Econ 201 Spring 2009 Lecture 6.1d

1. Econ 201Spring 2009Lecture 6.1d Finishing Up Monopolies: Tie-in sales, predatory pricing and dumping

2. Take Home Problem • Are these reasonable examples of 2nd degree price discrimination? • The traditional end of season sale. • Reduced prices for cinema and theatre in the afternoons. • Last minute bargain holidays. • Two parts to answering this problem: • Provide an explanation consistent with 2nd degree price discrimination • Provide an alternative explanation

3. A Quick True/False Question • Ch. 9, #6 • T/F Firms can benefit from charging a price below the market level in a competitive marketplace. Briefly explain, why or why not.

4. In Class Problem • The following is your demand schedule for buying trees to landscape your home: • a)at $6, you buy 5 trees. After this the seller offers to let you buy 1 more at $5. Do you? • b) after this, he offers to let you buy as many more as you want at $3. How may do you buy? • c) if he had initially offered to let you buy as many as you wanted at $3, how many would you have bought? • d) suppose that instead you could pay a membership fee of $5 to purchase as many trees as you wanted at $3 per tree, how many would you buy? (price at other nurseries is $4 per tree)

5. Possible Consumer Offsets to Price Discrimination • Some consumers might benefit from this type of pricing • “priced into the market" when they might not have been able to afford a product. • Possible that cross-subsidization may occur as the profits earned in one sector are used to subsidize the losses made in another market. • may be beneficial to society as a whole

6. Lots of Example’s from the Phone Industry • Cross-subsidization • Prior to the 1996 Telecomm Act which deregulated local phone service • Businesses where charged 2-3x the residential landline rate for the same service (B-1 lines), and charged higher toll rates • Business rates were used to subsidize • Residential landline rates (promoting “universal” access) • lifeline programs for rural and low-income customers • Low toll volume users (i.e., residential) rates

7. Other Monopolist Pricing Strategies • Zone Pricing: 3rd degree • Block Pricing: 2nd degree • Tie-in Sales • Predatory Pricing • Dumping • All aimed at extracting Consumer Surplus

8. Tie-In Sales • A tie-in sale: • consumer can only obtain the desired good (tying good) if he agrees also to purchase a different good (tied good) from the producer. • What it accomplishes: • (1) the tie-in can be a substitute for a lump sum payment tailored to extract the consumer’s surplus in the tying good market; • (2) the tie-in serves to price discriminate among types of consumers having different demand elasticities;

9. Optimal Pricing Strategyfor a Tie-in Sale • Lower price in the market where demand is more elastic • Raise price above MC in the more inelastic market

10. The IBM Example • IBM tied-in the sale of computer cards with its mainframe computers • IBM would not honor product warranty otherwise • IBM does not know individual firm’s WTP for a computer • However, if WTP is correlated with use, then high users -> use/demand more cards

11. IBM Example • So optimal pricing strategy • Can’t charge different prices, so set price so as to sell to both high and low demand customers • Price cards at > MC in order to extract CS • Boeing • Airplane market was more competitive • WTP correlated with miles • Tied-in on-board navigational systems

12. Predatory Pricing • Predatory pricing • firm sells a product at very low price with the intent of driving competitors out of the market, or create a barrier to entry into the market for potential new competitors. • If the other firms cannot sustain equal or lower prices without losing money, they go out of business. • The predatory pricer then has fewer competitors or even a monopoly, allowing it to raise prices above what the market would otherwise bear. • In many countries, including the United States, predatory pricing is considered anti-competitive and is illegal under antitrust laws. However, it is usually difficult to prove that a drop in prices is due to predatory pricing rather than normal competition, and predatory pricing claims are difficult to prove due to high legal hurdles designed to protect legitimate price competition.

13. The Standard Oil Case • Rockefeller’s Standard Oil Monopoly (1911) • The efficiencies of economies of scale and vertical integration caused the prices of refined petroleum to fall from over 30 cents a gallon in 1869 to 10 cents by 1874 and to 5.9 cents by 1897. During the same period, Rockefeller reduced his average costs from 3 cents to 0.29 cents per gallon. • Contrary to popular mythology, Standard Oil’s market share declined from 88 percent in 1890 to 64 percent by 1911. Because of intense competition the company's oil production as a percentage of total market supply had declined to a mere 11 percent in 1911, down from 3 percent in 1898. • McGee shows that rather than practicing predatory pricing. Std Oil was able to build its monopoly through the purchase of other refineries. • McGee, John S. "Predatory Price Cutting: The Standard Oil (N.J.) Case."J. Law and Econ. 1 (October 1958): 137-69.

14. Another Explanation • McGee, John, "Predatory Price Cutting: The Standard Oil (N.J.) Case," Journal of Law and Economics Vol 1 (April 1958) • Buy out other gas stations/refineries at a price higher than the competitive value, based on possible future monopolistic value

15. Dumping • "dumping" can refer to any kind of predatory pricing. • Term is now generally used only in the context of international trade law, where dumping is defined as the act of a manufacturer in one country exporting a product to another country at a price which is either below the price it charges in its home market or is below its costs of production. • The term has a negative connotation, but advocates of free markets see "dumping" as beneficial for consumers and believe that protectionism to prevent it would have net negative consequences. • Advocates for workers and laborers however, believe that safeguarding businesses against predatory practices, such as dumping, help alleviate some of the harsher consequences of free trade between economies at different stages of development

16. What’s the Downside to Monopolies? • Economically inefficient • Deadweight loss • Higher price and lower quantity demanded/supplied • Efficiency loss: consumers MV (WTP) > MC of resources used to produce the good • Transfer losses • From CS to PS • Economists have no opinion • Pareto efficient • No/less incentive for innovation

17. Natural Monopolies • In economics, the term monopoly is used to refer to two different things. This has been a source of some ambiguity in discussions of "natural monopoly".[1] The two definitions follow: • An industry is said to be a natural monopoly if one firm can produce a desired output at a lower social cost than two or more firms—that is, there are economies of scale in social costs.[2][1] Unlike in the ordinary understanding of a monopoly, a natural monopoly situation does not mean that only one firm is providing a particular kind of good or service. Rather it is the assertion about an industry, that multiple firms providing a good or service is less efficient (more costly to a nation or economy) than would be the case if a single firm provided a good or service. There may, or may not be, a single supplier in such an industry. This is a normative claim which is used to justify the creation of statutory monopolies, where government prohibits competition by law. Examples of claimed natural monopolies include railways, telecommunications, water services, electricity, and mail delivery. Some claim that the theory is a flawed rationale for state prohibition of competition.[3], [4] • An industry is said to be a natural monopoly (also called technical monopoly) if only one firm is able to survive in the long run, even in the absence of legal regulations or "predatory" measures by the monopolist. "[1] It is said that this is the result of high fixed costs of entering an industry which causes long run average costs to decline as output expands (i.e. economies of scale in private costs).

18. Market Conditions for a Natural Monopoly • Scale is such that it is cost-efficient for only 1 firm to supply the market, i.e., economies of scale

19. Telecommunications – an Example • Natural monopolies tend to be associated with industries where there is a high ratio of fixed to variable costs. For example, the fixed costs of establishing a national distribution network for a product might be enormous, but the marginal (variable) cost of supplying extra units of output may be very small. In this case, the average total cost will continue to decline as the scale of production increase, because fixed (or overhead) costs are being spread over higher and higher levels of output • The telecommunications industry has in the past been considered to be a natural monopoly. Like railways and water provision, the existence of several companies supplying the same area would result in an inefficient multiplication of cables, transformers, pipelines etc. However the perception of what constitutes a natural monopoly is now changing - in part because of the impact of new technology in reducing traditional barriers to entry within markets. • In the case of the telecommunications industry in the UK, British Telecom has faced increasing levels of competition from new telecommunications service providers during the 1990s - not least the rapid expansion of mobile and cable services. This has led to a change in the role of the industry regulator (OFTEL). Its main role now is not necessarily the introduction of even more competition into the telecommunications industry - but a policing role to ensure fair competition between service providers.