Business Applications of Microeconomic Theory

1. Business Applications of Microeconomic Theory Robert S. Pindyck May 2007

2. BUNDLING • Capture consumer surplus (15.010) • Vacation packages • Complete meal vs. à la carte • Complementary products • Operating system & applications software • Medical diagnostic imaging equipment and service of the equipment • Bundling to reduce cost • Means of deterring entry • Microsoft Office (Word, Excel,…) • Hotel/Resort room price includes meal • Bundles competing against bundles • Office productivity software • Vacation packages • Medical devices • In all cases, need some market power

3. Complementary Products • Two products are complements when increase in sales of one leads to increase in demand for the other. Good example is computer operating system and applications software that runs on that operating system. • Afirm that produces both products should set lower prices than would two independent firms, each of which sells just one. • Reason: lower price for one product generates additional sales of that product and the complementary product. Afirm that produces both products internalizes this demand spillover. • Bundling becomes profitable when profit-maximizing price for one of the goodsis zero (or negative).

4. Example • Firm sells two complementary products with demand curves: • Choose prices P1 and P2 to maximize total profit: • Suppose parameter values are: • In this case the profit-maximizing prices are P1 = $55 and P2 = $5. • Thus, the firm should sell Product 2 below its marginal cost. • Why? To generate more profit by stimulating additional sales of Product 1.

5. Product Line Pricing: If you sell products with interrelated demands (substitutes or complements), you must price the products jointly, not individually. • Dell: Computers and monitors • Adobe: Photoshop and Photoshop Elements • Xerox copiers: Machines and service • Supermarket: Gourmet foods and staples

6. Now set bo= 40 instead of 50. • In this case, the profit-maximizing prices are P1= $58.33 and P2= - $1.67. • Now, relatively low demand for Product 2 coupled with the strong complementary leads firm to set P2below zero to stimulate sales of Product 1. • In practice, negative price is unlikely to be more effective than price of zero. • Clear incentive to distribute the product at no charge. • If instead we set P2= 0, then profit maximizing price for first good is P1=$57.50 • The two goods can then be sold as a bundle, for price of $57.50

7. Bundling To Deter Entry • Suppose a firm has market power in production of two goods, A and B, but faces potential competition from entrant deciding whether to produce B. • Bundling the two products together might deter entry, because it reduces the size of the market for the entrant. • Bundling allows monopolist to defend both products without having to set low prices for each. • Bundling is particularly effective in this case when demands for the two products are positivelycorrelated and marginal costs are low. • “Monopoly Leveraging”

8. Suppose demands are perfectly positively correlated: consumers willing to pay $100for one product are also willing to pay $100 for the second. • A monopolist has been producing both products and selling each for $100. • Monopolist could bundle the two products and sell the bundle for $200. • Consider potential entrant who thought of selling the second product at a price of $100. • Entrant would face greatly reduced demand, since most consumers would be better off simply paying $200for the bundle. • Depending on size of sunk cost andfixed cost needed to enter, this could deter entry.

9. Examples • Hotel on Caribbean island has a restaurant. There are also some local restaurants. Demands are positively correlated. • Suppose meals are bundled with the room price. • Local restaurants may not have the scale to survive. Leveraging gives hotel market power in restaurants. • Microsoft Office: Bundle Word, Excel, etc. Demands for components are positively correlated. • Deters potential entrant in, say, spreadsheet programs. There is no longer sufficient potential scale to justify sunk cost of development.

10. Microsoft Windows and Internet Explorer. • Because IE is bundled, Netscape's potential market is reduced. • Netscape share fell from 85% to about 10%- 0% • Potential to deter entry in future operating systems: * Control JAVA. * Inter-temporal economies of scope.

13. BUNDLING—KEY POINTS • Can use to capture consumer surplus (15.010). Works best when consumers' preferences are negatively correlated. • Firm selling complementary products may want to price one product below marginal cost, or even at zero. Then bundle. • The firm and consumers are better off. • Often benefits: operational efficiencies (software), avoid finger-pointing (servicing high-tech equipment). • Bundling can reduce costs. • Bundling to deter entry: monopoly leveraging. • Need economies of scale or scope. • Can reduce competition and harm consumers • Bundles competing against bundles. • Reduces product differentiation and thus market power. • Can lead to lower prices, and benefit consumers.

14. BRAND PROLIFERATION AND ENTRY DETERRENCE • Brand Characteristics- Attribute Space • What kinds of brands to introduce? • Introducing brands to deter entry and maintain market power.

17. Brand Proliferation As A Barrier To Entry • Long-run total cost of producing and marketing a brand: • Demand function for each brand:

18. All brands charge same price p. Potential entrants face a demand curve with sharp kink at price p. Thus, any new entrant would also charge p. • Profits of a typical brand are: • Given p, let N* be the solution of ( p , N*) = 0. Already established brands are therefore profitable as long as N < N*.

19. Suppose there are four brands. For each competitor, local "brand density" is 4. • Suppose a new entrant comes in. New entrant locates mid-way between two existing brands. Thus, for new entrant, local brand density is 8, not 4.

20. Suppose there are N brands evenly distributed around circle. Then average brand density would be N. Suppose N is such that Each existing brand makes a profit, because N < N*. • What if a new entrant tries to come in? Since that entrant would face a local brand density of 2N, it would suffer losses. • Note the importance of brand immobility.

21. Nature Of Inter-firm Competition • Expect to see only limited price competition. However, expect to see very aggressive competition through advertising and new product introductions. • Self-reinforcing process: The more effectively established brands are differentiated through advertising, the less incentive any seller has to engage in price competition. • Also, because advertising expenditures are fixed costs, they help to deter entry. Anexisting brand will be kept on the market as long as variable costs are covered, but an entrant will only come in if it can expect to cover total costs.

22. Aggressive advertising also makes sense in terms of the optimal advertising-to-sales ratio: • EAis relatively high, and Epis relatively low. • Thus advertising-to-sales ratio should be high. • However, this means much of the extra profits from entry deterrence will be wasted away by heavy advertising and introduction of new brands.

23. We have seen some entry in the breakfast cereal market by privatelabelers. What made entry by an aggressive private labeler difficult in the past? What has changed to allow greater entry by private labelers? • How can we explain the successful entry of "natural cereals," which were introduced by new firms during the 1970s?

24. How to Explain the Success of Kashi?