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2586 results in Strategic management

Page 64 of 130

  • 18 - Innovation and R&D

  • from Part VII - R&D and intellectual property
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 497-530

  • Summary

    In this chapter, our goal is to examine the interplay between market structure and innovation. This is clearly a two-way relationship: on the one hand, firms’ incentives to invest in R&D depend on the structure of the product market they are acting in (i.e., on the number of rival firms and on the way they compete); on the other hand, firms are likely to use R&D to shape the structure of their market (e.g., by using R&D to increase their market share or to keep potential competition at bay). As the two effects are complex and intertwined, we simplify the analysis by assuming that firms can somehow appropriate the return from their R&D investments (we analyse how they actually manage to do so in the next chapter).We also break down the analysis into separate issues.

    In Section 18.1, we assess how market structure affects the incentives for conducting R&D, which are measured by the profit increase that the innovator gains from the innovation. First, incentives to innovate are compared in the two market structures where strategic considerations are absent, namely monopoly and perfect competition. It is shown that the latter generates larger incentives to innovate than the former. Next, we extend the analysis to include strategic interaction by considering oligopolies. We reach an ambiguous result: a higher intensity of competition may increase or decrease the incentives to innovate depending on the initial starting point, the size of the innovation and the way competition is increased. Finally, we study the possibility for the innovator to obtain additional revenues by licensing its innovation to other firms, be it inside or outside its own industry.

    In Section 18.2, we reverse our point of view by investigating how innovation may influence market structure. First, we reconsider a monopolist's incentives to innovate in situations where a competing firm threatens to enter the market. We show that the incumbent firm is often keener to invest in R&D than the entrant. Monopoly is thus likely to prevail over time, which indicates that innovation does indeed drive market structure. Second, we enrich the previous analysis by incorporating explicitly the time dimension. Indeed, a firm's main motivation when investing in R&D is often to be the first to come up with an innovation.

  • 13 - Marketing tools for experience goods

  • from Part V - Product quality and information
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 323-344

  • Summary

    In the previous chapter, we have looked at advertising and prices as two strategic variables that might be used to overcome asymmetric information problems. In this chapter, we will look at additional instruments that belong to the toolbox of a firm, such as a car manufacturer, which is confronted with asymmetric information. We focus on two broad classes of instrument, namely warranties (in Section 13.1) and branding (in Section 13.2).

    Warranties can be an effective tool to separate high- from low-quality products. A potential drawback is that consumers may not handle products with care if they hold a full warranty. This leads to a double moral hazard problem and makes this option possibly rather unattractive.

    Branding is another important tool for producers of experience goods. It is an essential success factor for many companies since they want to be recognized over time and across products. Firms can then rely on their brand, which stems from repeated interaction over time and on the use of one brand for several products so that consumers can correlate their beliefs about product quality across products – this latter practice is known as umbrella branding. An additional insight is that competition may substantially affect the logic of branding.

    Warranties

    Warranties are an everyday feature of experience goods. For instance, cars, consumer electronics and appliances typically come with warranties. Warranties establish liability between the manufacturer and the buyer in the event that an item fails (i.e., if the item is unable to perform satisfactorily its intended function when properly used). Usually, the warranty contract specifies both the performance that is to be expected and the redress available to the buyer if a failure occurs. Warranties serve many purposes. These include protecting manufacturers and buyers, assuring buyers against items which do not perform as promised, and helping dispute resolution between buyer and manufacturer. To meet these objectives, public authorities have formulated legislation imposing minimal warranties.

  • 9 - Menu pricing

  • from Part IV - Pricing strategies and market segmentation
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 220-242

  • Summary

    In this chapter, we start by emphasizing the difference between menu pricing and group pricing (Section 9.1). We then provide a formal analysis of menu pricing by a monopolist. We derive the conditions under which menu pricing leads to higher profits than uniform pricing; we also perform the same analysis in terms of welfare (Section 9.2). Finally, we turn to the analysis of menu pricing in oligopolistic settings; we consider in turn quality- and quantity-based menu pricing (Section 9.3).

    Menu pricing vs. group pricing

    The previous chapter described situations where the sellers are able to infer their buyers’ willingness to pay from some observable and verifiable characteristics of those buyers (like age, gender, location, etc.). In many situations, however, there exists no such reliable indicator of the buyers’ willingness to pay. How much a consumer is willing to pay is their private information. The only way for a seller to extract more consumer surplus is then to bring the consumer to reveal this private information. To achieve this goal, the seller must offer his product under a number of ‘packages’ (i.e., some combinations of price and product characteristics). The key is to identify some dimensions of the product that are valued differently across consumers, and to design the product line so as to emphasize differences along those dimensions. The next step consists of pricing the different versions in such a way that consumers will sort themselves out by selecting the version that most appeals to them. Such practice is known as menu pricing, versioning, second-degree price discrimination or nonlinear pricing. A few examples are given in Case 9.1.

    Case 9.1 Examples of menu pricing in the information economy

    The dimension along which information goods are versioned is usually their quality, which is to be understood in a broad sense (for instance, the quality of software might be measured by its convenience, its flexibility of use, the performance of the user interface, etc.). For instance, ‘nagware’ is a form of shareware that is distributed freely but displays a screen encouraging users to pay a registration fee, or displaying ads. In this case, annoyance is used as a discriminating device: some users will be willing to pay to turn off the annoying screen.

  • B - Competition policy

  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 729-737

  • Summary

    Throughout the book, we have described a number of situations where firms might restrict competition in their attempt to increase their market power at the expense of their competitors and/or of consumers: collusive agreements in Chapter 14, welfare-reducing horizontal mergers in Chapter 15, predatory behaviour in Chapter 16 and exclusionary practices in Chapter 17. To assess whether such conduct is detrimental or not, we measured its effect on economic welfare. That allowed us to show that not all restrictions to competition are detrimental (think of the vertical restraints that we discussed in Chapter 17). But in the case they are, we were forced to recognize that market forces are not always sufficient to curb market power and reduce prices, implying that public intervention, namely competition policy, may be desirable.

    Competition policy can be defined broadly (following Motta, 2004, p. 30) as ‘the set of policies and laws which ensure that competition in the marketplace is not restricted in such away as to reduce economic welfare’. In this appendix, our aim is to complement our previous analyses by giving a broad description of competition policy. We start by offering a brief historical perspective to understand where competition policy comes from (Section B.1). Then, focusing on the EU and the USA, we describe the relevant laws and link economic issues (exclusion, collusion, merger, etc.) to the particular laws (Section B.2). We proceed finally to a comparison of legal practice on both sides of the Atlantic. There exist important differences between the EU and the USA, but practices seem to converge nowadays (Section B.3).

    A brief historical perspective

    Competition policy was introduced in North America at the end of the nineteenth century and then spread across the rest of the world very gradually. Most European countries, as well as Japan, adopted competition policies in the mid-twentieth century. Other countries followed suit only recently in order to comply with regional agreements (such as the adhesion to the EU for Nordic and Eastern European countries) or with multilateral agreements (such as the membership of the WTO), or simply as part of a move towards a more market-oriented economic system (as was the case for a number of South-East Asian and Latin-American countries). To understand why some countries adopted competition policies earlier than others, it is useful to take a historical perspective.

  • Part II - Market power

  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 41-44

  • Summary

    Introduction to Part II: Market power

    Firms are assumed to maximize profits but the market environment limits their abilities to exploit consumers. Indeed, if we can believe the perfectly competitive paradigm, firms will end up selling at a price equal to marginal costs. In particular, if firms are price-takers and small compared to the industry, they will not exert any market power.

    But what happens if firms are not small compared to the industry they are operating in? This is certainly the case for heavyweights such as Coca Cola, Volkswagen Group, Samsung, ArcelorMittal, Gazprom, Anheuser-Bush InBev and the like. These large firms have seized a significant share of their respective markets. They can thus hardly be described as price-takers. Yet, as they face competition from a number of other firms, they cannot either be described as pure price-makers, like the monopolies we studied in the previous chapter. While these large firms undeniably exert market power, so do their smaller competitors. Market power – the ability to ‘make the price’ or to sell at prices above marginal costs – is thus collectively shared in those industries in which a few firms compete with one another. Such industries are called oligopolies (from the Greek ‘oligo’, which means ‘small number’). The vast majority of industries are oligopolies. The examples that spring to mind are the industries of these giant multinational firms that we mentioned above: soft drinks, cars, smartphones, steel, natural gas, beer, etc. But by simply looking around you, you will quickly realize that most of the goods and services you consume are produced, at least locally, by a small number of competing firms.

    The distinctive feature of oligopolistic competition is that firms cannot ignore the behaviour of their competitors. Indeed, competitors do exist (this is not a monopoly) and they are not small (this is not perfect competition). It follows that firms’ profits ultimately depend on the combination of the decisions taken by all the firms in the industry. Hence, firms’ decisions cannot be optimal if they do not take this interdependence into account. Firms must incorporate in their decision-making the anticipation of how their competitors are likely to act, and to react to their own decisions. Oligopolistic competition is thus synonymous with strategic interaction.

  • 5 - Product differentiation

  • from Part III - Sources of market power
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 111-137

  • Summary

    In most markets for consumer goods, there do not exist identical products from the viewpoint of consumers. Even if physical properties are hardly distinguishable, branding may achieve that products are differentiated. A number of questions ensue on how to apprehend product differentiation. How do consumers perceive products and services? To what extent do different consumers share the same perceptions? How similar are the demand curves of various individuals? Do consumers care for variety? The answers to these questions, and hence the modelling choices of the analyst, depend on the nature of the products or services under consideration. Think for instance of the car market, which has been the object of a number of empirical studies. Here, the assumption that consumers buy a single car, but that the population of consumers has heterogeneous tastes, is a natural assumption to make. For other consumer goods, neither discrete choice nor unit demand are natural assumptions to make. If you think of beer or carbonated soft drinks, the discrete choice assumption is often an appropriate assumption to make but consumers not only differ in their brand preference but also in their individual demand curves. In the case of wine, we believe that neither unit demand nor discrete choice are good approximations of actual consumer behaviour and therefore, are bad modelling assumptions: a large share of consumers actually enjoy some variety and buy variable amounts of quantity.

    In this chapter, we first address these questions by discussing some general approaches to differentiated products (Section 5.1). Then, we analyse discrete-choice models of horizontal and vertical product differentiation (respectively in Sections 5.2 and 5.3). In Section 5.2 we elaborate on the Hotelling model with linear and quadratic transportation costs, which have become standard workhorses in the industrial organization literature. The product positioning of a firm is guided by its attempt to provide a product that fits most tastes while avoiding competition from other firms by offering more specialized products. We elaborate on this trade-off. In Section 5.3 we focus on the observable quality choice by firms. Here, we add to our discussion of entry into product markets from Chapter 4 by showing that even negligible scale economies are sufficient for the property that only a small number of firms is viable in a market.

  • 20 - Markets with network goods

  • from Part VIII - Networks, standards and systems
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 577-611

  • Summary

    This chapter starts with a broad description of what network effects are: we distinguish between direct and indirect network effects, compare network effects to switching costs and report a number of empirical studies that have estimated the importance of network effects for various products (Section 20.1). We then proceed by characterizing demand and supply in network markets, looking first at a single good (Section 20.2) and next at several incompatible goods (Section 20.3). We will see that demand decisions may lead to multiple equilibria, leading to potential coordination problems, while supply decisions depend crucially on the level of compatibility between competing goods.

    Network effects

    Like instant messaging services, a large majority of information products and technologies exhibit network effects. Loosely defined, network effects refer to the idea that, other things being equal, it is better to be connected to a bigger network. In this section, we first make this idea more precise by distinguishing between direct and indirect network effects. We then draw the similarities and differences between network effects and switching costs. Finally, we provide some empirical evidence about the strength of network effects in various markets.

    Direct and indirect network effects

    Network effects can formally be defined as follows: a product is said to exhibit network effects if each user's utility is increasing in the number of other users of that product or of products compatible with it. Network effects are observed on two types of market.

  • • In network (or communication) markets, the benefit of consumers comes from the ability to communicate with other consumers via the network. In such markets, network effects are said to be direct and translate the fact that the more agents are present on a network, the larger the communication opportunities and the greater the incentives for other agents to join this network.

  • • In system markets, products are obtained by combining different components in a complementary way (often some hardware and a variety of applications). Here, the network effects are indirect by nature: they refer to the fact that the more applications are available for a hardware, the greater the incentives for consumers to purchase the system and the more application writers desire writing applications for this hardware.

  • 16 - Strategic incumbents and entry

  • from Part VI - Theory of competition policy
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 417-451

  • Summary

    If natural (or innocent) entry barriers in an industry are sufficiently large, entry is said to be blockaded for additional firms.56 In some markets, entry barriers are at a level that only a single firm can enter. In such a situation, the single incumbent firm can behave as a monopolist without fearing entry. In contrast, for lower entry barriers, entry is a threat that the incumbent cannot ignore. Facing potential entry, the incumbent will thus react strategically with a view either to make entry unprofitable or, at least, to minimize the harm that entry causes. Entry is said to be deterred in the former case, and accommodated in the latter.

    Because an incumbent is already established in the industry, it has the advantage of being able to act before a potential entrant decides whether or not to enter. However, acting before is not sufficient to influence the entrant's decision: the incumbent must also act in a credible way. We already raised this issue in Chapter 4 when analysing the Stackelberg game. In the present context, a threat to make the entrant's life impossible or hard if it enters can only be effective if this threat is turned into a commitment. That is, the incumbent's action must modify its incentives in such a way that if entry was to happen, it would be in the incumbent's best interest to carry out the threat.

    To achieve such commitment, the incumbent will invest prior to entry and in an irreversible way in some strategic variable that will affect its future conduct and, thereby, the profits the entrant could attain upon entry. It may also affect directly the entry cost so that this cost becomes endogenous. In Section 16.1, we show how the incumbent's investment decision depends on the strategic effect of this investment and on the type of product market competition. Combining these two dimensions with the two potential attitudes with respect to entry (deterrence or accommodation), we propose a taxonomy of entry-related strategies. Next, we apply this taxonomy to a number of specific examples of investments that an incumbent can make when facing the possibility of entry. In Section 16.2, we examine strategies affecting cost variables, namely investments in capacity, investments in R&D and strategies designed to raise the entrant's costs. In Section 16.3, we turn to strategies affecting demand variables.

  • Preface from the first edition

  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp xxiii-xxvi

  • Summary

    A large part of economic transactions takes place through markets. On these markets, firms take decisions in response to prevailing market conditions that affect the well-being of market participants. Such decisions are relevant to the field of Industrial Organization (IO) and their analysis lies at the heart of this book. Industrial Organization: Markets and Strategies indeed aims at presenting the role of imperfectly competitive markets for private and social decisions.

    Among the numerous decisions taken by firms is the make-or-buy decision, whereby firms compare the costs and benefits of manufacturing a product or service against purchasing it. Typically, the firm will prefer the ‘make’ option over the ‘buy’ option if the purchase price is higher than the in-house manufacturing cost or if outside suppliers are unreliable. Naturally, the firm must also have the necessary skills and equipment to meet its own product standards.

    There is a clear analogy between this generic dilemma and the decision process that led us to write this book. As industrial organization teachers since the start of our academic careers, we have both long relied on existing textbooks to support our courses. Yet, through the years, our needs became different from the offers of outside suppliers. That is, the ‘make’ option started to become more tempting than the ‘buy’ option.

    At the end of 2004 we firmly took our decision to ‘make’ a new textbook. At that time (and this still holds today), we could not find on the market any textbook in industrial organization that suited the type of courses at the advanced undergraduate or master level we were teaching. We knew that many of our colleagues shared our views. Our objective was thus to produce a new text that would greatly simplify the work of teachers who, thus far, had to combine material from different books and look for applications to meet their students’ needs. Naturally, benefits to teachers are meant to spill over to their students. Although we believe in formal modelling, we also believe that it is important not to overload students with techniques and to motivate the analysis with real-world cases. So, we endeavoured to write a book that blends up-to-date theoretical developments and real-life applications.

  • 15 - Horizontal mergers

  • from Part VI - Theory of competition policy
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 389-416

  • Summary

    Horizontal mergers (that is, mergers between direct competitors) in concentrated industries are an important issue for competition authorities. In this chapter, we explore whether mergers are profitable and/or welfare-enhancing. Merger control in the USA has a long tradition going back to the Clayton Act from 1914, according to which mergers that lead to a substantial lessening of competition are forbidden. The current approach is outlined in the 2010 Horizontal Merger Guidelines. Merger control in the European Union was introduced in 1990 (prior to that, individual member states were in charge) and substantially revised in the 2004 Horizontal Merger Guidelines. We refer you to Appendix B for more details on the legal aspects of competition policy.

    Although the empirical evidence on the profitability of mergers that actually took place is mixed, we should not observe (in expectation) unprofitable mergers under the assumption that managers maximize the net value of the firm. Thus, from an antitrust perspective, the worrying cases are profitable but welfare-reducing mergers. Mergers that are at the same time profit-increasing and welfare-reducing only occur in imperfectly competitive markets: mergers among competing firms with market power tend to reduce competition and thus have anticompetitive price effects. However, this does not imply that mergers are necessarily welfare-reducing because a merger may realize efficiency effects. Efficiency gains may stem from (1) production reshuffling among the plants that belong to the merged firm so that relatively efficient plants that were under-utilized before the merger turn out larger volumes, or production is adjusted to local demand with the effect that transport costs are reduced; (2) scale economies at a single plant (even if other plants use the same technology); (3) synergies by pooling certain functions; and (4) larger innovative capacity leading to future efficiency gains. A merger assessment then requires trading off welfare-reducing price effects with welfare-increasing gains in productive efficiency – this is called the Williamson trade-off .

    The final decision reached by the competition authority or the courts depends on the objective function that is used. In this chapter, we take total surplus as the relevant welfare measure. Note, however, that antitrust authorities tend to use consumer surplus as the relevant criterion. Applying this latter criterion typically raises the threshold for the efficiency gain that makes a merger socially desirable, since gains in profits that are due to higher prices are ignored.

  • 7 - Consumer inertia

  • from Part III - Sources of market power
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 162-194

  • Summary

    The first two chapters of Part III examined how firms choose two main elements of the marketing mix, namely product positioning and advertising, in order to gain market power. In that sense, market power was endogenous as it resulted from the firms’ strategic choices. In this chapter, strategic choices of this kind are absent as we mostly consider sources of market power that are exogenous to the firms’ conduct. In a nutshell, what confers market power to the firms is the presence of some form of inertia in the purchasing behaviour of the consumers. As we will observe throughout this chapter, such inertia may come from different sources and may enable firms to deploy various strategies.

    In Section 7.1, we consider environments in which firms sell identical products and do not make any advertisement. We show that firms can nevertheless enjoy market power if consumers are imperfectly informed about the existence and prices of available products. Not only are prices above marginal costs, but also prices may differ across firms and/or across time, a phenomenon known as price dispersion. We further show that such price dispersion may persist even when consumers incur costs to search for information about products and prices.

    In Section 7.2, we consider markets where switching firms is costly for the consumers, which induces them to purchase repeatedly from the same firm. This gives firms market power over those consumers who have purchased from them in the past. Because this form of consumer lock-in results either from environmental factors (such as learning costs) or from the firms’ conduct, we have here a mixture of endogenous and exogenous market power. More importantly, because market power results from consumers’ past choices, the problems we analyse in this section are inherently dynamic. We examine under which conditions switching costs make markets more or less competitive.

    Uninformed consumers and search costs

    In the previous chapter, we considered situations where consumers (i) did not know about the existence, characteristics or price of existing products and (ii) obtained ‘passively’ the relevant information through the firms’ informative advertising. Here, we maintain the first feature (at least some consumers lack information) but we modify the second: instead of being passive, information acquisition is now active in the sense that consumers can search for the information themselves.

  • Preface to the second edition

  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp xxi-xxii

  • Summary

    We are grateful for all the positive feedback from researchers, students and practitioners. In particular, we are very happy that our book is widely adopted in IO courses at the master's level and has also proved useful in many advanced bachelor as well as Ph.D. courses.

    The publisher provided us with a number of anonymous reviews, which contained suggestions on how to improve the book further, in particular with regard to reader-friendliness. We are grateful for the efforts by these researchers.

    The second edition keeps the same order of chapters. However, compared with the first edition, we have made two important expositional changes.

    First, at the end of each chapter we provide several exercises. Solutions to these exercises can be found at the end of the book. (As in the first edition, the textbook website contains additional exercises. Solutions to most exercises are available to instructors. We also continue to make slides for each chapter available on the textbook website.)

    Second, to improve the ease of use, endnotes of the first edition now appear as grey footnotes. Thus, we now have two types of footnote. Those in black contain additional information that helps the understanding. Footnotes in grey provide references and occasionally technical remarks. References are collected at the end of each part. We have thoroughly revised the content of the book; in addition to some corrections, we have shortened some expositions and added additional material (cases, formal models and verbal expositions) in several chapters. We want to mention two instances where we have reorganized content across chapters. First, the formal analysis of customer poaching has been moved to the section on behaviour-based price discrimination in Chapter 10. Second, some of the material in Chapters 18 and 19 has been reshuffled and expanded (e.g., the analysis of patent licensing and the comparison of patents, secrets and rewards as incentive mechanisms for innovation).

    We want to say thank you to a large number of researchers. In addition to the people we thanked in the first edition, some of whom provided additional comments and suggestions for the second edition, we would like to thank Olivier Bonroy (Grenoble), Daniel Halbheer (St. Gallen), Paco Martinez-Sanchez (Murcia), Michele Polo (Bocconi), Eva-Maria Scholz (Louvain-la-Neuve), Florian Schuett (Tilburg) and ChengsiWang (Mannheim). Apologies to those who also provided useful input but whose names got lost.

  • 10 - Intertemporal price discrimination

  • from Part IV - Pricing strategies and market segmentation
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 243-269

  • Summary

    In many markets, firms offer the same product in different periods and consumers buy only one item over the whole time horizon. This description of consumer behaviour fits particularly well for durable goods such as cars, washing machines (and other household appliances), computers and software (which does not wear out at all unless obsolescence is artificially imposed). It also fits for particular items that can be ordered in advance, such as a holiday package, a plane ticket or a concert ticket. While our insight derived in the first two sections of this chapter only applies to durable goods, we then obtain results that also apply to ticket sales.

    In the case of durable goods, consumers derive the benefit from the purchase of the good over a number of periods. Also, consumers can decide on the timing of their purchase. An example is furniture that consumers may want to replace. They may buy the piece immediately and replace the old piece, or keep the old piece for some time and thus postpone the purchase of the desired piece. Suppose that a firm sells a product over a number of periods and that both firm and consumers have discount factor δ. If the firm sells the product in the first period only at a uniform price, it makes the standard monopoly profit (see Chapter 2). If the firm can sell the product over several periods, we may think that this opens up the possibility of price discrimination, which is beneficial for the firm. Whether this conjecture is correct depends on a number of circumstances, as we will explore in this chapter.

    An important issue is whether a firm can commit to future prices and if the answer is negative, what kind of prices consumers expect. Clearly, even if a firm preannounces future prices, we must ask whether the firm has an incentive to deviate at some later point. Therefore, as a starting point, we consider the situation in which the firm lacks any commitment power and sets the period t price in that period, not earlier (Section 10.1). We then redo the analysis under the assumption that the firm has an instrument that gives it commitment power over future prices (Section 10.2).

  • 6 - Advertising and related marketing strategies

  • from Part III - Sources of market power
  • Paul Belleflamme, Université Catholique de Louvain, Belgium, Martin Peitz, Universität Mannheim, Germany
  • Book:
    Industrial Organization
    Published online:
    28 May 2018
    Print publication:
    30 July 2015, pp 138-161

  • Summary

    Every day, consumers in developed countries are subjected to hundreds of advertising messages. Advertising is indeed everywhere around us: on television, in our print magazines and newspapers, in our mail, on the Internet, on billboards in the streets, etc. It is estimated that around $140 billion have been spent on media advertising in the USA in 2012 (only including payments to media companies). To put this number in perspective, this represents 0.9% of US GDP and a spending of $444 per capita.

    In this chapter, we want to understand to what end and to what effect firms devote resources to advertising. We first investigate how advertising affects consumers (Section 6.1). Then, we look again at the marketing mix. This time, we take products as given but we examine how the combination of the other two Ps – promotion and price – is chosen by firms. We first perform the analysis in a monopoly setting (Section 6.2). This further allows us to discuss the welfare effects of advertising (Section 6.3). Finally, we analyse advertising decisions in oligopoly settings (Section 6.4).

    Views on advertising

    Firms would not use advertising if consumers were not responding to it. This truism immediately poses the following basic question: why do consumers respond to advertising? Economists have expressed three distinct views about this question. According to the first view, advertising is persuasive in that it alters consumers’ tastes; advertising therefore amplifies product differentiation and consumers’ loyalty to a particular brand. The second view holds that advertising is informative: advertising provides consumers with information about the existence, prices and characteristics of products, either directly or indirectly. The indirect channel refers to the idea that a firm's willingness to spend resources on advertisement can be interpreted as a signal that the quality of this firm's product is high (we will develop this kind of argument further in Chapter 12). Finally, the third view contends that advertising is complementary to the advertised product. Here, advertising does not modify consumers’ preferences and it does not matter whether it conveys information or not; what is central is that advertising enters as one argument into the consumers’ utility function and it does so in a complementary fashion with the advertised product.

Page 64 of 130