OT Should firms employ personalized pricing? joint work with Noriaki Matsushima

OT Our works related to this paper (1) Welfare Properties of Strategic R&D Investments in Hotelling Models (Economics Letters 2012). (2) Locating Outside a Linear City Can Benefit Consumers (JRS forthcoming). (3) When Small Firms Fight Back against Large Firms in R&D Activities (BE Journal of Economic Analysis & Policy 2010). (4) Congestion-Reducing Investments and Economic Welfare in a Hotelling Model (Economics Letters 2007). (5) Endogenous Cost Differentials between Public and Private Enterprises: A Mixed Duopoly Approach (Economica 2004). All are with Noriaki Matsushima

OT Strategic Commitment

OT Cournot Equilibrium Y1Y1 the reaction curve of firm 2 0 Y2Y2 the reaction curve of firm 1 Y1CY1C Y2CY2C

OT Shift of the Reaction Curve Y１Y１ the reaction curve of firm 2 0 Ｙ２Ｙ２ the reaction curve of firm 1 (after) Y１CY１C Ｙ２CＹ２C the reaction curve of firm 1 (before) the shift reduces the rival's output →resulting in the increase of its profits

OT Stories of the shifting reaction curve (1) Cost-Reducing Investments (2) Delegation, Reward Contracts (3) Divisions, Franchising (4) Financial Contract (5) Inventory (6) Capacity Investment (7) long-Term Contract (8) Durability (9) Product Differentiation

OT Cost-Reducing Investments Brander and Spencer (1983) Model Duopoly, homogeneous goods market First stage: Each firm i independently chooses I i (R&D investment level), which affects its production costs. Second stage: After observing firms' production costs, firms face Cournot competition. Payoff: Π 1 =P(Y 1 +Y 2 )-C 1 (I 1 )Y 1 -I 1

OT backward induction Second Stage: Cournot Competition Y 1 C (I 1,I 2 ), Y 2 C (I 2,I 1 ) The output of the firm is increasing in its own investment level and is decreasing in the rival's. (Remember the discussions in 2nd and 4th lectures) First Stage: The first order condition for firm 1 is P'Y 1 (∂Y 1 C /∂I 1 + ∂Y 2 C /∂I 1 )+P ∂Y 1 C /∂I 1 -C 1 '(I 1 )Y 1 - C 1 ∂Y 1 C /∂I 1 -1=0

OT First stage At the first stage The first order condition is P'Y 1 (∂Y 1 C /∂I 1 + ∂Y 2 C /∂I 1 )+P∂Y 1 C /∂I 1 -C 1 '(I 1 )Y 1 - C 1 ∂Y 1 C /∂I 1 -1=0 P'Y 1 ∂Y 2 C /∂I 1 -C 1 '(I 1 )Y 1 -1=0 (envelope theorem) Cost-Minimizing Level -C 1 '(I 1 )Y 1 -1=0 Investment level exceeds cost minimizing level under strategic substitutes~ strategic effect a decrease of its own marginal cost →a reduction of rival's production→an increase in the price→ gain of the profit ⇒ strategic use of R&D.

OT Shift of the Reaction Curve Y１Y１ The reaction curve of firm 2 0 Ｙ２Ｙ２ The reaction curve of firm 1 (after) Y１CY１C Ｙ２CＹ２C

OT Shifts of the Reaction Curves Y１Y１ the reaction curve of firm 2 (after) 0 Ｙ２Ｙ２ the reaction curve of firm 1 (after) Y１*Y１* Ｙ２*Ｙ２* the shifts reduce the profit of both firms ~ Prisoner's Dilemma

OT strategic complements case Y1Y1 The reaction curve of firm 2 0 Y2Y2 The reaction curve of firm 1 Y2CY2C Y1CY1C Cournot equilibrium

OT strategic complements case Y1Y1 The reaction curve of firm 2 0 Y2Y2 The reaction curve of firm 1 Y2CY2C Y1CY1C

OT Question: Suppose that firm 2's objective is convex combination of sales and profits. Y1Y1 0 Y2Y2 the reaction curve of the profit maximizer

OT Objective of firm 2 and Cournot equilibrium Y1Y1 0 Y2Y2 The profit of profit-maximizing firm (firm1) can be smaller than that of non-profit- maximizing firm (firm 2).

OT managerial incentive Deviation from the profit-maximizing behavior ~ a more aggressive behavior than the profit- maximizing behavior →resulting in a decrease of the rival's output, yielding an increase of its profit, through strategic interaction ~Delegation Game (Fershtman and Judd (1987)) The owners have incentives for offering a strategic reward contract (hiring an agent (management) who does not maximize the payoff of the principal).

OT Strategic Substitutes? Complements ？ In the context of quantity competition, strategies are strategic substitute under natural assumptions. In the context of price competition, strategies are strategic complement under natural assumptions.

OT Strategic Commitment and Spatial Competition

OT Two-Stage Location then Price Model The model of d'Aspremont, Gabszewics, and Thisse, (1979, Econometrica) Hotelling, mill pricing Introducing strategic commitment Investment→Location→Price Location ~ Maximal Differentiation Strategic complement at the last sage ～ reducing strategic investment for strategic purpose. von Ungern-Sternberg (1988), Ma and Burgess (1993), Ishibashi (2001), Matsumura and Matsushima (2004, 2007, 2010).

OT Maximal Differentiation ０１ Firm 1 Firm 2

OT Alternative Model Firms can locate outside the liner city Tabuchi and Thisse (1995), Lambertini (1997) Firms locate outside the city in equilibrium so as to relax the price competition.

OT Linear City ０１ Firm 1 Firm 2

OT Strategic Commitment in Location then Price Model revisited Investment→Location→Price In the alternative model, investment affect the rival’s location choice. Question: A higher level of cot reducing investment (increases, decreases) the distance between two firms

OT Linear City ０ １ Firm 2

OT Strategic Delegation in Location then Price Model Strategic wage contract →Location→Price Each firm put strictly positive weight on output in the alternative model, resulting in a larger consumer surplus. Matsumura and Matsushima (JRS 2012)

OT Linear City ０１ Firm 1 Firm 2

OT FOB Pricing versus CIF Pricing

OT FOB Pricing 0 1 Market 0 Market 1 Firm 1 Firm 2 P1+t P1+T P2+T P2+t

OT CIF Pricing 0 1 Market 0 Market 1 Firm 1 Firm 2 P1(0) P1(1) P2(0)

OT FOB Pricing versus CIF Pricing CIF pricing is more flexible than FOB pricing In the first stage, firms choose whether they adopt CIF pricing or FOB pricing. After observing the pricing strategies, firms engage in the standard two stage location then price game. Both firms choose CIF pricing, resulting in a lower equilibrium profit (Prisoners’ dilemma) Thisse and Vives (1988)

OT Interpretation of CIF Pricing CIF pricing corresponds to personalized marketing (Amazon, Google,…). Many firms in fact adopt personalized marketing but non-negligible firm do not adopt it. Why? An answer by the existing works→It is expensive. However, although collecting personal information is in fact time consuming and require some investment, its cost rapidly decreases. We explain it without assuming that CIF pricing is expensive.

OT Our Paper Introducing strategic R&D investment and initial cost difference. In the first stage, firms choose whether they adopt CIF pricing or FOB pricing. In the second stage, firms choose cost-reducing R&D levels. After observing the pricing strategies, firms engage in the standard two stage location then price game.

OT Results When initial cost difference is large, less efficient firm adopts FOB pricing so as to reduce the strategic behavior of the more efficient firm. If firm 2 adopts CIF, the equilibrium prices of firm 1 is costs of firm 2. Thus, R&D of firm 1 does not affects its prices. If firm 2 adopts FOB, the optimal single price of firm 2 depends on firm 1’s cost, and it is increasing in the firm 1’s cost. Thus, a higher level of R&D of firm 1 reduces the prices of firm 1. Therefore, firm 1 choose lower level of R&D to relax competition.

OT Why does only less efficient firm adopt FOB? The more efficient firm has a stronger incentive for R&D investments. Thus, the less efficient firm has stronger incentive to reduce the rival’s R&D and thus it has a larger incentive for adopting FOB pricing. This effect dominates the effect pointed by the effect pointed out by Thisse and Vives (1988).