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Lecture 8: Virgin Pricing Case; Collusion and Cartels AEM 4160: Strategic Pricing Prof. Jura Liaukonyte 2

Break Even Point  Monthly ARPU (average revenue per unit): $52 (p.3)  Monthly Cost-to-Serve: $30 (p.3)  Monthly Margin: $22  Time required to break even on the acquisition cost  = __________________  In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon): M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost LTV = M 1- r+ i - AC

LTV With Contracts  The annual retention rate in the industry  = ______________ LTV =- 370 =

LTV Without Contracts  Eliminate contracts -> churn rate increases to 6%  Calculate the LTV: LTV =- 370 =

Eliminate Hidden Costs  If hidden costs were eliminated, the margin would certainly be reduced.  Assume that it would be reduced to $18 from $22.  Break even would become _________= __________

What Happens to LTV?  Without hidden costs, but with contracts  Without hidden costs and without contracts LTV =- 370 = LTV =- 370 =

Option 3: Different Pricing Approach  Target audience: Youth  Loathe contracts  Fail credit checks  Ideal plan: no contracts, no menus, no hidden fees…  How to differentiate itself, and have a positive LTV  Look at the factors that affect LTV

Options for Lowering Acquisition Costs  Advertising costs per customer  Industry=from $75 to $100  Virgin planned ad costs = 60 mil/1mln= $60 (p.5)  Handset subsidies:  Current industry handset cost: $150 to $300 (assume $225) (p.5)  Current industry handset subsidy: $100 to $200 (assume $150) (p.9)  Current industry handset subsidy as a %: 67%  Virgin’s handset cost: $60 to $100 (assume $80)  Assume Virgin’s subsidy around 30% = $30

Acquisition Costs  Then Virgin’s AC would be just ____vs. industry average $370  Sales commission: $30  Advertising per gross add: $60  Handset Subsidy $30  Total: _______

Consumer Friendly Plan: How to Achieve Profitability  Break Even analysis: at what per minute price would Virgin break even:  Virgin’s monthly ARPU: ______________ where p=price per minute  Assume Virgin’s customers use 200 minutes per month (midpoint of estimate between 100 and 300, p.7)  Monthly cost to serve: ______________  Assume monthly cost to serve is 45% of revenues (Exhibit 11)  Monthly margin: _______________  p > ________ LTV = -_____ > 0

Other Price Points  What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents:  At 10 cents:  At 25 cents: LTV =- ____ = _____ LTV =- _____ = ____

Virgin’s Pricing Plan: What Happened?  A prepaid plan  No contracts  No hidden charges  No peak off peak hours  Very low handset subsidies  No credit checks  No Monthly bills  Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day  No exact numbers, but churn rate lower than 6%

FROM HERE FOR EXAM 2

Collusion 15

Collusion and Cartels  A group of firms who have agreed explicitly to coordinate their activities to raise market price or decrease market output.  Cartel members agree to coordinate their actions  Prices  Market shares  Exclusive territories  Prevent excessive competition between the cartel members Collusion Cartel An attempt to suppress competition

Why doesn't everyone collude?  Illegal.  In the US, collusive agreements cannot be enforced by legal contracts  International cartels do exist, however.  Hard to come to an agreement.  Strong incentives to cheat -- collusion may not be sustainable.

Types of Collusion  Tacit Coordination/Facilitating Practices.  Explicit Conspiracy.

1. Tacit Coordination  Spontaneous cooperation resulting from strongly perceived interdependence.  For example, following a rival’s price change.  Difficult to achieve with lots of firms.  Hard to find/prove/correct.  Facilitating practices:  Price matching  Most Favored consumer clause

2. Explicit Conspiracy  Price fixing agreement.  Formal cartel.  Per se illegal.

What are the Incentives to Collude?  Start with a simple model of a Bertrand Duopoly  Without collusion, p 1 *= p 2 *= MC=c and thus  i = 0  Industry quantity is set at the perfectly competitive level  For a monopolist, price is set where MR = MC:  P = a-bQ so MR = a -2bQ  Set c = a-2bQ and solve for monopoly quantity and price  Q M = (a-c)/2b and P M = (a+c)/2  So  M = (P M - c)*Q M = (a+c - 2c)/2 * (a-c)/2b = (a-c) 2 /4b  If each firm produces 1/2 Q M, each gets (a-c) 2 /8b

Collusion in the Prisoner’s Dilemma Framework Firm 2 Firm 1 ColludeDefect Collude Defect (a-c) 2 /8b, (a-c) 2 /8b 0, 0 But what about the two empty cells?

To fill in the two empty cells:  If one firm sets price at the monopoly level, what price will the cheater set?  p i * = p M -   Then the cheater gets all the demand and earns a profit only slightly less than what a monopolist would get:   C = (P M -  -c)*(Q M +  )  ((a+c)/2 -c)*(a-c)/2b = (a-c) 2 /4b  Profit of non-cheater is 0

Collusion in the Prisoner’s Dilemma Framework Firm 2 Firm 1 ColludeDefect Collude Defect (a-c) 2 /8b, (a-c) 2 /8b 0, 0 (a-c) 2 /4b, 0 0, (a-c) 2 /4b

Factors that Affect the Success of Collusion  Small number of firms in the market  Lowers search, negotiation and monitoring costs  Similar production costs  Avoids problems of side payments  Detailed negotiation  Misrepresentation of true costs  Lack of significant product differentiation  Again simplifies negotiation – don’t need to agree prices, quotas for every part of the product spectrum Low cost of an agreement

Collusion and cartels  Cartels have always been with us; generally hidden  Electrical conspiracy of the 1950s  Garbage disposal in New York  Archer, Daniels, Midland  The vitamin conspiracy  But some are explicit and difficult to prevent  OPEC  De Beers

Whistleblowers and Recent events  European Truck makers price fixing:  MAN and Scania, both owned by German auto giant Volkswagen as well as Daimler, DAF of the Netherlands, Iveco of Italy and Sweden's Volvo are accused of forming an illegal cartel between 1999 and 2011  MAN will escape the prosecution because it reported the price-fixing cartel  Likely to be one of the largest EU price fixing fines ($4 bn)  Unilever and Procter & Gamble (2011)  Fined 315 m euros for fixing washing powder prices  Tip-off by Henkel (German company) – whistleblower Whistleblower clause - leniency policy aimed at encouraging people involved in collusion to report it, by promising the first member to blow the whistle that they will not face fines or prosecution.

Fines in EU

F. Hoffman-LaRoche Ltd.Vitamins1999$500International BASF AG (1999)Vitamins1999$225International SGL Carbon AGGraphite Electrodes1999$135International UCAR International Inc.Graphite Electrodes1998$110International Archer Daniels Midland co.Lysine and Citric Acid1997$100International Haarman & Reimer Corp.Citric Acid1997$50International HeereMac v.o.f.Marine Construction1998$49International Hoechst AGSorbates1998$36International Showa Denko Carbon Inc.Graphite Electrodes1998$32.5International Fujisawa Pharmaceuticals Co.Sodium Gluconate1998$20International Dockwise N.V.Marine Transportation1998$15International Dyno NobelExplosives1996$15Domestic F. Hoffman-LaRoche Ltd.Citric Acid1997$14International Eastman Chemical Co.Sorbates1998$11International Jungblunzlauer InternationalCitric Acid1997$11International Lonza AGVitamins1998$10.5International Akzo Nobel Chemicals BV & Glucona BVSodium Gluconate1997$10International Cartel violations in the 90s html?mod

Ten highest cartel fines per case

INFORMANT

Example: Cell Phone Industry

Tacit Collusion  Industry is an oligopoly  Top four firms dominate almost the entire market  Same phone (e.g. iPhone from AT&T or Verizon?), data services (text, , etc)  Agreement on price is easier to come by and cheating is easier to catch  Less incentive to cheat because it is a one- time sale product rather than a product from which sellers could gain a series of sales Mechanisms Homogeneous Products Nondurable Goods

Tacit Collusion: Pre-Announced Rate Changes  Service providers typically pre-announce rate changes they plan on implementing  Advanced notice gives competing firms time to respond  Can test the market and competitors

Tacit Collusion: Infrequent High Changes in Rates  Rate changes in the industry have been high and infrequent, yet coordinated across all four firms  FOCUS: Text Messages  Supply is almost unlimited so in a competitive market prices should decrease not increase over time  Since 2005 price per text has doubled. [IBISworld]  Service providers do not claim that these increases were driven by higher costs so other methods must be at work.

Price Matching Guarantees  Price matching guarantees  Helps a firm to protect its consumers and charge a high price.  It makes your competitor “soft.”  Takes away the benefit for your competitor to undercut your price.

Counter-Intuitive?  Price matching guarantee is simply a mechanism for tacit collusion or competition reduction between firms.  Any offer of the price matching guarantee means effectively taking away any gains that its competitor might get from cutting price.  If a firm offers a price matching guarantee, then a search consumer will buy from it because the consumer knows that in the event that there is a lower price offered in the market the consumer is insured that it will match that price.  Since price matching takes away the gain from price cutting, no firm cuts price and price competition is reduced.

Example  Two firms: Firm 1 and Firm 2  Two prices: low ($4) or high ($5 )  3000 captive consumers per firm  4000 floating go to firm with lowest price  Payoffs = revenue Firm 2 LowHigh Firm 1 Low,, High,,

Example  Two firms: Firm 1 and Firm 2  Two prices: low ($4) or high ($5 )  3000 captive consumers per firm  4000 floating go to firm with lowest price  Payoffs in thousands of $ (revenue)  Both low = 5000*4 = $20K  Both high = 5000*5 = $25K  One high = 3000*5=$15K  Another low = 7000*4=$28K Firm 2 LowHigh Firm 1 Low 20,20 28,15 High 15,28 25,25

Contracting with Customers  The game is a prisoner’s dilemma  Both firms prefer: {High, High}  Only equilibrium: {Low, Low}  Cannot credibly promise to play High  Even if committed to High, other firm would still respond with Low  How to resolve this?  Third party contracts with customers

Price Matching  If one firm charges low, it does not gain any additional customers, since the competitor “automatically” matches it.  What is the effect on the game?

Price Matching Firm 2 LowHigh Firm 1 Low 20, 20 28, 15 High 15, 28 25, 25 Firm 2 LowHigh Firm 1 Low 20, 20 High 20, 20 25, 25