ECONOMICS 3200B
Lecture 9
Ch. 10, 12, 13
November 19, 2014
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Networks
• Networks – externalities
– PCs and software, smartphones and apps, game stations and games, tablets
and apps; wireless networks
– Economies of scope and scale
• Demand per period depends on price and cumulative sales (total
number of customers/users)
• Expectations regarding future size of network influences demand today
for longer-lived products
• Direct network effects
– Benefit to network user depends on how may other users are connected
via the network
• Indirect effects
– Benefit to users because size of network affects price and availability of
complementary products
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Networks
• Direct network effects
– Size of network depends on economies of scale, externalities of
additional connections
• Indirect effects
– Economies of scale in production of complementary products
– Similar in non-network industries – demand for complementary
products depends on total number of consumers
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Networks
• Strategic use of tie-in sales and product design
• Product compatibility reduces price competition
• Tipping point for networks – if one network overtakes another in terms
of size, the other may become insignificant
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VHS and Beta formats for video recording
Apple and DOS operating systems
Plasma vs. LCD vs. LED for flat screen TVs
Sony (Play Station), Microsoft (X-box), Nintendo (Wii)
Apple, Google Android, Microsoft (smart-phones)
• Use standard setting process to gain advantage for one
technology/network
• Announcements of future product availabilities (software) compatible
with a technology
• Switching costs – incentive to develop new products/services which
appeal to new customers because existing customers locked in
– Upgrades – software
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Networks
• Hub and spoke networks – telecommunications,
airlines
– Cost efficiencies
– Demand side effects
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Pricing
• Market power – short-term, longer-term
• Product characteristics – commodity vs. differentiated; network
– Basis for competition
– Cooperative behavior
• Market segments – ability to price discriminate
• Uncertainty re. demand curve (position, shape); competitors’
responses; costs
• Complementary goods – vertical integration
• Consumer information re. quality, reliability (lemons’ model)
• Economies of scale, scope; experience curves
• Signaling effects of price
• Competition law
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Vertical Controls
• Vertical controls – vertical integration and vertical restrictions
– Relationships between upstream and downstream firms
• Vertical integration – firm participates in more than one successive
stage of value chain (production/distribution chain)
• Advantages of vertical integration
– Internalization
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Lower transactions costs – avoid opportunistic behavior
Quality control
Coordination – feeder networks in transportation, JIT delivery
Uncertainty re. prices, availability
– Assure steady supply of key input
– Avoid government restrictions, regulations, taxes
• Regulated utilities and unregulated service companies
• Transfer pricing and allocation of profits
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Vertical Controls
Vertical integration
• Increase market power – foreclose entry, price discrimination
– Increase profits when selling product which is combined with another
input (supplied by competitive industry) to produce a final product (also
sold by competitive industry) – variable proportions production function;
problem does not arise with fixed proportions P.F
• Without vertical integration, competitive industry substitutes other input for
input supplied by monopolist
• Higher costs for downstream firm because input sold by monopolist at P > MC
– Close distribution channels, lock up key suppliers
– Interbrand competition – set up own distribution network to increase costs
of entry
• Ford’s attempt to buy back dealers in order to offset bargaining
advantages of large, independent dealers
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Vertical Controls
Vertical integration
• Eliminate externalities
– Quantity demanded depends upon P and other services provided
– Distribution: free riding among distributors – sub-optimal provision of
services (information, sales staff and waiting times, promotional activities,
after sales service (credit, free delivery), shelf space
– Maintain reputation for quality by controlling distribution
• Downstream retailer provides services
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Q = D(P, S)
S: level of services
Costs to retailer: (S) per unit of output
Total service costs: Q(S)
Vertically integrated solution: Max  = [P – C - (S)] D(P, S)
Optimal price and service level
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Vertical Controls
Vertical integration
• Double monopoly
– M has unit costs of C and sells product to R at P* = PM (C) > C
– R incurs no other costs and sells at PM (P*) > PM (C)
– Q[PM (P*)] < Q[PM (C)], so aggregate profits of R and M lower than if
single monopoly
– If R operates in competitive environment, no negative externality for M
since PC = PM (C)
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P
PM (P*)
P*
C
D
MR
Q2
Q
Q1
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Vertical Controls
Vertical restrictions
• Contracts instead of integration – transactions costs lower than costs of
internalization
• Contractual restraints (prices, forms of behavior) to approximate
outcomes form vertical integration at lower costs
• Upstream firm is monopolist selling to downstream firm(s) – has
bargaining advantage
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Vertical Controls
Vertical restrictions
• Types of contracts:
– Franchise fee – upstream firm charges downstream firm a fixed charge
plus a per unit price
– Resale price maintenance – upstream firms dictates selling price for
downstream firm (price ceilings, price floors)
– Quantity fixing – upstream firm dictates amount to be bought by
downstream firm (quantity forcing if quantity greater than free contracting
quantity; quantity rationing if quantity lower)
– Exclusive territories
– Tie-in sales
– Royalty
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Vertical Controls
Vertical restrictions
• Chicago School: observed vertical restraints meant only to improve
efficiency of real-world vertical relations and not exercise monopoly
power
– Address externality and free rider problems
– Store with reputation for stocking high quality products provides signal to
consumers and thus helps overcome lemons/moral hazard problems
• If certain of these products available at discount store, reputation suffers and
store no longer as valuable a signal of quality
• Consider case of Wal-Mart
• Cost advantages of vertical integration
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Vertical Controls
Vertical restrictions
• Consider case of double monopoly:
– M charges R a per unit price of C and charges a franchise/license fee of
M [PM (C)]
– P = PM (C) and total profits = M [PM (C)]
– Quantity forcing: M requires R to buy Q1 units at P= PM (C)
– Resale price maintenance (RPM): M requires R to set a maximum price
equal to PM (C)
• If demand at retail level depends upon services provided, R may provide suboptimal level of services
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Vertical Controls
Vertical restrictions
• Case of services provided by downstream retailer(s):
– Too high a price and sub-optimal level of services
– Franchise fee = single monopoly profit
– Quantity forcing sufficient to encourage R to charge correct price and
provide optimal level of services
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Vertical Controls
Vertical restrictions
• Multiple inputs case – M sells product which is combined with another
input (produced by competitive industry) to produce final product sold
by monopolist
– Franchise fee and unit price set at M’s MC(C) – no distortion in input use
– Tie-in with RPM – M sells both inputs to downstream firms, sets prices of
both inputs so as to not distort relative prices and extract monopoly profits
– Royalty on number of units sold with input sold at MC
– If final product sold by competitive industry – franchise fee no longer
works because profits = 0 for each of the downstream firms
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P
P2
P1
MC(PM, C*)
MC(C, C*)
D
MR
Q2
Q1
Q
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Vertical Controls
Vertical restrictions
• Intrabrand competition
• Downstream retailers are in competitive market
• Demand depends upon services (e.g., information about product)
provided by retailers
• Provision of pre-sale information by one retailer to consumers who
buys from retailer offering lowest price
• No incentive for any one retailer to provide information because
unable to recover costs of doing so
• Contractual solutions:
– RPM sufficient to guarantee price to cover costs of optimal level of
services – free rider problem still exists
– Exclusive territories
– M provides information and/or other services directly through retailers
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Vertical Controls
Vertical restrictions
• Interbrand competition
• Contractual solutions:
– Exclusive dealing – exclusive territories may be necessary to get retailers
to accept exclusive dealing and M may have to provide promotional
services (e.g. advertising)
– Limits returns to scale for downstream firms
– Increases search costs for consumers since retailers do not carry wide
range of products – Internet may overcome this problem in part
– Contractual solution more likely if M can set up own distribution network
(costs of internalization vs. costs of external transactions and price
competition because of interbrand competition)
– Long-term contract to limit shelf space available for competing products –
exclusive territories, promotional services provided by M, some sharing of
monopoly profits
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Vertical Controls
• Market foreclosure
• Commercial practices (including mergers, acquisitions) to reduce
buyers’ access to supplier(s) – upstream foreclosure; or reduce
suppliers’ access to buyer(s) – downstream foreclosure
– Exclusive dealing
– Tie-ins and/or products made incompatible with complementary products
sold by other firms
• Tie-ins pervasive: shoes, gloves come in pairs; cars with engines; land with
homes
• Tie-ins to protect investments in reputation, minimize problems with product
liability – repair/maintenance services to product
• Entry barrier if entrant has to offer both products
– One-stop shopping – single source of supply of entire range of products
(savings on search and transactions costs, reputation)
– Acquisitions
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Information
• For consumers
– Availability and prices
• Search costs – local monopolies
– Quality and other characteristics
– Reliability – Jetsgo and provision of services
• About consumers
– Preferences, reservation prices
– Demand curve – position, shape (price elasticity)
• For rivals
– Competitive advantages – cost structures, differentiation
– Strategies – technology, product development, capacity, geographic
expansion
– Strategic responses
– Market interaction a game with asymmetric and incomplete information
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Information
• Why information is limited
– Information varies in reliability – rational consumers do not rely
equally on information from all sources
– Cost to collect information
– Consumers can remember and recall readily only limited amount
of information (bounded rationality)
– Efficient to use simplified rules to process information – consumer
compares monthly bills for wireless service, not details
– Lack ability to process information – technology, healthfulness of
foods
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Information
• Quality
• Lemons' model:
– Ex ante, consumers expect quality uniformly distributed: S  [0, 1]
– Ex ante, expected quality is 0.5 – maximum price consumers
willing to pay (P* = expected S) equals expected quality level – P*
= 0.5
– Unit costs depend upon quality: C(S) = S
– Qualities S  [0.5+, 1] will not be supplied
• P – C < 0 for qualities in this range
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New feasible set: S  [0, 0.5], with expected quality = 0.25
Maximum price consumers willing to pay: P* = 0.25
Market degenerates to S=0
Rational consumers and producers expect only lemons to be
supplied (moral hazard for producers), so only lemons supplied
and P*=0
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Information
• Possible solutions to Lemons’ problem
• Full warranties provided by producers
– Producer compensates buyer in full if quality differs
from advertised quality or service not provided
– Quality must be able to be evaluated at low cost and
high degree of reliability ex post by consumers
– Credibility of warranty depends upon reputation of
producer/provider of warranty (Amex provides money
back guarantees to card holders for products purchased
with the card)
• Firms with long history more credible than start-ups – firstmover advantage; entry barrier
• 3rd party providers
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Information
• Possible solutions to Lemons’ problem
• Moral hazard problem if performance (quality) depends
upon use by consumers
– Adverse selection – case of insurance
• Deductibles, co-insurance
– Less than full warranty
• Warranty applies subject to certain conditions regarding use of
product
• Consumers may infer this as signal of low quality
• Standards and certification
• Advertising
– Investment as signal of quality only if quality can be evaluated at
low cost and high degree of reliability ex post by consumers
– Brand names/reputation
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Information
• Classification of products according to ex ante/ex post
information of consumers re. quality
– Search products: quality know ex ante
– Experience products: quality unknown ex ante (at least prior to 1st
time consumption/use), but known ex post after purchase and use
– Credence products: quality unknown ex ante and unknown ex post
even after purchase and use – services
– Importance of reputation
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Information
• Experience products – no warranties
• One-time purchase – e.g.., restaurants in foreign cities
– Assume two possible qualities – SL, SH – with corresponding unit
costs CL < CH and consumers’ willingness to pay PL < PH
– Assume: PH – CH > PL - CL
– Consumers imperfectly informed (non-rational expectations), buy
one unit ( no repeat purchases)
– Assume: U(SH, PH) > U(SL, PL)
– Incentive for producers to claim high quality product even though
low quality: PH – CL > PH – CH
– Lemons’ model
– Trip Advisor and other Web sites
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Information
• Experience products – no warranties
• Repeat purchase – some informed customers, e.g..,
restaurants in foreign cities again
– Assume some consumers informed of quality because of past
purchases
•  informed
– If producer’s quality is SH : H = PH – CH per unit and all
consumers buy
– If producer’s quality is SL : L = (1-  )(PH – CL ) per unit and only
uninformed consumers buy
– Monopolist supplies SH if H > L
•  PH > CH – (1- ) CL
• Sufficiently high price for high quality product, large proportion of
informed consumers, small unit cost differential
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Information
• Experience products – reputation, brand names
• Repeat purchase – repeated games
– Two-period game
– Price in pd. 1 is P1 : PH > P1 > PL (a priori probability that quality is
SH is X)
– If monopolist produces SH : H = (P1 – CH) + (PH – CH)
– If monopolist produces SL : L = (P1 – CL) + (PL – CL)
– Assume: PL – CL = 0
– H - L = (PH – CH) – (CH - CL)
• Future return from goodwill less cost disadvantage
– Two-period game: fixed end-point, Prisoners dilemma – no
incentive to build goodwill (brand name)
– Warranty
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Information
• Repeat purchase – repeated games
– In multi-period game with uncertain end-point or infinite number
of periods, incentive to build up goodwill and greater return on
goodwill
– Low introductory offer in period 1 to attract customers to high
quality product
– Reputation
– Alternatively, firm invests in advertising in period 1 – commitment
to demonstrate credibility
• Only high quality supplier can invest in advertising and earn return on
investment
– Leverage brand name into other products/geographic markets
• Overcomes entry barriers
• Examples: Armani into perfumes, glasses; Marriott into different
categories of hotels; Sony into different consumer electronic products;
Donald Trump into different city real estate markets
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Information
• Labor markets
– Information re. safety, promotion (future earnings) opportunities,
employment stability
– Reputation of employers
• Role of regulation – experience and credence products
– Certification to practice a profession
– Standards – environment, product quality, safety, workplace
– Liability laws, other laws – securities, environment, tort, banking,
transportation safety
• Outsourcing
– Transactions costs
– Information re. quality, reliability – ISO certification
– Reputation of outsourcer – e.g. Celestica
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Information
• Government regulation
– Consumers uninformed re. monitoring, enforcement,
scope of regulations/laws
– Moral hazard potential – consumers/financial
institutions overestimate scope of regulations/laws
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Safety
Deposit insurance
Bankruptcy of companies engaged in travel industry
Workplace safety
Risky investments – case of sub-prime loans
Too big to fail
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Brand Names
Signals a substitute for complete and
perfect information
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Educational attainment (MBA, CFA, CA, etc.);
institution at which degree received (reputation
of institution)
Track record, experience – reputation
Venture capitalists invest in grade A
management and grade B business plan but not
in grade A business plan and grade B
management
Appearance, behavior
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Brand Names
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Brand names a signal for quality – quality
difficult to measure without repeated use of
product; brand name developed over time
provides some assurance to consumers about
quality of product
Developing a brand name
Consumers willing to pay price premium for
established brand name products
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Travel abroad, willing to purchase brands recognized
from home (hotels, consumer goods, financial
institutions, entertainment)
Example of products from China
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Brand Names
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Brand names, warranties, money back guarantees
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Quality, reliability – consumers willing to pay price premium
Value of brand name –Audi, BMW, Coca Cola, Disney, Coach,
Trump, Apple, Starbucks, Zara, H&M, Harrods, Prada,
Burberry, Brioni, Canali, Toyota, GE, HSBC, IBM, McKinsey,
Goldman Sachs, Ikea, Sotheby’s, Patek Phillippe, McDonald’s,
Saks,Levis, etc.
Transferable to other markets? – geographic, product
Warranties a form of insurance – conditions attached to ensure
consumers do not abuse products (moral hazard)
Reputations, brand names valuable (value does not show
up on balance sheet unless company acquired and
goodwill is recorded – but goodwill and reputations can
be destroyed)
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