Third-Degree Price Discrimination in the Presence of Asymmetric Consumption Externalities

In this paper, we consider third-degree price discrimination in two markets in the presence of asymmetric consumption externalities; we establish that under plausible conditions, a firm reduces its price in the market with low price elasticity of demand. The firm can increase its profits by reducing the price for these consumers and enlarging the demand for other consumers, provided that positive consumption externalities exist. Moreover, we show that third-degree price discrimination enhances not only the firm’s profit but also total consumer surplus.

The Euro Illusion in Consumers’ Price Estimation: An Italian–Irish Comparison in the Third Year of the Euro

The euro illusion is a transient phenomenon that consists of currency-related asymmetries in the intuitive judgment of product prices made by consumers. The results of a cross-country study in the third year after the introduction of the euro show a strong price estimation asymmetry in a country with an extreme exchange rate (Italy) and a weaker effect in a country in which the nominal values of the new and the old currency are much closer (Ireland). These results rule out proposed explanations of the euro illusion in price estimation that assume the sole influence of plausible anchors (reference prices stored in memory within the plausible price range), supporting instead accounts also endorsing the role of implausible anchors (reference prices outside the plausible price range). Beyond contributing to our theoretical understanding of the euro illusion, this research starts to unveil the interplay between structural factors (i.e., the currency exchange rate) and psychological mechanisms that produce long-lasting difficulties for consumers after a monetary changeover.

The discriminatory incentives to bundle in the cable television industry

An influential theoretical literature supports a discriminatory explanation for product bundling: it reduces consumer heterogeneity, extracting surplus in a manner similar to second-degree price discrimination. This paper tests this theory and quantifies its importance in the cable television industry. The results provide qualified support for the theory. While bundling of general-interest cable networks is estimated to have no discriminatory effect, bundling an average top-15 special-interest cable network significantly increases the estimated elasticity of cable demand. Calibrating these results to a simple model of bundle demand with normally distributed tastes suggests that such bundling yields a heterogeneity reduction equal to a 4.7% increase in firm profits (and 4.0% reduction in consumers surplus). The results are robust to alternative explanations for bundling.

Product differentiation under imperfect information: When does offering a lower quality pay?

In this paper, we extend the Varian (1980) model to examine endogenous quality differentiation by firms, with a particular emphasis on the interplay between the firms’ product quality decisions and the ensuing price rivalry. Specifically, we assume that the price-sensitive (or informed) consumers hold a lower valuation for product quality than the brand-loyal (or uninformed) consumers. It is shown that the firms will choose differentiated qualities for a broad class of consumer utility functions and production technologies. We obtain two results. First, the equilibrium quality choices are efficient as they are also the welfare-maximizing qualities chosen by a social planner. The equilibrium qualities are as if one firm serves only its loyal consumers and the other serves only the price-sensitive consumers, even though they each serve both types of consumers (at least for some fraction of time). Second, the firm choosing the lower quality makes greater profits and also prices more aggressively, in the sense that it maintains a lower maximum price and offers discounts more often. The lower-quality product is more profitable because it yields higher social surplus when consumed by the price-sensitive consumers.

Framing effects in mixed price bundling

In mixed price bundling, the consumer has the choice of buying the individual products separately, as part of a bundle with a discounted price, or not purchasing them at all. Framing effects refer to how the price of the bundle is presented to the consumer. Past studies have focused on perceptual measures and aggregate level results, and have only looked at a subset of different types of price framing in any one study. In this paper we use discrete choice data to investigate whether price framing affects choice in mixed price bundles. We find that the joint, integrated frame results in the highest proportion of respondents choosing the bundle and the fewest choosing “none.” When the prices of items in a bundle are itemized, some consumers are more likely to compare prices separately to their reference prices to evaluate the attractiveness of the deal, but this actually reduces the probability of purchasing the bundle. However, the majority of consumers do not use reference prices and instead follow a simple economic choice model.

Optimal criteria for selecting price discrimination metrics when buyers have log-normally distributed willingness-to-pay

This paper investigates how a monopoly seller should determine the optimal set of pricing variables (pricing metrics) for third-degree price discrimination applications in which buyers have log-normally distributed willingness-to-pay (WTP). In a setup that closely resembles linear and probit regressions, this paper shows that when the monopoly seller is restricted to using one metric and no price discrimination cost exists, the pricing metric that best reduces the residual variance of buyers’ willingness-to-pay is the one that maximizes revenue. Equivalently, the explanatory power of willingness-to-pay is the ordering criterion. This paper also shows that this criterion is not universally true when willingness-to-pay follows other distributions. When the seller incurs price discrimination costs associated with different metrics, the ordering criterion becomes the explanatory power of each pricing metric divided by its cost. This paper also discusses how to apply this model to solve real-world pricing problems with contingent valuation models or using probit regression.

The shipping strategies of internet retailers: Evidence from internet book retailing

Managing the shipment of goods to consumers is one of the central aspects of retail competition on the internet. In this article, we analyze internet retailers’ shipping strategies using data from the internet book retailing industry. We find that, controlling for a variety of observable firm characteristics, firms with lower product prices offer lower shipping fees and higher quality shipping in terms of average delivery time, compared to firms with higher product prices. These patterns cannot be readily reconciled with a large class of models of competition under perfect consumer information. Theories based on imperfect consumer information can explain the findings better.

Grey Power: An Empirical Investigation of the Impact of Parallel Imports on Market Prices

The persistence of price discrimination across international markets with falling costs of unofficial importing is both paradox and policy concern. E-commerce facilitates a “grey” market in parallel imports, particularly for high-value goods such as electronics. This paper explores the impact of unofficial imports on price using a panel of product markets mediated via an Internet shopbot. It finds the presence of an import model lowers prices across the market. However, unlike the refurbished model it is not simply an inferior substitute. The import price discount increases over the model life cycle, suggesting that model-specific preferences fall as each model ages.

Competitive reasons for the Name-Your-Own-Price channel

This paper shows that the Name-Your-Own-Price (NYOP) business model can help soften competition. When consumers differ in their frictional costs (i.e., the shopping hassle) they experience when bidding at an NYOP retailer, the NYOP format can be a mechanism for differentiating a retailer from a posted-price rival. Beyond providing a motivation for using an NYOP mechanism, competition also has important implications for the optimal structure of the NYOP format. For example, this paper shows that prohibiting rebidding may benefit an NYOP firm by reducing price rivalry.

Beyond plain vanilla: Modeling joint product assortment and pricing decisions

This paper investigates empirically the product assortment strategies of oligopolistic firms. We develop a framework that integrates product choice and price competition in a differentiated product market. The present model significantly improves upon the reduced-form profit functions typically used in the entry and location choice literature, because the variable profits that enter the product-choice decision are derived from a structural model of demand and price competition. Given the heterogeneity in consumers’ product valuations and responses to price changes, this is a critical element in the analysis of product assortment decisions. Relative to the literature on structural demand models, our results show that incorporating endogenous product choice is essential for policy simulations and may entail very different conclusions from settings where product assortment choices are held fixed.

Intertemporal price discrimination with forward-looking consumers: Application to the US market for console video-games

Firms in durable good product markets face incentives to intertemporally price discriminate, by setting high initial prices to sell to consumers with the highest willingness to pay, and cutting prices thereafter to appeal to those with lower willingness to pay. A critical determinant of the profitability of such pricing policies is the extent to which consumers anticipate future price declines, and delay purchases. I develop a framework to investigate empirically the optimal pricing over time of a firm selling a durable-good product to such strategic consumers. Prices in the model are equilibrium outcomes of a game played between forward-looking consumers who strategically delay purchases to avail of lower prices in the future, and a forward-looking firm that takes this consumer behavior into account in formulating its optimal pricing policy. The model outlines first, a dynamic model of demand incorporating forward-looking consumer behavior, and second, an algorithm to compute the optimal dynamic sequence of prices given these demand estimates. The model is solved using numerical dynamic programming techniques. I present an empirical application to the market for video-games in the US. The results indicate that consumer forward-looking behavior has a significant effect on optimal pricing of games in the industry. Simulations reveal that the profit losses of ignoring forward-looking behavior by consumers are large and economically significant, and suggest that market research that provides information regarding the extent of discounting by consumers is valuable to video-game firms.

Illusory Price Increases after the Euro Changeover in Germany: An Expectancy-Consistent Bias

The aim of the present report is to review research demonstrating the role played by expectations for observed illusory price increases after the euro introduction in Germany. In laboratory experiments when participants are asked to estimate price changes in a restaurant following the euro introduction, the price estimates are found to be biased in the direction of the expectation of rising prices. The research also examines the extent to which a similar judgment bias is evident in other areas and how interventions counteract the bias. A further focus of the research is on the underlying process. In this respect the results show that the bias is based on a selective outcome correction process not previously described. Theoretical implications and practical implications for consumer policy issues are highlighted.

Too close to be similar: Product and price competition in retail gasoline markets

We examine how product and pricing decisions of retail gasoline stations depend on local market demographics and the degree of competitive intensity in the market. We are able to shed light on the observed empirical phenomenon that proximate gasoline stations price very similarly in some markets, but very differently in other markets. Our analysis of product design and price competition between firms integrates two critical dimensions of heterogeneity across consumers: Consumers differ in their locations and in their travel costs, as in models of horizontal differentiation. They also differ in their relative preference or valuations for product quality dimensions, in terms of the offered station services (such as pay-at-pump, number of service bays or other added services), as in models of vertical differentiation. We find that the degree of local competitive intensity and the dispersion in consumer incomes are sufficient to explain variations in the product and pricing choices of competing firms. Closely located retailers who face sufficient income dispersion across consumers in a local market may differentiate on product design and pricing strategies. In contrast, retailers that are farther apart from each other may adopt similar product design and pricing strategies if the market is relatively homogeneous on income. Using empirical survey data on prices and station characteristics gathered across 724 gasoline stations in the St. Louis metropolitan area, and employing a multivariate logit model that predicts the joint probability of stations within a local market differentiating on product design and pricing strategies as a function of market demographics and local competitive intensity, we find strong support for the central implications of the theory.

Cost of small business banking: a New Zealand study

The research reported in this article develops a model for assessing the cost of banking services faced by small businesses. The lack of price competition in the provision of small business banking services combined with limited transparency concerning actual fee levels prevents small businesses from readily estimating likely fee levels. Prior research and government reports note the difficulties faced by small business in relation to banking services and this research contributes to an understanding of the potential dead weight losses incurred resulting from poor signalling and information asymmetry and potentially a deficient public policy framework.

Heterogeneity distributions of willingness-to-pay in choice models

We investigate direct and indirect specification of the distribution of consumer willingness-to-pay (WTP) for changes in product attributes in a choice setting. Typically, choice models identify WTP for an attribute as a ratio of the estimated attribute and price coefficients. Previous research in marketing and economics has discussed the problems with allowing for random coefficients on both attribute and price, especially when the distribution of the price coefficient has mass near zero. These problems can be avoided by combining a parameterization of the likelihood function that directly identifies WTP with a normal prior for WTP. We show that the typical likelihood parameterization in combination with what are regarded as standard heterogeneity distributions for attribute and price coefficients results in poorly behaved posterior WTP distributions, especially in small sample settings. The implied prior for WTP readily allows for substantial mass in the tails of the distribution and extreme individual-level estimates of WTP. We also demonstrate the sensitivity of profit maximizing prices to parameterization and priors for WTP.

A Structural Model for Evaluating the Sector-specific Impacts of Preferential Trade Agreements

This paper develops and estimates a structural model of imperfect competition in international markets. The model incorporates a flexible non-linear demand framework with structural price equations. A general Conjectural Variation approach is developed to characterize strategic interaction. This allows the simultaneous evaluation of the sector-specific terms of trade effects of a Preferential Trade Agreement (PTA), and the extent of international competition in the sector under consideration. The model is then used to evaluate the impact of the Lebanese–Egyptian PTA on the iron and steel import sector in Lebanon. Results confirm the need for a structural approach in the empirical assessment of PTAs.

Manufacturer-owned retail stores

Increasingly, manufacturers sell their products in their own retail stores, and many of these stores appear to be in direct competition with independent retailers; i.e., both types of retail stores are physically co-located. We analyze one way this practice affects the retail market. We find that, when independent retailers compete against company stores (instead of just against other independent retailers), they (1) charge higher prices and (2) are more willing to engage in marketing efforts on behalf of the manufacturer’s brand. Furthermore, when company stores and independent retailers compete in the same market, the company store charges higher prices and provides more marketing effort. Anecdotal data are consistent with these model predictions.

Customer relationship management in competitive environments: The positive implications of a short-term focus

Researchers and business thought leaders have emphasized that firms must think and act with a long-term horizon when managing customer relationships. We demonstrate that, in contrast to this widely held view, profits in competitive environments may be maximized when firms ignore the future and instead maximize period-by-period profits from customers. Intuitively, while a long-term focus yields more loyal customers, it greatly increases short-term price competition to gain and keep customers. Consequently, overall firm profits and customer lifetime value may be lower when firms directly maximize multi-period profits from customers. Specifically, we analyze a model with segment-level pricing where firms in a duopoly can choose between period-by-period and multi-period profit maximization and demonstrate that, in many cases, a symmetric focus on period-by-period profit maximization emerges as the Pareto-dominant Nash equilibrium. We extend the model in two directions. First, we demonstrate that this superiority of the short-term focus endures even when a revenue expansion effect applies—that is, when customer loyalty leads to enhanced revenues. Second, we examine the case where customers are strategic and incorporate the long-term implications of their choices into their decision-making. Here we demonstrate that it may pay for firms to be myopic even when customers are strategic. The focus on multi-period surplus makes customers less price sensitive to price variations at the early stage of the game. Consequently, the focus on maximizing period-by-period profits enables the firms to charge higher upfront prices and leverage this lower price sensitivity into higher profits. Overall, our results highlight the paradox that, when it comes to managing customer relationships in competitive environments, a short-term focus may constitute the optimal long-term strategy.

Banking Competition and SMEs Bank Financing. Evidence from the Italian Provinces

This work investigates whether local differences in banking competition impact on the amount of bank debt used by Italian small and medium sized manufacturing firms. Sample selection and Double Hurdle models are adopted as the process, which results in the choice of bank financing may differ from that determining its amount. Our main finding is that more competitive banking markets seem to be associated with relatively higher usage of bank debt by less transparent firms. On the other hand, a higher banking competition seems to have no effect on the probability of receiving bank loans.

Advertising budgets in competitive environments

Firms can approach advertising competition either by setting advertising budgets (as in the percentage of sales method) or target sales levels (as in the objective and task approach). We study firms’ incentives to adopt one or the other posture using a two-stage model of duopolistic competition. In the first stage, each firm chooses to commit either to an advertising budget, letting its sales follow from the market response function, or to a desired sales level, promising to adjust its advertising spending accordingly. In the second stage, firms choose the actual levels of their advertising budget or sales target. When prices are exogenous, we show that, due to strategic effects, if a firm benefits from its rival’s advertising (as when advertising increases awareness of the product category) then setting an advertising budget dominates setting a sales target. On the other hand, if a firm is harmed by its rival’s advertising (as when advertising increases the firm’s share of a fixed market), then committing to a sales level dominates. We extend these results in several directions and show that when firms engage in price competition as well as advertising the nature of advertising and product-market competition interact to determine whether setting an advertising budget or sales target dominates.