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Part III. Sources of market power Chapter 5. Product differentiation Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Introduction to Part III Case. Competition in the banking deposit market • There exists market power • Positive intermediation margins • Lerner index: US, 23% / Japan, 20% / EU, 15% • Where does it come from? • Consequence of firms’ conduct • Marketing mix: Price - Product - Promotion • Price analysis of pricing strategies, see Part IV • Product Product differentiation Chapter 5 Web-banking, network of ATM, ... • Promotion Advertising Chapter 6 Informative: “Call 1-800 ING Direct. Hang up richer” Persuasive: “Britain’s best business bank” (Allied Irish) Complementary: “Washington Mutual. More human interest” © Cambridge University Press 2009 2 Introduction to Part III Case. Competition in the banking deposit market • Where does it come from? • Consequence of market environment • Consumer inertia Chapter 7 • Because of a lack of information It’s time-consuming to compare deposit rates of competing banks (and read the small prints) Source of price dispersion • Because of switching costs Moving accounts from one bank to another takes time (and possibly money) “Bargain-then-rip-off” pricing Customer poaching © Cambridge University Press 2009 3 Chapter 5 - Objectives Chapter 5. Learning objectives • Understand that product differentiation involves two conflicting forces: it relaxes price competition, but it may reduce the demand that the firm faces. • Be able to distinguish between horizontal and vertical product differentiation. • Reconsider the question of entry into product market. • Be exposed to some basic approaches to estimate differentiated product markets. © Cambridge University Press 2009 4 Chapter 5 - Views on product differentiation Views on product differentiation • Product differentiation depends on consumers’ preferences. • Characteristics approach • Preferences are specified on the underlying characteristics space • Discrete choice approach • Consumers have heterogeneous preferences and choose one (and only one) product among the available products • e.g., Hotelling model • Representative consumer approach • Consumers are assumed to be identical and have a variable demand for all products • e.g., linear demand model with 2 goods used in Chapter 3 © Cambridge University Press 2009 5 Chapter 5 - Views on product differentiation Views on product differentiation • Discrete choice approach • Horizontal product differentiation • Each product would be preferred by some consumers. • Vertical product differentiation • Everybody would prefer one over the other product. • More formally: if, at equal prices, • consumers do not agree on which product is the preferred one products are horizontally differentiated; • all consumers prefer one over the other product products are vertically differentiated. • Note 1: to account for supply side characteristics, modify the definition by replacing “at equal prices” by “prices are set at marginal costs”. • Note 2: Not easy to draw the distinction in practice © Cambridge University Press 2009 6 Chapter 5 - Horizontal differentiation A simple location model • Suppose constant price (e.g., regulated price): p • Decision for firms: how to position product (where to locate) in product space (in “linear city”): l1 ,l2 0,1 • Consumers • Mass 1 uniformly distributed on ; location = ideal point in product space; linear transportation cost • Consumers buy at most one unit from one of the firms • From product i, consumer x derives utility vi (x) r x li p • Indifferent consumer (l1 < l2): x̂ (l1 l2 ) / 2 • Firms’ demands: Q1 (l1 ,l2 ) (l1 l2 ) / 2, Q2 (l1 ,l2 ) 1 (l1 l2 ) / 2 © Cambridge University Press 2009 7 Chapter 5 - Horizontal differentiation A simple location model • Firms maximize profits w.r.t. their product location given the location of the competitor ( p c)(li l j ) / 2 if li l j ( p c) / 2 if li l j i (li ,l j ) ( p c) 1 (li l j ) / 2 if li l j • Unique Nash equilibrium: l l 1 2 • Lesson: If duopolists choose product locations 1 2 (but do not set prices), they offer the same product (no differentiation). • Insufficient differentiation from social viewpoint • To minimize total transport: l 1 © Cambridge University Press 2009 1 4 , l2 3 4 8 Chapter 5 - Horizontal differentiation Hotelling model • Now, firms choose location and price. • 2 stage model • • 1. Location choice (long term decision) 2. Price choice (short term decision) We already studied (in Chapter 3) the price stage with extreme locations (i.e., 0 and 1). We repeat the analysis for any pair of locations 2 scenarios: • • Linear transportation costs Quadratic transportation costs © Cambridge University Press 2009 9 Chapter 5 - Horizontal differentiation Linear Hotelling model • Consumers • Mass 1 uniformly distributed on ; location = ideal point in product space; linear transportation cost • Consumers buy at most one unit from one of the firms • From product i, consumer x derives utility • Firms vi (x) r x li pi • Choose first li in and then pi • Constant marginal cost of production, c • We look for subgame perfect equilibria. © Cambridge University Press 2009 10 Chapter 5 - Horizontal differentiation Linear Hotelling model (cont’d) • Price stage • • • Label firms such that l1 l2 If price difference “not too large”, there exists an indifferent consumer located in [l1, l2] l1 l2 p1 p2 r ( x̂ l1 ) p1 r (l2 x̂) p2 x̂ 2 2 What does “not too large” price difference mean? x̂ l1 p1 p2 (l2 l1 ) x̂ l2 p1 p2 (l2 l1 ) © Cambridge University Press 2009 11 Chapter 5 - Horizontal differentiation Linear Hotelling model (cont’d) © Cambridge University Press 2009 12 Chapter 5 - Horizontal differentiation Linear Hotelling model (cont’d) • Price stage (cont’d) • • • What if price difference is “too large”? Discontinuity in demand: for p1 p2 (l2 l1 ), no demand for firm 1 for p1 p2 (l2 l1 ), no demand for firm 2 Profits 0 l1 l2 ( p c) 1 ( p1 p2 ;l1 ,l2 ) 1 2 ( p1 c) p2 p1 2 © Cambridge University Press 2009 if p1 p2 (l2 l1 ), if p1 p2 (l2 l1 ), if p1 p2 (l2 l1 ). 13 Chapter 5 - Horizontal differentiation Linear Hotelling model (cont’d) 2 local suprema not quasiconcave in p1 Price equilibrium may fail to exist Happens when locations are too close. © Cambridge University Press 2009 14 Chapter 5 - Horizontal differentiation Linear Hotelling model (cont’d) • Location stage • • • Price equilibrium fails to exist for some pairs of location no subgame perfect equilibrium Where price equilibrium exists, firms want to move towards zone where price equilibrium does not exist. Instability in competition • Lesson: Although product differentiation relaxes price competition, firms may have an incentive to offer better substitutes to generate more demand, which may lead to instability in competition. © Cambridge University Press 2009 15 Chapter 5 - Horizontal differentiation Quadratic Hotelling model • Only difference: transport costs increase with the square of distance vi (x) r (x li )2 pi • Indifferent consumer l1 l2 p1 p2 r ( x̂ l1 ) p1 r (l2 x̂) p2 x̂ 2 2 (l2 l1 ) 2 2 • Price stage max p1 ( p1 c)x̂( p1 , p2 ) and max p2 ( p2 c)1 x̂( p1 , p2 ) p1* c 3 (l2 l1 )(2 l1 l2 ) p c 3 (l2 l1 )(4 l1 l2 ) * 2 © Cambridge University Press 2009 (unique price equilibrium) 16 Chapter 5 - Horizontal differentiation Quadratic Hotelling model (cont’d) • Location stage ̂ 1 181 (l2 l1 )(2 l1 l2 )2 ̂ 2 (l2 l1 )(4 l1 l2 ) 1 18 2 ̂ 1 / l1 0 for all l1 [0,l2 ) ̂ 2 / l2 0 for all l2 (l1,1] • Subgame perfect equilibrium: firms locate at the extreme points maximum differentiation • 2 forces at play • Competition effect differentiate to enjoy market power drives competitors apart • Market size effect meet consumers preferences brings competitors together • Balance depends on distribution of consumers, shape of transportation costs function and feasible product range © Cambridge University Press 2009 17 Chapter 5 - Horizontal differentiation Quadratic Hotelling model (cont’d) • Lesson: With endogenous product differentiation, the degree of differentiation is determined by balancing • the competition effect (drives firm to differentiation) • the market size effect (drives firm to differentiation). © Cambridge University Press 2009 18 Chapter 5 - Vertical differentiation Vertical product differentiation • All consumers agree that one product is preferable to another, i.e., has a higher quality • Consumers • Quality is described by si [s, s ] • Preference parameter for quality: [, ] • larger consumer more sensitive to quality changes • Each consumer chooses 1 unit of 1 of the products • Uniform distribution on [, ], mass M • Utility for consumer from one unit of product i r pi si © Cambridge University Press 2009 19 Chapter 5 - Vertical differentiation Vertical product differentiation (cont’d) • Firms • • • Duopolists 1. Choose quality: s1, s2 2. Choose price: p1, p2 Constant marginal cost, c Price stage • • Suppose s1 s2 Indifferent consumer is determined by the ratio of price and quality differences: p2 p1 r p1 ̂ s1 r p2 ̂ s2 ̂ for ̂ [ , ] s2 s1 © Cambridge University Press 2009 20 Chapter 5 - Vertical differentiation Vertical product differentiation (cont’d) • Price stage (cont’d) 0 p2 p1 p 1 ( p1 p2 ; s1, s2 ) 1 s2 s1 p1 ( ) if p1 p2 (s2 s1 ), if (s2 s1 ) p2 p1 (s2 s1 ), if p1 p2 (s2 s1 ). Solving the system of F.O.C.: p1* 13 ( 2 )(s2 s1 ) p2* 13 (2 )(s2 s1 ) (parameter restriction: 2 ) Even the price of the lowquality firm increases with the quality difference! © Cambridge University Press 2009 21 Chapter 5 - Vertical differentiation Vertical product differentiation (cont’d) • Quality stage • Substitute for second-stage equilibrium prices in profit function: (s , s ) 1 ( 2 )2 (s s ) 1 • 1 2 9 2 1 2 (s1, s2 ) 19 (2 )2 (s2 s1 ) Both profits in the quality difference equilibrium quality choices: • Simultaneous: (s1 , s2 ) (s, s ) or (s , s) • Sequential: 1st (2nd) chooses highest (lowest) quality • Lesson: In markets in which products can be vertically differentiated, firms offer different qualities in equilibrium so as to relax price competition. © Cambridge University Press 2009 22 Chapter 5 - Vertical differentiation Case. VLJ industry: “Battle of bathrooms” • Very Light Jets • 4 to 8 passengers, city-to-city, 60 to 90-minute trips You are not going to have women on a plane unless it has a lavatory. Jim Burns, Founder of Magnum Air Vertical differentiation Ed Iacobucci, CEO of DayJet Corp. VS Adam Aircraft A700 More expensive Has a lavatory Having a bathroom on board is not an issue for short trips. Eclipse 500 Less expensive No lavatory © Cambridge University Press 2009 23 Chapter 5 - Vertical differentiation Vertical differentiation and natural oligopolies • Analysis of Chapter 4 • • • Natural bounds to number of firms in oligopolistic markets main source: scale economies Number of firms determined by entry process In the presence of vertical differentiation • • There may be a limited number of firms even for negligible amount of scale economies. Intuition from previous model • • • • Recall equilibrium prices: p1* 13 ( 2 )(s2 s1 ), p2* 13 (2 )(s2 s1 ) Does not hold if 2 In that case, if entry cost (however small), low-quality firm does not enter natural monopoly Can be generalized to an n-firm oligopoly (see book) © Cambridge University Press 2009 24 Chapter 5 - Empirical analysis Probabilistic choice and the logit model • Discrete choice models • • Important to have consumers choosing differently to have a ‘smooth’ aggregate demand. How to formalize this? • • Consumers are heterogeneous by nature. assumption made in this chapter (& in most of the book) Alternative: probabilistic choice theory Ex ante (before some random variable is realized): customers are the same. Ex post (after this realization): customers are different heterogeneity results from randomness. Modelling customer behaviour as probabilistic is motivated by experimental evidence from the psychology literature. © Cambridge University Press 2009 25 Chapter 5 - Empirical analysis Probabilistic choice and the logit model (cont’d) • Random utility • Indirect utility function for a homogeneous good vi r pi i vi • i where E i 0 ‘Observable’ or ‘measured’ utility Reflects the preferences of a subpopulation for good i in expectation Binary discrete choice model • • • Consumers face 2 alternatives, 1 and 2 Denote ei the realization of i Choose alternative i if vi v j e with e realization of 1 2 , and E 0 © Cambridge University Press 2009 26 Chapter 5 - Empirical analysis Probabilistic choice and the logit model (cont’d) • Binomial logit • • • Assume that is logistically distributed F(e) 1 / [1 exp{e / }] Probabilistic demand is then of the form 1 exp{v1 / } Q1 1 exp{(v1 v2 ) / } exp{v1 / } exp{v2 / } Multinomial logit • Extension to n products Qi exp{vi / } n j 1 exp{v j / } © Cambridge University Press 2009 27 Chapter 5 - Empirical analysis Empirical analysis of horizontal differentiation • Demand side • • Consumers can choose among n products (+ an outside good, noted 0, with utility = 0) Market shares using multinomial logit (with ) i • exp{vi } 1 j 1 exp{v j } n All consumers have the same mean utility level vi xi i pi Vector of observed characteristics mean utility derived from unobserved characteristics © Cambridge University Press 2009 28 Chapter 5 - Empirical analysis Empirical analysis of horizontal differentiation • Demand side (cont’d) • • • Linear market shares in unobserved characteristics: logi log0 xi i pi If we consider i as an error term, we can estimate demand parameters () from this structural model. Supply side • • Nash equilibrium in prices ci wi i Costs: Relevant observable product characteristics on the cost side mean cost derived from unobserved characteristics © Cambridge University Press 2009 29 Chapter 5 - Empirical analysis Empirical analysis of horizontal differentiation • Estimation of the model • • Firm i’s profits: i ( pi ci )M i From F.O.C.: pi ci • i i / pi wi i / pi i wi 1 i i / vi Using multinomial logit: pi wi • i 1 1 i 1 i Can be jointly estimated with logi log0 xi i pi © Cambridge University Press 2009 30 i Chapter 5 - Empirical analysis Extension: the nested logit model • Limitations of the logit model • Restrictions are imposed on substitution patterns. • • • May be unrealistic Example: product introduction in the family van segment has different effects on the market share of a car in that segment or on an SUV. Possible answer: nested logit model • • Group different products together in different nests. Consumers select first among nests and then within the selected nest. © Cambridge University Press 2009 31 Chapter 5 - Review questions Review questions • In which industries is product differentiation important? Provide two examples. • What makes firms locate close to each other in the product space? And what does it make them to differentiate themselves from their competitors? • When is vertical product differentiation present in an industry? Discuss demand and cost characteristics. © Cambridge University Press 2009 32 Chapter 5 - Review questions Review questions (cont’d) • Does the number of firms in an industry with constant marginal costs necessarily converge to infinity as the entry cost turns to zero? Explain. • Why are we interested in empirically estimating models of product differentiation? (After all, to understand the intensity of competition in the short run, we only need to know the Lerner index.) © Cambridge University Press 2009 33 Part III. Sources of market power Chapter 7. Consumer inertia Slides Industrial Organization: Markets and Strategies Paul Belleflamme and Martin Peitz © Cambridge University Press 2009 Chapter 7 - Objectives Chapter 7. Learning objectives • Understand how firms can enjoy market power when consumers are imperfectly informed about the existence and prices of available products. • Identify the sources of spatial and temporal price dispersion. • Examine how switching costs and consumer lock-in affect competition. • Study the dynamic problem that arises in markets where firms are able to identify from whom consumers have bought in the past. © Cambridge University Press 2009 35 Chapter 7 - Uninformed consumers and search costs Context • Previous chapter • Consumers didn’t know about existence, price or characteristics of certain products. • They obtained passively information through ads. • This chapter • Same lack of information but consumers search for information themselves. • Main results • Positive search costs market power (even when firms produce a homogeneous good and compete in prices) • Equilibria can exhibit price dispersion. © Cambridge University Press 2009 36 Chapter 7 - Uninformed consumers and search costs Price dispersion • Price dispersion is observed in many industries • At any point in time, prices for essentially the same product are different across firms. • Possible explanation • Some consumers are better informed than others and obtain a better deal than the less informed. • 2 situations • Spatial price dispersion • One firm focuses on locked-in uninformed consumers, enjoys a large markup but sells few units. • The other firm also sells to all informed consumers; it sacrifices on its margin but sells many units. • Temporal price dispersion • All firms randomize over price. © Cambridge University Press 2009 37 Chapter 7 - Uninformed consumers and search costs Spatial price dispersion • A simplified (numerical) model • 700 consumers, same demand: q p • 2 firms, same product, same marginal cost: c • 100 consumers know the prices of both firms. • The other 600 only know the price of their neighboring firm; 300 buy at each firm. • Equilibrium of price competition? • If firm only sells to uninformed consumers • Optimal price: pm profit u 3x x . • For any price set by firm 1, one should ask whether firm 2 has no incentive to set a slightly lower price, so as to serve the informed consumers itself. © Cambridge University Press 2009 38 Chapter 7 - Uninformed consumers and search costs Spatial price dispersion (cont’d) • Equilibrium (cont’d) • Firm 1 won’t accept a profit lower than u. • p1 such that u (3) p1 ( p1) • Candidate equilibrium: p1 and p2 p1 • Both firms have the same profit. • Firm 2 only sells to its uninformed consumers. • Firm 1 sells to the informed consumers (on top of its uninformed ones). • Firm 2 has no incentive to deviate. • But firm 1 has ... (by selling at a price between 10 and 20, it keeps the informed consumers and makes a larger profit). • there is no pure-strategy equilibrium in the simultaneous price game. © Cambridge University Press 2009 39 Chapter 7 - Uninformed consumers and search costs Spatial price dispersion (cont’d) • Sequential game • Suppose firm 1 chooses first. • If 1 sets p1 , 2 finds it profitable to set p2 p1. • There is a subgame perfect equilibrium in which firm 1 sets p1 and firm 2 sets p2 . • But there exists another equilibrium in which firm 1 sets p1 and firm 2 sets p2 . • One checks that no firm has an incentive to deviate. • Lesson: A homogeneous product market with informed and uninformed consumers and sequential price setting may exhibit spatial price dispersion one firm consistently charges a high price and the other a low price. © Cambridge University Press 2009 40 Chapter 7 - Uninformed consumers and search costs Temporal price dispersion • Same starting point • 2 groups of consumers: some are informed about all the prices and others are not • Similar result • Although all firms sell the same product, the law of one price is violated: some consumers pay more than others. • What changes • Price dispersion is temporal: the same firm sets different prices at different points in time. • Equilibrium in mixed strategies: firms choose a probability distribution over some range of prices. © Cambridge University Press 2009 41 Chapter 7 - Uninformed consumers and search costs Temporal price dispersion (cont’d) • Why do firms set “random prices”? • Reason A. This prevents consumers from learning by • experience which is the firm that sets the lowest price on the market This reduces consumers’ incentive to search for price information. • Reason B. This makes it harder for competitors to gain market shares through undercutting There are fewer “price wars”, which increases profits. Formal model: see math slides • Lesson: If firms compete in a market with informed and uninformed consumers, the market may exhibit temporal price dispersion; that is, at equilibrium, firms randomize over prices. © Cambridge University Press 2009 42 Chapter 7 - Uninformed consumers and search costs Consumer search • So far, information acquisition was exogenous • Now: endogenous process • Consumers decide whether or not they want to acquire information (at some cost). • Previous results carry over if we assume that search costs (to know all prices) are high for one group and low for the other group. • In other situations, there is an incremental cost to know one more price consumers have to form expectations about possible prices. • We look for equilibrium configurations such that consumers don’t regret, on average, their decision to search for information. © Cambridge University Press 2009 43 Chapter 7 - Uninformed consumers and search costs The Diamond paradox • Model (Diamond, 1971) • Oligopoly producing homogeneous good at constant marginal cost c. • Consumers • Learn (for free) existence and price of the product of 1 firm (randomly drawn). • If they want more information (about at least one additional product), they must incur a cost z. • Equilibrium? • If search was free: p c for all firms. • No longer an equilibrium with z Why? • Suppose all other firms set p c. • Any firm can slightly its price without losing its consumers, because these consumers, observing this price, anticipate that it’s not worth searching for additional information. © Cambridge University Press 2009 44 Chapter 7 - Uninformed consumers and search costs The Diamond paradox (cont’d) • Equilibrium (cont’d) • Equilibrium prices don’t tend to c when z tends to 0. • Unique equilibrium: all firms set monopoly price, pm. • • • • Consumers expect all firms to set pm. they have no incentive to search for information. a firm cannot profit by unilaterally setting p pm. Same reasoning holds for all price below pm that all firms would choose. But in this case, any firm would have an incentive to deviate by setting a slightly higher price. • Any price above pm cannot be an equilibrium. • Lesson: If all consumers have positive search costs, oligopolistic firms will set price equal to the monopoly price. © Cambridge University Press 2009 45 Chapter 7 - Uninformed consumers and search costs Empirical investigation of price dispersion • How to measure price dispersion? • Start from price distribution. • To compare levels of price distribution across time and markets, use coefficient of variation (standard deviation / mean) • Alternative measure: sample range (difference between largest and lowest observed prices in the sample) • How to measure search intensity? • Proxy: variables that affect benefits or costs of search • Prediction: items that account for a large share of the budget or that are purchased with a higher frequency more search lower price dispersion • Compare online & offline markets (search more costly in offline markets). © Cambridge University Press 2009 46 Chapter 7 - Uninformed consumers and search costs Case. Does search intensity affect price dispersion? • Lower price dispersion for items that... • ...account for a large share of searcher’s budget? • Stigler (1961): coefficient of variation of Coal (small share of government’s budget): 14.7% Automobile (large share of household’s budget): 1.7% • ...are bought more frequently? • Sorensen (2000): market for prescription drugs purchase frequency measured by dosage and duration of therapy Price ranges for one-time prescriptions are estimated to be 34% larger than those for prescriptions that must be purchased monthly. • Online vs. offline markets • Mixed set of findings; price dispersion is still very present online although information costs © Cambridge University Press 2009 47 Chapter 7 - Switching costs Switching costs • Definition • A consumer makes investments specific to buying from a firm it is more valuable to buy different goods, or goods at different dates, from that firm. • Switching costs give rise to consumer lock-in • 2 contrasting effects on competition • Ex post. Once a consumer has bought from some firm, she is willing to pay more to continue buying from this firm (up to the switching costs she avoids to pay) demand is less elastic for “locked-in” consumers firms have more market power on those consumers • Ex ante. Competition to get consumers locked-in in the first place is fiercer the larger the switching costs. © Cambridge University Press 2009 48 Chapter 7 - Switching costs Case. Examples of switching costs • Transaction costs • Specialized suppliers (a critical component may be supplied by a single supplier) • Search costs (finding and evaluating new suppliers costs time) • Contractual costs • Breaking contracts can lead to compensatory damages • Loyalty programs (switching can cause customers to lose out on program benefits) • Compatibility costs • Durable purchases (replacing existing equipment can be expensive) • Information and databases (new systems are needed when companies change formats) • Learning costs • Brand-specific training (e.g., switching software means your team has to learn a new interface) • Uncertainty costs experience goods • Psychological costs credence goods © Cambridge University Press 2009 49 Chapter 7 - Switching costs Competitive effects of switching costs • Monopoly • Overall effect is neutral: average price and allocation remain unaffected • Illustration: 2 periods, unit demand; pm = monopoly price in the absence of switching costs; z = switching cost • Optimal prices: 1st period: pm z; 2nd period: pm z • Imperfect competition • 2 contrasting effects • Ex post: Lock-in price-setting power one expects higher prices • Ex ante: consumers are more valuable more competition for new consumers one expects lower prices • Net effect??? © Cambridge University Press 2009 50 Chapter 7 - Switching costs Competitive effects of switching costs (cont’d) • Imperfect competition (cont’d) • 2-period duopoly model (extension of Hotelling model) • Period 1: all consumers are inexperienced; they buy a differentiated product, anticipating potential lock-in in period 2 • After period 1, a share of consumers leave the market and are replaced by the same number of new consumers. • Period 2: all remaining consumers from period 1 face a switching cost if they buy from another firm than in period 1. • Firms set prices in each period 2nd-period profits depend on 1st-period prices (through 1st-period market shares) • 2 scenarios • Old consumers keep their preference from period 1 to 2. • Preferences in the 2 periods are unrelated. • See details in book. © Cambridge University Press 2009 51 Chapter 7 - Switching costs Competitive effects of switching costs (cont’d) • Imperfect competition: summary of results • Old consumers inherit 2nd-period preferences • Firms sell at a discount in the 1st period but still at a higher price than the one that would prevail absent switching costs. • Switching costs relax price competition. • Old consumers newly draw 2nd-period preferences • Firms sell at a discount in the 1st period. • 1st-period price is below and 2nd-period price is just equal to the price that would prevail absent switching costs. • Switching costs intensify price competition. • Comparison • In both scenarios: ‘bargain-the-rip-off’ prices (p1 p2) • Net effect on prices depend on the degree of lock-in no clear recommendation in terms of regulation © Cambridge University Press 2009 52 Chapter 7 - Switching costs Coupons and endogenous switching costs • Previous analysis: exogenous switching costs • Here: endogenous switching costs • Firms can reward ‘loyal’ consumers with coupons encourages repeat purchase • Overall, coupons the competitiveness of markets • Lesson: Suppose that all consumers stay in the market for 2 periods and newly draw their taste parameter in the 2nd period. Firms find it profitable to create switching costs by announcing coupons in the 1st period that loyal customers can redeem in the 2nd period. Coupons relax price competition: 1st- and 2nd-period prices are higher than in the absence of coupons (although loyal customers pay a lower price in the 2nd period). © Cambridge University Press 2009 53 Chapter 7 - Switching costs Estimating switching costs • Econometric methods • Direct: choice modelling to estimate values that consumers place on different product attributes • Compare choice probabilities of old and new consumers • Quantify impact on consumer choices of product feature that is expected to create switching costs • Indirect: use aggregate market data • Estimate cross-price elasticities of consumption of a particular brand between periods. • Test predicted effects on prices of change in switching costs • Non-econometric methods • Measure the actual level of customer switching? • Questionable: switching behaviour and switching costs are not necessarily negatively correlated. © Cambridge University Press 2009 54 Chapter 7 - Switching costs Case. Impacts of number portability • Switching costs and consumers’ valuation of number portability service in the Korean mobile communications market (Lee et al., 2006) • Probabilistic choice model compare choice probabilities of new vs. current customers • Absent switching costs, new and current consumers sharing the same preferences should make the same choice. • If current customers tend to choose the same alternative as the one they chose in the past with a higher probability than new customers may indicate presence of switching costs. • Conclusions • Switching costs have been lowered considerably since number portability has been in force. • But, a significant level of switching costs still remains despite number portability. © Cambridge University Press 2009 55 Chapter 7 - Customer poaching Customer poaching • What is ‘customer poaching’? • Firms make distinct offers to their rivals’ past customers in order to attract them. • Firms need to keep records of their customers. • Particular case of behaviour-based price discrimination (see Chapter 10) • Issue for competition authorities • Does customer poaching lead to higher overall prices? • Model to address this question: • 2 period duopoly model; horizontal product differentiation • Firms can set different prices in period 2 depending on whether or not consumers have bought the good in period 1. © Cambridge University Press 2009 56 Chapter 7 - Customer poaching Customer poaching: main results • Lesson: Customer poaching is an equilibrium phenomenon. It leads not only to lower prices for those consumers who switch firms, but also to lower prices for those consumers who do not, compared to a situation in which conditioning on past consumer behaviour is not possible. Consequently, firms make lower profits in the second period. • Lesson: Customer poaching with forward-looking consumers relaxes price competition in the first period but intensifies it in the second period. In total, firms would be better off if they could agree not to poach each other’s customers. On the opposite, poaching makes consumers globally better off. © Cambridge University Press 2009 57 Chapter 7 - Review questions Review questions • What is the effect of search cost on equilibrium prices? In particular, what happens if all consumers have positive search costs? • Provide two examples of industries in which search costs are likely to be important, and two examples of industries exhibiting switching costs. • Many markets exhibit price dispersion. In light of the theoretical analysis presented in this chapter, how can one explain such a phenomenon? Relate your discussion to the analysis in Chapter 3 in which firms have private information about costs. © Cambridge University Press 2009 58 Chapter 7 - Review questions Review questions (cont’d) • How can one (i) measure price dispersion, and (ii) empirically estimate switching costs? • Does an increase in switching costs lead to more relaxed or more intense competition? Discuss. • How do markets work in which firms poach customers? © Cambridge University Press 2009 59