Lecture 8: Virgin Case + Collusion

1. Lecture 8: Virgin Case + Collusion AEM 4160: Strategic Pricing Prof. Jura Liaukonyte

2. Break Even Point M = margin the customer generates in a year r = annual retention rate = (1-12*monthly churn rate) i = interest rate (assume 5%) AC = acquisition cost - AC Monthly ARPU (average revenue per unit): $52 (p.3) Monthly Cost-to-Serve: $30 (p.3) Monthly Margin: $22 Time 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):

3. LTV With Contracts The annual retention rate in the industry = ______________

4. LTV Without Contracts Eliminate contracts -> churn rate increases to 6% Calculate the LTV:

5. Eliminate Hidden Costs $ 29 cellular bill becomes $35 due to hidden costs Increase of 21% If these costs were eliminated, the $22 margin would be reduced to _______________ Break even would become _________= __________

6. What Happens to LTV? Without hidden costs, but with contracts Without hidden costs and without contracts Elimination of contracts drives LTV below zero Hidden costs boost the bottom line

7. Option 3: Different Pricing Approach • Target audience: Youth • Loathe contracts • Fail credit checks • Ideal plan: no contracts, no menus, no hidden fees… • How to differentiate itself, and have a positive LTV • Look at the factors that affect LTV

8. Options for Lowering Acquisition Costs • Advertising costs per customer • Industry=from $75 to $100 • Virgin planned ad costs = 60 mil/1min= $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

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

10. Consumer Friendly Plan: How to Achieve Profitability • Break Even analysis: at what per minute price would Virgin break even: • Virgin’s monthly ARPU: ______________ where p=price per minute • Assume Virgin’s customers use 200 minutes per month (midpoint of estimate between 100 and 300, p.7) • Monthly cost to serve: ______________ • Assume monlty cost to serve is 45% of revenues (Exhibit 11) • Monthly margin: _______________ • p > ________

11. Other Price Points • What if Virgin charged per minute price comparable to other industry prices, somewhere in between 10 and 25 cents: • At 10 cents: • At 25 cents:

12. Virgin’s Pricing Plan: What Happened? A prepaid plan No contracts No hidden charges No peak off peak hours Very low handset subsidies No credit checks No Monthly bills Price: 25 cents per minute for the first 10 minutes; 10 cents/minute for the rest of the day No exact numbers, but churn rate lower than 6%

13. Collusion

14. Collusion and Cartels • What is collusion? • An attempt to suppress competition • What is a cartel? • 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 actions • Prices • Market shares • Exclusive territories • Prevent excessive competition between the cartel members

15. Why doesn't everyone collude? • Illegal. • In the US, collusive agreements cannot be enforced by legal contracts • International cartels do exist, however. • Hard to come to an agreement. • Strong incentives to cheat -- collusion may not be sustainable.

16. Types of Collusion • Tacit Coordination/Facilitating Practices. • Explicit Conspiracy.

17. Tacit Coordination • Spontaneous 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 matching • Most Favored consumer clause

18. Explicit Conspiracy • Price fixing agreement. • Formal cartel. • Per se illegal.

19. What are the Incentives to Collude? • Start with a simple model of a Bertrand Duopoly • Without collusion, p1*= p2*= 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 -2bQ • Set c = a-2bQ and solve for monopoly quantity and price • QM = (a-c)/2b and PM = (a+c)/2 • So M = (PM - c)*QM = (a+c - 2c)/2 * (a-c)/2b = (a-c)2/4b • If each firm produces 1/2 QM, each gets (a-c)2/8b

20. Collusion in the Prisoner’s Dilemma Framework Firm 2 Collude Defect Collude (a-c)2/8b, (a-c)2/8b Firm 1 Defect 0, 0 But what about the two empty cells?

21. 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

22. Collusion in the Prisoner’s Dilemma Framework Firm 2 Collude Defect Collude (a-c)2/8b, (a-c)2/8b 0, (a-c)2/4b Firm 1 Defect (a-c)2/4b, 0 0, 0

23. Factors that Affect the Success of Collusion • Potential for monopoly profit • Demand relatively inelastic • Ability to restrict entry • Common marketing agency or trade association • Persuade consumers of advantages of buying from agency members • Low search costs • Security • Control access to the market • Persuade consumers that buying from non-members is risky • Use marketing power • Examples: National Realtor Association, American Dentist Association

24. Factors that Affect the Success of Collusion • Low costs of reaching a cooperative agreement • Small number of firms in the market • Lowers search, negotiation and monitoring costs • Similar production costs • Avoids problems of side payments • Detailed negotiation • Misrepresentation of true costs • Lack of significant product differentiation • Again simplifies negotiation – don’t need to agree prices, quotas for every part of the product spectrum

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

26. Detecting Collusion • Historically, what factors have made industries susceptible to collusion? • Fraas and Greer find markets with small number of firms and uncomplicated setting conducive to collusion. Also trade associations and common sales agencies facilitate collusion. • Hay and Kelley find similar results and additionally that product homogeneity increases collusion.

27. Collusion and cartels • Cartels have always been with us; generally hidden • Electrical conspiracy of the 1950s • Garbage disposal in New York • Archer, Daniels, Midland • The vitamin conspiracy • But some are explicit and difficult to prevent • OPEC • De Beers

28. Recent events • The 1990s saw record-breaking fines being imposed on firms found guilty of being in cartels • Illegal conspiracies to fix prices and/or market shares • Archer-Daniels-Midland $100 million in 1996 • Hoffman-LaRoche $500 million in 1999

29. Cartel violations in the 90s http://online.wsj.com/article/SB10001424052748704402404574529241844394428.html?mod

30. Tacit Coordination • Spontaneous 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 matching • Most Favored consumer clause

31. Practices that Facilitate Tacit Pricing • Firms can facilitate cooperative pricing by • Price leadership • Advance announcement of price changes • Most favored customer clauses • Price Matching

32. Price Leadership • The price leader in the industry announces price changes ahead of others and they match the leader’s price • The system of price leadership can break down if the leader does not retaliate if one of the follower firms defects

33. Example: Cell Phone Industry

34. Tacit Collusion • How does it work? • Industry is an oligopoly • Top four firms dominate almost the entire market • Homogenous products • Same 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 • Nondurable goods • Less incentive to cheat because it is a one-time sale product rather than a product from which sellers could gain a series of sales

35. Tacit Collusion:Pre-Announced Rate Changes • Service providers typically pre-announce rate changes they plan on implementing • Advanced notice gives competing firms time to respond • Can test the market and competitors

36. Tacit Collusion:Infrequent High Changes in Rates • Rate changes in the industry have been high and infrequent, yet coordinated across all four firms • FOCUS: Text Messages • Supply is almost unlimited so in a competitive market prices should decrease not increase over time • Since 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.

37. Price Matching Guarantees • Price 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.

38. 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.

39. Example • Two firms: Firm 1 and Firm 2 • Two prices: low ($4) or high ($5 ) • 3000 captive consumers per firm • 4000 floating go to firm with lowest price

40. Example • Two firms: Firm 1 and Firm 2 • Two prices: low ($4) or high ($5 ) • 3000 captive consumers per firm • 4000 floating go to firm with lowest price

41. Contracting with Customers • The game is a prisoner’s dilemma • Both firms prefer: {High, High} • Only equilibrium: {Low , Low} • Cannot credibly promise to play High • Even if committed to High, other firm would still respond with Low • How to resolve this? • Third party contracts with customers

42. Price Matching • If one firm charges low, it does not gain any additional customers, since the competitor “automatically” matches it. • What is the effect on the game?

43. Price Matching