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

4. 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

5. 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

6. 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

7. 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)

8. 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

9. 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 => 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 => consumer surplus goes up

10. 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 .

11. 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

12. Consumer welfare • Let uI() denote the utility of informed consumers and • uU() denote the utility of uninformed consumers • Then uI() > 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

13. 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

14. 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 => • price dispersion goes up

15. 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