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E312. Lecture 14 13 October 2005 Assignments Review pp. 72-75 (Monopolistic Competition) pp. 76-81 (Next class) Discussion of term project III. Imperfect Competition, Virtual Products and Network Industries A. Motivation B. Game Theory and Dynamic Incentives. a. Normal form games b. Nash equlibria c. Coordination games and the Prisoners Dilemma Preview d. Repeated Games and Trigger Strategies C. Monopolistic Competition and Price differentiation E. The Economics of Virtual Products (Information Goods) 1. Cost Characteristics LECTURE______________________________________________________________ III. Imperfect Competition, Virtual Products and Network Industries c. Dynamic Games. The primary reason that I introduce the normal form representation of this game is to provide a simple framework for considering the structure of a repeated game. Suppose you were one of only two gasoline stations in a small town (or one of only two sellers of anti-virus software). You could shade on each other’s prices, but you would both be better off if you did not. Would it be possible to devise a strategy for a repeated game that might avoid this outcome? Yes! Notice: What you need in the above game is for something to lower the high pay-off in the HL payoff box. In the repeated game, the present value (‘PDV’) of the HH strategy is 500 + 500/i = 500(1+i)/i Similarly for the LL outcome, the PDV is 200 + 200/i + . = 200(1+i)/i But consider the off-diagonal elements. It is extremely unlikely that a competitor will see his or her rival defecting, and continue to post a high price. Rather, it is more likely that the competitor will respond to a price cut with another price cut. For simplicity, let us consider a very simple version of such a response: Strategy: Play H Continue to play H until the rival plays L. Then play L forever after. This is referred to as a “grim” trigger strategy, “grim” in the sense that one slip prompts eternal punishment. It is, admittedly, a bit severe, but it is extremely useful for purposes of illustration. Consider the earnings in the HL box under a grim trigger strategy. The “defector” will earn 700 + 200/i The defected upon will earn 100 + 200/i To illustrate how this changes incentives for the game, consider i=.10. Firm 2 H L H 5500, 5500 2700, 2100 L 2100, 2700 2000, 2000 Notice that now H, H is the unique Nash equilibrium for the game. Firm 1 More generally, let us denote D as a “defection” or a play of L when the rival plays H. L refers to an LL outcome. Then a discount rate will support cooperation as long as H + H/(i) Or (H-D) > > D + L/(i) (H-L)/(i) (H-L)/(H-D)< i That is, as long as the costs of competition over cooperation are not too small relative to the short term gain of defection. The point here, is that even if firms do not explicitly conspire, they may be able to generate high prices as part of a noncooperative strategy in a repeated game. The success of such strategies depends on the plausibility of the model’s underlying assumptions. Specifically. 1) The number of players. We have illustrated a 2 firm case. Trigger strategies are possible with more than firms, however they become more difficult to implement absent coordination. The primary reason for this is that firms have difficulty distinguishing punishments from defections. 2) The monitorability of actions. Can a firm even tell when a rival defects? Is output monitorable? Are the terms of sale monitorable? Is demand stable? C. Monopolistic Competition and Price Differentiation. In the industry “Shakeout” from Monopoly to Dominant firm, to Oligopoly, to competition, one other structure is possible. It is monopolistic competition, which combines the pricing discretion of Monopoly with the entry exit of competition. 1.Assumptions a. Differentiated Products, each with a protectable “niche” b. Free entry and exit into nearby product or geographic space c. Many buyers (no buyer power) 2. Analysis. Since firms produce distinguishable products, each firm faces a downsloping demand curve. This implies, as in the case of monopoly that MR<AR (for the same reason as in a monopoly). Thus, given any cost structure a monopolistically competitive firm may earn profits in the short run. a. However, profits prompt entry. This Eq u ilig b r iu m f o r th e M o n o p o lis tic C o m p e tito r shifts in the residual demand curve. In an equilibrium, the monopolist competitor W e lf a r e c o s t o f earns zero profits. M o n o p o lis tic b. Notice that the Monopolistic C o m p e tito n s . Competitor is inefficient relative to a Competitor, even though zero profits are earned. Some commentators argue that many ”virtual” products will be monopolistically competitive. Sellers offer distinguishable products, with relatively low entry and exit costs. Does this imply that these firms are really less competitive than would be competitors? No. Some view this welfare cost as the price of differentiation. D. The Economics of Virtual Products (Information Goods) 1. Introduction. Many of the goods traded on the internet are virtual goods. That is, goods that can be reduced to digital format. (CDs, money, information, books, software, etc.) As we have mentioned previously, these goods are subject to two critical features that complicate competition: (a) Unusual production costs and (b) Network Externalities. We now take some time to consider these two characteristics in more careful detail. a. Cost Conditions. Consider production conditions for a book to be distributed over the internet. The publisher strikes a contract with a writer (say $45,000 for the development of the book, which will be given by the writer to the publisher in digital format. Suppose that the publisher must also pay $2000 for editing, and suppose that the publisher gives up some $3000 in opportunity costs for contracting with THIS author as opposed to another. Thus the FIXED costs of the e-book are $50,000. Now the cost to the publisher of distributing the book is $0.00. However, again in the contract with the writer, the publisher agrees to pay to the author a royalty of $0.50 per copy. Thus, the AFC, ATC and MC=AVC relations are as follows Quantity 0 1 5000 10,000 20,000 30,000 40,000 50,000 TFC 50,000 50 50 50 50 50 50 50 MC 0.5 0.5 0.5 0.5 0.5 0.5 0.5 ATC AFC 50,000.5 50,000 10.5 10 5.5 5 3.0 2.5 2.2 1.66667 1.8 1.25 1.5 1 Graphically, 20 15 MC 10 A TC AFC 5 0 0 20000 40000 60000 This looks a lot like the “Economies of scale” case we observed for long run competition. However, these cost curves arise in the short run. We will say that the firm has “short run economies of scale.” Short run economies of scale are a distinguishing characteristic of virtual products. b. Pricing with Virtual Products. Notice that to this point, we have argued that the optimal price for a firm to charge is the point where MR = MC. This result will generate an efficient outcome. However, it is a problem for the seller of virtual products, since the seller would go bankrupt. 20 15 10 5 0 0 10000 20000 30000 40000 50000 60000 If, for example, the seller posted a price of $.50 for the book and sold 20,000 books, the seller would have revenues of $10,000 – all of which would be distributed to the writer. The publisher would lose its fixed cost of $50,000. A second best option, is one that generates some deadweight loss, but allows the publisher to break even. The publisher should price where demand intersects AVERAGE Costs. 20 15 10 5 0 0 10000 20000 30000 40000 50000 60000 Note: This essentially is an application of Average Cost pricing. The net result is that competition in virtual products may have many of the characteristics of monopolistic competition. However, unlike other instances of monopolistic competition, the fixed costs are not always defendable. If rivals can copy a sellers costs, then a desperate competitive outcome will result.