Search and Ripoff Externalities

Transcription

1 Search and Ripoff Externalities Mark Armstrong Oxford University UCL: October 2014 Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

2 Introduction Markets contain a mix of savvy and non-savvy consumers Old intuition: savvy consumers protect the rest consumer protection policies only needed when there aren t enough savvy types present Recent focus: savvy consumers prey on the non-savvy This talk explores: when savvy consumers do protect the rest when instead non-savvy consumers protect (or are exploited by) the savvy when consumers have aligned or divergent views on regulation Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

3 Notions of savviness A consumer might be well informed about prices available in the market, and/or be able to discern product quality savvy consumer knows quality of wine from the label connoisseur can recognize old master painting in junk shop savvy consumer knows range of prices for a new TV before buying (eg., she is online) savvy consumer can interpret small print in contracts, food labels, etc A consumer might be strategically sophisticated, and understand the nature of the market game being played even if she cannot directly observe a product s quality, she understands the relationship in equilibrium between price and quality even if she doesn t observe prices, she anticipates equilibrium prices she foresees a firm s incentives to set future and add-on prices she foresees her own future behaviour and temptations Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

4 A framework There are two kinds of consumer: savvy and non-savvy proportion of savvy types is exogenous, σ [0, 1] the tastes of consumers do not differ across the two groups Consumers in equilibrium: V S (σ) is surplus of an individual savvy consumer V N (σ) is surplus of an individual non-savvy consumer since savvy consumer can follow non-savvy strategy and tastes are the same, expect V S V N V (σ) = σv S (σ) + (1 σ)v N (σ) is aggregate consumer surplus possible for aggregate consumer surplus to rise even if V N and V S decrease with σ Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

5 A framework Suppliers in equilibrium: Π S (σ) is profit from a savvy consumer Π N (σ) is profit from a non-savvy consumer comparison between Π S and Π N depends on context, but usually Π N Π S Π(σ) = σπ S (σ) + (1 σ)π N (σ) is industry profit (profits are zero in competitive markets) W (σ) = V (σ) + Π(σ) is total welfare Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

6 A taxonomy of markets Search externalities: non-savvy are protected by the savvy V N (σ) increases with σ Ripoff externalities: savvy prey on the non-savvy V S (σ) decreases with σ No externalities: V N and V S do not depend on σ We study two families of models: an indivisible product with price dispersion add-on pricing Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

7 Price dispersion Varian (1980): Symmetric firms supply homogeneous product to consumers consumers have idiosyncratic valuation v for product fraction σ of consumers observe all prices in the market and buy from the cheapest supplier (if v p) remaining 1 σ consumers visit single supplier and buy if v p [they might be strategically naive, and think the law of one price prevails, or not know of other suppliers] equal shares of non-savvy consumers for each supplier Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

8 Price dispersion In a mixed market with 0 < σ < 1, firms choose price with a mixed strategy and there is price dispersion savvy consumer obtains (weakly) lower price than any non-savvy consumer, so V S > V N, Π S < Π N Larger σ makes a firm s demand more elastic, and forces firms to set lower prices on average V S and V N increase with σ, Π falls with σ consumer policy which boosts σ welcomed by all consumers classic instance of a search externality Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

9 Variants of Varian: tacit collusion Schultz (2005) studies tacit collusion in Varian s model all rivals observe deviation to a lower price only σ consumers can react to the price cut Increasing fraction of savvy types has two effects reduces one-shot (mixed strategy) punishment profits increases fraction who are able to respond to a price cut, and so boosts deviation profits Two effects cancel out if δ is the discount factor, condition for collusion is n 1 1 δ which doesn t depend on σ so payoffs V S and V N don t depend on σ Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

10 Variants of Varian: uncertain match quality Symmetric firms compete to sell a horizontally differentiated product all consumers see all prices with probability α a consumer likes a given product, which is then worth 1 to her otherwise the product is useless, then worth 0 If all consumers can observe their match quality, model akin to Varian consumers buy from cheapest firm with a good match mixed price strategy since some consumers are captive with only one good match Suppose fraction 1 σ of consumers are non-savvy and cannot observe match quality ex ante they are rational, anticipate expected match quality α from all firms, and buy from firm with lowest price (if below α) these non-savvy consumers act to intensify price competition instance of ripoff externality Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

11 Add-on pricing Related insights apply to add-on prices, which are often less observed or considered than the core product s price Many examples: minibar prices in hotel room toner cartridges after buying printer after-care service for your new car extended warranty for new TV casual overdraft from your bank carry your luggage in the hold if it s slightly too large for the cabin Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

12 Add-on pricing: rational but uninformed consumers A monopolist supplies a core product, with cost C and price P and which consumers value at X if consumer has the core product, an optional add-on product is available with unit cost c if the add-on price is p, all consumers with core product will buy q(p) units of the add-on if s(p) = p q is consumer surplus from the add-on priced at p, consumer buys core product if X + s(p) P firm chooses add-on price p in advance all consumers see P, but only σ see p as well remaining 1 σ do not see p but foresee firm s incentives Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

13 Add-on pricing: rational but uninformed consumers Suppose firm offers same add-on terms to all consumers so V S = V N and Π S = Π N [when uninformed have passive conjectures about p] equilibrium add-on price satisfies (1 σ)q(p ) + (p c)q (p ) = 0 when σ = 1 add-on price is effi cient p = c when σ = 0 add-on price is monopoly price p M that maximizes add-on profit π(p) (p c)q(p) [With log-concave q] all consumers and the firm are better off with higher σ Hard to do competitive version of this model easier, and often more natural, to study models with naive consumers Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

14 Add-on pricing: naives do not foresee need for add-on Consider variant of add-on pricing model where naive consumers do not foresee they might need add-on service can see add-on price p (but aren t interested) they purchase myopically and buy core product if X P as before, savvy types are forward-looking and buy if X + s(p) P Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

15 Add-on pricing: naives do not foresee need for add-on Analysis is most transparent in competitive case (at least four firms) asymmetric pure strategy equilibrium has savvy types being offered cost-based tariff (P, p) = (C, c) naive types face bargain then ripoff prices, with add-on price p M that maximizes π(p) (p c)q(p), and core product price P = C π(p M ) which just ensures break-even these contracts do not depend on σ neither type wishes to take contract aimed at other type policy to limit ripoffs has no impact on savvy consumers Naive surplus isn t necessarily increased if ripoffs are eliminated subsidy funded by ripoffs mitigates ineffi ciency caused by myopic consumers participating too rarely Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

16 Add-on pricing: naives do not foresee need for add-on Many other situations where competitive deals offered to savvy and naive consumers do not depend on σ astrology (or similar), where savvy consumers know it doesn t work and will never buy it over-optimism about gym attendance (DellaVigna & Malmendier, Eliaz & Spiegler) insurance (Sandroni & Squintani) Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

17 Add-on pricing: bill shock Adaptation of Gabaix & Laibson (2006) Savvy types just pay headline price Naive types can be tricked into paying more they inadvertently buy add-ons they do not particularly want (eg., overdraft charges levied by bank, airport vs. online check-in, mobile call charges beyond contract limit) [similar outcomes if naive consumers can be persuaded to buy worthless add-on (eg., extended warranty for a very reliable TV), or are offered highly-priced add-ons, while cheaper substitutes are available with advance planning (eg., minibars)] Examples: Ryanair charges 70 to check in once at the airport, to check over-sized bag into the hold in UK retail banking in 2006, 75% of customers paid no unarranged overdraft fees, while 1.5 million customers paid more than 500 Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

18 Add-on pricing: bill shock Product has price P and cost C naive end up paying an (exogenous) extra amount R X is idiosyncratic value for product, where fraction of consumers with X P is Q(P) Both savvy and naive consumers have demand Q(P) for product savvy because they pay P naive because they think they will pay P Firms cannot distinguish savvy from naive in advance, so offer same price to all in competitive market the equilibrium price is P = C (1 σ)r savvy types just pay this P, but naive types pay C + σr payment increases with σ for all consumers Mark Armstrong () Search and Ripoff Externalities UCL: October / 19

19 Add-on pricing: bill shock Surplus of savvy and naive consumers with price P is V S = S(P) = Q ; V N = S(P) Q(P)R P some naives have negative surplus V S decreases with σ ambiguous impact on naive surplus, but if R not too large then V N also decreases with σ total welfare W rises with σ Regulation might constrain rip-off element R improves welfare and naive surplus but harms savvy types this lack of consensus makes these policies controversial in banking context, say, it may be poor people who are ripped off, which adds distributional dimension Mark Armstrong () Search and Ripoff Externalities UCL: October / 19