Transparency, prices and consumer welfare

1
Transparency, prices and consumer welfare

• Jan Boone
• Jan Potters
• TILEC, Tilburg University

2
Transparency

• More transparency is usually seen as an
  improvement
• it intensifies competition
• reduces prices
• reduces price dispersion
• increases consumer surplus

3
Story

• As consumers get to know the market better, they
  will be better able to find the firm that
  produces the product which gives them the best
  price/quality ratio.
• As firms understand that consumers will walk away
  to a competitor that offers a better deal, they
  offer better products at lower prices

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However,

• we also know of cases where the institutional
  setting restricts the choice sets of customers
• although patients are allowed to get a second
  opinion, they are not allowed to get 10 opinions
  before, say, an operation
• although someone convicted of a crime can appeal,
  the number of appeals is limited
• in economics you are allowed to send your paper
  to one journal only at a time for refereeing
• rationing in war time
• asylum seekers can apply for asylum in one
  country only at a time
• Although there are a number of reasons for this,
  one is the protection of the customers themselves

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Common element

• In all of these cases there is a scarce resource
  involved
• doctors/specialists
• judges
• referees
• supplies of bread and cigarettes in war time
• civil servants checking asylum requests
• these resources are limited and hence we prefer
  everyone getting something instead of some people
  getting a lot and others getting nothing
• Lifting the restrictions raises prices and
  reduces consumer welfare

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Transparency

• The formalizations of more transparency leading
  to lower prices and higher consumer surplus were
  done in a framework where
• goods are perfect substitutes
• firms produce with constant marginal costs
• In that case more transparency (for given prices)
  does not raise demand
• and higher demand does not lead to higher costs

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Our paper

• An increase in transparency has two effects
• competition effect firms produce more and lower
  their prices as the market becomes more
  transparent
• demand effect more transparency is like removing
  restrictions and hence raises demand and
  therefore prices
• The competition effect raises consumer welfare,
  the demand effect reduces consumer welfare
• Which effect dominates is determined by how fast
  marginal costs increase with output
• For the demand effect we need to assume that
  goods are imperfect substitutes (think of the
  'second opinion' if this is known to be
  identical to the 'first opinion' there is not
  much demand for second opinions)

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Illustration demand effect

• Suppose I am looking for a purple second hand car
• However, in Breda there are no purple second hand
  cars, so I don't buy one
• Now the internet is introduced (transparency ?)
  and using the internet I find that a purple car
  is on sale in Groningen
• Now I start to bid for this car and hence demand
  for the car in Groningen goes up because of the
  internet
• Suppose there is a customer in Groningen as well
  who wants to buy the new car, then because of the
  internet he has to pay a higher price for the car

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Supply of goods

• If the supply of goods is fixed (say, paintings
  by Rembrandt), an increase in transparency raises
  the number of buyers per seller and hence raises
  the market power of sellers gt price increases
  and consumer surplus goes down.
• If goods are supplied with CRS technology, an
  increase in transparency only has a competition
  effect and hence leads to more output and lower
  prices gt consumer surplus goes up

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Model

• Consumers have a taste for variety
• There are n firms selling goods
• A fraction ? of consumers know of all firms and
  buy from all firms (taste for variety)
• A fraction (1-?) of consumers knows only one firm
  and buys from that firm
• An increase in transparency is modeled as an
  increase in ?.

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Model

• For given output levels of firms, an increase in
  ? increases prices by the demand effect
• However, in Cournot and Bertrand equilibrium the
  rise in ? also has a competition effect raising
  output
• Assuming that production features 'strong enough'
  decreasing returns to scale the demand effect
  outweighs the competition effect and hence prices
  go up

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Consumer welfare

• Let uI(?) denote the utility of informed
  consumers and
• uU(?) denote the utility of uninformed consumers
• Then uI(?) gt uU(?) and
• uI(?) and uU(?) are decreasing in ? if the demand
  effect outweighs the competition effect
• Consumer welfare is defined as
• W ? uI(?) (1- ?) uU(?)
• If the demand effect is strong enough W goes down
  as ? goes up

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Endogenous transparency ?

• If customers decide themselves on how much to
  search, they take aggregate ? as given, so they
  maximize
• ?i uI(?) (1- ?i) uU(?) c(?i)
• Hence they overlook the negative externality on
  others if uI(?) and uU(?) are decreasing in ?
• market overinvests in search compared to social
  planner maximizing consumer surplus
• Hence starting from the private outcome, further
  stimulating transparency may reduce consumer
  surplus

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Price dispersion

• If more transparency leads to lower prices, it
  may raise price dispersion
• Reason is that there are two business strategies
  for firms
• compete on price in the transparent market
• charge high price to stranded consumers
• As transparency goes up, price goes down with
  former strategy while it remains unchanged with
  latter strategy gt
• price dispersion goes up

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Conclusion

• In the cases where more transparency leads to a
  demand effect and where firms produce with
  decreasing returns to scale
• an increase in transparency leads to
• higher prices
• lower consumer surplus
• If more transparency leads to lower prices, it
  may raise price dispersion