Network Competition:II. Price discrimination

J ean-Jacques LaffontPatrick ReyJ ean Tirole

M a a r t e n W i s m a n s ( 2 0 0 7 6 2 0 7 ) M i c h i e l U b i n k ( 2 0 0 7 6 2 0 4 )

Agenda

• Introduction

• The model

• Main insights

• Propositions

• Conclusions

Companion article

• Framework of interconnection agreements between rival operators

• Studied competition between interconnected networks

• Assumption of non-discriminatory pricing

Our article

• Relaxes the assumption of non-discriminatory pricing

• Shows that the nature of competition is affected by price discrimination (in the entry and mature phase of the industry)

Free competition

• Unconstrained interconnection agreements• Entrants may be handicaped (entry phase)

• Enforce collusive behavior (mature phase)

Our article

Fixed cost and marginal cost

• Marginal cost technically determined for on-net call

• Depends on interconnection price of rival network

for off-net call

Assumptions

• Percentage of calls terminating on net is equal to the fraction of consumers subscribing to the network

• The interconnection price charged by the two companies is equal

• Two differentiated networks in the market have full coverage and can serve all consumers

The model

Total marginal cost

C= 2C0 + C1

C0 = MC originating and terminating

C1 = MC in between

D emand stucture is differentiated à la H otelling

The model

Pi = On-net prices

^Pi = Of-net prices

i = Market share

a = Unit access charge

The model

Fixed cost and marginal cost

• Marginal cost technically determined for on-net call

• Depends on interconnection price of rival network

for off-net call

The model

Consumer Welfare is given by:

v(p) = Consumer variable net surplus

Consumer expectations and market shares

Price discrimination creates positive, tariff-mediated, network externalities. Customers of network i are better off the more (fewer) consumers join it if pi < p^i

(pi > p^i)

This article only focusses on a stable equilibrium situation

Main insights (1)

• Network interconnection eliminates network externalities under nondiscriminatory pricing

• Positive (negative) network externalities exist if the access price embodies a markup (discount) relative to marginal cost

Main insights (2)

• Ratio of off- and on-net call prices reflects the relative markup on access

• Price discrimination introduces a wastefull distortion in the consumers’ marginal rate of substitution between on- and off-net calls

Main insights ( 3 )

• Trigger intense competition for market share. The bigger the market share, the less off-net cost have to be paid

• When the networks are poor substitutes, price discrimination decreases the double markup for on-net calls and raises it for off-net calls; This price dispersion benefits those whose net surplus function is convex

• A full coverage incumbent can squeeze out smaller competitors by raising interconnection prices (anticompetitive concerns)

Stable symmetric equilibrium

When

= 0

a = Unit access charge (the charge asked by a rival firm for an off-net call)c0 = Marginal costs of terminating end of call

m = Markup on access (relative to total cost of call)

Stable symmetric equilibrium

The proportionality rule ( Lemma 1) says:

Because 1 + m = 0, there is an unique equilibrium under discriminatory pricing that is symmetric and moreover stable. (The price of on and off-net calls is equal)

Optimimal access charge

Aw = Unit access charge that is socially preferred

aπ = Unit access charge that maximizes profit

σ: = Index of substitutability.

When: σ = 0: aw < aπ = c0 Then: and profit is maximized

When: σ > 0: aw < c0 < aπ Then:

An small increase in the substitutability parameter σ first increases both aw and aπ and cares fore monopoly prices. If σ gets larger people are more interested in substituting providers and logically aπ and p decrease again.

Impact of price discrimination

Price discrimination may increase social welfare when applied to competition between equals:

(i) Price discrimination may alleviate double marginalization

(ii) Price discrimination intensifies competition

1. D ouble marginalization

If the two networks are poor substitutes and if there is a markup on access (a > c0 ), social welfare is higher under price discrimination than under uniform pricing.

The function W(p) reaches a max at p=c. Since all prices exceed the monopoly price because of the markup, a mean-preserving price spread stricly raises social welfare.

2. Intensified Competition

Price discrimination lowers the average price for small markups.

Pd = On-net price under discrimination

^Pd = Off-net price under discrimination

Pu = Price under uniform pricing

Nonlinear pricing

Firms know their consumers’ variable surplus function

Firms set two-part tariffs

Network i therefore charges:

Fi = Fixed fee (subscriber line charge)

Ti = Total revenue

Qi = Consumption of on-net calls

^Qi = Consumption of of-net calls

Nonlinear pricing

In a competition with nonlinear tariffs, if the access charge is small (a close to C0) or the networks are poor substitues, then:

(i) There exists a unique equilibrium (dynamic and stable)

(ii) The marginal prices are the perceived marginal costs Pi = c and ^Pi = (1+m)c

1. Unique equilibrium

Market shares are:

This defines a stable shared market equilibrium (from the point of view of consumer behavior) if which holds if either is small enough.

2. Marginal prices

By fixing the market shares, a network i maximizes over its marginal prices Pi and ^Pi. Marginal-cost pricing is obtained, thus:

Pi = C

^Pi = (1 + m)c

Blockaded entry

A sufficient condition for the full-coverage incumbent to enjoy the full monopoly profit is that the entrant's coverage not exceed:

μ0 = Minimum coverage that makes network 1 to enjoy full

monopoly profit

v(pm) = Consumer’s variable net surplus with monopoly price

v(pR) = Consumer’s variable net surplus with Ramsey price

Conclusions

Two key points of departure from the non-discriminatory pricing analysis:

• Raising costs through high access prices, leads to more intense competition for market share. Not necessarily to higher prices and profitability

• Price discrimination by a dominant operator should be opposed by potential entrants and customers. Entrants should be protected.