TOPIC 13: PREDATORY AND OTHER PRICING STRATEGIES

Topic 13| Part 1 29 October 2013Date

ANTITRUST ECONOMICS 2013David S. EvansUniversity of Chicago, Global Economics Group

Elisa MariscalCIDE, Global Economics Group

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Overview

Part 1

Price Discrimination/Com

plex Pricing

Limit Pricing

Part 2

Predatory Pricing

Loyalty Rebates

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Key Takeaways

Aggressive pricing is the essence of competition. Consumers benefit when companies cut their margins to the bone, offer low prices, and stimulate demand.

Aggressive pricing can also be a tool for eliminating competitors today so that a firm can secure significant market power and then raise its prices.

Distinguishing between pricing that is good or bad for consumers is difficult and likely has high rates of error. Critical to balance the false positives and false negatives in designing competition rules for pricing abuses.

4 Price Discrimination and Other Complex Pricing

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Price Discrimination and Other Complex Pricing

Basic price discrimination.

Charging different groups different prices (3rd degree price discrimination).

Charging separately for each unit (1st degree price discrimination).

Non-linear prices (2nd degree price discrimination).

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What is Price Discrimination?

Price discrimination refers to:

Charging different prices.

• To different people• At different times or • For different quantities

For the same good

Even though the costs are the same (or more accurately where the price differences aren’t accounted for by cost differences).

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Price Discrimination is Common in Competitive Markets

Airline seats. Few people on an airline flight are paying the same price even if they are sitting in the same class of seats.

Sales. At the beginning of every month French shops have legal sales.

American universities. The price of going to Harvard University varies from $0 to $50,250. Only a small portion pay the full price.

People who buy 10 cups of coffee at Caffe Nero get the next cup free.

Restaurants make very different profit margins on different dinners served the same night.

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Harvard does it …

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… and so does eBay

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Several Conditions Must Hold for Price Discrimination

Firm must have some market power (but as we’ve said most have some).

• Sales: early versus late buyers separate fashion conscious from not. • Universities: income proxy for willingness to pay and hard to sell

diplomas.• Pharmaceutical companies: charge different prices for same drug in

different countries.

Firm must have some way to identify customers who would be willing to pay more (time, age, sex, location, other behavior).

• Airlines: time of booking; resale hard.• Parallel trade is about efforts to bypass price discrimination by

arbitrageurs.• Fashion conscious can’t wait for the sales.

Firm must be able to limit arbitrage (otherwise low-paying customers will resell to high-paying customers).

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“Third-Degree Price Discrimination”

Firms charge different customers different prices for the same good.

Consider case where marginal cost and average cost is the same for every unit.

MC

D1(P1

)D2(P2

)q1

MR2

P2

MR1

P1

q2

Price

Output

P1 > P2

Group 2 pays lower price

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“Third-Degree Price Discrimination”

Optimal price is where MR1=MR2=MC.

Suppose E1 and E2 are the elasticities of demand for the two groups.

In general the percent markup over marginal cost should be the same for each group to maximize profits. (“Ramsey Pricing” formula named after Frank Ramsey, a mathematician, who wrote three classic papers in economics before dying at the age of 27.)

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11

11

11

EPMC

EP

11

1 1

EP

MCP

22

2 1

EP

MCP

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Welfare Consequences of 3rd Degree Price Discrimination

Tends to expand output and therefore makes social surplus bigger.

Tends to shift surplus from consumers to producers.

• Benefits one customer group while harming another customer group.

• Tends to increase social welfare whenever, as is often the case, it tends to increase output

• May increase or decrease consumer welfare.

Compared with charging a single price, discrimination:

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“First Degree Price Discrimination”

What’s the best a firm could do with price discrimination? Charge everyone as much as they would be willing to pay for each unit.

That gives the firm the entire area between the demand curve and the cost curve: that’s the most profit it could ever get; but it requires so much information and such complex pricing that it is seldom possible in practice.

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“First Degree Price Discrimination”

Each point may reflect different quantities purchased by individual consumers or an additional consumer that is willing to buy at that price.

MC

P1

D(P)

Output

P2

P3

q3 q2 q1

Price

Maximum profit for the firm; maximum total surplus; minimum consumer surplus.

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“Second Degree” Price Discrimination

• Two-part tariffs: access fee plus usage fee.

• Non-linear pricing: complex volume discounts.

• Tie-in sales: use a consumable product to meter demand for a durable product.

A firm might be able to approximate perfect price discrimination in several ways:

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“Second Degree” Price Discrimination—Two-Part Tariffs

Two-part tariff: Buyers pay a fixed fee (lump-sum fee) for the right to consume a good and a uniform price for each unit of product consumed.

Profit benefits of two-part tariffs include:

• Firms can charge a low usage fee to encourage increased consumption and use the fixed charge to recuperate the consumer’s higher surplus.

• This makes them at least as much profits as a uniform tariff (could always make the fixed charge 0 which replicates the uniform tariff).

Examples of two-part tariffs:

• Euro Disney: Charges a fixed charge with no usage element (probably due to convenience).

• Movie theatre: entrance fee and then pay for food.• Credit cards: pay annual fee plus get rewards (negative price) for each

transaction.

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Economics of Two-Part Tariffs

Two groups of consumers

• Group 1 has high demand.• Group 2 has low demand.

An average uniform price would lose some of the low demand consumers.

• Could charge a single two part tariff like before.

More profitable to charge two, two-part tariffs targeted at members of each group.

Example: Mobile phones,

• Many two part tariffs with different fixed monthly charges and variable call charges. Output

MC

Price

D

1Q1 Q2

Fee Members

of Group 1 =

D2

Fee Members

of Group 2 =

MR1MR2

P2

P1

Demand schedule is for member of group

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Tie-Ins and Metering for 2nd Degree Price Discrimination

Consider the case where a firm sells a durable good like a fax machine.

The customers use a non-durable product (like ink) with the durable good over its lifetime.

The price of the durable machine is like an access charge for the system.

The price of the “consumables” can be used to meter intensity and then value the use.

High-use customers might get a low marginal price for “consumables” so the average cost per use is lower than for low-use customers.

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Bundled Products and Price Discrimination: The Case of Block Booking

Suppose two products and two customers and each product costs $0.

Theatre 1 Theatre 2

Optimal Price Profit

Consumer Surplus

Gone with the Wind $8000 $7000 $7000

$14000 $1000

Gertie’s Garter $2500 $3000 $2500 $5000 $500

Bundle $10500 $10000 $10000$2000

0 $500

Change from Bundling $1000 ($1000)

Cost per Product 0

NOTE: Total surplus is unchanged--producers get $1000 profit and consumers lose $1000.Source: George J. Stigler, “United States v. Loew’s Inc.: A Note on Block Booking,” Supreme Court Review 152

(1963), pp. 152-157

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Demand Aggregation and Package Sales

Suppose two products and two customers and each product costs $0.

LawyerAccountant

Optimal Price Profit

ConsumerSurplus

Word processing 120 30 120 120 0

Spreadsheet 20 120 120 120 0

Bundle 140 150 140 280 10

Change from Bundling +40 10

Cost per Product 0

NOTE: Total surplus increases by 50--producers get +40 and consumers +10 (290 total value-280 total cost).

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Demand Aggregation

Out of 100 people 1-10 would pay $22 for component 1, 11-20 would pay $22 for component 2, …, 91-100 $22 for component 10; each would pay $2 for each of the other 9 components.

Costs are zero.

Profit-maximizing price is $22 (profits= $2200) and consumers only buy one component; price for separate components is $2 (profits= $2000) and each consumer buys all 10. No consumer surplus since complete extraction by producer.But consumers would pay $22 + 9 x $2 = $40 for all 10. So charge $40 for all ten. Profits = $4000. All consumers buy all components but still no consumer surplus.

Generally consumer surplus increases as a result of demand aggregation because more people are able to buy and get to keep some surplus.

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Price Discrimination and Static Social Welfare

Compare price discrimination with linear pricing in a simple static situation.

Price discrimination tends to increase profits as firm with market power gets more consumer surplus.

Price discrimination also reduces dead-weight loss of monopoly since it tends to expand output (but not always).Price discrimination has an ambiguous effects on consumer welfare—people who pay high prices lose while those who pay low prices gain (and remember those who pay low prices wouldn’t get the good at all without price discrimination).Bottom line: price discrimination usually increases social welfare but not necessarily consumer welfare.

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Price Discrimination and Dynamic Social Welfare

Economists tend to view price discrimination as beneficial or benign.

• Reduces dead-weight loss.• Enables firms to recover fixed costs and therefore may permit firms to enter

who couldn’t otherwise.• Additional profits can help firms recover risks and investments in entering

new businesses (see Baumol and Swanson).• And everyone does it—price discrimination persists in competitive markets

which suggests that it is efficient (See US Supreme Court decision in Illinois Works, 2006).

25 Limit Pricing

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Basic Story of Limit Pricing

Firm A is a monopoly and faces potential entry by less efficient firm B.

Firm A drops its monopoly price so that it is just lower than the minimum price firm B would need to make its entry profitable.

By doing this firm A discourages firm B from coming in and competing.

Entry of firm B could result in Bertrand competition thereby jeopardizing all profit or Cournot competition thereby jeopardizing some profit.

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Monopoly Facing Actual or Potential Entry

Limit pricing strategies

• Suppose monopoly is more efficient than entrants but…

• It is still profitable for entrants to come in if they can sell at less than the monopoly price.

• Monopoly may lower its price enough to make it unprofitable for entrants to come in (from PI to PI’).

MCI

MCE

MR

PI

Output

Price

PI ‘

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Monopoly Facing Actual or Potential Entry

Post-entry strategies:

• Monopoly has the choice of accepting entrant, or fighting entrant.• Decision depends on the ability to drive entrant out and reputational

benefits of being tough.

Entrant

Incumbent

-1

0

4

5

0

10

EnterStay out

AccommodateFight

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Reasons Not to Wait…

In some circumstances it may in fact be better to just drop prices after an entrant comes in. However, there are several reasons not to wait.

Entrants may not know the monopoly is more efficient. As a result of asymmetric information they mistakenly come in.

If they had not incurred any sunk costs monopolist could drop price and they would leave.

If they have incurred sunk costs then after entry it is better to stay in and drop the price.

Therefore monopolist may want to discourage “stupid” entry.

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Limit Pricing and Competition Policy

Suppose a dominant firm has not engaged in limit pricing.

Suppose a less-efficient entrant comes in.

The dominant firm will lower price below entrant’s price.

The entrant will leave the market if it doesn’t have sunk costs.

The dominant firm will then raise price back up until it happens again.

Should competition policy prohibit a dominant firm from dropping its price below the entrant’s price even though the entrant is less efficient?

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End of Part 1, Next week Part 2

Part 1

Price Discrimination and Other Complex Pricing

Limit Pricing