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1 Course outline I n Introduction n Game theory n Price setting – monopoly – oligopoly n Quantity setting – monopoly – oligopoly n Process innovation Homogeneous.

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Presentation on theme: "1 Course outline I n Introduction n Game theory n Price setting – monopoly – oligopoly n Quantity setting – monopoly – oligopoly n Process innovation Homogeneous."— Presentation transcript:

1 1 Course outline I n Introduction n Game theory n Price setting – monopoly – oligopoly n Quantity setting – monopoly – oligopoly n Process innovation Homogeneous goods

2 2 Price competition n Case study: AMXCO versus Vebco n Simultaneous price competition – Equal costs Bertrand paradox – Different costs Blockade, deterrence – Old customers, switching costs n Price cartel n Minimum-price guarantees n Executive summary

3 3 Example: AMXCO versus Vebco n Cooler pads, used in air conditioning equipment, traditionally made by hand. n Around 1960 AMXCO developed a method of producing cooler pads by machine and became the leading firm in the market. n Vebco distributed pads for AMXCO. When Vebco began to distribute its own hand- made cooler pads a price war followed: (Industrial Economics; Stephen Martin)

4 4 Vebco AMXCO began to distribute its own pads - terminated Vebco as a distributor - gradually gained market share Jan charged price 9,5 % below list - followed, not to lose market share - cut price to 14,5 % below list - cut price to 25 % below list - matched AMXCO price cut - cut price to 32,5 % below list March matched AMXCO price cut March 29, raised price to 25 % below list offered discounts of % below list Price war (Industrial Economics; Stephen Martin)

5 5 Discussion (1) n AMXCO, a dominant firm with cost advantage over fringe firms, set its price so close to list that it was profitable for Vebco to expand its output, even though Vebco had higher costs. A price war followed until Vebco sued for peace. AMXCO remained a dominant firm, but competition forced it to set lower prices. (Industrial Economics; Stephen Martin)

6 6 Discussion (2) n Vebco filed a private antitrust suit against AMXCO, alleging price discrimination in violation of the Clayton Act and attempted monopolization in violation of Sect. 2 of the Sherman Act. n A court found in favor of AMXCO. There is no injury to competiton, if the price remains above the firms average variable cost. (Industrial Economics; Stephen Martin)

7 7 Antitrust laws and enforcement, the US n laws – Sherman Act (1890) – Clayton Act (1914) – Federal Trade Commission Act (1914) n enforcement – Department of Justice – Federal Trade Commission (FTC)

8 8 Excerpts from US Antitrust Statutes (1) n Sherman Act – Section 1. Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is hereby declared to be illegal …. Every person who shall make any contract or engage in any combination or conspiracy hereby declared to be illegal shall be deemed guilty of a felony …. – Section 2. Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony ….

9 9 Excerpts from US Antitrust Statutes (2) n Clayton Act – Section 2. (a) That it shall be unlawful for any person engaged in commerce … to discriminate in the price between different purchasers … where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy or prevent competition … nothing herein contained shall prevent differentials which make only due allowance for differences in the cost of manufacture, sale, or delivery ….

10 10 Competition in prices The Bertrand model as a simultaneous price competition: p1p2p1p2

11 11 The Bertrand model n Market demand function n Demand function of firm 1 n Equal costs: n Different costs:

12 12 Demand function of firm 1 x 1 p 1

13 13 Profit function of firm 1 p 1 1 st case 2 nd case 3 rd case p 1

14 14 Equal costs Bertrand paradox n is a Nash equilibrium in the Bertrand model with equal marginal costs. n is the only equilibrium. – n Marginal cost pricing and no profits!

15 15 Exercise (discrete prices) n Assume discrete prices and monetary units (1$, 2$,...) as well as equal marginal costs c=10. n Find the Bertrand-Nash equilibria.

16 16 Ways out of the Bertrand-paradox I n Discrete prices n Capacity constraints – Assumption : – Is (c,c) an equilibrium? n Repeated play – is not an equilibrium in the one-shot game, – but may be sustained as an equilibrium of repeated game.

17 17 Ways out of the Bertrand-paradox II n Cost leadership Blockade or deterrence n Old customers, switching costs n Price cartel n Minimum-price guarantees n Product differentiation

18 18 Entry barriers n Free entry tends to drive profits down. n Entry barriers allow established firms to make profits without attracting competitors. n Entry barriers – government regulation (licences) – structural barriers (cost disadvantages) – strategical barriers (limit price, limit quantity)

19 19 Blockade, Deterrence, or Accomodation n Blockaded entry: There is no threat of entry even if established firms maximize profits. n Deterred entry: Established firms try to make entry unattractive to potential competitors. n Accommodated entry: Established firms do not deter entry and potential competitors become actual competitors.

20 20 Different costs Blockade or deterrence? I n Blockaded entry for both firms n Blockaded entry of firm 2: Bertrand-Nash equilibrium: Are there other equilibria?

21 21 Different costs Blockade or deterrence? II n Deterrence of firm 2: Bertrand-Nash equilibrium:

22 22 Blockade, deterrence and Bertrand paradox duopoly, Bertrand paradox no supply c 1c 1 c 2c 2 firm 2 as a monopolist deterrence blockade firm 1 as a monopolist blockade

23 23 Old costumers - switching cost n Repeat purchase switching costs n Sources: – learning processes (opportunity costs of time and direct costs) – transaction costs – strategic design by firms (bonus program)

24 24 Switching costs - examples n In the middle of the 1980s AT&T succeeded in becoming the supplier of digital switches (5ESS) to Bell Atlantic. From then on, all the changes in Bell Atlantics telephone system had to be provided by, and negotiated with, AT&T. n My tax consultant closed his office and sold his customer data to another tax consultant. n My bank closed the office I used to frequent.

25 25 The model with switching costs n All costumers are old costumers of firm 1 n Demand function of firm 1 n deterrence of cost leader (firm 2) possible if:

26 26 Switching costs - blockade, deterrence and Bertrand paradox duopoly, Bertrand paradox no supply c 1c 1 c 2c 2 deterrence firm 1 as a monopolist blockade firm 2 as a monopolist blockade deterrence

27 27 Worth of old costumers at

28 28 Price cartel n For sufficiently small cost differences (Bertrand paradox or deterrence), a cartel might be established. n There are strong incentives to deviate from the cartel prices.

29 29 The cartel, graphically c 2c 2 no supply firm 2 as a monopolist c 1c 1 firm 1 as a monopolist cartel

30 30 Exercise (price cartel) Consider two firms competing in prices. The demand function is given by X(p)=20-2p. Suppose that the equal and constant unit costs are given by 6. a) Find the optimal cartel price. b) Assume equitable devision of profits. Calcu- late the maximum profit difference a deviating firm could achieve.

31 Most-Favored-Customer Clause (MFC) q A MFC guarantees a customer the best price the company gives to anyone. q MFCs are very common in business-to-business contracts. q They sound like a good deal for your customers, indeed the main effect is to shift the balance in favor of the seller. Brandenburger/Nalebuff: Co-opetition

32 MFC: Example In 1971 members of the American Congress figured that they should find a way to lower campaign expenses. Thus, the politicians voted themselves an MFC for television spots. The law didnt quite have the desired effect. Knowing that, in an election year, politicians are going to purchase significant chunks of airtime, the networks want to get as much as they can for these spots. So with an election coming up, how will a network respond when a commercial customer comes to negotiate the rate for an ad spot? It will be very though on price. Giving a concession is extremely costly, since any discount must be extended to all the politicians buying spots. The network would likely end up losing more from the lower price paid by all politicians than it would gain from getting some extra business. One result of the law was that the networks ended up making more money than before. Brandenburger/Nalebuff: Co-opetition

33 MFC: the sellers perspective Pros 1. Makes you a thouger negotiator. (Id love to give you a better price, but I cant afford to.) 2. Reduces your customers incentive to bargain. (The customer is guaranteed that no one else can get a better price, even if he does no negotiating at all.) Cons 1. Makes it easier for a rival to target one of your customers. 2. Makes it harder for you to target one of your rivals customers. Brandenburger/Nalebuff: Co-opetition

34 MFC: the customers perspective Pros 1. Allows you to benefit from any better deal subsequently offered to other customers. 2. Ensures you that youre not at a cost disadvantage relative to rivals. 3. Eliminates the risk of looking bad if other customers strike better deals. Cons 1. When others have MFCs, its harder for you to get a special deal. Brandenburger/Nalebuff: Co-opetition

35 Meet-the-Competition Clauses (MCC) p An MCC is a contractual arrangement between company and customer that gives the company an option to retain the customers business by meeting any rival bids. p An MCC doesnt force you to meet the competition. It simply rewards you, if you do so, with the assurance of the customers continued business. Brandenburger/Nalebuff: Co-opetition

36 MCC: Example In January 1994 the Miami Dolphins football team was sold for $138 million to H.W. Huizenga. A pretty good buy - almost a steal. When Dolphins owner J. Robbie died in 1990, the team was passed to his nine children. Following the death of their father, the Robbies sold Huizenga a 15 percent stake together with a right of first refusal (the buyers counterpart to an MCC) on any future sale. Thus, the Robbie children couldnt sell the team without first giving Huizenga an opportunity to match the best offer. Put yourself in the shoes of a prospective bidder. You invest time, effort and money lining up financing. Will you be able to outbid Huizenga? Doubtful. If it make sense for you to acquire the team at a certain price, it will make sense for Huizenga, too. The best offer was the $138- million bid that Huizenga matched when he bought the team. What should the Robbie children have done? Brandenburger/Nalebuff: Co-opetition

37 MCC: Pros and Cons Pros 1. Reduces the incentive for competitors to bid. (You can undercut any rival bid as far as its a good deal.) 2. Takes the guesswork out of bidding - you know what you have to beat. 3. Lets you decide whether to keep the customer. Cons 1. Allows competitors to bid without having to deliver. (Your rival can make a low bid, fully expecting that you will match and lowers your profit without having to put himself on the line.) Brandenburger/Nalebuff: Co-opetition

38 38 Minimum-price guarantees n Minimum-price guarantees assure consu- mers the lowest price charged by any firm. n If firm 1 offers a minimum-price guarantee, its actual price will be equal to the minimum of the prices charged by the two firms:

39 39 Exercise (Bauhaus) n Sollten Sie ein identisches Produkt inner- halb von 14 Tagen ab Kaufdatum woanders noch günstiger finden, so erhalten Sie bei uns das Produkt zu einem 12% günstigeren Preis als beim Wettbewerber. n

40 40 Minimum-price guarantees, graphi- cally - firm 1s profit function 1 st case2 nd case p 1 3 rd case p 1 Firm 1 offers a minimum- price guarantee. Firm 2 does not.

41 41 Minimum-price guarantees, graphi- cally - firm 2s profit function 1 st case 2 nd case 3 rd case p 2 Firm 1 offers a minimum- price guarantee. Firm 2 does not.

42 42 Two-stage model 1 2 minimum-price guarantee by firm 1 minimum-price guarantee by firm 2 p 1 p 2

43 43 Four possibilities n Neither firm 1 nor firm 2 offers a minimum- price guarantee: Bertrand paradox n Only firm 1 offers a minimum-price guarantee. n Only firm 2 offers a minimum-price guarantee. n Both firms offer a minimum-price guarantee.

44 44 Unilateral minimum-price guarantee (2 nd stage) n is a Nash equilibrium. n is the only equilibrium. – n Uniliteral minimum-price guarantees result in the Bertrand paradox.

45 45 Reaction correspondence of firm 1 (2 nd stage) Firm 1 offers a minimum- price guarantee. Firm 2 does not.

46 46 Reaction correspondence of firm 2 (2 nd stage) Firm 1 offers a minimum- price guarantee. Firm 2 does not.

47 47 Bilateral minimum-price guarantee (2 nd stage) n is a Nash equilibrium. n isnt the only equilibrium. – n Are there any dominant strategies ?

48 48 Reaction correspondence of firm 1 (2 nd stage) Both firms offer a minimum- price guarantee. is a dominant strategy.

49 49 Both firms offer a minimum- price guarantee. Reaction correspondence of firm 2 (2 nd stage)

50 50 Nash equilibria (2 nd stage) Both firms offer a minimum- price guarantee.

51 51 Minimum-price guarantee (1 st stage) Payoff matrix

52 52 The game in extensive form F1 g ng F2 g ng g F1 F2 p1p1 p1p1 p1p1 p1p1 p2p2 p2p2 p2p2 p2p2 A players strategy: 1. decision for or against a guarantee 2. decision on prices in all 4 possible situations

53 53 Equilibria in extensive form games n A strategy is of the following form: n Which of these strategy combinations are equilibria? – ((g,p M,c,c,c),(g,p M,c,c,c)) ? – ((g,p M,c,c,c),(g,p M, p M,c,c)) ? – ((ng,p M,c,c,c),(ng,p M, p M,c,c)) ? – ((g,p M, p M,c,c),(ng,p M, p M,c,c)) ? – ((ng,c,c,c,c),(ng,c,c,c,c)) ?

54 54 Executive summary I n Homogeneity leads to an aggressive price war suppressing profits. n In case of equal costs, zero profits (the Bertrand paradox) result. In case of unequal costs, the cost leader will prevail. n Ways out of the Bertrand paradox: – capacity constraints, – repeated play, – cost leadership, switching costs, – price cartel, – minimum-price guarantees, – product differentiation.

55 55 Executive summary II n reduce consumers uncertainty about fair prices, n make it impossible to be underbid by the rival, n discourage entry, and n may accomplish the monopoly outcome if given by both firms. Minimum-price guarantees


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