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Slide1

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Text to 37607:APPLE53 netID

Go online to AEM 4160 class websiteClick on “attendance tracking” – in green fontSubmit your netID

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Slide2

Lecture 8: Virgin Pricing Case; Collusion and Cartels

AEM 4160: Strategic Pricing

Prof. Jura Liaukonyte

2

Slide3

Break Even PointMonthly ARPU (average revenue per unit): $52 (p.3)

Monthly Cost-to-Serve: $30 (p.3)Monthly Margin: $22Time required to break even on the acquisition cost = __________________In the cellular industry the monthly margin is relatively fixed across periods, therefore the traditional LTV can be simplified (assuming infinite horizon):

M = margin the customer generates in a yearr = annual retention rate = (1-12*monthly churn rate)i = interest rate (assume 5%)AC = acquisition cost

LTV =

M

1- r+

i

- AC

Slide4

LTV With ContractsThe annual retention rate in the industry

= ______________LTV =

- 370 =

Slide5

LTV Without ContractsEliminate contracts -> churn rate increases to 6%

Calculate the LTV:LTV =

- 370 =

Slide6

Eliminate Hidden Costs

If hidden costs were eliminated, the margin would certainly be reduced. Assume that it would be reduced to $18 from $22. Break even would become _________= __________

Slide7

What Happens to LTV?Without hidden costs, but with contracts

Without hidden costs and without contracts

LTV =

- 370 =

LTV =

- 370 =

Slide8

Option 3: Different Pricing ApproachTarget audience: Youth

Loathe contractsFail credit checksIdeal plan: no contracts, no menus, no hidden fees…How to differentiate itself, and have a positive LTVLook at the factors that affect LTV

Slide9

Options for Lowering Acquisition CostsAdvertising costs per customer

Industry=from $75 to $100Virgin planned ad costs = 60 mil/1mln= $60 (p.5)Handset subsidies:Current industry handset cost: $150 to $300 (assume $225) (p.5)Current industry handset subsidy: $100 to $200 (assume $150) (p.9)Current industry handset subsidy as a %: 67%

Virgin’s handset cost: $60 to $100 (assume $80)Assume Virgin’s subsidy around 30% = $30

Slide10

Acquisition CostsThen Virgin

’s AC would be just ____vs. industry average $370Sales commission: $30Advertising per gross add: $60Handset Subsidy $30Total: _______

Slide11

Consumer Friendly Plan: How to Achieve ProfitabilityBreak Even analysis: at what per minute price would Virgin break even:

Virgin’s monthly ARPU: ______________ where p=price per minuteAssume Virgin’s customers use 200 minutes per month (midpoint of estimate between 100 and 300, p.7)Monthly cost to serve: ______________Assume monthly cost to serve is 45% of revenues (Exhibit 11)Monthly margin: _______________

p > ________LTV =

_____

>

0

Slide12

Other Price PointsWhat if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents:

At 10 cents: At 25 cents:

LTV =

- ____ =

_____

LTV =

- _____ =

____

Slide13

Virgin’s Pricing Plan: What Happened?

A prepaid planNo contractsNo hidden chargesNo peak off peak hoursVery low handset subsidies

No credit checksNo Monthly billsPrice: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the dayNo exact numbers, but churn rate lower than 6%

Slide14

FROM HERE FOR EXAM 2

Slide15

Collusion

15

Slide16

Collusion and Cartels

A group of firms who have agreed explicitly to coordinate their activities to raise market price or decrease market output.Cartel members agree to coordinate their actionsPricesMarket sharesExclusive territories

Prevent excessive competition between the cartel membersCollusionCartel

An attempt to suppress competition

Slide17

Why doesn't everyone collude?Illegal.

In the US, collusive agreements cannot be enforced by legal contractsInternational cartels do exist, however.Hard to come to an agreement. Strong incentives to cheat -- collusion may not be sustainable.

Slide18

Types of Collusion

Tacit Coordination/Facilitating Practices.Explicit Conspiracy.

Slide19

1. Tacit CoordinationSpontaneous cooperation resulting from strongly perceived interdependence.

For example, following a rival’s price change.Difficult to achieve with lots of firms.Hard to find/prove/correct.Facilitating practices:Price matchingMost Favored consumer clause

Slide20

2. Explicit ConspiracyPrice fixing agreement.

Formal cartel.Per se illegal.

Slide21

What are the Incentives to Collude?

Start with a simple model of a Bertrand Duopoly Without collusion, p1*= p2*= MC=c and thus i = 0 Industry quantity is set at the perfectly competitive level

For a monopolist, price is set where MR = MC:P = a-bQ so MR = a -2bQSet c = a-2bQ and solve for monopoly quantity and priceQM = (a-c)/2b and PM = (a+c)/2

So 

M

= (P

M

- c)*Q

M

= (

a+c - 2c)/2 * (a-c)/2b = (a-c)2/4b If each firm produces 1/2 QM, each gets (a-c)2/8b

Slide22

Collusion in the Prisoner’s Dilemma Framework

Firm 2

Firm 1

Collude

Defect

Collude

Defect

(a-c)

2

/8b, (a-c)

2

/8b

0, 0

But what about the two empty cells?

Slide23

To fill in the two empty cells:If one firm sets price at the monopoly level, what price will the cheater set?

pi* = pM- Then the cheater gets all the demand and earns a profit only slightly less than what a monopolist would get:

C = (PM--c)*(QM +)  ((a+c)/2 -c)*(a-c)/2b = (a-c)

2

/4b

Profit of non-cheater is 0

Slide24

Collusion in the Prisoner’s Dilemma Framework

Firm 2

Firm 1

Collude

Defect

Collude

Defect

(a-c)

2

/8b, (a-c)

2

/8b

0, 0

(a-c)

2

/4b, 0

0, (a-c)

2

/4b

Slide25

Factors that Affect the Success of Collusion

Small number of firms in the marketLowers search, negotiation and monitoring costsSimilar production costsAvoids problems of side paymentsDetailed negotiationMisrepresentation of true costsLack of significant product differentiationAgain simplifies negotiation – don

’t need to agree prices, quotas for every part of the product spectrumLow cost of an agreement

Slide26

Collusion and cartels Cartels have always been with us; generally hidden

Electrical conspiracy of the 1950sGarbage disposal in New YorkArcher, Daniels, MidlandThe vitamin conspiracyBut some are explicit and difficult to preventOPECDe Beers

Slide27

Whistleblowers and Recent eventsEuropean Truck makers price fixing:

MAN and Scania, both owned by German auto giant Volkswagen as well as Daimler, DAF of the Netherlands, Iveco of Italy and Sweden's Volvo are accused of forming an illegal cartel between 1999 and 2011MAN will escape the prosecution because it reported the price-fixing cartelLikely to be one of the largest EU price fixing fines ($4 bn)Unilever and Procter & Gamble (2011)

Fined 315 m euros for fixing washing powder pricesTip-off by Henkel (German company) – whistleblowerWhistleblower clause - leniency policy aimed at encouraging people involved in collusion to report it, by promising the first member to blow the whistle that they will not face fines or prosecution.

Slide28

Fines in EU

Slide29

Fines in EU

Slide30

F. Hoffman-

LaRoche Ltd.

Vitamins

1999

$500

International

BASF AG (1999)

Vitamins

1999

$225

International

SGL Carbon AG

Graphite Electrodes

1999

$135

International

UCAR International Inc.

Graphite Electrodes

1998

$110

International

Archer Daniels Midland co.

Lysine and Citric Acid

1997

$100

International

Haarman & Reimer Corp.

Citric Acid

1997

$50

International

HeereMac v.o.f.

Marine Construction

1998

$49

International

Hoechst AG

Sorbates

1998

$36

International

Showa Denko Carbon Inc.

Graphite Electrodes

1998

$32.5

International

Fujisawa Pharmaceuticals Co.

Sodium Gluconate

1998

$20

International

Dockwise N.V.

Marine Transportation

1998

$15

International

Dyno Nobel

Explosives

1996

$15

Domestic

F. Hoffman-LaRoche Ltd.

Citric Acid

1997

$14

International

Eastman Chemical Co.

Sorbates

1998

$11

International

Jungblunzlauer International

Citric Acid

1997

$11

International

Lonza AG

Vitamins

1998

$10.5

International

Akzo Nobel Chemicals BV & Glucona BV

Sodium Gluconate

1997

$10

International

Cartel violations in the 90s

http://online.wsj.com/article/SB10001424052748704402404574529241844394428.html?mod

Slide31

Ten highest cartel fines per case

Slide32

INFORMANT

http://www.youtube.com/watch?v=DPXTsPS-hyw

Slide33

Example: Cell Phone Industry

Slide34

Tacit Collusion

Industry is an oligopoly Top four firms dominate almost the entire marketSame phone (e.g. iPhone from AT&T or Verizon?), data services (text, e-mail, etc)Agreement on price is easier to come by and cheating is easier to catch

Less incentive to cheat because it is a one-time sale product rather than a product from which sellers could gain a series of salesMechanisms

Homogeneous Products

Nondurable Goods

Slide35

Tacit Collusion:Pre-Announced Rate Changes

Service providers typically pre-announce rate changes they plan on implementingAdvanced notice gives competing firms time to respondCan test the market and competitors

Slide36

Tacit Collusion:Infrequent High Changes in Rates

Rate changes in the industry have been high and infrequent, yet coordinated across all four firmsFOCUS: Text MessagesSupply is almost unlimited so in a competitive market prices should decrease not increase over timeSince 2005 price per text has doubled. [IBISworld]Service providers do not claim that these increases were driven by higher costs so other methods must be at work.

Slide37

Price Matching GuaranteesPrice matching guarantees

Helps a firm to protect its consumers and charge a high price.It makes your competitor “soft.” Takes away the benefit for your competitor to undercut your price.

Slide38

Counter-Intuitive?Price matching guarantee is simply a mechanism for tacit collusion or competition reduction between firms.

Any offer of the price matching guarantee means effectively taking away any gains that its competitor might get from cutting price. If a firm offers a price matching guarantee, then a search consumer will buy from it because the consumer knows that in the event that there is a lower price offered in the market the consumer is insured that it will match that price.Since price matching takes away the gain from price cutting, no firm cuts price and price competition is reduced.

Slide39

ExampleTwo firms: Firm 1 and Firm 2

Two prices: low ($4) or high ($5 )3000 captive consumers per firm4000 floating go to firm with lowest pricePayoffs = revenue

Firm 2

Low

High

Firm 1

Low

,

,

High

,

,

Slide40

ExampleTwo firms: Firm 1 and Firm 2

Two prices: low ($4) or high ($5 )3000 captive consumers per firm4000 floating go to firm with lowest pricePayoffs in thousands of $ (revenue)Both low = 5000*4 = $20KBoth high = 5000*5 = $25KOne high = 3000*5=$15KAnother low = 7000*4=$28K

Firm 2

Low

High

Firm 1

Low

20,20

28,15

High

15,28

25,25

Slide41

Contracting with CustomersThe game is a prisoner

’s dilemmaBoth firms prefer: {High, High}Only equilibrium: {Low , Low}Cannot credibly promise to play HighEven if committed to High, other firm would still respond with LowHow to resolve this?Third party contracts with customers

Slide42

Price MatchingIf one firm charges low, it does not gain any additional customers, since the competitor

“automatically” matches it.What is the effect on the game?

Slide43

Price Matching

Firm 2

Low

High

Firm 1

Low

20

,

20

28

,

15

High

15

,

28

25

,

25

Firm 2

Low

High

Firm 1

Low

20

,

20

20

,

20

High

20

,

20

25

,

25