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EC231, Industrial Economics

1: Strategic Behaviour

Price Search, Switching,

Information and Advertising

Michael Waterson

Plan for the term

We will cover four topic areas:

• Search, switching etc

• Price discrimination and bundling

• Vertical Integration etc

• Innovation and Technical change

– Probably spending more time on the first two

– Evidence as well as theory

• Classes start next week, for the even week groups

(2,4,6,8); for the odd number (3,5,7,9).

• Requirements will be 2*problem sheets, 1*essay and a

1.5 hour exam.

• Plan for today: Cover Search cost and switching cost

models 2

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Reasons for differences in prices across

similar products

• Product differentiation (last term)

– Different prices due to physically different products

• Price discrimination (or bundling)

– Firms taking advantage of differences in consumer

requirements/ characteristics

• Search and/ or switching costs

– Differences in consumer characteristics due to their

own behaviour

– May be linked with price discrimination sometimes.

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Information and pricing

• Consumers don’t have full information

– Either about the product, or about the price for

the product; we’re only considering issues on

pricing at the beginning

• What are the implications, in particular for

competition?

– Depends on how, and how much, people

search for prices

• Motivating examples (tyres, electricity) showing

price dispersion

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Example 1: Tyres

• Buying a Michelin Classic, 175/70R13 T in

Gloucester, road leading South

• Just Tyres price = £40 per tyre, fitted,

complete

• Tyreservices price = £56 per tyre, ditto

– (Data collected by Which? Researchers)

• Search cost significant (?) or

• People don’t search for tyres very much

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Example 2: Electricity price data- bill range

excluding incumbent for direct debit customers

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15

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25

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Feb

-99

Jun-9

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Pe

rce

nta

ge

HIGH USERS (4950) LOW USERS (1650)

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Electricity (cont)- gains from switching (direct debit,

again)

-15

-10

-5

0

5

10

15F

eb-9

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Jun-9

9

Oct

-99

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-00

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Average BG gain Average RANDOM gain

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Explanations: Search cost and

switching cost.

• Search cost of seeking out new suppliers

(first figure)

– Note, this can’t be explained by switching cost

because all these tariffs from other operators

require a switch

• Switching cost of changing to a new

supplier (second figure, essentially)

– Not all goods have a switching cost, but

electricity does (tyres don’t necessarily).

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Modelling search costs • How much search should a consumer do?

• Search Technologies:

– Cost of search is an amount c per search (e.g. phoning tyre dealers)

– Or A lump sum payment k gains you a given set of searches (e.g. Confused.com)

• Search Approaches:

– Sequential search: Make a decision after every search

– Non-sequential search: Make a decision to carry out a given number of searches

– Sequential search is only likely to be relevant for the first technology

(Note insurance example, though)

Modelling search costs (2)

• If search costs an amount c every time, only limited search.

• Assume prices differ across firms.

• On average, the more firms searched, the lower the expected lowest price received.

• Should continue until the expected gain from the next search is less than the expected cost- i.e. stop just before this (possibly a target being reached).

– Whether search is sequential or non-sequential

• [Of course, if search costs a fixed amount k, then either do it or not, dependent on the fallback position]

• Note- not every search can be carried out on the internet (e.g. a kitchen fitter).

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Dice illustration • Obviously just an illustration- assume prices

distributed according to the numbers on the die.

• Average value if shake once = 3.5

• Average lowest value if shake twice = 2.53 (1/36*6 + 3/36*5 + …+ 11/36*1)

• E(Gain from second search) = 0.97

• Average lowest value if shake 3 times = 2.04

• E(Gain from 3rd search) = 0.49

• And so on.

• So if c = 0.5, stop after 2 searches.

• Example assumes distribution of prices is given. But what will this look like?

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“Tourist trap” (Diamond) model

• n firms trading currency. Each consumer wants to buy 100 units. Consumer has a general idea about the distribution of prices, searches randomly.

• Cost to check price is c per store.

• So, in effect, pays: p1.100 + c at first store.

• Would go to second store if

• p2.100 + 2c < p1.100 + c

• i.e. would not engage in more search if:

• (p1 - p2).100 < c

• So, first firm can charge: p1 p2 + c/100

and not lose custom.

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Tourist trap (cont)

• In other words, however many stores there are, price will be above competitive price at some stores.

• All firms may think alike. Therefore, they may all charge p* = pc + c/100.

• But then that means a firm can charge

• p1 p* + c/100 and get away with it.

• Argument continues until p = pm

• If a single-price equilibrium exists, it will be at pm (Diamond)

• If not, firms charge different prices.

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“Tourists and Natives” model (Salop/Stiglitz)

• Two types of firms, high price and low price

• Half (say) of consumers (natives) are well

informed about prices, half ill informed (tourists).

• All the well-informed consumers go to the low

price stores. Half of the tourists do, by chance.

Half of the tourists go to the high price stores, by

chance.

• So on average, high price stores receive 1/4 of

sales, low price stores receive 3/4 of sales.

• Can an equilibrium exist, with high price stores?

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Equilibrium in Salop/Stiglitz

• Yes, given sufficient supply of tourists: Monopolistically competitive equilibrium. High price stores and low price stores can each make normal profit, after allowing for fixed costs, i.e. fixed costs per unit sold are higher for high price stores.

• See Carlton and Perloff, ch. 13, including appendix, for more detail on this model.

• But this model relies on very specific assumptions in order to get its equilibrium, and can only give rise to a two-price equilibrium, not one with many prices

• Extensions to more complex models- mixed equilibria.

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Stahl’s search model (AER 1989) (brief)

• Two types of consumers, “shoppers” who face zero

search cost and “searchers”, who face a search cost of c

(constant across this group) per visit

– The searchers continue until they reach their

reservation price

• How will the two groups of consumers behave?

– It turns out firms set prices such that searchers

search only once in equilibrium

• What prices will firms set in this situation?

• No pure strategy equilibrium exists (unlike in Salop and Stiglitz)

– Because if one firm reduced price a little it would get all the shoppers

– No two firms can set the same price

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Stahl (cont) • Any equilibrium involves

more than one price and mixed strategies, with a price distribution

• As the share of consumers with complete information rises, average prices fall

• See also Belleflamme and Peitz on this type of model- they describe a slightly different alternative, the Varian model.

• Can be generalised to a model with a range of search costs, so long as some people have zero.

f(p)

pMC r

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Implications of search models

• Non-zero search cost can mean very little search takes place. If so, all prices may be very high; there need not be dispersion in prices. (Professions??)

• It is rational to engage in only limited search.

• Search costs can lead to multiple prices in the market, in particular to two-price or multi-price equilibrium. Ignorant consumers pay more on average.

• Different levels of search/ different search costs lead naturally to some price dispersion in the market.

• Individual firms selling in different ways may be able to take advantage of differential searching behaviour

• As the share of consumers with complete information increases, average prices fall.

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Empirical modelling of search costs-

Sorensen (JPE 2000) example

• Examines prediction that price dispersion will arise when there is a positive probability that a randomly chosen consumer knows only one price.

• Differences in search costs among consumers who purchase products with different frequencies.

• Tests proposition arising from search theory that consumers will have greater incentives to price-shop for repeatedly purchased prescriptions than rarely purchased prescriptions.

• So is price dispersion lower and margins lower for repeatedly purchased drugs?

• Note the different institutional setup in the US for these products

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Sorensen’s data and modelling framework

• Uses detailed micro-data on retail prices for drug

prescriptions

• Sample: Top-selling prescriptions (around 160)

across 20 pharmacies in 2 upstate New York

cities. Plus data on drug characteristics.

• Model (in part):

(purchase frequency, acquisition cost,

generic comp, therapy type)

Range f

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Sorensen’s results (abstract)

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-.336

(.123)

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Brown and Goolsbee (JPE 2002)

• Examine price effects of increasing use of internet for

searching for term life insurance in US, 1992-1997. I.e.

Internet increases , assuming internet search is costless.

• Need to control for different characteristics, etc.

• Result: Increased internet use reduces average price,

but effect on dispersion is indeed non- monotonic

• Points for reflection:

• Why do we get a range of prices, even for those within

homogeneous goods purchased over the internet via

price comparison sites (e.g. computer memory)?

• Why do firms participate in price comparison sites?

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Switching costs Consumers make many decisions with potentially long-term effects,

some trivial, some big

•Choosing an electric toothbrush

•Choosing a fixed rate mortgage

•Selecting a mobile phone contract

•Buying a games machine

•Buying a particular type of camera (e.g. digital “4/3 rds”)

•Choosing a life partner!

•Making a change can then be costly, in time or money- Switching Costs

Example

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Modelling Switching costs

• Klemperer example:

• Suppose a 2 period model, 2 firms. Marginal

cost = 10,

• Demand

• In period 1, the firms act as Cournot competitors.

Then in period 2, they can choose to offer a

“loyalty discount” of 10

• What is the outcome in period 2?

1 2100 ;q p q q q

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Klemperer- First period

1 1 1

11

1

1 2

1 2

( ). (90 ).

90 0

90 2 0

Similarly for firm 2, hence

30; 40; 900i

p c q q q

q qq

q q

q q p

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Second period

• Both set loyalty discount of 10, each sets p = 65 (before discount), qi = 22.5, earns profit i = 1012.5.

• How can this second period equivalent to collusive equilibrium exist? How can it be an equilibrium?

• Suppose one firm sets output at 22.5, why will the other do so also?

• For this to work, needs switching cost high enough.

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Lose own sales to rival

Lose/ gain sales at market elasticity

Gain sales from rival

p1

q

p1=p2+s

p1=p2-s

0

p2

Second Period Duopoly Competition

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Switching costs- further considerations

• Should also consider the impact on 1st period activity. A

bonus to selling to people in 1st period.

• Therefore expect “introductory offers”, “bargains then

ripoffs”, coupons for future purchases.

• Under Bertrand competition, price in first period will be

as low as c – s.

• Switching costs include compatibility costs, learning

costs (computer), transactions costs (banks), quality

uncertainty, contractual costs, shopping costs, etc.

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Different types of goods (Nelson) and

information considerations

• Search Goods- – The consumer can ascertain the features of the

good before purchase. The problem is not knowing where/ at what price, they may be found. E.g.Tyres (for normal car)

• Experience Goods- – Consumer must consume the product in order to

ascertain its quality. (Consumer may well know where to get the product.) (Jaguar XJ; perfume)

• Credence Goods- – Even after consumption, you are not able to

ascertain the quality. Maybe after prolonged consumption. (Veterinary services/ virus program)

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The role of advertising- search goods

• In general, there would be no point in firms advertising if

consumer knowledge was perfect.

• Depending on the nature of consumers lack of

information, different types of advertising may be used.

• Consumers have an incentive to engage in search- done

already.

• Consumer associations may provide information.

• Low price firms have an incentive to engage in

Informative Advertising (price, location, etc.)

– Example, next slide

– Models to show effect of price information

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B

A

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The effect of improving consumer info about

search goods Estimate of Price at

Store A

9 10 11

Estimate 9.5 A B B

at B 10.5 A A B

11.5 A A A

If B charges 10.5 and A charges 10, B makes 1/3 of sales

After more

info Estimate of Price at

Store A

9.7 10 10.3

Estimate 10.2 A A B

at B 10.5 A A A

10.8 A A A

If B charges 10.5 and A charges 10, B makes 1/9 of sales

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Implications of better information on price

• Improved information increases the share of low

price stores

• In turn, this will lead to competitive pressure on

the high price store(s).

• This suggests that informative advertising

regarding price increases competition, reduces

price dispersion and reduces average price.

• Informative advertising regarding existence does

not necessarily have an impact on price-

– see next slide.

• Suggestive models only

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Implications of advertising existence

Consumer

numbers

Valuation

of productQuantity

Demanded

v2v10

0

v2

Price

v1

After advertising

No impact of advertising on price elasticity of demand at any given

price

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Advertising existence (cont)

• Informative advertising regarding existence does not

necessarily have an impact on price.

• Product existence- rightward shift in demand

• If advertising simply tells consumers the product exists,

this arguably scales up demand. No impact on demand

elasticity at a given price.

• So, moving from a situation of no advertising to

price advertising of search goods has generally

beneficial effects on competition and on consumers.

• This doesn’t necessarily imply anything about moving

from a situation with some advertising to one with more

advertising.

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Examining the effects of advertising

for search goods • Classic example is optometrists

• In some US states, advertising allowed, in others not, or in some states not allowed, then becomes allowed.

• They advertise existence, and sometimes price, or indications of price

• See Love and Stephen (I J Ec Bus 1996) survey: prices generally lower in places/ times that allow advertising

• Are spectacles search goods?

• No implications for advertising generally

• Note case of simple glasses availability.

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Experience

goods and

advertising

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Experience goods and Advertising

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Experience goods

• How do consumers discover the quality?

• How do firms demonstrate quality?

• Signals of quality- Price, Persuasive Advertising,

Warranties etc.

• Suppose a good (an experience good) is either

satisfactory, or not.

• Advertising persuades the consumer to try it (maybe in

part by giving information of some sort).

• But note also the link to product differentiation models-

you might also be trying to make your product stand out

by advertising, to horizontally or vertically differentiate it.

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Consumer

numbers

Valuation of product

v1B

v1A v2

B v2A

Price

v2A

v2B

DB

DA

Quantity

Impact of persuasive advertising (possibly)-

outward shift in demand

B = before; A = after

Demand is less elastic with respect to price after the advertising-

so we may expect price to rise.

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Modelling advertising for experience goods

(or new search goods)

• Dorfman-Steiner framework

• Dixit/ Norman welfare impact of advertising

• Milgrom/ Roberts- advertising as a signal

• Dorfman-Steiner: Why are some goods much more

advertised than others?

Starting point: q = q(p, A)

- agnostic as to specific mechanism

- Could be persuasive ads or could be informative of

the product

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( , )

( , ) . ( , ) ( ( , ))

q q p A

p A p q p A C q p A A

. . 0 (1)p p q pq p q C q

. 1 0 (2)A A q Ap q C q

From (1)

( ) / 1/q pp C p

From (2)

( ) / 1/ ( . )q Ap C p p q

So / . [( / ). ] / /A p A pA p q A q q

The Dorfman- Steiner maths (for a monopolist)

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Implications/ predictions of the Dorfman-

Steiner result

[Note that we can think of this, appropriately

interpreted, as the result for any firm]

• Advertising to sales ratio will be higher in

industries where the marginal productivity of

advertising is higher (has more impact)

• and in industries where demand is rather

inelastic with respect to price

• Some very big companies barely advertise at all

e.g. Shell, BP, AstraZeneca, BHP, Rio Tinto

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Top 20 Advertisers, UK (Nielsen)

2008 Company £m

1 Proctor/ Gamble 177

2 COI Comms 176

3 Unilever 148

4 Reckitt Benckiser 92

5 B Sky B 90

6 Tesco 88

7 DFS 82

8 Kelloggs 78

9 Asda 76

10 L'Oreal 75

11 Nestlé 62

12 Sainsbury 61

13 Orange 58

14 Morrison 57

15 BT 55

16 T-Mobile 55

17 Ford 51

18 M&S 51

19 Vodafone 50

20 Argos 47

The UK’s biggest

advertisers, 2008

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£

D1

D2MR1 MR2

q1 q2

p2

p1

q

c

0

Dixit and Norman-

Welfare effects of

advertising- does it benefit

consumers as well as firms?

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Implications

1 1

2 1

1

.

(net of the costs of advertising)

On post-advertising tastes:

.

For a small change

W - .

If the firm spends on advertising up

to the point that =0, net effect negative.

W q p

W q p

q p

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Milgrom and Roberts model (much simplified)

• Does the high quality product have an incentive to advertise in a manner different from the low quality product? If so, the presence of advertising provides a signal as to quality.

(A, B) - product which is of quality A, consumers believe it to be of quality B (A and B take on values H, high and L, low).

• Firm producing high quality product wants to advertise to make consumers believe it is high quality if:

• (H, H) – pa.A (H, L)

• Firm producing a low quality product prefers not to advertise if

• (L, L) (L, H) – pa.A

• i.e. if there is not sufficient gain from making consumers believe the product is high quality.

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• so there is a separating equilibrium iff:

(H, H) - (H, L) pa.A

(L, H) - (L, L) (1)

• In this case, advertising does provide a

signal of high quality, or reputation.

• Alternatively, there may be a pooling

equilibrium, in which advertising does not

provide a signal about quality, since both

advertise to the same level- if (1) not true.

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• Milgrom and Roberts look at when

separating equilibrium is likely to happen.

(N.B. role of repeat sales)

• A partial explanation of basically

uninformative advertising about newish

products.

• Not necessarily beneficial to consumers.

• Overall conclusion- impact of advertising

depends very much on the assumptions

underlying what it does.

Other methods of obtaining information on quality

• Advertising can provide useful information on the quality

of the product, although it may well be biased

information

• There are various other means by which consumers can

obtain information, either searching themselves,

obtaining information from other consumers, or obtaining

information from quality certifiers

• Consider the last of these briefly.

• Dranove and Jin JEL December 2010

– Series of (US) examples, plus some theory and

empirics.

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Features of Disclosure mechanisms

• Disclosure systematically measures and disseminates

information about product quality (sometimes looking at

inputs rather than outputs), where this is difficult to

ascertain otherwise

• Disclosure is usually conducted via third-party certifiers,

separate from the producers (sometimes the

government)

• Disclosure standardises quality assessment so that

results are comparable across sellers/ providers

• Why? – to provide consumer confidence in the product

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