lec 1 - search and switching costs
TRANSCRIPT
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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
20
25
30
35
40
Feb
-99
Jun-9
9
Oct
-99
Feb
-00
Jun-0
0
Oct
-00
Feb
-01
Jun-0
1
Oct
-01
Feb
-02
Jun-0
2
Oct
-02
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-03
Jun-0
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Oct
-03
Feb
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Jun-0
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Oct
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Feb
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Jun-0
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Oct
-05
Feb
-06
Jun-0
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Oct
-06
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
9
Jun-9
9
Oct
-99
Feb
-00
Jun-0
0
Oct
-00
Feb
-01
Jun-0
1
Oct
-01
Feb
-02
Jun-0
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Oct
-02
Feb
-03
Jun-0
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-03
Feb
-04
Jun-0
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-04
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-05
Jun-0
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Oct
-05
Feb
-06
Jun-0
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-06
Pe
rce
nta
ge
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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