Economics of Management Strategy BEE3027

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Economics of Management StrategyBEE3027

• Lecture 5

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Reminder!!!

• Essay deadline 27th April.
• Should you wish to pick your own topic, please
  come and see me BEFORE the Easter break.
• Essays will be evaluated on the following
  criteria
• Good knowledge of the material
• Ability to construct a solid, coherent argument
• Evidence of outside reading.
• Readings and assignment for this week
• Oz Shy, Industrial Organization, chapter 13

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Peak-Load pricing

• The peak-load pricing problem was first studied
  in the context of public utility pricing, such as
  transportation or electricity.
• However it is a widely utilised pricing tool in
  industries such as
• Hotels
• Airlines
• cinemas.

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Peak-Load pricing

• There are three factors that characterise the
  peak-load pricing problem
• Demand must vary across different periods
• Capital must be leased or rented for long
  periods
• Firms production capacity must be fixed in the
  medium term
• There is no possibility to store excess output.

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Peak-Load pricing

• Consider the case of an airline which must set
  output in high and low seasons.
• The monopolist faces two costs
• Capacity cost, r, which refers to the rental cost
  of airplanes
• Variable cost, c, which refers to the cost per
  passenger.
• Hence, for each plane carrying K passengers, the
  total capacity cost is rK

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Peak-Load pricing

• So, the airlines total cost equals
• We know that the monopolist will set Q such that
  MRMC.
• The question facing the monopolist is that MC is
  now a function of passenger cost as well as
  capacity!

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Peak-Load pricing

• They key to answering this problem is to realise
  that in low season, it is unlikely that the
  airline will be flying at full capacity.
• Therefore, by selling one more seat, costs will
  only increase by c.
• Hence

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Peak-Load pricing

• So in essence the high-season customers carry
  the capacity and operational costs, while the
  low-season customers only pay the latter.
• What is the welfare impact (profits consumer
  surplus) of this type of pricing?
• In other words, what would happen if firms would
  be forbidden to charge different prices along the
  year?

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Peak-Load pricing

• The answer depends on the difference between
  high-season and low-season demands.
• If it is too big, then the firm may not serve
  low-season customers at all.
• In this case, this type of price discrimination
  is efficient.

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Tying

• Requirements tying is a practise whereby a
  monopoly manufacturer of good A requires
  customers to also purchase a another good B from
  itself.
• In other words, the monopolist leverages its
  market power from one market to the other.
• The two goods may or may not be complements.
• E.g. Cameras and film, copiers and toner,
  operating systems and software applications.

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Tying

• So far weve worked under the assumption that
  firms sell only one product.
• In reality, firms often sell a variety of
  products
• Proctor Gamble (household goods)
• HP (PCs and printers).
• If consumers have different reservation values
  for different products, how can firms exploit
  this?

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Tying

• Consider a monopolist who sells goods X and Y
• There are two consumers, 1 and 2.
• Each consumer demands at most one unit of each
  good.
• Each consumer has a different valuation of each
  good.

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Tying
X Y
Consumer 1 H L
Consumer 2 L H
Consumer valuations of X and Y are either H or L
H gt L gt 0
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Tying

• If the monopolist is not allowed to use tying, it
  has two options
• Sell both goods at a low price such that both
  consumers purchase
• Px Py L
• Profit 2L 2L 4L
• Consumer Surplus (H-L)(H-L) 2(H-L)
• Welfare 4L2(H-L) 2H 2L

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Tying

• Sell both goods at a high price such that each
  consumer only buys one unit.
• Px Py H
• Profit H H 2H
• Consumer Surplus 0
• Welfare 2H

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Tying

• Monopolist will choose pricing policy which gives
  it highest profit.
• It will set PxPy H if
• 2H gt 4L gt H gt 2L
• Conversely it will set PxPy L if
• H lt 2L

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Tying

• Now suppose that the monopolist is able to sell
  both goods as a package.
• The optimal price for the package is H L.
• This yields the monopoly profit 2(HL)
• Consumer surplus 0!

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Tying

• As long as consumer preferences are negatively
  correlated, tying will increase monopoly profits.
• A further possibility arises if we allow for
  consumer preferences to be more diverse.
• Suppose we add a third type of consumer who gains
  equal utility from consuming either good.

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Tying
X Y
Consumer 1 4 0
Consumer 2 3 3
Consumer 3 0 4
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Tying

• If tying is not possible, monopolist can
• Set Px Py 3
• Profit 4 x 3 12
• CS 2x(4 3) 2
• Set Px Py 4
• Profit 2 x 4 8
• CS 0

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Tying

• If tying is permitted
• Set Pp 6
• Profit 6
• CS 0
• Set Pp 4
• Profit 3 x 4 12
• CS 6 2 4.
• Monopolist would pick a package price of 4.

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Tying

• If monopolist can charge a separate price for
  package AND each item in isolation (mixed tying)
• Px 4, Py 4, Pp 6.
• Profit 2 x 4 6 14
• CS 0

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Tying

• Monopolist sets Px Py such that
• Consumer 2 is not willing to buy goods
  separately
• But Consumers 1 and 3 are not willing to do so.
• Monopolist sets Pp such that
• Consumers 1 and 3 are willing to buy package
• But Consumer 2 is not.
• By employing mixed tying, monopolist is able to
  extract entire consumer surplus.
• This only works as long as valuations are
  negatively correlated

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Microsoft vs. EU Commission

• In 2000, the commission expanded the
  investigation to include the effects of tying
  Windows Media Player (WMP) with Windows 2000.
• The investigation found that this tying practise
  significantly reduced the incentives of media
  content companies to offer their products to
  competing firms on the media player market.
• See also discussion in Church Ware concerning
  US vs. Microsoft regarding tying practises in the
  web browser market.