Industrial Organization & CS

Nikoloz Pkhakadze

Lecture 4, Tying, Durable Goods

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Plan For Today
In the previous lecture we considered different types of price
discrimination
▶ First Degree price discrimination allows the monopolist to
extract the whole consumer surplus but needs a lot of
information, namely individual demand of each customer
▶ The second degree price discrimination allows to the monopolist
to extract some part of consumer surplus. The monopolist
needs to know distribution of individual demands
▶ The third degree price discrimination allows to extract
additional surplus from consumers if monopolist manages to
segment the market
Today we consider bundling and tying - as another tool for
monopolist to extract additional consumer surplus
And after that we consider a monopolists problem when
produced good is durable
Reading: Cabral sections 10.4 and 10.5; Shy 5.5 and 14.1
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Bundling and Tying
Bundling:Packages containing more than one unit of the
product is offered. A firm bundles if consumers have to choose
between buying a number of units of the product at a given
price, or not buying at all.
▶ Examples of bundling include all quantity discounts (buy one
unit, and get the second one for free), volume discounts,
unlimited phone calls, and frequent-flyer mileage earned by
passengers who convert them to free tickets.
▶ Depending on information monopolist has and segmentation
abilities, bundling is a particular cases of first or second degree
price discrimination and could be mimicked by two-part tariffs,
so we won’t consider it further
Tying Offering packages containing at least two different
products
▶ Car with an installed audio system, a computer with some
software packages
▶ Non-complementary products could be tied too
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Tying - Examples
Two types of consumers and two goods (A and B) produced by
a monopolist with MCA = MCB = 0. Seller maximizes revenue
Unit demand, Willingness to pay for package is sum of WTP for
goods contained in package

If equal shares of each type of consumers and monopolist does

not tie - revenue is maximized when PA = 900 and PB = 200,
RNT = 2 × 200 + 2 × 900 = 2200. But if seller ties and sets
PAB = 1200 then RT = 2 × 1200 = 2400 > 2200 = RNT
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Tying - Examples

However tying is not always beneficial for the monopolist

If equal shares of each type of consumers and monopolist does

not tie - revenue is maximized when PA = 900 and PB = 200,
RNT = 2 × 200 + 2 × 900 = 2200. But if seller ties and sets
PAB = 1100 then RT = 2 × 1100 = 2200 = 2200 = RNT

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Tying - Examples
Tying could be even harmful

If equal shares of each type of consumers and monopolist does

not tie - revenue is maximized when PA = 900 and PB = 500,
RNT = 1 × 500 + 2 × 900 = 2300. But if seller ties and sets
PAB = 1100 then RT = 2 × 1100 = 2200 < 2300 = RNT
Tying works when there is negative correlation between WTP
across goods

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Tying - Examples
Mixed Tying

Figure: From Cabral - Problem of Microsoft

Separate pricing: Pw = Pe = 50,

RNT = 40 × 50 + 40 × 50 = 4000
Tying: Pwe = 50, RT = (40 + 40 + 20) × 50 = 5000
Mixing: Pw = 50, Pe = 50, Pwe = 60,
RM = 40 × 50 + 40 × 50 + 20 × 60 = 5200
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Regulation
Regulators are not very keen on tying practices

Antitrust laws prohibit tying when it leads to reduced

competition.

If firm has monopoly power in market A, it may try to extend its

market power to market B by selling AB bundle.

This might foreclose its competitors in previously competitive

market of good B

Please read Luis Cabrals’ note about merger case which was
blocked by European antitrust agency

http://luiscabral.net/economics/teaching/gehon.pdf

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Durable Goods Monopoly
The market models we considered work more for flow goods -
perishable goods which are purchased repeatedly
These models also work for durable goods when long time
periods are assumed
Durability is relative - for modeling purposes we say that good is
durable if it can be consumed in many different periods
In 1972 Coase suggested that a monopolist who produces a
durable good will behave differently from the monopolists we
have considered so far, and will earn less profit
Imagine you inherited whole stock of a durable good1 and you
want to sell it. You face a downward sloping demand curve
P = 1 − q- what would you do?
1
One day in your spam folder, you found an email informing you that someone
with same family name as you living somewhere in central Africa bequeathed you
this stock
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Durable Goods Monopoly

Monopolist would sell 50% of it’s stock for 0.5 - what would he
do with the rest of the stock? - sell in next period for 0.25
Consumers will anticipate that price in the next period will be
lower and depending on type of demand and their patience they
might wait, so the demand in the first period should be different
from 1 − q

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Durable Goods Monopoly
Model I - continuum case

Continuum of consumers, downward sloping demand.

Consumers live for 2 periods and good lasts for 2 periods.
MC = 0
One-period demand for the services of the good is p = 100 − q.
Monopolist and Consumers play the following Game:
▶ Set of players: seller and buyers.
▶ Set of actions: Seller chooses quantity in period 1, and quantity
in period 2. Buyers choose whether to buy in each period as a
function of price.
▶ Payoffs: Sum of surpluses in each period (without discounting)

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Durable Goods Monopoly
Model I - continuum case
This is a sequential move game of perfect and complete
information
As a solution we’ll use Sub-game Perfect Nash Equilibrium
which we can find using backward induction
If monopolist produces q¯1 units in period 1, residual market
demand in period 2 will be

p2 = 100 − q¯1 − q2 ⇒ MC = MR2 (q2 |q¯1 ) = 100 − q¯1 − 2q2

100 − q¯1 100 − q¯1
⇒ q2 = ⇒ p2 = ⇒
2 2
(100 − q1 )2
⇒ Profit in period 2 π2 = p2 q2 =
4
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Durable Goods Monopoly
Model I - continuum case
Now we need to find the demand in the first period
Which consumers will buy the good in period 1? Those
consumers who would prefer to pay period one price p1 and
enjoy good for two periods
Willingness to pay for q¯1 th unit is 100 − q¯1 and consumer surplus
of the consumer who buys this last unit for two periods will be
2(100 − q¯1 ) − p1
If the the consumer buys good in the second period it’s surplus
would be
100 − q¯1 100 − q¯1
100 − q¯1 − p2 = 100 − q¯1 − =
2 2
Marginal buyer should be indifferent between buying in period 1
and 2 so
100 − q¯1 3q1
2(100 − q¯1 ) − p1 = ⇒ p1 = 150 −
2 2
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Durable Goods Monopoly
Model I - continuum case

So demand in period 1 is p1 = 150 − 3q21

Since marginal cost is 0, the monopolist’s two period surplus is

3q1 (100 − q1 )2
π1 + π2 = p1 q1 + p2 q2 = (150 − )q1 +
2 4
Which is maximized when
q1
150−3q1 −50+ = 0 ⇒ q1 = 40 ⇒ p1 = 90, q2 = 30 p2 = 30
2
So, total profit is

π1 + π2 = p1 q1 + p2 q2 = 90 × 40 + 30 × 30 = 4500

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Durable Goods Monopoly
Model I - Renting instead of selling
Alternatively monopolist could rent instead of selling - which
basically makes the good durable for only one period
In this case in both periods demand for the good is p = 100 − q

and monopolist will rent q1 = q2 = 50 in each period for

p1 = p2 = 50 and will make total profit equal to
50 × 50 + 50 × 50 = 5000 > 4500
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Durable Goods Monopoly

Lowering level of durability is one way of solving the problem of

consumers’ expectations.

Other possibilities are

▶ Renting (lease, temporary licenses of software, cutting product
support)

▶ Artificially decreasing the value of consuming old good

(temporary licenses of software, cutting product support,
advertising and trying to make new release more fashionable)

▶ Credibly limiting the production or announcing future prices are

not going to drop

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Durable Goods Monopoly
Model II - discrete case

In discrete case if consumers are different enough than

monopolist can use durability for price discrimination.

Assume we have just 2 (types of) consumers

▶ High type: - Per period willingness to pay equal to 250
▶ Low type: - Per period willingness to pay equal to 100

Cost of production is still 0

If monopolist rents the good it will charge 250 per period (since
250 > 2 × 100) so total profit will be 500

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Durable Goods Monopoly
Model II - discrete case

What if monopolist sells - is renting still better?

If none of the consumers have bought in the first period, the

price in the second period will be 250 - leaving both types with 0
surplus

So, high type knows that not buying in the first period leaves
her with 0 surplus (for 2 periods) - so she would agree to pay in
the first period 250 + 250 − ε, ∀ε > 0(surplus ε)

In the second period, the low type is still on the market and he
would agree to pay 100 - So total surplus for monopolist is
almost 600 > 500

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