Business and Industrial Economics

FIVE CENTRAL ASSUMPTION OF PERFECT COMPETITION

Atomicity

- Product homogeneity product differentiation

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- Perfect information (every agent, firms and consumers) know the price charged by every firm

- Firms have access to all technologies

- No entry and exit barriers (free entry and exit)

- downward-sloping demand curve. (Firm has the market

Firm is a price-maker. Each firm faces a

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power). Monopolistic Competition in the Short Run

Monopolistic Competition in the Long Run

Social welfare loss:

Productive inefficiency: firms do not produce anymore at the minimum of average cost curve.

- Allocative efficiency: price is not equal to marginal cost.

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monopolistic competition is not good in terms of efficiency.

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Hotelling models of product differentiation lead to similar conclusion

Hotelling is an economist.

Consumers distributed e.g. on ice cream with two

firms selling ice cream, they cannot choose the

price but the location in order to maximize their

profits (price is not discriminating but the location

for customers since they want to minimize their

travelling).

Every consumer will buy at least one unit of a

product and they want to minimize the distance

from where the firms locate. The location is

maximising social welfare if it is at ¼ (A) and ¾

(B) but this solution will never merge because

firm B wants to move where A (B’) is because

there she would take ¾ of the market. Nash

equilibrium (no one would move): in the middle.

Hotelling (re-elaborated): firms at the two extremes.

QUESTION

Goods 1 and 2 are not homogeneous (transport costs). Producers 1 and 2 face negatively sloped demand

curves. Accordingly, producers 1 and 2 charge p>MC (i.e., market power). Higher transport costs (i.e.,

higher “love for variety”) imply higher market power.

What are the welfare implications of product differentiation?

PRICE DISCRIMINATION

Internet and digital markets are perfectly competitive markets. Internet is the more competitive market:

there are more favourable conditions for the consumer.

Many observers believe it:

Information enhancements on the demand side

“...The explosive growth of the Internet promises a new age of perfectly competitive markets. With

perfect information about prices and products at their fingertips, consumers can quickly and easily find

the best deals. In this brave new world, retailers' profit margins will be competed away, as they are all

forced to price at cost..." (The Economist, November 1999).

monitor more easily suppliers through internet (e.g. easy to search for the lowest price).

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Information improvements on the supply side

“...The Internet is a nearly perfect market because information is instantaneous and buyers can compare

the offerings of sellers worldwide. The result is fierce price competition by sellers” (Business Week, May

1998).

observe behaviours

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More information means more perfectly competitive markets!

One of the five central assumption of perfect competition is the perfect information.

Moreover:

No “menu costs”: changing the price of a good costs a “click”, there is no need to print a “menu”: no costs

in changing prices.

Low geographic barriers, markets become more global and global.

Not really.

has perfect competition become more common?

à Baye, Morgan & Scholten’s project (c.a. price of 5,000

homogenous products over time sold in Internet).

Average difference for all these products in the time

span 2000-2007 between the “lowest and highest

seller” range from 30-50%.

High price dispersion between sellers of

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homogeneous products.

Why for many (homogeneous) goods sold in the Web we do not observe a unique price and perfect

competitive outcomes?

1) Brand reputation matters: importance of trust that increases brand reputation.

Brynjolfsson and Smith, 2000, MS:

- TRUST (p. 578):”… trust is among the most important components of any effective Internet

marketing program (see, e.g., Urban 1998). Indeed, we note that the importance of trust may arise

directly from the characteristics of the Internet. Specifically, while the importance of factors such as

may be reduced on the Internet,

search costs factors such as trust may play an enhanced role because

Most

of the spatial and temporal separation between buyer, seller, and product on the Internet.

consumers have little history or physical contact with Internet retailers and they must be wary of a

falling prey to a site that posts low prices but is proficient only in charging credit cards, not delivering

the goods.”

2) “Service-premium strategies” differentiate homogeneous products (delivery time capability, refund

policies, ease of ordering through websites): differentiate by adding services to products.

Internet search on “price comparison portal” Bizrate.com.

Services typically added to differentiate a product: delivery time, return process, information to finalize

transaction, …

The more a firm invest in service-premium strategies, the more it spends, but the more is capable to

raise price.

3) Increased possibilities for collusion. A high amount of information may incentivize firms to collude

(instead of having the opposite effect).

e.g. two major online bookstores: comparison of the price on a given sample of books: price are quite

similar and when the book is not anymore in the top five the price increases in both cases.

Sustainable over time: no firms have an incentive for moving from collusive agreement.

this is a typical temporal dynamics of a market where “bog players” are colluding. Why?

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INTUITION:

Firms collude on price.

In periods of:

High demand High incentive to deviate from the cartel (i.e. higher profits at the expense of

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- the other firms) collusive price has to be reduced in order to reduce the incentive to deviate

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and make sustainable the cartel.

Low demand Low incentive to deviate from the cartel (i.e. lower profits at the expense of the

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- other firms) collusive price can be raised since incentive to deviate is low and the cartel is

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still sustainable.

4) Increased recognisability of consumers through their web-shopping, more possibilities of tailoring

offer to customers and propose different versions of products (price discrimination strategies).

Increased recognisability of consumers and possibilities for personalized offers: internet helps in

understanding customer preferences and personalize offer: the consumer may buy r not without

knowing the offer to other consumers.

PRICE DISCRIMINATION STRATEGIES: capacity of offering different products at different prices.

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PRICE DISCRIMINATION

Why do firms want to “discriminate”?

Perfect price discrimination (I°)

(Pigou, 1920): One consumer - One price for each unit sold.

Each customer is charged a different price – exactly matching exactly his/her willingness to pay for each

unit Max producer surplus.

- Max Social Welfare.

- Equity problems: no consumer’s surplus.

- Problems:

- Which is the wtp of each consumer is difficult to know

- Difficult to avoid arbitrage (absence of resale).

-

3° Price discrimination

The purpose is to make more profits.

“Group” Pricing: different prices for different groups of consumers, same price within the same group.

Selection by (exogenous) indicators: (seller want to segment the market according to some indicators)

Age

- Occupation

- Geography

-

Examples: geographical market segmentation (books in India and UK); special discounts (senior (over

65 pay less), student, …).

Example of a 3 degree price discrimination: may be also cause by a cost differential.

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Trick: apply elasticity rule to each market segment.

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Divide the market in sub markets and try to maximize the profits in each one of them. It is always better

for the firm to perform a price discrimination if there is the possibility and less elastic markets are

richer.

2° Price discrimination

Self-selection by consumers: seller cannot directly identify consumer type, but can still induce

consumers to distinguish themselves. This selection may be based on the willingness of consumers to

consume:

different quantities (so price paid by consumers depends on the quantity of the good consumed:

- non linear-pricing, bundling)

different versions of the same product (Versioning): (often) case of VERTICAL

- DIFFERENTIATION (premium vs basic version).

It is an ancient pricing mechanism (transportation): “It is not because of the few thousand francs which

would have to be spent to put a roof over the third-class carriages or to upholster the third-class seats

that some company or other has open carriages with wooden benches... What the company is trying to

do is to prevent the passengers who can pay the second-class fare from traveling third class; it hits the

poor, not because it wants to hurt them, but to frighten the rich. And it is again for the same reason that

the companies, having proved almost cruel to third-class passengers and mean to second-class ones,

become lavish in dealing with first-class passengers. Having refused the poor what is necessary, they

give the rich what is superfluous.” (Jules Depuit, “On Tolls and Transport Charges”, 1849)

Very much used also nowadays e.g. end of season sales, 2x1, cinema 2€ one day per month.

With the price discrimination we make consumers reveal themselves and their preferences: most of the

time is not easy to find features (exogenous characteristics) to segment the market.

VERSIONING

to sell more than one version of the same product (e.g. premium and basic) at different prices

Aim:

targeting different segments of consumers (experts and beginners). This applies also when the low

quality version has the same cost of production of the high quality one (or even higher) (to create more

than one version first of all is created the premium one and then the basic by disabling some services

and so on which are the costly services):

Software: Basic version obtained by degrading the premium through the disablement (bearing

- some costs) of some functions;

Information services about share prices: the “delayed” version is produced with some additional

- costs with respect to the “immediate” version.

Leave that consumers choose the version they prefer (self-selection).

Versioning is possible along different dimensions.

Profits with low uniform pricing (no

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discrimination) = 5000€ (sell only the immediate version)

With 1 price discrimination (seller recognize the

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willingness to pay of customers) = 7000€ - with 1 price

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discrimination (4000+3000) –

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