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Industrial

International Journal of Industrial Organization Organization

ELSEVIER 14 (1996) 227-242

H e l m u t Bester a'*, E m m a n u e l Petrakis b't

"CentER, Tilburg University, P.O. Box 90153, 5000 LE Tilburg, Netherlands

bUniversidad Carlos Ili de Madrid, Departamento de Economia, Calle Madrid 126, 28903

Getafe, Spain

Abstract

Sending out coupons allows the sellers to separate market segments with different

degrees of consumer brand loyalty. This kind of price discrimination is profitable for

the individual seller when the cost of couponing is sufficiently low. In equilibrium,

however, couponing increases competition and reduces profits. A n increase in the

cost of couponing decreases consumer surplus while the impact on profits and social

surplus is ambiguous.

1. Introduction

oligopolistic industry. Sales promotion is a complementary, and in some

cases even more important marketing strategy than media advertising for a

firm to increase its market share. Coupons and rebates count for the bulk of

b i l l i o n s o f d o l l a r s s p e n t e a c h y e a r o n t h e s e p r o m o t i o n a l activities. In 1989,

* Corresponding author at: Department of Economics, Free University Berlin, Boltzmannstr.

20, D-14195 Berlin, Germany.

t We wish to thank two referees for their comments.

S S D I 0167-7187(94)00469-2

228 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

nearly $100 billion worth of coupons (potential savings) were sent out to

consumers in the United States through Sunday newspaper inserts (see

Koselka, 1990). Manufacturers in the United States distributed 310 billion

coupons in 1992, representing a 6% increase over the year before (see

H u m e , 1993). Rebates are virtually equivalent to coupons except that they

impose some additional redemption cost on the customer, namely the cost

of mailing and waiting for the cash refund. For our purposes coupons and

rebates play the same role and we will treat them interchangeably in our

analysis.

We investigate the role of coupons in a market that is segmented due to

location or brand loyalty. By offering a rebate, a manufacturer can attract

some consumers who are otherwise more inclined to buy a competing brand.

In the location interpretation of our model, consumers face a transportation

cost. Supermarkets, department stores, and shopping-malls can use coupon-

ing of specific residential areas to compete more effectively in their rivals'

h o m e markets. In the alternative interpretation, consumers differ in their

degree of brand loyalty. By price discriminating between his own customers

and the clientele of competing manufacturers, the seller can increase his

own market share. Of course, this requires marketers to use tightly focused

coupon distribution programs as they are offered by special marketing

companies. Targeted coupons have been used successfully by Trump's

Castle to lure gamblers from competing casinos, by Stop & Shop stores to

win customers from other grocery stores, and by L'Oreal Visuelle to attract

users of Cover Girl and Revlon makeup (see Zeldis, 1987).

With couponing the manufacturer has at least partial control of the type

of household reached. Thus, he is able to offer a reduced price to a specific

segment of the market. Coupons can serve as a price discrimination device.

Only those consumers who have received a coupon are able to benefit from

the rebate. Since this enables the manufacturer to separate market seg-

ments, coupons are more than just a low price offered to all consumers. It is

worth mentioning that the use of coupons as a discriminating device does

not depend on the market structure. Coupons would also be used in a

m o n o p o l y version of our model. An alternative explanation of coupons has

b e e n proposed by C r e m e r (1984) and Caminal and Matutes (1990). In these

models, coupons create a lock-in effect because the consumer is offered a

rebate on future purchases of the product. The seller can stabilize his

market share by creating an artificial cost of switching suppliers, This is in

direct contrast with our model, where coupons tend to make switching more

attractive. Yet another explanation (Gerstner and Hess, 1991) is that the

seller can motivate retailer participation in the sales promotion by offering

rebates to the consumers.

T h e literature on the price discrimination aspects of coupons is rather

scarce. Narasimhan (1984) studies the consumers' decision to use a coupon.

H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 229

advantage of coupons. Thus, price discrimination can be achieved through

self-selection. Caminal and Matutes (1990) is, to our knowledge, the only

study of oligopolistic behaviour, but in a repeat purchase context. In their

model the consumer receives a rebate only after purchasing a second unit

from the same seller. The role of coupons is to create a switching cost in the

second period. If the firms precommit to a discount, competition in that

period is decreased and the equilibrium profits increase.

In contrast, in our model coupons increase competition between firms.

Each individual seller has an incentive to reduce the brand loyalty of the

other firms' clientele in order to increase his market share. But, offering a

rebate amounts to reducing the consumers' switching cost and so competi-

tion is intensified. In equilibrium, each seller's profits are lower than if

coupons or price discrimination were not allowed. Price discrimination in

combination with oligopolistic competition leads to lower prices; the

consumers as a whole are better off when the sellers compete by using

coupons.

The finding that firm profits may be lower as a result of price discrimina-

tion is similar to the findings of Thisse and Vives (1988) and Anderson and

L e r u t h (1993). The general idea is that firms compete on more fronts with

discrimination. Levy and Gerlowski (1991) show that "meeting competition

clauses", whereby a seller announces to meet the competitor's price, may

reduce equilibrium profits. We may view such clauses as a special type of

coupon; they allow the seller to discriminate between those consumers who

only receive his own ad and those who receive ads also from other firms.

The paper is organized as follows. Section 2 presents a simplified

example, where we abstract from the costs of issuing coupons and from

differences in the consumers' degree of brand loyalty. Section 3 describes

the general model. We study the equilibrium marketing behaviour of the

firms in Section 4. Section 5 provides some comparative statics and welfare

results. All proofs are relegated to an appendix.

2. An example

example of the more general model studied in the following sections. We

study a duopoly market characterized by some segmentation according to

location or brand loyalty. Using the language of the locational application,

the model considers the following situation. There are two sellers, A and B,

located in different neighbourhoods of some geographical market. The

sellers' production costs are normalized to zero. In each locality there is a

unit mass of consumers with a totally inelastic demand for one unit of the

230 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

good for all prices between zero and v > 0. When a consumer purchases the

good from the seller in the distant location, he has to pay a transportation

cost, s < v.

Shilony (1977) studies the equilibrium of this market when the sellers

compete by setting prices in a standard Bertrand fashion. If v <~ 2s, both

sellers will post the price p * = v in equilibrium. Undercutting the com-

petitor's price is not profitable since this would yield a profit of at most

2 ( v - s)~< v. The price-setting game between the duopolists fails to have a

pure strategy equilibrium if v > 2s. Indeed, any combination of prices

(PA, PB) would allow one of the two sellers to gain either by undercutting

the other seller or by increasing his price by some small amount. Shilony

(1977) shows that there is a unique symmetric mixed strategy solution where

each seller gains an expected profit higher than s.

We now introduce oligopolistic price discrimination. Even though the

seller is unable to identify the origin of the customers at his store, he can

separate them through coupons. Each seller is able to offer the good at

different prices in the two regions by mailing coupons to the other region.

Coupons entail a legally binding promise by the seller to offer a rebate upon

presentation. In our example we abstract from mailing costs and assume that

seller i can costlessly send coupons to all consumers in region j. The coupon

entitles the bearer to buy the good from seller i at the price Pi -- ri, while

buyers without a coupon have to pay Pi.

In this simple example, competition between the duopolists, A and B,

results in the following equilibrium outcome:

P -PB * =p* =s, r A* = r * : r* =s.

B (1)

As is usual in this kind of model, the equilibrium is based on the tie-

breaking rule that consumers buy from the closer firm if prices are equal.

This can be justified by taking the limit as heterogeneous consumer tastes

b e c o m e homogeneous (see Anderson and de Palma, 1988). Each consumer

is indifferent between buying the good from seller A or seller B. If he buys

at the neighbouring store, has to pay the price p* = s; otherwise, has to pay

p* - r * = 0 but incurs the transportation cost s. In equilibrium, it must be

the case that each consumer buys at the local store. If not, the local seller

would have an incentive to lower his price slightly below s. Clearly, the

outcome described by (1) constitutes an equilibrium: by charging a price

above s a seller would lose all his customers. Charging a price below s can

never be optimal, since each seller enjoys a local monopoly position for all

prices up to s. Actually, the equilibrium is unique (after elimination of

dominated strategies with Pi - ri < 0)" if some seller i were to charge a price

Pi > s, then the opponent could induce all consumers in region i to switch by

offering pj - rj slightly below Pi - s. Accordingly, a price Pi > s cannot be

part of equilibrium behaviour. The same argument shows that both sellers

H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 231

must offer the rebate r* = s. Obviously, given p* this is the highest rebate a

seller is willing to offer. If seller i sets r~ < s, then seller j would optimally

charge his local customers the price pj > s, which was already shown to be

inconsistent with equilibrium.

The example demonstrates that price discrimination increases competi-

tion. The consumers have to pay lower prices and the finns' profits are

reduced. Indeed, each seller earns a profit of s, which is lower than the

profit he gets in the absence of discriminatory pricing. In what follows we

will verify this observation in a more general model. In fact, the above

example has some unappealing features because the consumers' purchasing

decisions have to be based on a tie-breaking rule. Even though the

equilibrium requires both sellers to use coupons, this marketing instrument

is actually ineffective since no consumer is induced to switch. If the sellers

had to pay a mailing cost, the above equilibrium would therefore collapse.

The subsequent model will overcome these difficulties by introducing some

consumer heterogeneity.

3. The model

purchase costlessly from a neighbourhood store, but incur some visiting cost

if they venture to a more distant store. There are two firms, A and B,

located in different regions that produce a homogeneous good at zero cost.

Each region is inhabited by a unit mass of consumers who have a common

reservation utility v for the good. Each consumer can costlessly visit the

store at his home location, while he has to pay a transportation cost s to go

to the other seller. It is assumed that s is uniformly distributed on [0, s]

across the population of consumers in each region. This assumption differs

from Shilony's (1977) model of mixed pricing in oligopoly, where all

consumers have the same visiting cost. It generates continuous demand

functions, and guarantees the existence of a pure price-setting equilibrium in

the absence of couponing (see Bester, 1992).

The firms offer the good at prices PA and PB, respectively. Without loss of

generality, let 0 ~<Pi ~< v, i = A, B. The seller cannot distinguish buyers from

different regions once they enter the store. Similarly, he is uninformed

about the visiting cost of the individual buyer. This means that he cannot

make his price offer contingent upon such information. But, seller i may

p r o m o t e purchases by offering the consumers at location j ~ i a rebate r~,

with 0 <<-r i <~P i . T h e seller may offer such rebates by mailing coupons to the

other region. Since he cannot discriminate between consumers with different

values of s, offering a single rebate r~ at location j is optimal. Also,

distributing coupons in the local market cannot increase seller i's profit.

232 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

who incur switching costs.

W h e n firm i sends coupons to a fraction h i ~ [0, 1] of the consumers at

location j, it has to pay the mailing cost k(hi). Each consumer is equally

likely to receive the rebate. This means, with probability h i that a consumer

in region j has to pay only Pi - ri for the good available at location i. T h e

b u y e r who has not received a coupon is not entitled to a rebate and has to

pay P r We assume that consumers do not interact with each other so that

trading coupons is not possible.

T h e marketing strategy of firm i may be described by x i = (pi, r i, Ai). The

cost function k ( . ) is assumed to satisfy the following restrictions:

k(0)=0, k'(h)>0, k"(h)>0, k'(0)<3/4, k'(1)>5/9. (2)

T h e marginal cost of couponing is increasing in the n u m b e r of households

reached. This assumption is standard in the advertising literature (see

Butters, 1977, and G r o s s m a n and Shapiro, 1984). The underlying idea is

that the manufacturer can distribute coupons via mail and by placing ads in

a set of magazines or newspapers. The probability that a given consumer

receives a coupon through one of these media is independent of receiving a

c o u p o n through the other media. In this case, the cost of making sure that a

fraction A of consumers receives at least one coupon becomes a convex

function of A. The additional assumptions on k ' ( . ) guarantee that each

m a n u f a c t u r e r will choose some advertising intensity 0 < h i < 1. In addition,

we restrict the analysis to the case v >3. This ensures that competition is

sufficiently strong so that setting Pi = v cannot be optimal for seller i.

4. Equilibrium

b o t h regions. In addition he knows the price charged by each of the sellers.

In this situation, advertising conveys no information about the existence or

the price of a good. Distributing coupons only serves to price discriminate

b e t w e e n buyers from different regions. By offering a rebate the seller

increases the attractiveness of his product for those consumers who have to

spend the cost s in order to visit his store.

T o c o m p u t e each seller's demand, we have to distinguish four groups of

consumers. In each of the two regions the purchasing decision of the

consumers who have received a coupon differs from those without a coupon.

A consumer at location A who has not received a coupon from firm B

purchases the good at his h o m e location as long as PA ~<PB + S. If, however,

he gets a coupon of value r B, he will buy from seller A only if PA <~PB --

r a + S. W h e n consumer s at location B is not offered a rebate, he will be

H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 233

attracted by firm A's price offer ifpA + S ~<PB" Otherwise, with a coupon r A,

he will purchase from firm A if PA - rA + s ~<PB.

Given the consumers' demand decisions, firm A's profit, IiA(XA,XB),

depends on both firms' sales strategies and is given by

+PA( 1 -- AA)D(PB - P A ) + (P* - rA)AAD(p. --PA + rA)

- kOA), (3)

where

D(z)=--z/~, for 0~<z~<~,

D(z)=-O, for z~<0, (4)

D ( z ) = 1, for z ~>~.

By symmetry, firm B's profit equals HB(XA, XB)= HA(XB, XA). To study

equilibrium advertising in this market, we consider the Nash equilibrium in

the sellers' game. Thus, a pair (x*, x~) of marketing strategies constitutes an

equilibrium if IIA(X~, X*) >t IIA(XA, X~) for all XA, and liB(x*, x~) ~ l i s ( x * ,

XB) for all x B.

Our first result characterizes the symmetric pure strategy equilibrium and

provides a sufficient condition for its existence. To state the result, we define

p(h) --= - k " ( h ) / k ' ( A ) . In utility theory, p(- ) is well known as the coefficient

of absolute risk-aversion. Negative values of p(A) indicate the degree of

convexity of k(h) at h.

* * be an equilibrium such that X *A = X R

*=

(p*, r*, A*). Then (p*, r*, A*) is given by the solution to

p* =~/(1 + 0.5A*), r* = 0.5p*, k'(A*) = p * / ( 4 + 2A*).

Moreover, a sufficient condition for the existence of a symmetric pure strategy

equilibrium is that p(A) ~< - 2 for all A @ [0, 1].

profits. Indeed, it is easily established that both sellers would charge the

price/~ =~ if distributing coupons were not possible. By Proposition 1, all

consumers pay a price below ~ in the equilibrium with couponing. The

consumers gain and the sellers lose by the feasibility of couponing.

Fig. 1 illustrates that the equilibrium is indeed unique: The P - P schedule

depicts all p-A combinations such that p =~/(1 + 0.5A); the K - K schedule

describes the function p = k'(A)(4 + 2A). Assumption (2) ensures that the

two functions intersect at some point (p*, A*) within the area (0, ~) x (0, 1).

This intersection determines the equilibrium values p* and A*.

234 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

/ (P*~)

Fig. 1. Equilibrium (p*, h*).

With the help of Fig. 1 we can easily establish some comparative statics

properties of the equilibrium outcome (p*, r*, A*). For instance, an increase

in the marginal cost k ' ( . ) leads to a higher equilibrium price p* and a lower

level of advertising A* because the K - K schedule is shifted upwards. How

does the equilibrium react to a change in the consumers' transportation

cost? Increasing the parameter ~ is equivalent to increasing each consumer's

switching cost by the same factor. In Fig. 1 this leads to an upward shift of

the P - P schedule. Consequently, both p* and A* are increased.

Not all consumers who are couponed will make use of the rebate.

Redeeming the coupon is worthwhile only when s ~< r* = p * - r * . Accord-

ingly, the redemption rate is ( p * - r * ) / ~ = 1 / ( 2 + A * ) . That is, more than

one-half of the coupons are not returned to the manufacturer. Using the

above comparative statics results, it follows that the equilibrium redemption

rate is increasing in the marginal cost of couponing. A cost increase reduces

the n u m b e r of households that are couponed, but the fraction of households

that redeem the coupon is increased. An increase in the consumers'

transportation cost has the opposite effect: more households are couponed,

but a lower fraction return the coupons. Note, however, that the total

n u m b e r of coupons actually redeemed is given by A*/(2 + A*), which is

increasing in 3,*. This number is, therefore, negatively related to the

marginal cost of couponing and positively related to the level of consumer

switching costs.

Of course, the result that the coupon offers a 50% price rebate is specific

to the setting of our model. In particular, the uniform distribution of

switching costs is important in this context. We can show that the sellers

would optimally offer a lower rebate if the distribution of s puts more weight

on low switching costs. The intuition is that attracting high cost consumers

through a rebate is not profitable when these consumers represent only a

small fraction of the total population.

Proposition 1 only provides an implicit characterization of the equilibrium

H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 235

values p*, r*, and A*. To obtain an explicit solution of the equilibrium, we

have to look at a parametric example of the cost function k(- ). The simplest

example is k(A)= cA 3. This function satisfies restriction (2) if-s/c < 27. The

equilibrium described by Proposition 1 is then given by

A* = [1 + S ( 3 d ) - 1 / 2 ] 1/2 -- 1.

Note that within the family of cost functions k()t)= cA ", Proposition 1

guarantees the existence of a symmetric pure equilibrium as long as a / > 3.

The equilibrium characterization by Proposition 1 is derived from the

first-order conditions that the profit-maximizing marketing strategies xA and

x B necessarily have to satisfy. Unfortunately, the first-order conditions are

not sufficient for profit maximization. By (3), the firms' profit functions are

concave in Pi, ri and Ai, but not jointly concave in (p~, r~, A~). Because of this

non-concavity, we have to be careful that no seller can increase his profit by,

for instance, simultaneously lowering his price and his advertising intensity.

The restriction p(A) ~ - 2 guarantees that such deviations from (p*, r*, A*)

are not profitable. For any given A~, the first-order conditions determine

p*()ti) and r*(Ai) so that seller i's profit can be written as

///(p*(A~), r*(Ai), A~, xj). Since p(A) ~< - 2 ensures that the cost function

k(. ) is sufficiently convex,//~,.(p* (Ai), r* (Ai),)t i, xi) is concave in )ti. Accord-

ingly, the first-order conditions are sufficient for a global optimum if

p(a) <~ - 2.

For specific cost functions, we can prove the existence of a pure strategy

equilibrium even when the condition p ( A ) ~< - 2 is not satisfied for all

A ~ [0, 1]. The following result extends Proposition 1 to the case k(A) = cA ~,

a > 1, by imposing a restriction on ~/c. Also, we consider the cost function

k ( A ) = - c I n ( l - A ) , which Butters (1977) has derived from a simple

underlying advertising technology.

strategy equilibrium for s/c sufficiently small. I f k ( A ) = - c l n ( 1 - A), then

there is a symmetric pure strategy equilibrium for s/c sufficiently large.

monotone function of A. This allows us to replace the global condition on

p(. ) in Proposition 1 by a local condition. For k(A)= cA ~ we have p ( A ) =

( 1 - a)/A, which is increasing in A. In this case, the existence result is

obtained because A* becomes small for low values of ~/c. In contrast, for

k(A) = - c l n ( 1 - A) the parameter p(A) equals - 1 / ( 1 - A) and decreases

with A. Accordingly, we have to guarantee that A* is close enough to unity

by assuming that ~/c is large.

236 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

(Pi, ri, hi), it is continuous. This implies that there is a symmetric mixed

strategy Nash equilibrium when a pure equilibrium fails to exist (see

Dasgupta and Maskin, 1986). In such an equilibrium the sellers choose a

random marketing policy. Since for a given h i, seller i's profit is concave in

(Pi, r~), it follows from the first-order conditions that the optimal Pi is

positively related with h i. Similarly, the optimal r i increases with Pi. In the

mixed strategy equilibrium, therefore, each seller chooses h i stochastically

and he combines higher values of h i with higher prices Pi and higher coupon

values r i.

5. Welfare

depends on the advertising cost k ( - ) and the transportation cost parameter

7. As a measure of consumer welfare, we consider aggregate consumer

surplus, C, which depends on (p*, r*, h*) according to

C(p*, r*, A*) = 2(1 - A*)(v - p*)

[0.71

The first term represents the utility of the consumers who do not receive a

coupon. The other consumers' purchasing decision depends on the rebate r*

and the switching cost s. Consumer s will make use of the coupon only if

v-p*>~v-p * + r * - s . Finally, we define social welfare as the sum of

producer profits and consumer surplus. We begin by studying the relation

between welfare and s.

surplus and social welfare are decreasing in s.

brand loyalty or geographical differentiation. When the sellers are able to

influence the parameter ~ by their choice of product differentiation, they will

seek to maximize 7. This is in line with the familiar principle of 'maximal

differentiation', as described by D ' A s p r e m o n t et al. (1979). An increase in

has a two-fold impact on consumer surplus. First, the consumer has to pay

higher prices. Second, he is more likely to receive a coupon. The above

result demonstrates that the first negative effect outweighs the second

positive effect. Indeed, as was shown before, the coupon redemption rate

decreases with 7. Finally, social welfare is negatively related to 7: the higher

H. Bester, E. Petrakis / Int. J. lnd. Organ. 14 (1996) 227-242 237

is 5, the higher is the coupon distribution intensity, A*, and the number of

coupons actually redeemed, ~ * / ( 2 + A * ) . This means that the resources

spent on couponing and the consumers' aggregate travel costs increase with

7.

the symmetric pure strategy equilibrium. I f ~7(A ) = A ~, then equilibrium profits

and social surplus are increasing in c. I f r/(A) = -In(1 - A), then equilibrium

profits and social surplus are decreasing in c for s/c sufficiently large.

As a result, the consumers become worse off. The impact on equilibrium

profits and social welfare, however, is ambiguous. Of course, seller i gains

by a reduction in c when the marketing strategy xj of his opponent is kept

fixed. Similarly, lower resource costs of couponing increase welfare when

(x A, xB) remains unchanged. In addition to these direct effects, however,

there are indirect effects. Lower advertising costs make competition more

aggressive, which tends to reduce the sellers' prices and their profits. At the

same time, there is a negative impact on welfare as the sellers waste more

resources on couponing and the consumers switch sellers more often. Which

of these effects dominates, depends on the advertising cost function k ( . ) .

As the first part of Proposition 4 demonstrates, an increase in the cost of

couponing may make the sellers better off. A similar observation has been

made in models of informative advertising (see Bester and Petrakis, 1992;

Grossman and Shapiro, 1984; and Peters, 1984).

6. Conclusions

oligopolistic competition. By couponing those consumers who have some

preference for a competing brand, a seller can increase his market share.

Coupons may compensate the consumer for a costly movement to another

brand. In contrast to the repeat-purchase explanation, coupons reduce

consumer switching costs in our model. The price discrimination model

predicts that couponing intensifies competition between the sellers, leading

to lower prices and profits.

Our simple model may be extended in several interesting directions. We

assumed that all the consumers have the same valuation for the good. As a

result, total demand was fixed. Introducing some dispersion of consumer

valuations would make aggregate demand elastic. As couponing increases

competition, it would raise aggregate output. Couponing may have a

positive effect on social welfare if the elasticity of demand is sufficiently

238 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

high. Also, the value of the coupon relative to the price of the product

would presumably depend on the distribution of consumer valuations.

Removing the symmetric structure of the model would be another

interesting extension. In our model, the sellers were identical and so they

used the same marketing strategy. This would no longer be the case when

different production technologies are considered. An extension along these

lines could provide insights into the relation between a firm's efficiency and

its marketing policy. Similarly, we could study the role of a firm's size when

the number of consumers differs across market segments. We might expect

that smaller firms have a higher incentive to distribute coupons because they

can gain more by attracting consumers from other market segments.

Appendix

chooses x i. Then the following m u s t hold: "(i)" pj --s <~Pi - ri <Pj; "(ii)"

pj - 5 ~<p~ < P i +5; and "(iii)" p~ >~ min[pj - %, 0.5pj].

Therefore, firm i could increase its profit by not mailing coupons. If

p~ - r~ <p~ -~, all consumers at location j who receive a coupon from firm i

strictly prefer to switch. Therefore, firm i could increase its profits by slightly

decreasing r~. This proves (i). To prove (ii), note that all consumers at j

strictly prefer to switch to firm i if Pi <Pj---S" Therefore, firm i could

increase its profit by slightly increasing Pr If Pi ~>Pj +~, no consumer at

location i buys from firm i. But then firm i could get higher profits by setting

Pi slightly below Pi +~, while keeping pi - r~ constant. Finally, (iii) follows

by differentiating H/ in (3) with respect to p~ and keeping Pi -- r~ constant.

This yields OH~(XA, X B IPi -- re = const.)/Op~ > 0 for pi < min[pj -

r,, 0.5pj]. Q.E.D.

chooses xj. Then Pi - ri = 0.5pj.

ri must maximize ( P i - r i ) D [ p j -

( p ~ - r~)]. By Lemma 1, the solution must satisfy the first-order condition

Pi - 2(Pi - ri) = 0. Q.E.D.

L e m m a 3. Let p(A) -- - k " ( ) t ) / k ' ( A ) ~ - 2 f o r all A @ [0, A2]. Then k'(A2) >

(1 + }k2 -- } k l ) 2 k ' ( A 1 ) f o r all 0 ~< h~ < h 2 ~< 1.

H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 239

for /~1 = /~2" Therefore, L e m m a 3 holds if 0G(A~, A2)/OA1 < 0 for all 0 ~</~1 <

h2~<l. Differentiation shows that OG(A1,A2)/OAI<O is equivalent to

p(A~) < - 2/(1 + A 2 - A1). Since - 2 < - 2/(1 + h 2 - As), L e m m a 3 holds if

p(A) ~< - 2 for all h ~ [0, h2]. Q . E . D .

first-order condition for the optimal choice of/~i implies k'(A*) = [p*/212/~.

We show that firm A cannot gain by setting PA > P * only if p* ~>~/(1 +

0.5A*). By L e m m a 2, firm A will optimally set PA - rA = 0.5p*. Therefore,

the profit from choosing PA E (p*, p* +~) together with AA = A* equals

-- k ( a * ) . (7)

then for PA close enough to p* we obtain OIIA/OPA> 0 SO that firm A could

gain by charging a price slightly above p*. As a result, we must have

p* ~>~/(1 + 0.5A*).

Finally, we show that firm A cannot gain by setting PA < P * only if

p* ~<s/(1 +0.5A*). The profit from choosing p A E ( p * - r*, p*) together

with AA = A* and PA -- rA = 0.5p* equals

+ A*(p*/2)2/-g - k(A*). (8)

then for PA close enough to p* we obtain a//A / OpA< 0 SO that firm A could

gain by charging a price slightly below p*. As a result, we must have

p* ~<s/(1 + 0.5A*).

T o prove the second part of the proposition, let firm B use the strategy

x B = ( p * , r*,A*) such that p*, r*, and A* satisfy the conditions of

Proposition 1. We will show that adopting the same strategy is a best

response for firm A.

First we show that choosing PA > P * is not profitable for firm A. By

L e m m a 2, firm A will optimally set PA - rA = 0.5,o*. Therefore, the profit

from choosing PA ~ (P*, P* +s) together with AA equals

- k(AA). (9)

AA = A*. This implies

240 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

cannot gain by adopting some strategy x A ~ (p*, r*, h*) such that PA > P * "

TO complete the argument, we show that choosing p A < p * is not

profitable for firm A. As firm A will optimally set PA -- rA = 0.Sp*, its profit

f r o m choosing PA E (p* - - r * , p*) together with AA equals

+ ha[P*/212/'g -- k(AA). (11)

condition PA(P*--PA) = ~ [ k ' ( h * ) - k'(hA)], so that XA < h* by the convexity

of k ( . ). This equation can be rewritten as

by L e m m a 1, PA >~ 0.5p*. Therefore, the above equation yields the solution

ferentiation of H A yields

= [2[gk'(~,*)] 1/2 - 2(1 + a* - AA)[~k'(aA)]~/2]/~. (14)

Thus, firm A cannot gain by adopting some strategy x A # (p*, r*, h*) such

that PA < P * ' Q.E.D.

equilibrium, we have to show that OllA/OPA > 0 in (14). For k ( h ) = c)t ~ we

have O(A)= ( 1 - a ) / h , which is increasing in h. Thus, by L e m m a 3, it

suffices to show that p(h*) ~< - 2, i.e. that h* ~<0.5(a - 1). By Proposition

1, k ' ( h * ) = ach *'~-1 = p * / ( 4 + 2A*) = 0.255/(1 + 0.5}L*)2, SO that s/c =

4 a A * ~ - l ( 1 + 0 . 5 A * ) 2. Therefore, we obtain h * < ~ 0 . 5 ( a - 1 ) for s/c suffi-

ciently small.

For k(h) = - c In(1 - A) we obtain OIIA/OpA > 0 in (14) if H(A A, h*) ------(1 -

A*) - ~ - ( 1 + h * - h a ) z ( 1 - - h a ) - 1 > 0 for all h a < h * . The function H ( . ) is

concave in AA with H(A*, h * ) = 0 and 0H(h*, h*)/OA A < 0 for A* > 0 . 5 .

T h e r e f o r e , H(AA, h*) > 0 for all h A < A* if H ( 0 , h*) > 0 and A* > 0.5. This is

the case for A * > 0 . 6 1 9 . By Proposition 1, k ' ( h * ) = c / ( 1 - h * ) = p * / ( 4 +

2A*) = 0.255/(1 + 0.5A*) 2 so that ~/c = 4(1 + 0.5h*)2/(1 - h*). Therefore, we

obtain A* > 0 . 6 1 9 for ~/c sufficiently large. Q . E . D .

H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242 241

=p* - A*p*Z/43 - k(A*) = 4k'(A*)(1 + 0.5A*) - A*k'(A*) - k(A*)

= 4k'(A*) + A*k'(A*) - k(A*). (15)

positively related b e c a u s e A* is an increasing function of ~.

C o n s u m e r surplus equals

= 2v - 8k'(A*) - 3A*k'(A*). (16)

d e c r e a s i n g in 3.

Social welfare equals W = 2//~ + C = 2v - 2k(A*) - A*k'(A*). A n increase

in 3 leads to a higher value of A* so that the social welfare is

reduced. Q.E.D.

e a c h c o n s u m e r ' s equilibrium utility will decrease with c and so c o n s u m e r

surplus is a decreasing function of c.

F o r k ( h ) = cA ~ we have Ak'(A)/a = k(Z). T h e r e f o r e

is increased. This p r o v e s that H,. and c are positively related for k(A) = cA r.

B y the p r o o f of Proposition 3, social welfare equals

= 2v - (or + 2 ) ~ -p*)p*/(2o~). (18)

raise W if k ( A ) = cA ~.

N o w consider k(A) = c0(A) = - c In(1 - A). By the p r o o f of P r o p o s i t i o n 3

we h a v e

OH/Oc = (4 + A*)r/'(A*) -.0(A*) + c(4 + A*)~"(A*)0A*/0c;

(19)

OW/Oc = -2.0(A*) - A*n'(A*) - c[3,O'(A*) + A*.0"(A*)]0A*/Oc.

B y P r o p o s i t i o n 1, c . 0 ' ( A * ) = 3 / ( 2 + A*) 2 so that

242 H. Bester, E. Petrakis / Int. J. Ind. Organ. 14 (1996) 227-242

OH (8 + 2A*)'~'(A*) 2 8 + 2A*

0--7 - ff'(a*)(2 + x*) + 2 ~ ' ( a * ) - n ( a * ) - 4 - a* + In(1 - a*);

(21)

OW (6 + h*)~'(h*) 2 6 + a*

0~- - f f ' ( a * ) ( 2 + ,X*) + 2 r t ' ( h * ) - 2 n ( a * ) - 4 - A* + 2 In(1 - a * ) .

p r o o f o f Proposition 2, ~ / c = 4 ( l + 0 . 5 A * ) z / ( 1 - a *) and so a * - - + l as 3/

c - - + ~ . This proves that OPi/Oc<O and OW/be<O for ~/c large

enough. Q.E.D.

References

Anderson, S.P. and A. de Palma, 1988, Spatial price discrimination with heterogeneous

products, Review of Economic Studies 55, 573-592.

Anderson, S.P. and L. Leruth, 1993, Why firms may prefer not to price discriminate via mixed

bundling, International Journal of Industrial Organization 11, 49-61.

Bester, H., 1992, Bertrand equilibrium in a differentiated oligopoly, International Economic

Review 33, 433-448.

Bester, H. and E. Petrakis, 1992, Price competition and advertising in oligopoly, CentER

Discussion Paper No. 9222, Tilburg University.

Butters, G., 1977, Equilibrium distribution of prices and advertising, Review of Economic

Studies 44, 465-492.

Caminal, R. and C. Matutes, 1990, Endogenous switching costs in a duopoly model,

International Journal of Industrial Organization 8, 353-373.

Cremer, J., 1984, On the economics of repeat buying, Rand Journal of Economics 15,396-403.

Dasgupta, P. and E. Maskin, 1986, The existence of equilibrium in discontinuous economic

games, I: Theory, Review of Economic Studies 53, 1-26.

D'Aspremont, C., J.J. Gabszewicz and J.-F. Thisse, 1979, On Hotelling's stability in

competition, Econometrica 47, 1145-1150.

Gerstner, E. and J. Hess, 1991, A theory of channel price promotions, American Economic

Review 81, 872-886.

Grossman, G. and C. Shapiro, 1984, Informative advertising with differentiated products,

Review of Economic Studies 51, 63-81.

Hume, S., 1993, Coupons set record, but pace slows, Advertising Age 64, 25.

Koselka, R., 1990, How to print money, Forbes 146, 118-120.

Levy, D. and D. Gerlowski, 1991, Competition, advertising and meeting competition clauses,

Economics Letters 37, 217-221.

Narasimhan, C., 1984, A price discrimination theory of coupons, Marketing Science 3,

128-147.

Peters, M., 1984, Restrictions on price advertising, Journal of Political Economy 92, 472-485.

Shilony, Y., 1977, Mixed pricing in oligopoly, Journal of Economic Theory 14, 373-388.

Thisse, J.-F. and X. Vives, 1988, On the strategic choice of spatial price policy, American

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