2008 MT#2 (plus answers)

Part I. Theory: One hour

1. Explain the following formula. Include a discussion of the economic significance of the various terms on the right-hand side. Add drawings if helpful.

A/R = (p-MC)/p * η = η / ε . [in case the fonts scramble, (p-MC)/p * eta = eta / epsilon]

Answer:This is the basic formula for understanding advertising, tying the elasticity of demand to advertising to the elasticity of demand. A/R is the share of advertising expenditures in revenue, and eta and epsilon are our elasticities, building upon our normal relationship between (p-MC)/p for the gross profit margin and (one over the) elasticity of demand.

We would expect that this ratio is higher for experience goods than for search goods, since for the latter simple statements of product details and price suffice. Product differentiation lower the price elasticity of demand, so we would expect to find higher advertising for such goods, and little or none for homogeneous commodities.

Graphs can illustrate why a shift in demand from advertising generates more revenues when price elasticity is smaller. Examples of products, spurious differentiation and so on can elaborate, as well as using advertising to serve as an entry barrier, and a prisoners dilemma where firms dare not advertise, leading to excessive advertising as additional expenditure serve merely to steal market share from rivals and not to expand demand in the aggregate for that class of goods.

2. Surely the temptation to discount to gain market share is great; why then does Bertrand competition seem to be relatively unusual?

Answer: Bertrand competition is where firms compete on price; in our “pure” case this generates a prisoners dilemma game that leads to firms setting p = MC, even in a duopoly.

There are lots of reasons why B.c. is not universal. At the beginning of the term we noted that capacity constraints dampen the advantages of price reductions, of course with the proviso that such constraints are binding (at which point there is no benefit from additional price reductions). Most recently, we noted that the greater product differentiation is, the more market power a firm has, so that a price reduction fails to generate additional revenue (MR low).

However, various collusive behaviors provide additional explanations. These include multimarket contact, so that firms hesitate to lower prices in one market for fear it will generate (retaliatory) reductions in other markets. Second, firms in frequent and on-going (long-term) contact can reach tacit understanding about price reductions, refraining from discounting for fear of generating a price war. Third, when there is a dominant firm, we often observe price leadership (with smaller firms underpricing by only a little) – though this story is in part a version of the capacity constraint idea.

In the first two cases, and particularly in the case of repeated contact, demand uncertainty can (should?!) generate the occasional price war, because firms cannot distinguish a “legitimate” response to a drop in demand from a nefarious attempt to steal market share.

Part II. Vertical and other Issues: One Hour

3. Comment on double marginalization issues in the context of T&T Chapter 7. (Of course, you might first need to explain what double marginalization is…)

Answer: Dbl marg is where a firm with market producing an intermediate good sells to a firm with market power selling a final good. The downstream firm sets its own price at MR=MC but this MC reflects the market power of the upstream firm and results in final market price higher than would be achieved by joint profit maximization.

One response is vertical integration; in the film industry, an antitrust case eliminated that option, and firms moved to various complicated vertical contracting/distribution structures. We should remember that our theory indicates two-part tariffs and other non-linear pricing schemes can be used to avoid dbl marg and thereby maximize profits. In particular, a firm could auction off movie (distribution) rights, capturing downstream consumer (distributor) surplus, while setting a low (marginal) price. In fact movie theaters often face complicated contracts, with various fees and maximum prices on popcorn (so that theaters can’t cross-subsidize “too low” pricing on films and hence lower payments to producers and/or distributors with higher concession sales). This latter was not in the book, but it does describe declining MC over time (as D and hence MR is presumably lower after the opening week) and otherwise indicates that “linear” (fixed price) sales are not the norm. Block booking, exclusive dealing, tracking, splitting and so on serve to lessen dbl marg problems, but also have other cost reduction or incentive or efficiency characteristics. Similarly, firms separate DVD sales from theater sales, and sales of tie-in products.

4. Comment on the following article. You may of course wish to draw upon the issues raised by Professor Nik-Khah in his talk.

“Sprint to ‘rejuvenate’ Nextel network”

By Paul Taylor in New York

Financial Times Published: October 31 2008 02:12

Sprint Nextel, the third-largest US mobile network operator, plans to keep and “rejuvenate” its Nextel network after failing to find a buyer for the unit.

The company, formed through the $36bn acquisition of Nextel Communications by Sprint three years ago, put Nextel up for sale earlier this year after struggling with integration problems and customer defections.

Sprint, which took an asset impairment charge to write off the Nextel purchase at the end of last year, was reportedly seeking a minimum of $5bn for the unit, just enough to cover its debts. But potential bidders including several private capital firms, backed off after the credit markets turned sour. Nextel’s nationwide network is based on a proprietary technology called iDen developed by Motorola. Its customers include many in the construction industry and other small businesses who value the network’s “push-to-talk” walkie-talkie feature built into all its handsets.

In a filing with the US Securities and Exchange Commission on Thursday Sprint said that after a “careful review of the iDen business, Sprint intends to retain and rejuvenate this important asset”. As part of that effort, Sprint said it had extended its long-term partnership with Motorola which provides equipment and support for the network, and will introduce a services of new handsets including a BlackBerry Curve model. “The iDen network is a key differentiator for Sprint,” said Dan Hesse who took over as Sprint Nextel’s chief executive at the start of this year. “It allows us to offer products and services no other carrier in the industry can match.”

Answer:The key item here is that they suffered badly from the winners curse, paying $35 billion for something worth $5 billion or less.

In addition, we do see innovation. However, it clearly isn’t working; they are retaining the asset for lack of a better alternative. The impact of splitting up the US spectrum in regions has been to impede, not generate innovation. To my knowledge no US cell phone company has been an innovator, just the opposite, the US has lagged markets elsewhere almost across the board. It simply doesn’t pay to innovate if all you can capture is one local or regional market (even if in principle you could license technology to firms in other markets).

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