11) Economics of Strategy

What is Price Discrimination

Increasing profit by selling the same good at different prices based on reasons not linked to cost

Condition Requirements for Price Discrimination

Firms must:

• Have some market power

• Not have consumers able to resell the product

• Be able to identify and charge consumers separately

• Have consumers with differing elasticities of Demand

Types of Price Discrimination

Perfect Price(1st Degree)

Hurdle Pricing (2nd Degree)

Group Pricing (3rd Degree)

Perfect Price Discrimination (1st Degree)

Charging Consumers their reservation (maximum) price

For this to work, the consumer mustn’t know the reasonable cost, or evaluate the quality

Perfect Price Discrimination Effect and Examples

This provides producers with maximum surplus, and consumers with minimum

This is rare and hard to achieve, but can be seen in:

• Highly specialised industry (surgeons, lawyers)

• Auctions (particularly silent auctions

Hurdle Method (2nd Degree)

When customers self select their need, based on their Elasticity of Demand

The business offers a range pricing schemes (bulk pricing, coupons, timed discounts)

The “hurdle“ is an inconvenience with each price scheme (finding coupons, the time, cost, etc)

Less price sensitive customers would pay the premium, while more sensitive would spend the effort to find coupons and reduce the price

Hurdle Method Effect and Examples

Less price sensitive customers would pay the premium, while more sensitive would spend the effort to find coupons and reduce the price

Examples include:

• Airplane discounts for not choosing a seat

• Bulk Purchasing

• Coupons / Timed Discounts

Group Pricing (3rd Degree)

Producer identifies and charges market segments individually

• Such as Age, Gender, Ethnicity, etc

Consumer is stereotyped with the segment’s elasticity

Key Element of Price Discrimination

Price discrimination is only on the same good sold at different prices

Economy vs Business vs First-Class plane seats aren’t price discrimination, they’re separate goods with their own benefits and costs

Graphing Perfect Price Discrimination

Under Perfect Price Discrimination, marginal revenue raises to match the demand curve

• The demand curve represents reservation pricing now charged

This makes the intersection of MR and MC now align with the demand curve, giving allocative efficiency, but only producer surplus, no consumer surplus.

Graphing Group Pricing

To graph group pricing, the total market graph is broken into multiple graphs, for each segment

We assume the same ATC and MC, but the demand curve elasticity changes for each segment

The pricing for less elastic segments will me less than in more elastic ones

Welfare under Price Discrimination

Producer Surplus:

• Firms surplus raises, earning higher profits, capturing consumer surplus

Consumer Surplus:

• Surplus falls

• Not all consumers lose however. Less elastic consumers that wouldn’t have participated under the market price, might now because the discriminated price for them is lowered

Efficiency under Price Discrimination

Allocative efficiency can be reached as raising MR to match the Demand curve incentivises producers to be efficient

The market wouldn’t be distributively efficient however, as producers would capture most of the economic surplus

Game theory

The study of Strategic interaction between interdependent firms/entities

Universally studied and applied concept

• Game theory exists within politics, defence, family, biology, etc

Applications of Game Theory

We assume the “games“ are non-cooperative (as banned by the government)

Firms will choose their actions based on expected response from competition

Some factors have optimal levels, but are also influenced by competition, including:

• Level of output (best to keep low and charge high, but risks being flooded by others)

• Advertising (Best to avoid heavy expense, but competitors may out advertise you)

• Pricing (Best to keep high, but competitors may undercut it)

• Excess Capacity (Best to avoid investment, but new firms could join and compete)

Prisoners Dilemma

When it is “best” for both businesses to make a decision

But if one of them lies they profit and the other loses

If both of them lie they both lose

They’re not allowed to cooperate, and if they did, how would they trust each other

Dominant Strategy and Nash Equilibrium

Dominant Strategy:

• The strategy that provides the best outcomes despite the opponents moves

• This doesn’t imply the best outcome

• Such as making the action, because losing with the opponent is less costly than not making the action while the opponent makes it. Despite this blocking the best outcome

Nash Equilibrium

• The stale mate where players can’t make a decision to improve outcomes without convincing / having opponents change their decisions

Escaping the Dilemma

Firms can signal intent to cooperate with each other and hold an alliance

• reduce advertising, lower production, etc

Firm’s will typically cooperate on easily seen factors such as pricing, but not on more hidden factors such as budgets (advertising budget for example)

Beach Location Game

Ice cream sellers on the beach tend to be together in the middle and not spread out

This is because if one went further down the beach, the other could move between them and the centre, stealing their business. A process that when repeated, leads them to both be in the centre.

This also applies to political parties, how the major parties lay in the middle of the spectrum.

Burn the Boats

Making a decision to reduce business options to deter opponents.

If a fabrication company wanted to break into the Perth monopoly, they may understand that it is more costly for the existing company to flood the market with cheap produce than to allow for the co-existence

To counter this, the existing company invests in expanding productive capabilities (an investment they wouldn’t have made otherwise), “burning the boat” of not producing for cheaper, as now they will make more profit by flooding the market.

Founded with the Spanish invasion of Mexico as they eliminated possibility of retreat