(c) 2000-2007, I.P.L. Png & D.E. Lehman
choosing its capacity)
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OutlineOutlineOutlineOutline
pricing capacity capacity price/capacity leadership e t i i o etitio restraining competition antitrust (competition) policy
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Restraining Competition:CartelsCartels
Cartels are agreements among sellers (or buyers) to raise the price above (below, for a buyers’ cartel) the competitive levelbuyers cartel) the competitive level
Cartels are generally illegal Where legal their effectiveness will depend Where legal, their effectiveness will depend
on the number of sellers, the relation of industry capacity to market demand, the y p y ,extent of sunk costs, the extent of barriers to entry and exit, and the homogeneity of the product
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product
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Restraining Competition:Horizontal IntegrationHorizontal Integration
Horizontal integration is the combination of two entities in the same, or similar, businesses under a common ownership.
Vertical integration is the combination of the assets for two (or more) successive stages of production under a common ownership.H i t l i t ti h th t ti l t Horizontal integration has the potential to increase market power.
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OutlineOutlineOutlineOutline
pricing capacity capacity price/capacity leadership t i i titi restraining competition antitrust (competition) policy
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Antitrust (Competition) Policy:Competition LawsCompetition Laws
Prohibit collusion on price or other means Prohibit monopolies or monopsonies from p p
abusing market power Prohibit mergers or acquisitions that would g q
substantially lessen competition in the market.
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Antitrust (Competition) Policy:Merger GuidelinesMerger Guidelines
Post-merger HHI
Increase in HHI
0 50 50 100 1000 - 50 50 - 100 > 100
> 1 800 safe suspect suspect> 1,800 safe suspect suspect
1,000 – safe safe suspect1,8000 – 1,000 safe safe safe
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SummarySummarySummarySummary
Prices are strategic complements Production capacities are strategic substitutes Sellers who can commit to capacity before their Sellers who can commit to capacity before their
competitors may have a first mover advantage, potentially to the point of excluding all potential entrantsentrants
Restraining competition – either through agreement or horizontal integration – can increase profits for sellerssellers
Anti-trust (competition) authorities monitor industry behavior. The Herfindahl-Hirschman Index is a commonly used gauge for screening mergers
120(c) 2000-2007, I.P.L. Png & D.E. Lehman
commonly used gauge for screening mergers