Economics of Management Strategy BEE3027 Lecture 5

Reminder!!! Essay deadline: 27 th 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 XY Consumer 1HL Consumer 2LH 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 XY Consumer 140 Consumer 233 Consumer 304

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 = 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 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.