Economics of Management Strategy BEE3027

Economics of Management StrategyBEE3027 Lecture 5

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

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.

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; • Firm’s production capacity must be fixed in the medium term; • There is no possibility to store excess output.

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

Peak-Load pricing • So, the airline’s total cost equals: • We know that the monopolist will set Q such that MR=MC. • The question facing the monopolist is that MC is now a function of passenger cost as well as capacity!

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:

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?

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.

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.

Tying • So far we’ve 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?

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.

Tying Consumer valuations of X and Y are either H or L H > L > 0

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 = 4L+2(H-L) = 2H + 2L

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

Tying • Monopolist will choose pricing policy which gives it highest profit. • It will set Px=Py = H if: 2H > 4L => H > 2L • Conversely it will set Px=Py = L if: H < 2L

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(H+L) • Consumer surplus = 0!

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.

Tying

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

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.

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

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

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.

Economics of Management Strategy BEE3027