Testing profit maximization

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Testing profit maximization?

• Monopolies

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Reasons for rejecting monopoly pricing hypothesis

• Firms do not maximize profits
• The theory does not include important elements of
  actual markets
• Presence of potential entrants (contestable
  markets)
• Strategic demand withholding
• Incomplete information about demand

3
Do firms maximize profits?

• Remove ability for buyers to withhold demand
• Simulated demand curves
• Remove potential competitors
• Harrison, McKee and Rutstrom
• Incomplete information about demand
• The seller has to learn about the demand
  condition from experience
• Demand is stationary across periods

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Experimental Evaluation of Institutions of
Monopoly Restraint

• Harrison, McKee and Rutstrom
• Constant, Increasing and Decreasing marginal cost
  conditions
• No human buyers no strategic demand withholding
• Pre-tested for risk neutrality
• Unregulated, subsidized, franchised and
  subsidized, contested

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Monopoly effectiveness

• Unregulated Constant MC Experienced
• 78 of monopoly profits
• Unregulated Increasing MC Experienced
• 23 of monopoly profits
• Unregulated Decreasing MC Experienced
• 71 of monopoly profits
• Inexperienced UD
• 38 of monopoly profits

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Profit maximization?

• Cleanest test of these three papers
• No strategic buyer behavior
• No changes in demand conditions over time
• Learning still appears necessary experience
  level changes behavior
• Increasing MC appears more difficult than
  constant or decreasing
• Cognitive resources?

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Natural Monopoly and Contested Markets

• Coursey, Isaac, and Smith JLE 1984
• Natural Monopoly
• Decreasing average cost
• Entry barrier if already sunk
• If the fixed cost is recurring decreasing AC is
  not by itself an entry barrier
• Contested Market hypothesis
• Even in the presence of decreasing average cost
  there is potential competition
• Potential entrants provide discipline on the
  pricing behavior of the incumbent due to threat
  of entry

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Testing rejection of monopoly pricing

• While maintaining the profit maximization
  assertion

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A-C-E

• Assertion monopoly firms are maximizing profits,
  buyers choices depend only on price and marginal
  value
• No strategic considerations like demand
  withholding
• Test Condition/Assumptions manipulable and
  observable entry barriers, firms have identical
  technologies, ceteris paribus
• Event Predicted When entry barrier is reduced to
  zero the incumbent will set a price at zero
  profits so entry will not occur

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The model Two firms profit maximize

• Max1 P1Q1(P1, P2)-WL1-RK1
• Max2 P2 (Q2(P1, P2)-Ce-WL2-RK2
• Ce is the entry cost for firm 2
• Q1a-bP1 if P1lt P2
• Q10 if P1gt P2
• Choice variables Pi, (Qi), Li, Ki
• Exogenous variable W, R, Ce
• If market is small enough then at a low enough
  price only one firm will serve the market

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Comparative statics

• Change in entry barrier Ce
• Infinite entry cost single seller
• Zero entry cost duopoly
• Because a decrease in Ce will decrease P2
• The predicted response for firm 1 is to lower P1
  to below P2
• Nash Equilibrium is P1P2MC
• Only one firm will remain then, two would be
  unprofitable

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Risk of confounds

• The pricing decision may be influenced by other
  (un-modeled) variables
• Ceteris paribus is not automatically fulfilled in
  the data whether from field or laboratory
• This can only be tested in a control condition
• Thus the need for comparative statics

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• Single seller is not pricing at Pm
• Buyer withholding is one cause
• Lowering entry barrier still has a strong effect
  on price
• Convergence to competitive pricing
• Verify that standard monopoly model does not
  include two important factors
• Demand withholding
• Potential competition
• Ceteris paribus condition of the theory is
  violated

15
Do sellers maximize profits?

• Monopoly may be confounded by buyer strategies
• Monopolist may expect buyer strategizing and act
  to avoid it
• Demand would no longer be a simple linear
  function of price different assertion of buyer
  responses
• Duopoly
• Presence of trust may result in market sharing
  arrangement
• Aversion to losing a pricing war
• Changes the assertion of profit maximization to a
  utility function including trust or war aversion
• Stationary preferences must still be maintained

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The Effects of Market Organization on
Conspiracies in Restraint of Trade

• Isaac, Ramey and Williams, JEBO, 1984
• Motivation for using PO markets
• Implies a price commitment that cannot be
  negotiated during trades
• Costly negotiations
• Retail markets
• We are only interested in the single seller
  markets
• Experimental sessions po92, po94, po102, and
  po107

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Predictions

• Po competitive price
• Qo 7
• Pm Po0.60
• Qm3
• Price at which 4 units are demanded (allowing one
  per seller) P4Po0.25

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Po102 Monopoly

• High efficiency
• Low monopoly effectiveness
• Mean prices close to Po
• Appeared to have been satisficing?

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PO94 Monopoly

• Low efficiency
• High monopoly effectiveness
• Demand withholding disappeared

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Implications for applied use of profit
maximization models

• Rejecting monopoly pricing
• May not be a rejection of the profit maximization
  assertion
• It may be a violation of the ceteris paribus
  assumption
• Trading rules and institutions matter
• Double Auction vs. Posted Offer and demand
  with-holding
• Contesting firms may not be visible in data
• Inferring demand conditions may be difficult
  under some cost conditions