Compendium: Industrial Economics

Very preliminary
Espen R. Moen and Christian Riis
Norwegian School of Management
April, 2018

Contents
1 Introduction 4

2 Regulation and competition policy 7

3 E¢ ciency 8
3.1 Producer surplus . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Consumer surplus . . . . . . . . . . . . . . . . . . . . . . . . . 14
3.3 Integral formulation . . . . . . . . . . . . . . . . . . . . . . . . 16
3.3.1 Example 1: the linear demand curve . . . . . . . . . . 17
3.3.2 Example 2: the iso elastic demand curve . . . . . . . . 18
3.4 Generalizations to more than one market . . . . . . . . . . . . 19
3.5 First best allocation . . . . . . . . . . . . . . . . . . . . . . . 20
3.6 Bargaining and the Coase theorem . . . . . . . . . . . . . . . 21
3.6.1 Exercises: . . . . . . . . . . . . . . . . . . . . . . . . . 23

4 Vertical market structure 24

4.1 Double marginalization problem . . . . . . . . . . . . . . . . . 25
4.1.1 Coordinated pricing decisions . . . . . . . . . . . . . . 25
4.1.2 Independent pricing decisions . . . . . . . . . . . . . . 26
4.2 Double marginalization: market vs regulation? . . . . . . . . . 28
4.3 Fixed price contract . . . . . . . . . . . . . . . . . . . . . . . 30
4.4 Regulation may make the problem worse . . . . . . . . . . . . 30
4.4.1 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . 31

1
5 Investments in quality 36
5.1 Monopoly and investments in quality . . . . . . . . . . . . . . 37
5.2 Socially optimal quality . . . . . . . . . . . . . . . . . . . . . 39
5.3 Comparing the market solution and the e¢ cient solution . . . 40
5.4 "Constrained e¢ cient" quality level . . . . . . . . . . . . . . . 42
5.5 Quality choice in a vertical chain . . . . . . . . . . . . . . . . 43
5.5.1 The case of competitive retailing: No RPM . . . . . . . 45
5.5.2 The case of competitive retailing: RPM . . . . . . . . . 46

6 Price discrimination and quality choice 47

6.1 Benchmark model with one consumer . . . . . . . . . . . . . . 49
6.2 Introducing two types of consumers . . . . . . . . . . . . . . . 53
6.3 Analytical solution . . . . . . . . . . . . . . . . . . . . . . . . 58
6.4 Ban on price discrimination . . . . . . . . . . . . . . . . . . . 60
6.5 Price discrimination and e¢ ciency . . . . . . . . . . . . . . . . 61
6.6 Quality distortions - a comparison . . . . . . . . . . . . . . . . 62
6.7 Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
6.7.1 Exercises on quality choice . . . . . . . . . . . . . . . . 63

7 Ramsey pricing 68
7.1 Formulation of the Ramsey problem . . . . . . . . . . . . . . . 68
7.2 Ramsey vs monopoly prices . . . . . . . . . . . . . . . . . . . 71
7.3 Implications for regulation . . . . . . . . . . . . . . . . . . . . 72
7.4 Optimal regulation - "price cap" . . . . . . . . . . . . . . . . . 72
7.4.1 Exercises Ramsey pricing . . . . . . . . . . . . . . . . . 73

8 Access pricing 79

8.1 Competition in a vertical structure . . . . . . . . . . . . . . . 81

8.2 Chicago school argument . . . . . . . . . . . . . . . . . . . . . 81
8.2.1 Fierce competition downstream (Bertrand competition) 82
8.2.2 Imperfect competition downstream . . . . . . . . . . . 83
8.2.3 The integrated network competing with independent
service providers. . . . . . . . . . . . . . . . . . . . . . 85
8.3 Chicago school argument - modi…cations . . . . . . . . . . . . 86
8.3.1 Imperfect contracts and the "hold-up" problem in a
bilateral monopoly . . . . . . . . . . . . . . . . . . . . 86
8.3.2 Hold up problem and vertical integration . . . . . . . . 91

2
 8.3.3 Entry barriers, raising rivals costs . . . . . . . . . . . . 91
8.3.4 Contracts and externalities . . . . . . . . . . . . . . . . 92
8.4 Access price regulation . . . . . . . . . . . . . . . . . . . . . . 94
8.4.1 "Price-minus" principle . . . . . . . . . . . . . . . . . . 95
8.4.2 Partly crowding out . . . . . . . . . . . . . . . . . . . . 96
8.5 Access price regulation based on average margin . . . . . . . . 98
8.6 Competition between integrated networks . . . . . . . . . . . 99

9 Pricing in the transport sector 100

9.1 Theory - pricing models in transport sector . . . . . . . . . . . 102
9.2 Peak load pricing –congestion pricing . . . . . . . . . . . . . . 102
9.2.1 If capacity does not bind . . . . . . . . . . . . . . . . . 104
9.2.2 If capacity binds . . . . . . . . . . . . . . . . . . . . . 104
9.3 Priority pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 107
9.3.1 Exercises transport pricing . . . . . . . . . . . . . . . . 108

10 Damage compensation 112

10.1 Compute the harm associated with a small overcharge . . . . . 113
10.2 Compute the harm –…nite overcharge . . . . . . . . . . . . . . 114
10.3 Market e¤ects - duopoly competition downstream . . . . . . . 115
10.4 Perfect competition and complete pass-on . . . . . . . . . . . 116
10.5 Market strategic e¤ects . . . . . . . . . . . . . . . . . . . . . . 116

11 Bookmarket - RPM contracts 117

11.1 How is competition impacted by RPM? . . . . . . . . . . . . . 118
11.2 Cost structure and incentives . . . . . . . . . . . . . . . . . . 118
11.3 Investment in quality - no vertical restraints . . . . . . . . . . 119
11.4 Equilibrium sales e¤ort . . . . . . . . . . . . . . . . . . . . . . 120
11.5 Optimal price response . . . . . . . . . . . . . . . . . . . . . . 121
11.6 The impact of RPM . . . . . . . . . . . . . . . . . . . . . . . 121

12 Appendix A 122
12.1 Dependence in demand . . . . . . . . . . . . . . . . . . . . . . 122

3
The compendium is based on the slides used in the course Industrial Orga-
nization and Economics Consulting. It is organized according to sequence of
topics as presented in the course, and is de…nitely not meant to be a "text
book". It focuses primarily on the theory part, and the aim is to explain
more deeply the underlying principles of the models used in the course.
The course’s text book is Pepall et.al. "Industrial Organization", 5. edi-
tion. The text book is rich in examples and cases, however there are weak-
nesses when it comes the formal analysis of the models (examples will be
given).

1 Introduction
Industrial organization analyses the boundary of …rms and the relationship
between …rms and markets. industrial organization constitutes the theoret-
ical underpinning of economics consulting. The purpose of this course is
twofold: First to give the students a sound theoretical understanding of the
…eld of industrial economics. Second to demonstrate how the principals of
industrial organization are applied within economics consulting, through real
world cases.
The cases discussed include:

Access pricing telecommunication and the regulatory authorities recent

reregulation of the mobile market.

Port pricing - the appeal court’s verdict in the Hurtigruten - Bodø havn
case

Google case - EU commission’s decision of July 2017

Book market - ESA’s investigation and the …xed price contract

Grocery market - retail chain dominance

The cases are often real cases from economics consulting. However, the
way we are presenting the cases will typically deviate from the presentations
in consulting reports or for a court of law. The cases are usually complex;
many players are involved, the environment is unstructured, and there are
many mechanisms at play simultaneously. In this text we do not present the

4
cases in detail, that will be too time consuming and the context may be very
speci…c to the case at hand and hence give little general knowledge. Instead
we will go deeper into some of the aspects (typically the main aspect) of the
case. We will do this by deploying economic theory, at a deeper and a more
technical level than typically done in the consulting reports. Our aim is to
show how economic forces are at play in the cases, and how we as economists
can capture these forces in mathematical structures and thereby understand
each of them at a deep level. Our aim in this text is not to be "lawyers", i.e.,
not to give an as comprehensive and exhaustive list of relevant factors in the
case and optimally weigh them together to get the de…nite answer. That is
something better learned at the work place.
We want to point out that the models we construct are not ment to be
general models that capture all relevant aspects of the case. On the contrary,
a model is often tailormade to capture the logic of one particular mechanism.
The underlying assumptions of the model may be violated in other parts of
the case, in which other mechanisms are at play. Sometimes it is possible
and even warranted to integrate several mechanisms in one model, but this
is not the general rule, and may often be too time consuming. However,
we do believe that models are vital for economics consulting, particularly in
complicated matters like antitrust and vertical restraints. History here shows
as we see it (slightly sexist) that "a man with a model against a man without
a model is like a man with a gun against a man without a gun". The man
with the gun usually wins.
In the analysis, the acting agents are typically …rms. The consumers play
a more passive role, as price takers who chose whichever option is the best for
them. We assume that the …rms have as objective to maximize pro…ts. For
instance, when we analyse Telenor’s (or other …rms’) incentives to outsource
part of the production, we assume that they will do so if that maximize their
pro…t, without regard to the employment prospects of their employees. Fur-
thermore, we assume that the …rms respond rationally to the situation at
hand. This is in accordance with the standards of our legal system, where
it is typically assumed that professional, comersial agents are able to pur-
sue and protect their own interests. Note howerver, that the assumption of
rationality may not be as adequate in other settings, for instance in issues
related to the marketing control act, in which private persons are granted
special protection.
The cases represents quite di¤erent market structures, but have two com-
mon features: 1) one or a few …rms have dominant positions, and 2) a core

5
element of the political debate regards the vertical structure in the market.
The dominance problem is well known from introductory courses in mi-
croeconomics, and is discussed under the heading "monopoly pricing". We
know that a …rm with market power has incentives to raise its prices above
marginal cost, which creates an e¢ ciency loss (deadweight loss of monopoly
pricing).
In the course we want to take a broader perspective: in particular, are
there other potential distortions associated with dominance? E.g. has a
dominant …rm incentives to choose the optimal product quality, or is it a risk
at it uses its market control to save costs by reducing quality (after all the
customers have few alternatives)? The monopolists price level is above the
optimal level, but what about the price structure? Is there is a risk that a
monopoly conducts harmful price discrimination, by treating some customers
di¤erently from others?
In the long run, are monopolists more or less innovative than …rms com-
peting …ercely? As John Hicks, the British Nobel-prize winner once said:
"The best of all monopoly pro…ts is a quiet life".
Finally, a dominant …rm may face competition from smaller competitors,
and from future potential entrants. Does a dominant …rm have incentives to
foreclose competitors from the market, given that it has the means?
To provide answers to these questions, we have to understand the incen-
tive structure in the market. And this will be the key part of any assessment
of the various policy proposals that come up in the political debate, in the dis-
cussions about how the government and the competition authorities should
deal with the lack of competition. A recent proposal from Arbeiderpartiet, a
proposal which also got support from some members of Høyre, regards price
setting in the grocery market. The concern is that large food suppliers as
Orkla, Tine, Ringnes etc., provide the dominant grocery chains with more
favorable contract terms than smaller stores. According to the proposal, the
grocery market will function more e¢ ciently if the dominant suppliers were
not allowed to price discriminate between downstream grocery stores. Maybe
the proposal will work, maybe it will not. But to say something about the ef-
fect of the proposal, and whether it is the right medicine (given that that the
competition problem is real) we have to analyze the competitive structure,
and understand the underlying mechanisms driving price setting.
The second important feature of the markets analyzed in the course is the
vertical structure. It is common to think about vertical structures as value
chains - as a sequence of processing activities each activity adding value to the

6
product. How does market dominance impact value creation in the vertical
chain? Say there is a bottleneck somewhere in the chain, a dominant …rm
large enough to dictate the terms of trade: does it matter if the bottleneck
is upstream or downstream? Is it harmful to consumers if a dominant …rm
upstream merges with downstream …rms, and leverage its market dominance
to a new level? Take the Norwegian book market as example, large publishing
houses have over time bought up independent book stores and established
large dominating book store chains owned by the publishing houses. Is this
good or bad news for the readers?
Similar patterns are found in the telecommunication market. Both Te-
lenor and Telia are now integrated with some of the previously independent
service providers, like Chess and OneCall. How will the integration process
impact competition in the mobile market? Would it be better if these service
providers were not owned by the integrated networks?
The vertical structure of markets are mostly ignored in introductory mi-
croeconomics courses. However, the following cannot be stressed to much:
the e¤ects of collaboration and integration vertically (between upstream and
downstream …rms) have substantially di¤erent e¤ects from collaboration hor-
izontally (between competitors). It is a basic insights that …erce competition
horizontally is bene…cial to consumers, and that any collaboration on prices
is harmful – and illegal, according to section 10 of the Norwegian Compe-
tition Act. In contrast, coordination on prices vertically, between upstream
and downstream …rms, are often bene…cial to society. This is key in under-
standing the e¤ect of regulation and competition policy associated with the
complex vertical structure we …nd in the sectors discussed in the course.
This text is organized as follows. I …rst provide a theoretical introduction
to main concepts and models. Then I discuss some om the cases more in
detail.

2 Regulation and competition policy

The Norwegian Competition Authority’s (Konkurransetilsynet) responsibil-
ity is to enforce the Norwegian competition act (konkurranseloven). The aim
of the law is to promote competition in order to contribute to an e¢ cient use
of the resources in the society. When applying this law, particular attention
is to be paid to the bene…t of consumers.
The competition authority works within three main areas. The …rst re-

7
gards unlawful cooperation between …rms, covered by section 10 in the act.
The classic example of and unlawful cooperation is collusion, secret aggre-
ment between …rms to limit competition and thus keep prices at a high level.
The second regards abuse of a dominant position, which is section 11 of the
act. A …rm is considered dominant if its market share exceeds 40-50 percent,
and is expected to have the power to act independently of its competitors.
The …nal area is control of mergers and acquisitions, section 16. According
to the law any merger or aquisition involving …rms with a turnover above a
threshold valued must be approved by the competition authorities.
Enforcement of the competition act is often referred to as ex post com-
petition policy. The competition authorities intervenes if …rms have acted
unlawfully. Note that it is not illegal to have market power or being a domi-
nant …rm. It is the abuse of market power which is illegal. If the competition
authorities concludes that one or more …rms have acted unlawfully, the au-
thority has the power to impose a …ne, or it may take the case to the court.
Market regulations, as sector regulation in telecommunication and energy
markets, are founded on a di¤erent principle. It is referred as ex ante policy.
Market regulation has been particularly important within the telecommu-
nications sector where the Norwegian Communications Athority (nasjonal
kommunikasjonsmyndighet, NKOM) is the regulator. NKOM may intervene
and restrict business behavior if they …nd a …rm has the power to abuse
market power, independent of whether an abusement actually has occured.
This contrast to the competition authority, which intervenesl if and only if
if …nds that an abusement has taken place.
Regulatory authorities can also act ex post, and as the competition au-
thority, has the authority to impose …nes if a …rm abuses its market power.
The telecommunication sector is regulated under the The Electronic Com-
munications Act (Ekomloven) from 2003.

3 E¢ ciency
In any policy analyses, you need a benchmark, a measure of e¢ ciency -
otherwise there is no way you can provide a meaningful assessment of policy
proposals. The standard measure of consumer welfare in competition analysis
is total consumer surplus net of total production production costs. Note that
this measure is neutral with respect to income distribution, it just adds up
consumers’willingnesses to pay for the various goods supplied in the market.

8
 Total social surplus is de…ned as the sum of consumer and producer sur-
plus. As mentioned in the previous section, the purpose of the competiton
act is to promote e¢ ciency with special regard to the bene…t of consumers.
As e¢ ciency refers to the sum of consumer and producer surplus, wheras
consumer bene…t refers only the former, the formulation of the aim of the
act has given rise to controversies about its interpretation, and how it should
be implemented in practice.

3.1 Producer surplus

Producer surplus is de…ned as the …rm’s revenue net of production costs.
Producer surplus measures the value created in a …rm during a period of
time, e.g. a year. This raises the issue of how to deal with investments. The
standard measure of producer surplus as it is applied in introductory courses
in microeconomics, the area between the price and the marginal cost curve,
corresponds to revenue net of variable production costs, sometimes referred
to "quasi rent". As the …rm’s …xed costs are not included, the quasi rent
does not re‡ect the pro…tabiliy of the …rm.
To obtain a measure of pro…tability, the …rm’s …xed costs must be de-
ducted in which capital costs are the main part. The cost of capital is typi-
cally evaluated as a user cost of capital. This will be discussed later.
In measuring production costs, the correct prices used correspond to the
opportunity cost of each input. For inputs purchaced in ordinary markets,
as energy, intermediates etc. the market price re‡ects the …rm’s opportunity
cost. For internal resources the correct price refects the …rm’s best alternative
use of the input, which may deviate from the market price. However, in most
cases the market price can be used as a simple representation, and in a long
run perspective, for an optimizing …rm, the opportunity cost will re‡ect the
market price.
We proceed as follows. We …rst derive the producer surplus in the simplest
possible setting with a competitivie …rm producing one single output, q, using
just one input v. Afterwards we show that the simple intuition from the
example can be generalized to multi product …rms and …rms with market
power.
Let q = f (v) represent the …rm’s production function. With p as the

9
product price, and w as the input price, the …rm’s surplus is:

= pq wv
= pf (v) wv

The …rst order condition for pro…t maximization is

pf 0 (v) = w

which de…nes the …rm’s input demand as function of input price w (for a
given p),

v (w)
v (w) inserted in the pro…t function yields

(w) = pf (v (w)) wv (w)

Di¤erentiate w.r.t. w yields

d (w) dv (w)
= (pf 0 (v (w)) w) v (w)
dw dw
= v (w)

where we have used the …rst order condtion pf 0 (v (w)) = w. Altertrnatively,

the result can be derived directly from the envelope theorem. Note the
interpretation: the reduction in pro…t due to a small increase in the input
price is eqaul to v (w), which is the …rm’s demand of the particular input.
Suppose the input price is w. The producer surplus can be expressed as
follows:
Z 1
d (w)
(w) = (1) dw
w dw
Z 1
= v (w)dw
w

which is the area between the input demand curve and the input price, as
illustrated in the following …gure.

Figure

10
 Exercise: Suppose f (q) = q 1=2 . Derive the input demand function, and
show that the …rm’s surplus can be expressed as the area under the input
demand curve.
We can illustrate the producer surplus from the …rm’s cost function. In-
verting the product function f (v) yields v(q), and then the cost function

c(q) = qv(q)

The producer surplus is then

(q) = pq c(q)

Maximising with respect to q yields the well known …rst order condition

p c0 (q) = 0;

price equal to marginal cost. The …gure below gives a graphical representa-
tion,

11
where producer surplus is the shaded area.
Note that the shaded area in this …gure corresponds exactly in size to the
the shaded area in the previous …gure. However, deriving producer surplus
from the input side has the advantage that it does not depend on the …rm’s
degree of market power. To illustrate this, consider a monopoly …rm. With a
monopoly …rm the …rs order condition is represented by marginal cost equal
to marginal revenue, illustrated in the left part of the …gure below.

If we derive producer surplus from the input side, the procedure is not
impacted by the …rm’s strategic position in the market, the area below the
input demand function represents the surplus independent of whether the
…rm is a monopoly …rm or a competitive …rm. The left part of the …gure
is the classic representation of producer surplus with market power. Note

12
that to provide a precise representation of pro…t, information on the demand
elastisity is needed.
We generalize the result in two directions. Consider a multi product …rm,
which is a common characteristics of larger …rms in regulated sectors, e.g.
telecommunication …rms. Second we allow the …rm to have market power in
some or all submarkets.
With vector notation, the …rm’s net revenue is

(q; v) = p(q)q wv

where p(q) is the product price vector and w the input price vector. The
…rm maximizes (q; v) subject to the production possibility set, the feasible
combinations of inputs v and outputs q.1
Denote by q (w) and v (w) the optimal input/output choices given input
prices w. Hence the …rm’s pro…t is

(w) = p(q )q wv

From the envelope theorem we have

@ (w)
= vi (1)
dwi
Consider input 1, and to simplify notation, suppose there are two inputs.
Let us evaluate the pro…t at input prices w1 and w2 hence:

(w1 ; w2 ) = p(q )q w1 v1 w2 v2

We can reformulate the pro…t as follows:

Z 1
@ (w1 ; w2 )
(w1 ; w2 ) = (1; w2 ) dw1
@w1
Zw1
1

= (1; w2 ) + v1 (w1 ; w2 )dw1

w1

which corresponds to the result in the simple one input, one output case with
a competitive.
1
Mathmatically, the production possibility set can be represented by a relation
H(q; v) = 0, which for each set of input levels v describes the feasible combinations of
outputs q. The technical part is not important for the argument in the text.

13
 Hence the impact of an increase in the input price on producer surplus
does not depend on whether the …rm is competitive or has market power
in the product market. Furthermore, the production structure can complex.
Note that with a multiproduct …rm (1; w2 ) is not nesecarily zero, repre-
senting the …rm’s surplus from production which does not use input 1, or can
substitute away from this particular input.
This representation of producer surplus simpli…es the analysis of the im-
pact of changes in input prices on …rm’s pro…t.

3.2 Consumer surplus

At least conceptually, producer surplus or pro…t is a well de…ned term. The
consumers’ value of having access to a market is less so. Consumers are
not pro…t centers. In consumer theory we use the term utility to capture an
individual’s well being, and in standard consumer theory (with the exception
of expected utility) it is assumed that only the ranking of the alternatives
that are relevant, not the di¤erences in the level of the utility they give rise
to. Furthermore, it is even more problematic with interpersonal comparisons
of utility, if one agent gain from a change and another loses, it is by no means
trivial to weight the two agents’changes in utility together.
In this book we will focus on the concept of the willingness to pay for a
good. We will use the aggregate willingness to pay for as a criteroin for the
welfare of the consumers. This is not unproblematic. It may well be that a
superrich person has a higher willingness to pay for a good than a dirt poor
person, even though the rich person does not really care about getting the
good while it is a matter of life or death for the poor person. On the other
hand, it seems reasonable that a fair income distribution is better achieved
by aggregate policies like income taxation than through industrial policy, and
hence that distributional concerns should pay a minor concern for the latter.
This may favor the use of aggregate consumer surplus as a welfare measure.
Another issue is that the willingness to pay for one more unit of a good,
for a given consumption level of the good, actually may depend on the price
of the good. This is related to the income e¤ect of demand. The demand for
(one more) unit of a good will depend on the person’s real income level. If a
person has paid a high price for 10 units of the good, her apetite for the 11th
unit may be smaller than if she paid a lower price for those goods simply
because she is running short of money. This is particularly relevant if the
seller o¤ers a two-part tari¤ (p; T ), where p is the price per unit purchased

14
and T is a …xed fee. If T is high, the consumer has less money to spend
on buying the units, and this may in‡uence her demand. However, in most
cases the expences associated with buying a good is small relative to the
person’s total income, and the income e¤ects therefore of little importance.
In such circumstances the willingness to pay as we de…ne it below will be a
good aproximation for the value of the good to the consumer.
The standard (Marshallian) measure of gross consumer surplus is the
area under the demand curve. Suppose q(p) is a downward sloping market
demand curve. The curve shows how much consumers wish to buy at any
given price p. Let p(q) represent the inverse demand curve, the mirror image
of q(p), and drawn in the …gure below.

Gross consumer surplus is the area under the demand curve is, the shaded
area in the …gure. Analytically, gross consumer surplus is the integral
Z q
p(z)dz
0
Net consumer surplus, or simply "the consumer surplus", is obtained by
subtracting consumer expenses, pq, from the gross measure. Let CS be the
consumer surplus2 , then
Z q
CS = p(z)dz pq
0
2
It can be shown that consumer surplus, de…ned as above, is a precise meausure of
consumers’valuation if there are no income e¤ects.

15
 The integral formulation of demand curve is convenient as it allows us to
deal with di¤erent speci…cations of the demand function. A brief introduction
is given here:

3.3 Integral formulation

We have gross consumer surplus de…ned as
Z q
p(z)dz
0

Suppose we increase q with one unit. What will be the impact on consumer
surplus? As illustrated in the …gure below, the additional unit is valued at
p(q), which is the marginal valuation at the level of supply q. Hence we
should expect that the derivative of the integral with respect to q equals
p(q), which actually is true.

Rq
Mathematically, we can di¤erentiate 0 p(z)dz with respect to q which
yields excactly p(q): Rq
d 0 p(z)dz
= p(q)
dq
In some cases it is possible to solve the integral explicitly. Two such cases
are the linear curve and the iso-elastic demand curve. Let us do that:

16
3.3.1 Example 1: the linear demand curve
Let the demand curve be

p(q) = D q
where D is a …xed number. Gross consumer surplus is:
Z q Z q
p(z)dz = (D z)dz
0 0
We solve the integral:
Z q
1 2 1 2
(D z)dz = jDz z = Dq q
0 2 2
How is gross consumer surplus impacted by q, total consumption? We take
the derivative
d Dq 21 q 2
=D q
dq
which is exactly the same as we obtain by di¤erentiating the integral in the
…rst hand, recall that Rq
d 0 (D z)dz
=D q
dq
Let us split gross consumer surplus in net surplus and consumer expenses:
1 2
Dq q
2
1
= D q+q q q
2
1
= (D q) q + q q q
2
1
= (D q) q + q 2
2
1 2
= pq + q
2
where 21 q 2 is net consumer surplus, and pq are the consumer expenses, see
the …gure below.

17
3.3.2 Example 2: the iso elastic demand curve
The iso elastic demand curve has a constant demand elasticity. The demand
elasticity is de…ned as
dq p
" = Elp q(p) =
dp q
If we specify the demand function as follows
"
q=p

we have a demand curve exhibiting constant elasticity. We can take the

inverse, which yields
1
p(q) = q "
Gross consumer surplus is:
Z q Z q
1
p(z)dz = z " dz
0 0
We can solve the integral:
Z q
1 1 1
+1 1 1
+1 " " 1
z " dz = 1 z " = 1 q " = q "

0 "
+ 1 "
+1 " 1

18
and we can decompose gross consumer surplus into the sum of net consumer
surplus and consumer expenses:
" " 1
q "
" 1
" " 1
= q " pq + pq
" 1
" " 1 1
= q " q " q + pq
" 1
" " 1 " 1
= q " q " + pq
" 1
" " 1
= 1 q " + pq
" 1
1 " 1
= q " + pq
" 1
" 1
where " 1 1 q " is net consumer surplus, and pq are the consumer expenses.
Note also that the derivative of gross consumer surplus with respect to q
is p(q). We …nd:
" 1
"
d " 1
q " " 1 1
1
=q " =q " = p(q)
dq

3.4 Generalizations to more than one market

In the course we consider production sectors that consists of more than one
market segment, e.g. consisting of a business market segment with di¤erent
characteristics than the household segment, but both served by the same
company. If there are no dependences in demand between the segments,
we can simply add up the consumer surpluses as de…ned above. How much
consumers wish to buy of good 1 is not impacted by the price of good 2, and
vice versa.
Social welfare will then be the sum of consumer surplus over the two
segments Z Z
q1 q2
p1 (z)dz + p2 (z)dz
0 0
If there are dependences between the two segments, the situation is more
complicated. For completeness I add a section on this in Appendix A.

19
3.5 First best allocation
Given our measure of social welfare, we can derive the conditions for an e¢ -
cient allocation. Considering one market segment in isolation, social welfare
is maximized at the level of production which solves the following maximiza-
tion problem: Z q
max p(z)dz c(q)
q 0
Di¤erentiate with respect to q yields the …rst order condition

p(q) c0 (q) = 0

which says that price should be equal to marginal cost, a result known from
introductory micro courses. This result is straight forward to generalize to
several market segments, e¢ ciency requires that price equals marginal cost
in each single segment. This is trivial with independent demand, in which
case …rst best is de…ned as
Z q1 Z q2
max p1 (z)dz + p2 (z)dz c1 (q1 ) c2 (q2 )
q1 ;q2 0 0

Di¤erentiating this expression shows that a …rst best allocation is repre-

sented by the following two conditions:

p1 (q1 ) c01 (q1 ) = 0

p2 (q2 ) c02 (q2 ) = 0

Price should equal marginal cost in each segment.

In introductory microeconomics courses, it is common to associate a …rst
best allocation with perfect competition: if a market has the characteristics
of perfect competition, the equilibrium allocation will be socially e¢ cient
(Pareto optimal). This is an important result, which is known as the "…rst
fundamental theorem of welfare economics".
But it does not follow from the theorem that if the market is not compet-
itive, the allocation will be ine¢ cient. In the course we will consider market
con…gurations in which e¢ ciency is obtained despite dominance. One exam-
ple is bilateral monopoly - trade between two dominating …rms. Since this
insight is important for our analysis, I will say a few words about it, before
we continue.

20
3.6 Bargaining and the Coase theorem
The Coase theorem states that if agents can approach and negotiate and
there are su¢ ciently low transaction costs, bargaining will lead to an e¢ cient
outcome regardless of the initial allocation of property rights.
We will here present a simple example of the principle, and we will use the
vertical value chain as example. Suppose two …rms, A and B, can approach
each other and negotiate a contract. A is an upstream …rm which makes
an investment, and B is a downstream …rm which realizes the value of the
investment in the market.
If they make a deal, …rm A invests an amount q which creates value V (q)
at cost C(q). A pays the investment cost C(q) whereas …rm B realizes the
value V (q) in the market. A lumpsum transfer T from B to A splits the gains
between the two parties.
If they sign a contract, the relationship creates net value

V (q) C(q):

If the they do not agree, and split up, we assume that A obtains uA as its
best alternative and B obtains uB . Suppose the investment q and the transfer
T are contractable.
We can make some observations:

1. The relationship creates value beyond what the two parties can make
on their own if and only if

V (q) C(q) > uA + uB

2. The value of the relationship (and thus the size of the pie for which
the two parties bargain over) is as large as possible if q is set such that
V (q) C(q) is maximized. Refer to q as the investment level which
maximizes value added. It follows that q is determined by the …rst
order condition V 0 (q ) = C 0 (q ).

3. The two parties have a con‡ict of interest in how to split the pie.
Let T be the agreed transfer from B to A (the compensation for A’s
investment cost). Then it is clear that A wants T to be as large as
possible, and B wants T to be as small as possible.

21
 4. The two parties have a common interest in making the pie as large
as possible, that is to agree on q . Note that if an ine¢ cient level of
investment q^ is proposed in the negotiation, for any T^, there exists a
counter o¤er q and a transfer T which is preferred by both parties
to the o¤er q^ ,T^. Given q^ it follows that the investment q creates
additional value of size

[V (q ) C(q )] [V (^
q) C(^
q )]

which can be shared between the parties.

Based on these observations, we assume that the bargaining outcome

satisfy:

1. If the parties sign a contract, they agree on q , the investment level

which maximizes the value of the relationship.

2. An agreement is reached if the relationship creates value, that is if

V (q ) C(q ) uA uB > 0

3. The parties split the surplus according to their bargaining strength:

(a) If A has all bargaining power, B obtains uB . This yields the

transfer:
T = V (q ) uB
Note that A receives all value beyond what B can guarantee itself.
B keeps uB which is his opportunity cost.
(b) If B has all bargaining power, A obtains uA . This yields the
transfer:
T = C(q ) + uA
Here A receives the lowest possible compensation, the cost of the
investment in addition to his opportunity cost.
(c) If they have equal bargaining power, they split the gain in two
equal parts, hence T is set such that
1
T = C(q ) + uA + (V (q ) C(q ) uA uB )
2

22
 In the further discussion, we can think about a market where one part
sets the prices, as a market where this part has all bargaining power. This
part then provides a "take it or leave it o¤er", and the other part accepts or
rejects. For example, if the seller sets the price, the buyer’s only choice is
between "buy it" or let it go.

3.6.1 Exercises:
Consumer welfare
Qu. 1: Just to refresh the math: let gross consumer surplus be
Z q
p(z)dz
0

suppose p(z) has the following functional form

p(z) = D az
Compute the integral.

Solution:
Z q
1 2
(D az) dz = jq0 Dz az
0 2
1 2
aq = Dq
2
Observe the following - a linear demand curve corresponds to a quadratic
utility function.

Qu. 2: Try also the following speci…cation:

1
p(z) = z "

Note that " is the demand elasticity, assumed to exceed one.

Solution:
Z q
1 1 1
z " dz = jq0 1 z1 "

0 1 "
1 1 1
= 1q
"
1 "

23
4 Vertical market structure
From now on, the vertical structure of markets will be the main focus. Let me
add one comment to this. Isn’t it so that there is a vertical structure already
build into the standard models, as we know them from introductory courses?
Think about the concept "…rm" as it is introduced in the production theory
part of elementary microeconomics. The …rm purchases primary production
inputs in the market, and uses its production function to transform the inputs
to …nal products. In most "real" cases the transformation from inputs to …nal
products is sequence of re…nement processes, in which each step adds some
value to the product.
In some cases, the re…nement process is entirely an internal process in one
single …rm. Thus represents a vertically integrated value chain - everything
takes place inhouse. Hence the model of competition between …rms, as it is
presented in elementary courses, can be considered as competition between
vertically integrated production units.
The question is, does it matter if the sequence of re…nement processes
is split between companies? That some …rms are upstream, buying primary
inputs, transforming them to semi…nished products, and then sell them to
downstream …rms …nalizing the production process. Will this vertical disin-
tegration in the value chain impact e¢ ciency?
The question belongs to the general question about the boundaries of
…rm - should the …rm do the whole process inhouse, or is it more e¢ cient
to "outsource" some some of the tasks. Part of it has to do with the issue
of technical specialization. It could be that a …rm becomes more technically
e¢ cient if it specializes in a more narrow set of tasks - like Raufoss indus-
tripark producing bumpers for Volvo. But more importantly, the vertical
structure impacts the incentive structure, which will be the focus here.
In the discussion we explore alternative speci…cations of the decision
processes in the value chain. Take the relationship between an upstream
and a downstream …rm. As independent …rms, you can think about them
simply as price setters, where each …rm independently set their respective
prices. Alternatively, we can think about prices as the outcome of a bargain-
ing process. Furthermore, the contract governing the transfers between the
…rms can be more or less complex, depending on details in the market. In
the discussion we explore di¤erent alternative descriptions of these processes.
An essential part of the discussion is the degree of market power. The
simplest case, and a natural starting point, is the monopoly model. The intro-

24
ductory microeconomics case can then be thought of as a vertically integrated
monopoly. Let us now consider a market where there is one monopoly …rm
upstream supplying a downstream monopolist. We begin with the double
marginalization problem:

4.1 Double marginalization problem

We have one monopoly …rm upstream and one downstream. Denote by r the
wholesale price. The upstream …rm’s pro…t is then
U
= rq c(q)

whereas the downstream …rm’s pro…t is

D
= (p(q) r) q

We want to explore how the vertical structure as such impacts e¢ ciency,

hence we use the vertically integrated …rm as a benchmark. The integrated
monopoly pro…t is
U
+ D = p(q)q c(q)
We can interpret vertical integration as perfect coordination of pricing
decisions.

4.1.1 Coordinated pricing decisions

Joint pro…t is
= p(q)q c(q) (2)
The …rst order condition for maximum is

p(q) + p0 (q)q = c0 (q) (3)

which has the standard interpretation: the left hand side, marginal revenue,
should equal the right hand side, marginal cost.
A convenient reformulation of the …rst order condition is as follows:
!
q 1
p(q) 1 + p0 (q) = p(q) 1 + 0 p = c0 (q)
p q (p) q

25
hence3
1
p(q) 1 = c0 (q)
"(p)
where "(p) = q 0 (p) pq is the demand elasticity. Sometimes we assume that
the elasticity is constant (iso elastic demand curve), in which case " is a …xed
number, independent of p.
The left hand side of (3) is the marginal revenue, and let us refer to that
at as m(q), in which case the …rst order condition can be written
m(q) = c0 (q):
The …rst order condition determines q M , the monopoly output.
We next explore independent price setting.

4.1.2 Independent pricing decisions

The downstream …rm pays the wholesale price r and maximizes
D
= (p(q) r) q
with …rst order condition
p(q) + p0 (q)q = r
hence it produces up to the level at which marginal revenue equals the whole
sale price

m(q) = r
with second order condition for maximum
m0 (q) < 0
we see that the standard representation with a downward sloping marginal
revenue curve is su¢ cient for the …rst order condition to represent a solution
to the maximization problem4 .
3
Note that the slope of the inverse function is equal to the inverse of the slope of the
original function. That is, since p(q) is inverse to q(p), we have p0 (q) = 1=q 0 (p).
4
A downward sloping marginal revenue curve is not just as trivial as the assumption of a
downward sloping demand curve. Even with a downward sloping demand curve, marginal
revenue can be non-monotone (if the elasitisity of demand changes in demand level) and
discontinuous (if the demand curve is kinked).

26
 Note that m(q) = r is one equation which maps the wholesale price r into
a downstream …rm production level q D (r). Hence it has the interpretation
of the downstream …rm’s demand for deliveries as function of the wholesale
price. That is, m(q) is the demand curve the upstream …rm faces.
Hence the upstream maximizes pro…t
U
= m(q)q c(q)

Let us compare this expression with the integrated monopoly’s pro…t

function, equation (2) above:

= p(q)q c(q)

Note that the di¤erence between the two expressions: the upstream …rm faces
a demand curve m(q), whereas the integrated …rm faces demand curve p(q).
We can show that demand curve m(q) yields a higher price than demand
curve p(q). Note that the …rst order condition for the upstream …rm is:

d U
= m(q) + m0 (q)q c0 (q) = 0
dq
whereas for the integrated …rm we have
d
= m(q) c0 (q) = 0
dq

Since the marginal revenue curve is downward sloping, m0 < 0, it follows

that the upstream …rm’s marginal revenue is smaller than the integrated
…rm’s - hence it produces less, that is, it charges a higher price.
This is illustrated in the following …gure, with the integrated …rm to the
left and the upstream …rm to the right.

27
 The double marginalization problem is severe, not only because joint prof-
its is lower than if the …rms coordinate the price setting, but also because
consumers are worse o¤ than with an integrated monopoly. It is often for-
mulated as: "the only thing which is worse than a monopoly is a chain of
monopolies."
The problem has a simple intuition: the downstream …rm charges a con-
sumer price which is a mark-up on the wholesale price, which already includes
a mark–up. Thus, the downstream …rm sets a "margin on the margin" - cre-
ating a "double margin" - which is bad for producers and bad for consumers.
If double marginalization is a problem, is regulation the proper medicine,
or is it a problem which is better dealt with in the market?

4.2 Double marginalization: market vs regulation?

Is the double marginalization problem an argument for price regulation? In
most cases "no", as the market participants have incentives to avoid the
problem, and have the means to solve it.
Double marginalization occurs if …rms independently set uniform prices,
that is …xed prices per unit of the product. Since we have two monopoly
…rms making a deal, we have a market setting known as bilateral monopoly.
In most cases one would expect that a bilateral monopoly may design a
contract which realizes all gains from trade between the two parties. Just
think about a bargaining process between the two parties. The parties have a

28
con‡ict of interest in how to split the gains from trade - however they have a
common interest in making the pie as large as possible. Hence any contract
o¤er which is ine¢ cient in that it does not realize all gains from trade, is
dominated by an e¢ cient contract o¤er, see the discussion above. The two
parties can simply split the additional value created by the e¢ cient contract.
This argument is related to the more general "Coase theorem" which says
that if there are su¢ ciently low transaction costs, and symmetric information,
bargaining will lead to a Pareto e¢ cient outcome regardless of the initial
allocation of property rights.
Typically, B2B contracts are more complex than simple uniform price
contracts. In most cases, the parties do not bargain over "a price per unit",
but they bargain over the total payment charged for a package of deliveries.
A simple representation of this is a two part tari¤. With a two-part tari¤
the transfer from the downstream …rm to the upstream …rm is

rq + T

where r is the variable part of the tari¤, a payment per unit, and T is a …xed
transfer. Uniform prices is the special case with T = 0.
The nice feature of a two part tari¤ is that the parties have two pricing
instruments to play with, and they have two goals. They can use the variable
part r to maximize value creation, and the …xed transfer T to split the
pie. With only one instrument, it is impossible to distinguish between value
creation and value distribution, which leads to ine¢ ciencies.
More precisely, the integrated monopoly maximizes

= p(q)q c(q)

with …rst order condition

m(q) = c0 (q)
with solution
q = qM
In the two part tari¤, set the variable price r as

r = c0 (q M )

The downstream …rm then maximizes

D = p(q)q rq T

29
with …rst order condition
m(q) = r
Since r = c0 (q M ) it follows that downstream …rm’s production decision
replicates the integrated monopoly’s:

qD = q M

Another example of a market based contract which deals with the problem
is RPM, resale price maintenance (…xed price contract).

4.3 Fixed price contract

In a …xed price contract, the upstream …rm sets the …nal price. The whole
sale price can then be subject to negotiations between the parties (which
basically is the pricing model used in the Norwegian book market, see later
discussion).
Note that if the upstream …rm, given demand curve p(q), sets the price
p, it also …xes the total sale q = q. Hence the downstream …rm’s payment,
the wholesale price multiplied with q, takes the form of a …xed transfer.
Hence there are two instruments, q and r. According to the logic above,
one instrument, q, is used to maximize value creation; the other instrument,
r, is used to split the value between the two parties.
Maximizing total value requires that

q = qM

where q M is the integrated monopolists optimal quantity, determined by

m(q) = c0 (q)

4.4 Regulation may make the problem worse

A potential problem with price regulation is that the regulatory schemes are
too coarse. Incentive contracts are typically …ne-tuned to simultaneously
maximize value creation and to share the values between the parties in a
proper way. Each contract has unique features, and they will di¤er in terms
depending on the identity of the …rms on each side.
Price regulation is typically standardized, with a uniform set of terms
of trade. Even if the regulation is balanced "on average", it will create

30
distortions as it may not re‡ect the heterogeneity in the market - …rms di¤er
in many respects, and the optimal contracts re‡ect these di¤erences.
This is an example of regulatory ine¢ ciencies, that must be taken into
account in that regulation can only be justi…ed if the market distortion is
su¢ ciently severe.
So far we have focused on price as the decision parameter. Firms makes
a lot of other decisions, investment decisions, choice of quality, marketing
decisions, investment in research and development etc. We will now focus on
the set of decisions that impact consumers willingness to pay for a product,
for a given price. We can think about that as the choice of quality, marketing,
sales service etc.

4.4.1 Exercises
Double marginalization:
Derive the marginal revenue for the integrated …rm, and the upstream
…rm, in the following two cases:

1. Linear demand curve, p(q) = D q

1="
2. Iso elastic demand curve, p(q) = q .

Solution: We have, recall that m(q) = p(q) + p0 (q)q

m(q) = D 2q
m(q) + m0 (q)q = D 4q

and with iso-elastic demand:

" 1 1="
m(q) = q
"
2
" 1 " 1
m(q) + m0 (q)q = q 1="
< q 1="
" "

In both cases we see that marginal revenue is smaller for the upstream
…rm (which is a general result).

More on the double marginalization problem

31
 Suppose demand is linear and represented by
p(z) = D z (4)
Qu. 1) Show that marginal revenue equals
mr(z) = D 2z

Solution: Revenue is:

p(z)z
we di¤erentiate w.r.t. z
mr(z) = p(z) + p0 (z)z
= D z + ( 1) z
= D 2z
Qu. 2) Consider a monopoly facing demand
p(z) = D 2z (5)
Let marginal cost be constant equal to c.
Show that the solution of the monopoly’s optimization problem, given
demand curve (22), corresponds to the solution you will get if demand is rep-
resented by (21), assuming that the market consists of one upstream producer
and one downstream retailer charging linear prices.

Solution: Suppose the demand curve is p(z) = D 2z. With this demand
curve, the marginal revenue is
mr(z) = p(z) + p0 (z)z
= D 2z + ( 2) z
= D 4z
The monopoly chooses z such that mr(z) equals marginal cost.
Consider next an upstream and downstream producer signing a linear
price contract. Refer to r as the wholesale price. The downstream …rm
maximizes
(z) = p(z)z rz
= (D z) z rz

32
with …rst order condition

mr(z) r
= D 2z r = 0

The upstream …rms sets r taking into account that downstream production is
determined by the …rst order condition D 2z r = 0. Hence the upstream
…rm solves the following problem:

max rz cz
r

subject to
D 2z r=0
Since the constraint represents a one to one mapping from r to z, we can
reformulate the optimization problem as an maximization problem in z. From
the constraint, solve for r, and then substitute out r in the objective function:

rz cz = (D 2z) z cz
with this formulation, we see that the upstream …rm faces a maximization
problem which corresponds exactly to the maximization problem of a hypo-
thetical monopolist facing demand curve D 2z.

Qu 3) We continue with demand curve (21) and marginal cost c. Suppose

the upstream …rm o¤ers the retailer a two part tari¤ [r; T ] where r is the per
unit charge and T is a lump sum transfer. Derive the optimal r.

Solution: We can formulate the problem as follows: with a two part

tari¤ the downstream …rm pays

rz + T

the upstream …rm. Given a contract [r; T ] the downstream …rm maximizes

D (z) = p(z)z rz T
= (D z) z rz T

with …rst order condition

mr(z) = r
D 2z = r

33
 The upstream …rm’s pro…t is:

(r c)z + T

With a two part tari¤, the upstream …rm faces two constraints. The …rst
is the incentive constraint, represented by the downstream …rm’s …rst order
condition D 2z = r. The second is the participation constraint, in that
the downstream …rm must be better o¤ signing the contract than rejecting it
(without this constraint the planner would set T = 1). Let the participation
constraint be a break even constraint,

D (z) = p(z)z rz T
= (D z) z rz T 0:

To sum up we solve the following problem:

max (r c) z + T
r;T

s:t:
D 2z = r
(D z) z rz T = 0

Note the following. As T is a lump-sum transfer, it will not impact the

downstream …rm’s production decision. Hence the upstream …rm will always
set T as large as possible (which explains why we can replace the weak
inequality in the participation constraint with equality).
Furthermore, since the upstream …rm can use a …xed term to transfer
pro…t, it is best o¤ maximizing pro…t. If we use the participation constraint
to substitute out T in the upstream …rm’s pro…t function we obtain:

(r c) z + T
= (r c) z + (D z) z rz
= (D z) z cz

which is exactly the pro…t function for an integrated monopolist.

If the upstream …rm sets r = c, whole sale price equal to marginal cost,
the downstream …rm’s …rst order condition will be

D 2z = c

34
which we recognize as the …rst order condition for the solution of an inte-
grated monopolist’s problem.
This is a well known result: with two instruments the principal can use
the wholesale price to induce the down stream …rm to maximize total pro…t,
and then extract the pro…t using the …xed term T . Hence the contract terms
will be:

r = c
2
M D c
T = =
2
D c 2
where we recognize 2
as the maximum pro…t an integrated monopolist
can obtain.

Qu. 4) Suppose the two …rms negotiate the terms of the contract [r; T ].
Derive the equilibrium in the following three situations:

The upstream …rm has all bargaining power (can make a "take it or
leave it o¤er")

The downstream …rm has all bargaining power

They have equal bargaining power (split the gain …fty …fty)

Solution:
The …rst bullet point refers to a situation which corresponds to the pre-
vious exercise. Take it or leave it o¤er means that upstream …rm sets r and
T , conditional on the incentive and the participation constraints.
Consider the second and third bullet point. Note that the two parties
have a common interest in maximizing total wealth, to split a large pie is
better than to split a small one. Thus, as long as negotiations are e¢ cient
(they typically are if the parties have access to the same information), the
two parties will both strictly prefer to set r = c, which is exactly what is
needed to make the pie as large as possible. Hence, they negotiate over the
distribution of the pie, that is the …xed term T .

35
 If the downstream …rm has all bargaining power it will extract all pro…t,
hence the equilibrium contract will be (assuming that the upstream …rm’s
participation constraint is a break even constraint)

r = c
T = 0

With equal bargaining power, they split the pie …fty …fty, hence:

r = c
2
1 D c
T =
2 2

5 Investments in quality
In this section we focus on choice of quality as a decision problem. We can
think about quality in a broad sense, capturing the more dynamic aspects of
competition.
So far we have analyzed price setting. The choice of price is a static
decision as the …rm takes demand and cost structures as given, and maximizes
pro…t. Over time both demand- and cost-structures are subject to changes.
Demand changes as product quality over time increases, and new technology
generations are introduced. On the cost side, process innovations reduce
production costs over time.
Both product- and process innovations are impacted by …rm investments.
One aspect of this is quality improvements, …rms investing in new and better
product types. In the growth literature these processes are typically explored
within an explicit dynamic framework, however deep insights can be gained
from a more static approach; e.g. a two stage approach, where …rms invest
in the …rst stage, and equilibrium prices and quantities are determined in the
second stage. So although the models we will explore are static, they can be
thought of as simple representations of a dynamic market.
How does the market structure impact the incentives to invest in qual-
ity? Suppose the demand function (consumers’marginal willingness to pay)
depend on quality s, described as follows

p(q; s);

36
where p(q; s) is increasing in s for any given q. As illustrated in the …gure,
improved quality s shifts the demand curve upwards.

Suppose the …rm’s cost function is c(q; s), which is increasing and convex
in both arguments. The …rm has now two choice parameters, production
level q and quality level s, and the …rm maximizes

p(q; s)q c(q; s)

We analyze …rst the monopoly …rm’s optimization problem, and, as before,

use social welfare de…ned as consumer surplus as a benchmark:
Z q
p(z; s)dz c(q; s)
0

5.1 Monopoly and investments in quality

The monopoly pro…t is
M
= p(q; s)q c(q; s)

The …rst order conditions for the monopoly’s choice of q and s are

m(q) cq (q; s) = 0 (6)

dp(q; s)
q cs (q; s) = 0
ds

37
where m(q) is the marginal revenue,

m(q) = p0 (q)q + p(q):

The equations (6) are two conditions that simultaneously determine the
monopoly production and quality, q M ; sM . The …rst equation has a known
interpretation: marginal revenue equal to marginal cost. Consider then the
…rst order condition for choice of quality:

dp(q M ; s) M
q cs (q M ; s) = 0
ds
M
The term dp(qds ;s) has the interpretation of the marginal consumer’s mar-
ginal valuation of quality (evaluated at q M ). In a …gure it can be illustrated
as follows:

A higher quality level shifts the demand curve upwards. Hence the …rm
can charge a higher price without losing any customer. Note the following:
if the …rm increases s it can extract the marginal consumer’s additional
valuation associated with the quality improvement. The fact that it is the
marginal consumer’s valuation that matters has e¢ ciency implications. Let
us compare the following two situations.

38
 In the two situations, the marginal return from investments in qualities
are identical from the monopoly’s point of view, hence the …rm’s prospects
of extracting pro…t from quality improvements are exactly the same.
But the two situations are not identical from a welfare point of view.
In the left …gure, inframarginal consumers’ valuations increase a lot from
the investment, in the …gure to the right, very little. As every consumers
valuation of quality matters to the social planner, it follows that the quality
improvement creates much more additional value in case a compared to case
b.
Formally, we show this in the next section.

5.2 Socially optimal quality

The social planner maximizes
Z q
p(z; s)dz c(q; s)
0

with associated …rst order conditions:

p(q; z) cq (q; s) = 0
Z q
dp(z; s)
dz cs (q; s) = 0
0 ds
These two conditions simultaneously determine the e¢ cient price and quality
level, p and q .

39
 The …rst condition is well known - the planner wants to set the price
equal to marginal cost. The second condition can we write as follows (we
just multiply and divide by q ):
R q dp(z;s)
0 ds
dz
q cs (q ; s) = 0
q
We have the following interpretation
Rq dp(z;s)
dz
0
q
ds
is the average consumer’s marginal valuation of quality

As indicated above, the planner takes the interest of all consumers into
account, hence the e¢ cient level balances marginal quality cost with the
average valuation of the improvement.
Thus there is a source of distortion associated with quality choice, but, as
we will see, it is not clear if the equilibrium quality ends up being to high or to
low from a social perspective. Furthermore, there are some methodological
issues, which the text book suppresses, and which are important for the
interpretation of the results.

5.3 Comparing the market solution and the e¢ cient

solution
Let’s compare the monopoly solution q M ; sM with the socially best solution
q ; s . Obviously any combination of q; m which deviates from the optimal
q ; s represents a distortion. Let’s go one step further, and see if we can say
anything more precise about the equilibrium quality in the market in light
of social e¢ ciency.
There is a pitfall here. What is the proper comparison? There are two
decision parameters, and if we just compare the numbers sM and s , we end
up in the trap comparing apples and bananas, in the sense that we compare
the …rm’s preferred quality, given production level q M , with the socially best
quality level, given production level q . This may lead to absurd conclusions,
illustrated by the following:
Suppose quality is highly appreciated by a small group of consumers
with marginal willingness to pay p(q M ; sM ), that is the consumers located
just around q M , whereas inframarginal consumers do not care. Hence the
M
marginal valuation of the quality improvement, dp(qds ;s) , is substantially larger

40
 R qM
than the average consumer’s valuation, 0 dp(z;s)
ds
dz=q M . It follows that the
monopolist preferred quality is much higher that what would have been the
socially optimal level: sM > s . It is even possible to think about this
e¤ect so strong that the monopoly quantity q M exceeds the socially optimal
production level q , see the …gure below.

Note that the higher quality shifts the demand curve outwards, and if
this shift is su¢ ciently large, it is certainly possible to construct a situation
where q M exceeds q . Does this mean that the monopoly produces too much
compared to social e¢ ciency? No that would be an absurd conclusion. Given
its quality level sM , the monopoly …rm sure produces to little, production
in a monopoly is always downward distorted. However, this methodological
problem arises in the text book:

Illustration: the text book’s speci…cation The textbook’s speci…ca-

tion of cost and demand is

c(q; s) = (c + (s)) q
q
Q(p; s) = s (A p) ! p=A
s
which yields the integrated monopoly’s choice of quality

dp(q M ; s) 0
(s) = 0
ds

41
 First best quality satis…es
Rq dp(z;s)
0 ds
dz 0
(s) = 0 (7)
q
Given the speci…cation of demand, we can explicitly solve for s and sM .
It follows that s = sM . The authors conclude:
"..the speci…c result that the integrated monopolist chooses the socially
optimum service level re‡ect the particular demand and cost relationships
that we have assumed, and is not fully general. Nevertheless, the result
is useful because it does show a rather general interest that the manufac-
turer has in providing retail services" (page 468) This is misleading. As we
will see below, the speci…cation of the demand curve in the book represents
preferences for which the marginal consumer valuates quality more than the
average consumer. Hence the quality level ends up being too high from an
e¢ ciency standard.
To make the comparison correct, we have to introduce the concept "con-
strained e¢ ciency".

5.4 "Constrained e¢ cient" quality level

Suppose the social planner can impact the quality level but nothing else.
Then we can ask the question: conditional on production level q M , is the
…rm’s chosen quality sM too high or too low considered from a social per-
spective? That is, would the planner want to increase quality, e.g. subsidize
quality investments, or reduce it, that it tax it?
In other words we want to compare the the value of s which solves the
…rm’s …rst order condition
dp(q M ; s) 0
(s) = 0
ds
with the quality level which solves the following equation
R qM dp(z;s)
0 ds
dz 0
M
(s) = 0: (8)
q
Note the di¤erence between (7) and (8). The former gives the socially optimal
quality given q , whereas the latter gives the socially optimal quality level
given q M .

42
 We reach the following conclusions:
If R qM dp(z;s)
0 ds
dz dp(q M ; s)
>
qM ds
the constrained e¢ cient quality level is higher than the equilibrium level.
If R qM dp(z;s)
0 ds
dz dp(q M ; s)
<
qM ds
the constrained e¢ cient quality level is lower than the equilibrium level.

5.5 Quality choice in a vertical chain

We showed that a chain of monopolies is worse than an integrated monopoly
when it comes to pricing decisions, due to the double marginalization prob-
lem. Is there a similar problem associated with the choice of quality?
Suppose the downstream …rm sets the quality and maximizes its pro…t
given a quality cost function (s).

D = (p(q; s) r) q (s)
The …rst order conditions will be

m(q D ) = r
dp(q D ; sD ) D
q = 0 (sD )
ds
We can compare the quality level chosen by the downstream …rm with
the quality level an integrated monopolist would choose. Say the marginal
cost upstream is constant equal to c, we have the following two equations:

m(q M ) = c
dp(q M ; sM ) M
q = 0 (sM )
ds
As r > c (double marginalization) we have q M > q D . Regarding quality
choice, which one is largest depends on whether

dp(q D ; sD ) D > dp(q M ; sM ) M

q q
ds < ds

43
 The downstream …rm’s quality choice may deviate from the hypothetical
integrated monopolist for two reasons. First, due to the double marginal-
ization problem, everything else equal, the integrated monopoly’s produc-
tion, q M , exceeds q D . The second e¤ect is of less signi…cance, the marginal
consumer’s valution of quality may di¤er between production level q M and
production level q D . Note that the quality dimension enhances the negative
e¤ect of double marginalization, due to the interaction between the two in-
struments. Because production is low, due to double marginalization, the
equilbrium quality level tend to be low. Low quality reduces demand, and
hence yields a lower marginal revenue.
Take the following speci…cation of deman as an example:

p(q; s) = D + s q

With this speci…cation of demand, the marginal consumer’s valuation of qual-

ity equals the average consumer’s. Note that

dp(q; s)
=1
ds
which means that the …rst order condtion for quality is
0
qD = (sD )

for the downstream …rm, and

0
qM = (sM )

for the monopoly.

The positive externality downstream quality choice imposes on upstream
…rms is of relevance for the discussion about the Norwegian book market, see
part 2. Note that the upstream …rm’s pro…t is:

U = (r c) q D

As q D increases in s, a higher quality increases pro…t upstream proportionally

to the upstream margin r c.

44
5.5.1 The case of competitive retailing: No RPM
Chapter 17.4.3 in the textbook introduces competitive retailing. Compet-
itive retailing is there de…ned in the standard way as the situation where
competition between many retailers bring the retail price-cost margin down
to zero. Hence the double marginalization problem disappears.
Competitive retailing, as de…ned in the book, requires that the service cost
function is per unit sale, otherwise the cost function will exhibit increasing
returns to scale5 . Hence in their model, total service cost is

(s)q

Assuming that all retailers are identical, they construct an equilibrium

where each …rm chooses the same quality level, and charges a price equal to
unit cost
pD = r + (sD )
Note that this can only be correct if all consumers appreciate quality
equally much. The speci…cation of demand reveals that inframarginal con-
sumers appreciate service to a lower degree than the marginal consumers.
Hence, given the service level sD in the market, the single …rm can deviate
from the presumed equilibrium, approach a small set of consumers for which
sD is not optimal - optimize the service level for this group, and make a
pro…t.
Hence in equilibrium, there will be an in…nite number of …rms, where
each …rm "specializes" in a certain quality, serving the consumers who have
this exact service level as their preferred. It follows that the service level
in equilibrium is socially e¢ cient, in that it is tailor-made each consumer’s
type.6
The equilibrium described in the book is correct in one special case. If
the marginal valuation of quality equals the average valuation everywhere,
that is, there is no di¤erentiation in consumer preferences for quality - then
each …rm will choose the same quality.
5
Note that the book describes competitive retailing as a market in which the retail prce
cost margin is competed down to zero, this would not be possible if there are …xed costs.
6
So far we have adopted the reasonable assumption that consumers are heterogeneous,
in that inframarginal consumers di¤er from marginal consumer. An alternative interpre-
tation would be that consumers are identical, but with service preferences that varies
depending on how much the consumer actually buys. It can be shown that also with this
interpretation, the equilibrium is ‡awed.

45
 Exercise: Can you specify a demand function for which the marginal
valuation of quality always equals the average valuation?
Hence to analyze downstream competition in a model with quality choice,
we have to allow for equilibria with di¤erentiation in quality. This brings us
to the next topic, price discrimination and quality choice.

5.5.2 The case of competitive retailing: RPM

Suppose now that the manufacturer o¤ers the retailers a whole sale price r
as well as a binding retail price p. In this case, competition together with
the zero pro…t constraint of the retail sellers imply that the quality o¤ered
in the market is given by

(s) = p r
It follows that the manufacturer can perfectly govern the quality level of the
retailers by varying the price margin p r . The pro…t to the manufacturer
is given by

m
= q(p(q; s) r c)
= q(p(q; s) (s) c)

This is exactly the same expression as the expression for the pro…t of the
integrated monopolist. It follows that the manufacturer can and will set the
rpm margin p r so as to implement the quality level s that maximizes total
pro…t in the chain, equl to her own pro…ts. Note, however, that in this case,
all the consumers get the same quality level, independently of their indivud-
ual willingness to pay for quality. Hence the quality level is not tailored to
the preferences of di¤erent groups of consumers. In order to achieve such tai-
loring, the manufacturer needs more instruments. For instance, if there are
two groups of customers, and the optimal (pro…t-maximizing) quality level
is s1 when selling to customers of type 1 and s2 when selling to customers of
type 2, this can be obtained by giving the retailers serving market segment
1 a margin of (s1 ) and those serving market segment 2 a margin of (s2 ).
Price and quality discrimination will be discussed in detail the next section.

46
6 Price discrimination and quality choice
Price discrimination generally is a important topic in the literature on reg-
ulation and competitive structure. In many of the cases discussed in the
course, it is claimed that a dominant …rm discriminates in price in favor of
some …rms and at the cost of others. We will come back to other forms of
price discrimination, here I introduce a model of price discrimination of sec-
ond degree, a topic discussed in the text book, and relate this to the choice
of quality.
Price discrimination is often referred to in the policy discussions. A com-
mon claim is that price discrimination is used to foreclose competitors from
the market, and to build up entry barriers, in order to protect own market
power. In contrast, it is a well established result that price discrimination
is important to enhance e¢ ciency in markets with large …xed costs, a cost
structure which is a common characteristics in the cases discussed in the
course.
The IO literature distinguishes between price discrimination of …rst, sec-
ond and third degree. First degree (perfect) price discrimination has limited
empirical relevance. However it points at one important reason why price dis-
crimination may be important for e¢ ciency. If prices can be individualized,
the dominant …rm has an incentive to maximize value creation and extract
all gains from trade associated with each customer7 . Hence …rst order price
discrimination yields e¢ cient allocation, see …gure below
7
You can literally think about …rst degree price discrimination as the monopoly ap-
proching each single consumer, negotiating individiualized contracts. If the the …rm as all
bargaing power, the equilibrium as characterized above occurs. If the single consumer has
some bargaining power, e¢ ciency is still obtained with a di¤erent split of total value (see
the section on bargaining).

47
 Price discrimination of second degree is well known from telecommuni-
cation markets and the transport sector, where there is huge variability in
price models and contract terms . Each …rm o¤ers price menus from which
their customers choose.
We will explore second degree price discrimination within a model which
also includes choice of quality. We can then utilize the insights from the
previous section, and also capture some of the e¤ects associated with choice
of price models.
One important conclusions follow from these models: price discrimination
of second degree (as price discrimination in general) has potentially strong
e¢ ciency enhancing e¤ects in infrastructure and network markets (telecom-
munication, air industry etc). In those markets a substantial fraction of
total cost is common and …xed (sunk), hence …rms must charge a mark-up
on marginal cost in order to cover total cost. Price discrimination allows
…rms to expand faster, and to expand into market segments which would not
be pro…table under the restriction of uniform prices.
We conduct the analysis within the simplest possible setup. Let’s begin
with one monopolist.
Assume there are two types of consumers, "rich" and "poor", and each
consumer buys (at most) one unit of the product. To capture the logic from
the previous section (competitive retailing) we assume that the …rm can o¤er
a menu of contracts. The …rm can restrict the o¤er to one contract type,
consisting of a price p and quality s. If if o¤ers a menu, we refer to contract
H as the contract which is targeted consumer type H, and to contract L the
other one.

48
 Utility functions

UH (pH ; sH ) = uH (sH ) pH
UL (pL ; sL ) = uL (sL ) pL

Cost of quality per customer

(si )

(si ) is increasing and convex.

Each consumer has preferences over price and quality. As we do in con-
sumer theory, we can calculate the marginal rate of substitutions (the slope
of the indi¤erence curve). We have:

dpH @UH (pH ; sH )=@sH

= = u0H (sH );
dsH @UH (pH ; sH )=@pH
dpL @UL (pL ; sL )=@sL
= = u0L (sL )
dsL @UH (pL ; sL )=@pL
Let’s …rst go through the core elements of the model, without heteroge-
neous consumers.

6.1 Benchmark model with one consumer

Suppose there is one single consumer who wants to buy at most one unit of
the product.
The consumer’s utility function is

U (s; p) = 2 + ln s p

We assume that the consumer’s reservation utility u = 0, hence the con-

sumer refrains from buying the product if it provides the consumer with a
negative utility.
Suppose the quality cost function is

(s) = s

The …rm’s pro…t function is then

(p; s) = p s

49
 In a diagram we can illustrate the consumer’s indi¤erence curves in a
diagram with p on the vertical axis. With the speci…cation of preferences we
have the slope of the indi¤erence curves:
dp 1
M RS = =
ds s

Note that utility increases for any movement in south east direction, as
indicated by the arrow. The shaded area shows the combinations of price
and quality which provide the consumer with a utility at least as high as the
reservation utility.
In the same diagram we can illustrate the …rm’s iso pro…t curves. As the
pro…t is
(p; s) = p s
we …nd the slope of the isopro…t curve as:

dp @ (p; s)=@s
= =1
ds @ (p; s)=@p

We can illustrate the isopro…t curves in the same diagram as the con-
sumer’s indi¤erence curves

50
 I have drawn two iso pro…t curves. Note that pro…t increases in north
west direction.
Assuming that the …rm provides an o¤er, the pro…t maximizing o¤er is
given by p ; s in the …gure. s maximizes the value created by the con-
tract, and by charging p the …rms extracts the entire surplus. Note that
price quality combination is on the highest iso-pro…t curve compatible with
the consumers reservation utility. Formally the …rm solves the constrained
maximization problem:
maxp s
p;s

s:t:
2 + ln s p 0
where the constraint is known as the participation constraint.
We can solve the maximization problem using the Lagrange technique,
though it is simpler to just substitute out p in the pro…t function from the
constraint, assuming that the constraint binds. The latter follows directly
from the observation that the …rm will always raise the price so that the
consumer’s utility equals the reservation utility (extract all rents).
Hence the …rm solves the following problem
max 2 + ln s s
s

with …rst order condition

1
1=0
s
51
hence
sM = 1
Inserting sM = 1 in the utility function yields

2 + ln sM p=2 p=0

hence
pM = 2
What can be said about the quality level? It follows that quality level is
…rst best, the same quality as the social planner would choose. Let’s provide
three arguments for this conclusion.

1. We know from the section investment in quality that the monopolists

choice of quality deviates from the socially e¢ cient level if the marginal
consumer’s valuation of quality deviates from the average consumer’s
valuation. Since there is only one consumer, the marginal valuation
equals the average per de…nition.
2. A Pareto-optimal allocation (with two agents) can be derived by max-
imizing the utility (pro…t) of one agent, holding the utility of the other
agent …xed. This is equivalent to pro…t maximization problem stated
above.
3. Coase theorem argument: Since all agents with an interest are present,
and information is symmetric, the bargaining outcome will be e¢ cient.
Note that the model can be interpreted as a bargaining where one part
(the …rm) has all bargaining power.

Let me add a couple of other observations. Note that e¢ cient quality

level is the same regardless of how the surplus is divided. Say that the
consumer can guarantee itself the utility level u1 > 0 as indicated in the
…gure. The consequence of that would be that the price the …rm charges
declines to p = 2 u1 , whereas the optimal quality level remains to be s = 1.
This is due to the fact that the consumer’s preferences for quality has zero
income e¤ect. Note that the utility function is linear in money - the marginal
valuation of quality is exactly the same, independent of the consumer’s utility
level.
Removing that income e¤ect has a very convenient implication in that the
conditions for e¢ ciency are independent of how surplus is shared between the

52
two parties. Say that the two parties, the consumer and the …rm, negotiated
over price and quality. The more bargaining power the consumer has, the
lower will be the price, but they will always agree on the same quality level. If
there were income e¤ects in the consumer’s preferences, the e¢ cient quality
will depend on the parties respective bargaining strengths.

6.2 Introducing two types of consumers

Let us now introduce two types of consumers, one poor (L) and one rich (H).
Both consumer’s reservation utilities are 0. Let the utility functions be

UH (sH ; pH ) = 4 + ln sH pH

and
UL (sL ; pL ) = 2 + ln sL pL
We consider two cases:

Case 1: = 0:5

Case 2: =2

Note that the two types di¤er in two respects. First, the rich consumer
has a higher utility level, and thus a higher willingness to pay. Second, as we
will show, the marginal valuation of quality di¤er. The latter implies that the
marginal consumer’s valuation of quality di¤er from the average consumer’s
valuation, which may lead to distortions.
The …rm’s pro…t function is now

(pL ; pH ; sL ; sH ) = pL sL + p H sH

We begin with the representation of consumer preferences, and go through

the analysis in several steps.
Step 1: Make a graphic representation of the two consumers’indi¤erence
curves; one diagram for case 1, and one for case 2.

53
 We …nd the rich consumer’s MRS:
1
dUH (sH ; pH ) = 0 = dsH dpH = 0
sH
hence
dpH
=
dsH sH
Obviously, we have two possible situations. Either H’s indi¤erence curves
are steeper than L’s (if > 1) or L’s are steeper than H’s (if < 1), as
illustrated.
Step 2: Consider the contract o¤er [s; p] = [1; 1]. Let A be the set of
contract o¤ers the poor consumer prefers to [s; p] = [1; 1]. Let B be the set
of contract o¤ers the rich consumer prefers to [s; p] = [1; 1]. Illustrate A and
B graphically.

54
 Note that everything below the indi¤erence curve passing through [s; p] =
[1; 1] is preferred to [1; 1].

Step 3: Show that there exist combinations [s; p] such that

1. [s; p] that are in A, but not in B, and

2. [s; p] are in B, but not in A.

Use these two sets to explain how the …rm can di¤erentiate the contract
o¤ers under the constraint that both agents incentive constraints must be
satis…ed. Hence one contract is preferred by L and the other contract by H.

55
 Consider the …gure to the left, in which H’s indi¤erence curves are steepest
( > 1). Suppose the …rm o¤ers two contracts, a and b. Note that H prefers
a to b, whereas L prefers b to a. Hence the contracts yield separation in the
market. Note that unless the slopes of the indi¤erence curves are identical,
it is always possible to specify contract terms such that a separation between
the two types is obtained. Another example is a and c. However, if the …rm
o¤ers contract a and d, separation will not occur, since both types prefer the
d-contract to the a-contract. Hence to obtain separation, you have to …x one
contract (say a) and then pick an alternative contract in either of the two
segments 1 and 2.

Step 4: The poor consumer’s preferences corresponds to the single con-

sumer’s preferences we started up with in part 1 of this exercise. Suppose
now that the …rm o¤ers L a contract which corresponds to the solution in
part 1. Given this contract o¤er, assume the …rm optimizes the contract
o¤ered to H (remember that the two contracts must satisfy the incentive
constraints). Show that the …rm will always di¤erentiate the contract terms,
as long as 6= 1.

The …gure illustrates the two situations. Consider the …gure to the left,
> 1. The contract p ; s is the solution which maximizes the …rm pro…ts

56
if type L is the only type in the market. Recall to two characteristics of the
solution: i) the consumer is on his reservation utility, and ii) the marginal
rate of substitution equals the slope of the iso-pro…t curve. The latter means
that the contract is e¢ cient.
Suppose type H is present i the market. The …rm can choose to continue
o¤ering the contract p ; s , that is have the same contract terms for both
types. However the …rm can do better. Suppose the …rm continues o¤ering
contract p ; s , but in addition o¤ers a contract pH ; sH which it hopes will
be chosen by H. For H to prefer the new o¤er to p ; s it must belong to the
segment 2 (ref previous exercise). Among all contracts in segment 1, the …rm
prefers the one which maximizes pro…t - that is a contract which is on the
highest possible indi¤erence curve. Obviously that is pH ; sH , the tangency
point of the iso-pro…t curve and the indi¤erence curve.
Note that the …rm cannot raise p further, if it did, type H will prefer
p ; s to pH ; sH .
Furthermore, whenever 6= 1, it is possible to gain from market separa-
tion (see the …gure to the right illustrating the situation with < 1).

Step 5: The …nal step is to show that the …rm can do better by modifying
the contract o¤er given to L. You can show the result graphically, but
try also to solve the problem analytically - with the simple speci…cations of
preferences and pro…t functions, it should be possible.

57
 The contract indicated by a and b corresponds to the solution discussed in
the previous question. As mentioned, the …rm cannot raise the price further
in the contract pH ; sH , as the high type then will switch to the low type’s
contract p ; s . However the …rm can do better. It can modify the contract
o¤er the low type buys, by reducing both s and p, as indicated by contract
o¤er c in the …gure. Doing that lower’s the pro…t obtained by selling to the
poor consumer (note that c is on a lower iso pro…t curve than a), but makes
it possible to raise the price pH in the rich consumer’s contract (contract
terms d in the …gure). The latter raises pro…t.
Look again at L’s new contract. Note that it represents a downward
movement along a given indi¤erence curve uL = u. The impact of this
movement on the pro…t is in the beginning negligible, since the slope of the
iso pro…t curve is almost the same as the slope of indi¤erence curve. Hence it
costs very little to make a small distortion in L’s contract (distortion, as we
deviate from an e¢ cient contract). However, the modi…cation of L’s contract
makes it much less attractive to the rich consumer (as his relative valuation
of quality s is higher). Hence the …rm can raise pH a lot. This is known as
rent extraction.
The optimal set of contracts balances these two e¤ects.
To conclude: the optimal contracts satisfy the following (general feature):

L obtains his reservation utility uL = u (hence L’s participation con-

straint binds)
Ls contracted is ine¢ cient (if > 1 the quality level is too low com-
pared to …rst best, if < 1, it is too high)
H obtains a utility level above her reservation utility uH > u.
H’s incentive constraint binds (H is indi¤erent between the two contract
o¤ers)
H’s contract is e¢ cient.

Let us now provide the analytical solution.

6.3 Analytical solution

The …rm maximizes pro…t, conditional on two sets of constraints: i) the incen-
tive constraints and ii) the participation constraints. With two buyers this

58
yield in total four constraints. However, we know from the discussion above
(see the bullet points) that two of the constraints will not bind: the high type
obtain a utility strictly above his reservation utility, and the poor consumer
strictly prefers pL ; sL to pH ; sH . Hence we have two binding constraints, and
we can specify the problem as follows:

M ax pL sL + pH sH
pL ;sL ;pH ;sH

s:t:
2 + ln sL pL = u
4 + ln sH pH = 4 + ln sL pL

where the …rst constraint is the poor consumer’s participation constraint,

and the second constraint is the rich consumer’s incentive constraint. The
Lagrangian is:

L = pL sL +pH sH (2 + ln sL pL u) ( ln sH pH ln sL + pL )

First order conditions are:

LpL = 1 + =0
1 1
LsL = 1 + =0
sL sL
LpH = 1 + =0
1
LsH = 1 =0
sH
ln sL pL = u
ln sH pH = ln sL pL

From the third equation we get = 1. Inserted in the fourth yield

1
=1
sH
which we recognize as the condition for e¢ cient quality level in H’s contract
(MRS equal to the slope of the iso pro…t curve).

59
 Since = 1 we get = 2 from the …rst equation. Inserted in the
second equation yields
1 1
1+2 = 0
sL sL
1 1
=
sL 2
We know the the e¢ cient quality level for the low type is
1
=1
sL
we see that the quality level is ine¢ ciently high if < 1 and ine¢ ciently low
if > 1, exactly as we know from the graphical elaboration.
The …nal step is to evaluate the equilibrium from a social perspective. In
particular, are the quality choices socially optimal? If not, what can you say
about the distortions.
As is clear from the …gure H’s contract is e¢ cient, but not L’s. The …rm
has an incentive to distort Ls contract in a way that makes it less attractive
to H. The reason is that H’s incentive constrained binds, and by making L’s
contract a less attractive choice, the …rm can extract more rent from the
rich consumer. However, the …rm will never make quality distortions in H’s
contract - the more attractive the contract is to H, the more rent the …rm
can extract from o¤ering the contract.

6.4 Ban on price discrimination

Suppose the planner are not allowed to di¤erentiate the contract o¤er, hence
must o¤er the same contract [s; p] to both agents. This case corresponds to
the model discussed in the text book in chapter 17.
Note that there are two possible outcomes. Either the …rm sells only
to one type (that will be the high type), or he sells to both, see the two
alternatives in the …gure below.

60
 In the …rst case, the best the …rm can do is to choose contract a in
the …gure. The …rm extracts all rents from the rich consumer (he is on
his reservation utility), and the contract maximizes value creation (e¢ cient
contract).
If the …rm sells to both, the best it can do is o¤er contract b in the …gure
to the right. Note that the contract o¤er must be on the reservation utility
uL = u, or below. The highest pro…t is then represented by the tangency
point.

6.5 Price discrimination and e¢ ciency

If price discrimination is prohibited, there will be an e¢ ciency loss of the
…rm, due to the prohibition, ends up serving only the rich customers.
Exercise: Suppose the high agent’s preferences are represented by the
utility function
UH (sH ; pH ) = + ln sH pH
Derive the critical value of , such that for values of above this critical
value, the monopolist serves only the rich consumers, whereas for values
below, both types are served.
Comment: The model does not capture one important e¢ ciency enhanc-
ing feature of a ban on price discrimination. With a more realistic description

61
of consumer demand, with downward sloping demand curves, price discrimi-
nation distorts the distribution of consumer goods across consumers. Recall
that an e¢ cient distribution of consumer goods requires that marginal rate
of substitution between any two goods must be the same for all consumers.
This condition is not satis…ed under price discrimination.

6.6 Quality distortions - a comparison

If price discrimination is prohibited, we are back in the general model dis-
cussed in the section "Investments in quality": the …rm optimizes the mar-
ginal consumer’s quality level. In equilibrium, the …rm puts all weight on
the marginal consumer (the one who is indi¤erent between buying and not
buying), in optimizing the quality level.
If 6= 1, the marginal consumer’s valuation of quality (the poor con-
sumer) deviates from the average consumer’s valuation (which will be the
average of the high and the poor consumer’s preferences. This conclusion cor-
responds exactly to the conclusions from the section "Comparing the market
solution and the e¢ cient solution".
If the …rm can discriminate on price, the pattern is di¤erent. We showed
that the high agent’s quality level was optimized, whereas the low agent’s
quality level is distorted. In other words, the distortion is on the marginal
consumer, not on the inframarginal.

6.7 Competition
In the previous section we assumed that the market were monopolized. Sup-
pose instead that the market is competitive with free entry. The model then
corresponds to section 17.4.3. in the text book, "competitive retailing".
In equilibrium, any active …rm gets zero pro…t. If not, it would be possible
for a new …rm to enter, and make a pro…t from o¤ering a slightly more
favorable contract.
The equilibrium has the following characteristics:
1) Both consumers get access to their respective preferred qualities. The
argument is exactly the same as the argument we used show that the equi-
librium as described in the book, is not really an equilibrium. Suppose that
one of the consumers does not get access to her preferred quality. Then a
…rm can enter, optimize the quality, and make a pro…t.
2) Active …rms gets zero pro…t.

62
 Hence, the rich consumer’s quality will be sH = , whereas the poor
consumer’s quality will be sL = 1. Finally, zero pro…t implies:

pL = sL = 1
pH = sH =

6.7.1 Exercises on quality choice

Exercise 1: The monopoly …rm’s …rst order condition for choice of quality
is

dp(q M ; s) M
q cs (q M ; s) = 0
ds
We also know that the constrained e¢ cient quality, given q M , is
R qM dp(z;s)
dz M
0 ds
M
q cs (q M ; s) = 0
q

For now, consider q M as given. The exercise is to compute and compare

R qM dp(z;s)
dp(q M ;s) dz
the terms ds
and 0
qM
ds
with the following three speci…cations of
demand:

1
p(q; s) = D q
s
p(q; s) = D + s q
p(q; s) = s (D q)
Note that the …rst speci…cation is the one used in the textbook.
Solution: Note the following, you are supposed to evaluate the deriva-
tives for quality level q = q M . Let’s …rst calculate the monopoly pro…t with
the three speci…cations of demand.
1 D c
p(q; s) = D q ! qM = s
s 2
M D+s c
p(q; s) = D + s q ! q =
2
c
D
p(q; s) = s (D q) ! q M = s
2
63
Note that q M is increasing in s in all three cases.
We di¤erentiate with respect to s

@p(q M ; s) qM
=
@s s2
@p(q; s)
= 1
@s
@p(q; s)
= D qM
@s
and insert for q M

dp(q M ; s) 1D c
=
ds s 2
dp(q M ; s)
= 1
ds
dp(q M ; s) D + sc
=
ds 2
We next calculate the marginal impact on the average consumer. We inte-
grate and divide by qM
R qM dp(z;s) R qM z
0 ds
dz 0 s2
dz 1 qM
M
= M
=
q q 2 s2
R qM dp(z;s) R qM
0 ds
dz 0
1dz
M
= =1
q qM
R qM dp(z;s) R qM
0 ds
dz 0
(D z) dz 1
M
= =D qM
q qM 2
Next, we insert qM
R qM dp(z;s)
0 ds
dz 1D c
=
qM s 4
R qM dp(z;s)
0 ds
dz
= 1
qM
R qM dp(z;s) c
0 ds
dz 3D + s
M
=
q 4

64
 1
Let’s compare: if demand is p(q; s) = D s
q we have

dp(q M ; s) 1D c
=
ds s 2
R qM dp(z;s)
0 ds
dz 1D c
M
=
q s 4
We see that the monopolist has a stronger incentive to invest in quality than
the planner (quality is more valuable to the marginal than to the average
consumer).
If p(q; s) = D + s q then
dp(q M ; s)
= 1
ds
R qM dp(z;s)
0 ds
dz
= 1
qM
which is as expected, since consumers are homogenous with regard to the
preferences for quality.
Finally if p(q; s) = s (D q) we have
dp(q M ; s) D + sc
=
ds 2
R qM dp(z;s)
0 ds
dz 3D + sc
=
qM 4
Since the average consumer appreciate quality more than the marginal con-
sumer, the monopolist has to weak incentives to invest.
Exercise on constrained e¢ cient quality level
Suppose the government can regulate the quality level (which is actually
quite common - e.g. safety standards), but nothing else. Hence we have a
simple game where the planner chooses s and the …rm chooses p.
Let the …rm’s cost function be

c(q; s) = cq + (s)

so the quality cost is a …xed cost independent of the production level.

Demand is represented by

p(q; s) = D + s q

65
 We consider two alternative speci…cations of the game:
1: Simultaneous game
The …rm and the planner make their choices independently and simulta-
neously
2: Sequential game

Stage 1: the government sets quality s

Stage 2: the …rm chooses p and produces.

Solve the two games, and compare the quality levels with the quality level
the government would have chosen, if the government could choose both price
p and quality q (which is the …rst best allocation).

Solutions:
Consider …rst the simultaneous game. The …rm chooses price p and the
government sets quality s. We use the Nash equilibrium concept: that is,
both choices are best replies.
The social planner maximizes social surplus, for a given q, that is solving
Z q
max (D + s z) dz c(q; s)
s 0

or Z q
max p(z; s)dz cq (s)
s 0
which yields …rst order condition:
Z q
dp(z; s) 0
dz (s) = 0
0 ds
Note that this is one equation which determines s as function of q : the
planner’s reaction function, or best response function.
The …rm solves the following optimization problem:

maxp(q)q c(q; s)
q

or written as
max (D + s q) q cq (s)
q

66
with …rst order condition:

max (D + s q) q cq (s)
q

Qu. 2) Second best quality and production level

First best allocation maximizes social welfare (sum of producer and con-
sumer surplus). From the …rst lecture (see the slides January 17.) we have
the following speci…cation of the …rst best problem:
Z q
max p(z; s)dz c(q; s)
q;s 0
Suppose there is a …xed production cost, hence total costs are represented
by
c(q; s) + F
We add the constraint that production should be self-…nancing, hence the
second best problem can be formulated as follows:
Z q
max p(z; s)dz c(q; s)
q;s 0
subject to the constraint

p(q; s)q c(q; s) F 0:

Use Lagrange to solve the problem. Pay attention to the following:

The sign and size of the Lagrange multiplier are important for the
interpretation of the …rst order condition.

The hard part is to really understand the …rst order conditions. In

particular, you will …nd that both the average consumer’s valuation
of quality and the marginal consumer’s have an impact on the second
best quality level. Why is that? I will be impressed if you can give a
precise answer!

67
7 Ramsey pricing
A common feature of the cases discussed in the course is that …xed and sunk
costs represents a substantial part of total costs. Examples are telecommu-
nications networks, infrastructures, Internet markets etc.
With large common costs, …rst best prices (marginal cost) are incom-
patible with cost recovery, since average production cost exceeds marginal
cost.
Thus …rst best e¢ ciency requires transfers. Without subsidies, the pricing
model at best satis…es the condition for second best prices, that is price
structures which maximize welfare subject to the …nancial constraint. This
is in the literature known as the Ramsey problem.

7.1 Formulation of the Ramsey problem

Consider a market consisting of several segments (we focus on two segments).
Suppose demand is independent (can be relaxed), and we also assume that
marginal costs are constant (which can also be relaxed).
We solve the problem from a welfare perspective, in that we maximize
consumer surplus net of production costs conditional on the …nancial con-
straint.
Mathematically the optimization problem is:
Z q1 Z q2
maxW = p1 (z)dz c1 q1 + p2 (z)dz c2 q2
q1 ;q2 0 0
subject to
p1 (q1 )q1 c1 q1 + p2 (q2 )q2 c2 q 2 F 0:
Note that if F = 0, the optimal prices equals marginal cost.
We use the Lagrange multiplier technique to solve the problem
The Lagrangian function is
Z q1 Z q2
L= p1 (z)dz c1 q1 + p2 (z)dz c2 q2
0 0

+ ( p1 (q1 )q1 c1 q1 + p2 (q2 )q2 c2 q 2 F)

where is the Lagrange multiplier.

68
 The solution of the problem is given by the …rst order conditions:
@L
= 0
@q1
@L
= 0
@q2
and the constraint

p1 (q1 )q1 c1 q1 + p2 (q2 )q2 c2 q 2 = F

These three functions determine the optimal production levels, q1 and q2

and the value of the Lagrange multiplier, (which thus is endogenously
determined).
Let’s …rst give an interpretation of . From the envelope theorem it
follows that the impact of an increase of F on social surplus, in optimum,
is captured by . Evaluated at q1 , q2 we have the following (I refer to any
math textbook)
dW @L
= = <0
dF @F
To give an economic intuition: suppose we relax the constraint slightly (F
down), or make it more strict (F slightly up). Then measures the marginal
impact the change in F has on the value of the objective function (here social
welfare).
Let’s now derive the solution to the Ramsey problem. We have:
@L
= p1 (q1 ) c1 + ( p01 (q1 )q1 + p1 (q1 ) c1 ) = 0
@q1
@L
= p2 (q2 ) c2 + ( p02 (q2 )q2 + p2 (q2 ) c2 ) = 0
@q2
We can rewrite the …rst condition as follows

p1 (q1 ) c1 + ( p01 (q1 )q1 + p1 (q1 ) c1 ) = 0

(1 + ) (p1 (q1 ) c1 ) = p01 (q1 )q1
p1 (q1 ) c1 q1
(1 + ) = p01 (q1 )
p1 (q1 ) p1 (q1 )
p1 (q1 ) c1 1
=
p1 (q1 ) 1 + "1

69
 where the last step follows from the de…nition of demand elasticity "1 :
p1 1
"1 = q10 (p1 ) =
q1 (p1 ) p01 (q1 ) p1q(q1 1 )

Generally, with many (independent) market segments i, we have

pi (qi ) ci 1
=
pi (qi ) "i 1 +
X
(pi (qi )qi ci q i ) = F
i

known as the "inverse elasticity rule". We see that the markup on marginal
cost relative to price should be higher the less price sensitive demand is. This
principle has a simple interpretation: if the price exceeds marginal cost, there
will be a deadweight loss (e¢ ciency loss), see the …gure

Note that the e¢ ciency loss is approximately a triangle of size

(p c) q
;
2
that is the mark-up (in kroner) multiplied with the reduction in production
created by the mark-up, and divided by 2 since it is a triangle. Obviously, for
a given mark-up, the e¢ ciency loss is higher the more production is reduced
(that is, the more price sensitive demand is).

70
 Hence, if price sensitivity di¤er between market segments, welfare is im-
proved if the mark-up is increased in segments with low price sensitivity, and
increased in segments with high. Think about the extreme case, a market
segment with completely inelastic demand. As the mark-up has no e¤ect on
demand, there is no associated deadweight loss - such segment would be the
perfect object of taxation.
The next step is to derive the monopoly solution, and compare it with
the Ramsey solution.

7.2 Ramsey vs monopoly prices

The monopoly maximizes

max = p1 (q1 )q1 c1 q1 + p2 (q2 )q2 c2 q 2 F

q1 ;q2

with …rst order condition

pi (qi ) ci 1
=
pi (qi ) "i
Let us compare this with the Ramsey solution,
pi (qi ) ci 1
=
pi (qi ) "i 1 +
It follows that the price pro…le chosen by the monopolist corresponds to
socially best pro…le. As formulated by Tirole in his Nobel prize lecture,
"regulated prices should be “business-oriented,”similar to, but overall lower
than those set by an unregulated monopoly".
From the social planner’s …rst order condition we …nd:
p1 (q1 ) c1 p2 (q2 ) c2
"1 = "2 =
p1 (q1 ) p2 (q2 ) 1+
whereas the monopolist chooses:
p1 (q1 ) c1 p2 (q2 ) c2
"1 = "2 =1
p1 (q1 ) p2 (q2 )
However the price level is higher with a monopoly. Welfare is maximized
if prices are set at a level at which the …nancial constraint binds - that is,
total revenue covers exactly total cost.

71
 Note the following: the two price levels are equal if the monopoly prices
yields a revenue which exactly corresponds to total costs, in which case there
is no monopoly rent in equilibrium. In the equation above, this is repre-
sented by a value of approaching in…nite (for an explanation of this, see
the exercises below).

7.3 Implications for regulation

The previous section has an important implication for how one should think
about regulation. The fundamental problem in the market is the level of
prices (monopoly pricing), not the structure of prices (price pro…le). Hence
the regulatory instruments should target the source of the problem, the price
level - and let …rms have discretion with respect the choice of price pro…le.
This is known as price cap regulation, see below.
In principle, you could think about a detailed regulation model in which
the regulatory authorities set all prices, according to the Ramsey model.
There are two reasons why this is not a good idea. First, Ramsey prices
depends on the properties of the demand structure (the demand elasticities)
and cost structure (marginal cost). Accounting data may yield information
about the cost structure, but generally the …rms are much better informed
than the regulator about demand- and cost structures. Second, it is not
needed: since the …rms have incentives to choose a price pro…le which corre-
sponds to the socially optimal pro…le, it is su¢ cient to target the core of the
problem: that it the price level.
This is known is "incentive regulation", discussed in the next section.

7.4 Optimal regulation - "price cap"

A simple procedure for regulating the price level, is the set a ceiling at which
level the …rms can not raise the prices further. With several market segments,
the ceiling must necessarily have the form of a maximum average price.
Let p denote a cap on prices de…ned as follows

p1 ! 1 + p2 ! 2 p (9)

where ! 1 and ! 2 are parameters (weights) …xed by the regulator.

Hence the regulated …rm is free to set prices p1 , p2 under the restriction

72
that (9) must hold. The …rm’s problem:

max = (p1 (q1 ) c1 ) q1 + (p2 (q2 ) c2 ) q 2 F

s:t: p1 ! 1 + p2 ! 2 p

The Lagrangian is

(p1 (q1 ) c1 ) q1 + (p2 (q2 ) c2 ) q 2 F ( p1 (q1 )! 1 + p2 (q2 )! 2 p)

with …rst order conditions

pi (qi ) ci 1 !i
= 1 (10)
pi (qi ) "i qi

Let us compare this with the Ramsey formula

pi (qi ) ci 1
=
pi (qi ) "i 1 +

The obvious question is: how should the regulator set ! 1 and ! 2 ? Note
that the right hand side of (10) is independent of i if ! i is proportional to
qi . If so, the price pro…le chosen by the regulated …rm, corresponds to the
Ramsey pro…le. Certainly, the planner has limited information about qi , but
it seems reasonable to think that it is easier for the regulator to get access
to information about production levels than to get access about demand
elasticities.
Comment: Regarding the interpretation of . If the constraint is not
binding = 0, the price ceiling is higher than the monopoly prices, and thus
the regulation does not bind.

7.4.1 Exercises Ramsey pricing

Consider a regulated market, consisting of two independent market segments,
1 and 2. The demand functions in the two segments are:
1
p1 (q1 ) = q1 3

and 1
p2 (q2 ) = 2q2 2

73
 The cost structure is
C(q1 ; q2 ) = c1 q1 + c2 q2 + F
where F is a …xed common cost.
Suppose the regulator can regulate the prices p1 and p2 . The regulator’s
target is to maximize social surplus, conditional on a break even constraint.
Thus the constraint is:
p1 q1 + p2 q2 c1 q 1 c2 q 2 F 0
Use the Lagrangian multiplier technique to solve the regulator’s optimiza-
tion problem. How large is the optimal mark-up in segment 1 (that is p1p1c1 )
relative to the mark-up i segment 2?
The Lagrange multiplier has the following interpretation:
dW
=
dF
that is: the marginal impact on social welfare, in optimum, from an increase
in the …xed cost, equals (thus is positive). Obviously, social welfare
declines if F increases. Try to show that social welfare does not decline
linearly in F , and provide intuition to this result.

Solution: The monopolist maximizes total pro…t with respect to q1 and

q2
= p1 (q1 )q1 c1 q1 + p2 (q2 )q2 c2 q 2 F
Insert the demand functions yield
2 1
= q13 c1 q1 + 2q22 c2 q 2 F
The …rst order conditions for a maximum are:
2 23 1
1 = q c1 = 0
3 1
1
1
2 = q22 c2 = 0
hence
2
p1 c1 = 0
3
1
p2 c2 = 0
2
74
which yield relative markups:
p1 c1 1
=
p1 3
p2 c2 1
=
p2 2

3
21
q1 =
3 c1
2
1
q2 =
c2
We can calculate consumer surplus in each of the sectors:
Z q1 Z q1
1 1 1 13 3 23
p1 (z)dz = z 3 dz = jq01 z = q
0 0 1 13 2 1
and Z q2 Z q2
1 2 1 1
p2 (z)dz = 2z 2 dz = jq02 1 z1 2 = 4q22
0 0 1 2
We can also simplify sales revenue:
1 2
p1 q1 = q1 3 q1 = q13
1 1
p2 q2 = 2q2 2 q2 = 2q22
We got the following expression for the Lagrangian function:
3 23 1 2 1
q1 c1 q1 + 4q22 c2 q2 + q13 c1 q1 + 2q22 c2 q 2 F
2
We di¤erentiate w.r.t. q1 and q2
2
1 2 23 1
q13 c1 + q c1 = 0
3 1
1 1
1 1
2q22 c2 + q22 c2 = 0

that is
1 2 1
q1 3
c1 + q 3
c1 = 0
3 1
1 1
2q2 2
c2 + q2 2
c2 = 0

75
which yields solutions
1
q1 3
c1 1
1 =
q1 3 31+
1
2q2 2
c2 1
1 =
2q2 2 21+

or, inserting from the demand functions

p1 c1 1
=
p1 31+
p2 c2 1
=
p2 21+
We see that the optimal margin in segment 1 is only 2/3 of the optimal
margin in segment 2:
p 1 c1 2 p 2 c2
=
p1 3 p2
The reason is that demand in segment 2 is more elastic than in segment 1.
Finally a comment on . We know that
dW
= <0
dF
If it had been a linear relationship between W and F , then the second deriv-
ative would have been zero. The question is, how does depend on F ?
We can use the optimality conditions for p1 and p2 to provide an answer.
Note that if F increases, then the price level must increase in order to cover
the higher cost level. Since in optimum, the following two equations hold,
p1 c1 1
=
p1 31+
p2 c2 1
= ;
p2 21+
it follows that higher prices imply a higher (if the left hand sides increases,
so do the right hand sides). Hence the second derivative is negative
d2 W d
= <0
dF 2 dF
76
since d =dF > 0.
The interpretation is this: as you raise the price above marginal cost, you
create a distortion - a deadweight loss of monopoly. The deadweight loss
is a triangle approximately equal to the margin, p c, multiplied with the
di¤erence between optimal production and equilibrium production, q q,
and then divided with the number 2, since it is a triangle. Note that as
you increase p, the margin goes up. If this is the only thing that happens,
then the deadweight loss will increase linearly in p. However since q q
also increases, the deadweight loss increases more than proportionally in the
margin.
This is basically the intuition behind the following additional implication
of the Ramsey-result: there should be a mark-up in every market segment.
Why? It is on average better to have small markups in all segments than
high markups in a few.

Ramsey versus the monopolist’s problem.

We continue with the same speci…cations of demand as in the previous
exercise, that is
1
p1 (q1 ) = q1 3
and 1
p2 (q2 ) = 2q2 2

The cost structure is

C(q1 ; q2 ) = c1 q1 + c2 q2 + F

where F is a …xed common cost.

Solve the monopolist’s pro…t maximization problem. Calculate the rela-
tive markups:
p 1 c1 p 2 c2
;
p1 p2
and compare those with the corresponding mark-ups from the solution of
the Ramsey problem. In the comparison, try to explain what happens in the
model as F increases up to the level at which the monopoly …rm breaks even.

Solution: The monopolist maximizes total pro…t with respect to q1 and

q2
= p1 (q1 )q1 c1 q1 + p2 (q2 )q2 c2 q 2 F

77
 Inserting from the demand functions yields
2 1
= q13 c1 q1 + 2q22 c2 q 2 F

The …rst order conditions for a maximum are:

2 23 1
1 = q c1 = 0
3 1
1
1
2 = q22 c2 = 0

hence (let M refer to monopoly solution)

2 M
p c1 = 0
3 1
1 M
p c2 = 0
2 2
which yield relative markups:

pM
1 c1 1
M
=
p1 3
M
p2 c2 1
M
=
p2 2
Hence
pM
1 c1 2 pM
2 c2
M
= M
p1 3 p2
In the Ramsey problem we calculated (* refers to social (second best)
optimum)
p1 c1 1
=
p1 31+
p2 c2 1
=
p2 21+
Note that the monopoly and the social planner have the same preferences
regarding how price should be balanced. However the price levels di¤er, since
1+
< 1, generally the monopoly prices exceed second best prices.
Note however that if is very large, the second best prices become close
to monopoly prices - which is intuitive: we showed that (see solutions set

78
4) is an increasing function of F . As F goes up, and conditional on the
…nancial constraint, prices must increase (otherwise there will be a de…cit).
Final observation: we could think about a situation where F is so high
that the unregulated monopoly’s net pro…t is exactly zero - total revenue
equals total cost, in which case pM = p . Since

pM
1 c1 1
M
=
p1 3

and
p1 c1 1
=
p1 31+
this obviously means that must converge to in…nity (which is the only way
1+
can be equal to 1). How can this result be interpreted?
Think about the Ramsey problem - in which case we maximize consumer
surplus conditional on a …nancial constraint. Clearly, if F is su¢ ciently
large, there is only one possible allocation compatible with the constraint -
the monopoly quantities. If F is increased even further, the optimization
problem ceases to have an solution, as there exists no allocation such total
costs can be covered by total revenue. Hence the market breaks down.
Think about the impact on social welfare associated with a small increase
in F , evaluated exactly at the level of F at which the …rm breaks even before
the increase, but after the increase runs a de…cit. Hence, before the increase,
social welfare is exactly equal to consumer surplus (since the monopoly breaks
even). After the increase, consumer surplus drops to zero. Since consumer
surplus is positive, there is a discontinuity in social welfare as function of F .
This discontinuity explains why a marginal increase in F has an in…nitely
negative e¤ect on welfare at this critical value of F .

8 Access pricing

In this section, the primary focus is on regulatory policy in network markets.

I will use telecommunication as an example. However, the models explored
are general, with applications in a broad set of di¤erent markets.
The telecommunication market is subject to a speci…c sector regulatory
scheme. The regulation is legally based on a separate act, "Ekom-loven",

79
which provides the regulator with means that go far beyond the competition
acts’. E.g., the regulator can intervene in the market if they …nd that the
market structure potentially may lead to abuse of dominance –whereas under
the competition law, the competition authorities (Konkurransetilsynet) must
prove that an actual abuse has occurred. In the literature, the former is often
referred to as "ex-ante regulation", the latter to "ex-post".
Competition in telecommunication has two "dimensions", as illustrated
in the …gure.

The left side of the …gure illustrates competition between an integrated

network, "Telenor," on one side and independent service providers on the
other. The speci…c feature is that the independent service providers need ac-
cess to Telenor’s network (upstream) to compete downstream. Hence service
providers as Teletopia and TDC are at the same time Telenor’s competitors
and its customers. In this chapter, the primary focus will be on this particu-
lar dimension, for which the terms of access and regulation of access, are the
main issues.
The right-hand side of the …gure illustrates competition between inte-
grated networks, here exempli…ed with Telenor and Telia. As we will come
back, there is some signi…cant and interesting interrelation between access
pricing and competition between integrated networks.
In the Norwegian mobile market, it is currently three integrated networks,
Telenor, Telia, and Ice. Ice is a newcomer and has so far coverage only in
parts of the country.

80
 So-called "MVNOs" (TDC, Hello, Ventelo) are partly integrated (e.g.,
with their own sim-cards), but do not have their own network. Hence they
need access to one of three integrated networks. As pure service providers
(Teletopia, Fjordkraft, etc), MVNOs compete for customers in the …nal user
market. Note that some of the service providers are owned by the integrated
networks (e.g. Chess, Talkmore, One Call).

8.1 Competition in a vertical structure

Consider an upstream monopolist (bottleneck) which supplies downstream
…rms competing in the consumer market. Can the monopolist use its market
power to monopolize or restrict competition downstream (that is to extend
it market power)?
It is often claimed that a …rm with market power in one level in a vertical
chain, has incentices to leverage its market power to adjacent markets. A case
we discussd n classis the EU commission’s decision against Google in 2017.
In the press release regarding the 2.4 billion euro …ne the Commission states:
«It objects to the fact that Google has leveraged its market dominance in
general internet search into a separate market, comparison shopping.» " Is it
possible to raise monopoly pro…t in this way? We begin with the Chicago
school which provides a simple and convincing answer: «no – there is only
one monopoly pro…t»

8.2 Chicago school argument

I refer to section 1.3.2. in the textbook, where this is brie‡y discussed.
What is best for an (upstream) monopolist: vertical integration or down-
stream competition? Furthermore, does it matter? Consider the following
three market con…gurations, each with a monopoly upstream:
1: all downstream …rms (including the integrated networks own retail
division) are equally e¢ cient, and compete …ercly
2: independent retailers are more e¢ cent than the integrated network’s
own retail division
3: imperfect competition downstream

81
8.2.1 Fierce competition downstream (Bertrand competition)
Suppose we have a bottleneck network upstream, and a n service providers
downstream. Let consumers’ willingness to pay be P (Q). We have the
upstream marginal cost in the network equal to c, and a downstream marginal
cost cS (which is the same for all …rms). Refer to r as the whole sale price.
Consider …rst full integration, in which case the integrated network is the
sole supplier of the services. Hence there are no independent service providers
downstream. The integrated network’s pro…t is

I = (P (Q) cS c) Q (11)

Let us compare this situation with a market where there are no integration.
With no integration, the pro…t functions are:

U = (r c) Q(P )
S = (P cS r) qS

where X
qs = Q
In the latter case, downstream competition competes the margin down to
zero. Hence the market price P will be:

P = cS + r

With this market con…guration, the upstream monopolist maximizes

max (r c) Q(P ) s:t: P = cS + r

r

Substuting out for r in the objective function yields

U = (P cS c) Q(P ) (12)

Note that the pro…t functions (11) and (12) ends up being identical. With
full integration, the network sets P directly, with the aim of maximizing U .
With no integration, the network sets r, and given r, downstream …rms
compete. Competition downstream drives the margin down to zero, P =
cS + r, which maps the wholesale price r into a consumer price P . That is,
the network sets P indirectly, in that it can steer P using r as an instrument.

82
 Let P M be the monopoly price, the price that maximizes U. With no
integration we …nd the optimal wholesale price as follows:

r = PM cS

Note that a single instrument, the wholesale price r, is su¢ cient for the
network to achieve the following: i) maximizise total value, and ii) extract
all value created as pro…ts. This is simply due to Bertrand competition
downstream. Since any pro…t downstream is competed away, all pro…t in the
vertical chain ends up with the upstream monopoly anyhow.
Consider next imperfect competition downstream.

8.2.2 Imperfect competition downstream

Consider the other extreme, with one monopoly service provider downstream.
This model corresponds to the situation discussed in the chapter on double
marginalization. The upstream network sets r, the downstream …rm charges
a monopoly mark up on its marginal cost, which is cS + r. Since r includes
a mark up - we end up with a "margin on a margin" - a double marginaliza-
tion, which we know yields a total pro…t below the integrated monopolist’s
pro…t level (and since the price exceed the monopoly price, it is also bad for
consumers).
As discussed, the upstream network can use a two-part tari¤ or an RPM
contract to avoid the double marginalization problem. A simple example of
a two part tari¤ which solves the problem is:

r = c
T = M

where r is the variable part (the wholesale price) and T is a lump sum
transfer from the service provider to the network. Note the simple structure:
the network charges a wholesale price equal to marginal cost upstream -
hence the service provider’s marginal cost equals the true marginal cost in
the vertical chain. It follows that the service provider will charge a price that
maximizes total pro…t. The network then extracts this pro…t using the lump
sump transfer T .
If downstream competition has the characteristics of oligopolistic compe-
tition, the situation is slightly more complex - but the main conclusion goes
through. Note the following: the network sets the wholesale price r, which is

83
part of downstream …rms’marginal costs. Raising r increases marginal cost
downstream, which completly or partially will be passed on to consumers.
Hence consumer price P is an incrasing function of r. This will hold inde-
pendent of the details in downstream competition. Since P is increasing in
r, there exists an r such that P = P M , as illustrated in the …gure:

In the …gure P M is the price an integrated monopolist would charge.

Downstream …rms’marginal cost is r + cS . Note that if the upstream mo-
nopolist set the whole sale price according to the solid blue line in the …gure,
downstream …rms are induced to charge P M in the market. The exact link
between r and P M depends on the details. With Bertrand competition (per-
fect competition in the …gure) we know that a wholesale price, r = P M cS ,
does the job. Since there is no pro…t downstream, the …xed transfer has no
role in that special case.
With monopoly downstream, we showed that the optimal wholesale price
was r = c. This yields the downstream …rm with a pro…t, before transfer
T , which is the entire monopoly pro…t. This is extracted by the upstream
monopoly through a transfer T = M :
With imperfect competion, the mechanism is basically the same - by the
choice of r the network can induce service providers to charge a price that
maximizes total value in the vertical chain, that is P M . As illustrated by
the …gure, the more intense competition is, the higher must r be in order to

84
support P M . Since competition is imperfect, each service provider obtains
a pro…t (before transfer T ) equal to some pro…t level D (with magnitude
depending on the degree of competition), which will be extracted by the
network through the lump sum transfer: T = D .
Note that in all these market con…gurations, the network earns the monopoly
pro…t. We will now show the …rst important result: the network has no in-
centive to distort competition downstream.

8.2.3 The integrated network competing with independent service

providers.
In the previous section we showed that the upstream network using a two-part
tari¤ i) maximizes total pro…t created in the vertical chain, and ii) extract
the total value as pro…t. Indeed, if the integrated network is more e¢ cient
than independent service providers in serving …nal customers, the network
has an incentive to monopolize the downstream market segment. Due to it
superior e¢ ciency, this would also be warranted.
Suppose instead that independent suppliers are more e¢ cient than the
upstream network in serving customers. In this situation, maximizing value
creation in the vertical chain requires that …nal customers are served by
independent retailers. It follows from the principle above that the network
indeed has an incentive to sign contracts with the service providers. This
is known as the principle of optimal outsourcing. If it is more e¢ cient to
outsource an activity than to do it in-house, the …rm has an incentive to sign
contracts with more e¢ cient …rms.
Note that the argument does not hinge on the assumption that the net-
work can extract all pro…t. In the section on bargaining, we showed that if
the two parties can create additional value by signing a contract, they have
an incentive to do so, and maximize total value created. In the current set-
ting, if the extra value created by a superior service provider is subject to
negotiations, then regardless of the parties respective bargaining strengths,
the upstream monopolist is better o¤ signing an e¢ cient contract than to
"insource" the activity.
Hence, in this simple context the upstream monopoly has no incentive to
"leverage" its market power to the adjacent downstream segment.
The next section introduces some modi…cations, and shows that in certain
situations a monopoly may have incentives to foreclose more e¢ cient …rms.

85
8.3 Chicago school argument - modi…cations
1. Imperfect contract and the "hold-up" problem

2. Entry barriers, raising rivals costs (current and future rivals) by creat-
ing bottlenecks.

3. Contracts and externalities

8.3.1 Imperfect contracts and the "hold-up" problem in a bilat-

eral monopoly
We consider a market with a monopoly upstream facing a downstream re-
tailer. Suppose a downstream …rm’s quality investments impacts consumers
willingnesses to pay for the services,

p(q; s);

where s is the quality.

Suppose the two …rms negotiate the contract terms. The upstream …rm’s
production costs are
CU (q) = cq
The downstream …rm invests in quality s, and we refer to (s) as the
quality cost function. Ignoring any other costs downstream, the downstream
…rms total cost will be
CD (q) = rq + (s)
where r is the wholesale price.
Consumer demand is represented by a down sloping demand curve

p(q; s)

which is increasing in quality s.

The two …rms negotiate the contract terms consisting of a variable part
r and a …xed transfer T (two part tari¤). Hence the upstream …rm’s pro…t
is
U = (r c) q + T
whereas the downstream …rm’s pro…t is

D = p(q; s)q rq (s) T:

86
 We consider two alternative speci…cations of the game:

Alternative A (Long term contract):

Stage 1: Contract terms [r; T ] are negotiated
Stage 2: The downstream …rm chooses q and s

Alternative B (Short term contract):

Stage 1: Downstream …rm invests in s. The investment is sunk.
Stage 2: Contract terms [r; T ] are negotiated
Stage 3: Downstream …rm chooses q

We solve the models by backward induction, starting with the last stage.
Alternative A follows the same logic as before. The two parties have
incentives to sign an e¢ cient contract, which realizes all gains form trade.
Formally, given contract terms [r; T ] the downstream …rm solves the following
maximization problem:

maxp(q; s)q rq (s) T

q;s

with …rst order conditions

dp(q; s)
p(q; s) + q r = 0 (13)
dq
dp(q; s) 0
q (s) = 0 (14)
ds
(21) is the standard condition; marginal revenue equal to marginal cost.
The term dp(q;s)
ds
in (22) is the marginal consumer’s marginal valuation of
quality. Remember that the monopolist takes into account how quality im-
pacts the marginal consumer’s choice between buying and not buying (if
marginal consumers have a high marginal valuation of quality, investing a
lot in quality is an e¤ective way to capture more customers). Inframarginal
consumers’valuations are irrelevant since they buy anyway. However, from a
social welfare perspective, all consumers’preferences matters, including the
inframarginal.
Consider next the …rst stage, and suppose the downstream …rm’s outside
option is zero. The outside option is what the party receives if the negoti-
ations are terminated, in which case there will be no contract. Hence, the
upstream monopoly’s outside option is to insource downstream retailing, that
is to foreclose the downstream …rm.

87
 Total pro…t, if they reach an agreement, is

+ D
U
= (r c) q + T + p(q; s)q rq (s) T
= p(q; s)q cq (s)

The …rms have a common interest in maximizing total pro…t. Note that
any contract proposal which yields a lower total pro…t than what is possible
to create, will be dominated by a proposal which maximizes total pro…t: they
can simply split the gain, and both be better o¤.
There is a con‡ict of interest in how to split the pie. Let denote the
downstream …rm’s relative bargaining strength, which means that the down-
stream …rm captures a share of total pro…t.
Total pro…t is maximized if (take the derivative of U + D with respect
to q and s):

dp(q; s)
p(q; s) + q c = 0 (15)
dq
dp(q; s) 0
q (s) = 0 (16)
ds
Comparing (23) and (24) with (21) and (22) you see directly that if the
variable part r is set equal to marginal cost c, then the downstream …rm’s
production decision, as well as its quality choice, correspond to what is opti-
mal for the two parties together. Since T is a lump sum transfer, it does not
impact the production and quality decisions.
Note: the two part tari¤ is essential for this result. With two instruments,
the role of the variable part r is to provide e¢ cient incentives, and the …xed
part T splits the pie. If the contract was a uniform price contract, with no
…xed fee, an e¢ cient solution would not be reachable. However, business
contracts are typically more sophisticated than uniform price contracts.
To conclude, with a two part tari¤, production and quality choices corre-
spond to an integrated monopoly’s optimal choices, refer to that as q M and
sM , and the two …rms’pro…t levels will be

D = p(q M ; sM )q M cq M (sM )
U = (1 ) p(q M ; sM )q M cq M (sM )

88
 This also means that if the downstream supplier is more e¢ cient than the
upstream in retailing, the upstream monopoly has no incentive to foreclose
the more e¢ cient downstream …rm.
Consider next alternative B, in which there are three stages:
Stage 1: Downstream …rm invests in s. The investment is sunk.
Stage 2: Contract terms [r; T ] are negotiated
Stage 3: Downstream …rm chooses q
I referred to this alternative as a "short term contract". As we will see,
this sequence of stages creates an ine¢ ciency which is avoided if the parties
can sign a long term contract. We begin with stage 3:
Given contract terms [r; T ] and given s which is …xed in period 1, the
downstream …rm solves the following maximization problem:

maxp(q; s)q rq (s) T

q

Note that (s) is a …xed (and sunk) cost.

The …rst order condition is
dp(q; s)
p(q; s) + q r=0 (17)
dq
Consider next stage 2. The outside options are now essential. If the
negotiations are terminated, the upstream …rm obtains its outside option,
which is to serve the market as an integrated monopolist. However, as the
downstream …rm has already invested in quality, which is a sunk cost, with
no contract the downstream …rms pro…t will be (s). If we refer to as
the outside options, we have:

U = I

D = (s)

where I is the integrated networks pro…t.

Note the following, the net value of reaching an agreement, is the total
pro…t created beyond what the parties can make on their own. In other words,
we …nd the value of the coalition if we take joint pro…t, given that they reach
an agreement, and subtract the outside options. This is reasonable, if the
sum of outside options exceeds joint pro…t if they sign a contract, the are
better o¤ without the contract.

89
 The value of the contract is then split between the parties.
We have as before, joint pro…t:

+ D
U
= (r c) q + T + p(q; s)q rq (s) T
= p(q; s)q cq (s)

We subtract outside options:

U+ D U ( (s))
= p(q; s)q cq I

The surplus is split between the parties, hence the downstream …rm gets a
share and the upstream a share 1 .
In stage 1, the downstream …rm invests in quality. The …rm’s optimization
problem is:
max (p(q; s)q cq I) (s)
s

with …rst order condition (if it is optimal for the downstream …rm to sign a
contract)
dp(q; s) 0
q (s) = 0
ds
which is one equation which determines sD as function of .
Note that, because quality investments are sunk before the contract is
negotiated, e¢ cient bargaining splits gross pro…t (before investment cost is
deducted), instead of net pro…t. Another way to say it is the following; the
two parties split the revenue ‡ows but not the investment cost.
Obviously, this has a negative impact on the downstream …rm’s invest-
ment incentives. Unless the downstream …rm has all bargaining power ( =
1), it is not possible to obtain an e¢ cient solution.
Furthermore, it is certainly possible that the downstream …rm …nd that
it cannot obtain a positive pro…t. If the downstream …rm invests sD it obains
pro…t
(p(q; sD )q cq I) (sD )
which can be positive or negative. In the latter case, the terms of access does
not provide the downstream …rm with a margin which covers the investment
cost.

90
 The problem would have been solved if the two parties could negotiate
before the downstream …rm invests (that is signing a long term contract) -
however this requires not only that a long term contract is feasible and not
subject to renegotiations.

8.3.2 Hold up problem and vertical integration

If the the two parties cannot sign a long term contract, due to the hold up
problem there will be distortions. If the upstream supplier can merge with
the most e¤cient downstream …rm, quality investment decisions impact on
on total value creation is internalized, and e¢ ciency is restored. However, if
a merger is not feasible, a foreclosure of a more e¢ cient …rm may occur in
equilbrium, that is if the the bene…t of integration (internalizing the e¤ects of
quality investments) dominates the lower internal e¢ ciency level. However,
despite the fact that a more e¢ cient downstream …rm is foreclosed, total
value creation has increased.

8.3.3 Entry barriers, raising rivals costs

An upstream monopolist has an incentive to sign e¢ cent contracts with su-
perior downstream …rms. However it has also an incentive to protect its own
monopoly position upstream. In some situations the former may come at the
cost of the latter. Two moments are stressed in the literature. The …rst is
known as the "ladder of investment" e¤ect. The idea is that investments by
new entrants are gradual as their customer base increases, hence over time,
what once was a small downstream may over time expand and become a
full‡edged integrated network. As the threathens the upstream …rm’s posi-
tion as a market leader, the monopolist may have an incentive to foreclose
downstream …rms it may consider as a potential future competitor.
A second version of the same idea related to service provider’s as a po-
tential takeover candidate. Entering into a new market as a network owner
requires huge …xed and sunk investments. If the …rm in addition has to build
up a customer base from scratch, the entry cost might be too large to justify
the investment. If however, su¢ cently large independent service providers
in the market, with their own customer bases, are attractive targets for a
new entrant. Hence the monopolist, forseeing such threaths, may gain from
a slower growth in the market for independent retailers. Raising the access
price is one possible mean to achieve this.

91
 Suppose an independent retailer is foreclosed by an upstream bottle-
neck.The monopolist "protects its market power by raising entry barriers"

8.3.4 Contracts and externalities

Consider an upstream monopolist who signs a contract with a downstream
retailer. When the agreement is signed, say with retailer A, could it be that
the monopolist has an incentive to sign an additional contract with one of
the retailer’s opponents, retailer B? And if so, how will it impact the …rst
retailer A?
If the contracts are associated with negative externalities, that is A is
harmed if B obtains a contract, A may hesitate to sign the contract in the
…rst place - at least it will demand more favorable contract terms. Hence it
strikes back on the monopolist.
Let’s …rst study the problem formally: we have two potential independent
retailers downstream A and B. The upstream monopolist can sign a contract
with one of the retailers, with both, or monopolize downstream (hence serving
customers with its retailing division).
Let the demand function in the market be

P =D q

where D is a …xed parameter and q is total production. There is a …xed

marginal cost upstream, and to simplify, there are no costs downstream.
The monopolist can initiate negotiations at any time, negotiations are
commercial and the contracts are non-public. We make the contracts as
simple as possible: consisting of a delivery q and a payment T .
Consider the negotiations between the monopolist and retailer B. From
the logic of bargaining we know that the monopolist will o¤er a contract
which maximizes joint pro…t - and say that the monopolist has all bargaining
power, hence it uses T to extract the entire surplus.
Joint pro…t from the contract with B is given by:

(D qA q B ) qB cqB

Maximizing with respect to qB yields:

D qA c
qB =
2

92
which creates value
2
D qA c
B =
2
a pro…t ‡ow the monopolist can extract using the transfer T .
There is, however, one critical issue here: …rm B has no information about
qA , neither the content of the contract or whether a contract with A exists.
Thus, how can B calculate the pro…t level the contract eventually creates?
Something he has to do in order to make an assesment of the contract o¤er,
including the proposed transfer TB .
Since B does not know anything about As contract terms, he has to make
som conjecture, and suppose his beliefs are rational in the following sense: he
thinks through the problem and calculates what would be the optimal o¤er
to provide retailer A, qA , and the corresponding transfer TA . Given this, he
accepts the contract o¤er qB ; TB if it gives him a non-negative pro…t. Note
that A is in a symmetric position, she is unaware of the contract terms B
eventually obtains.
What they know is that the monopolist face two potential retailers, and
at any time has the incentive to negotiate, and renegotiate the contracts term
in order to maxize the value the contract creates. Hence, given the outcome
of the negotiations with A (that is given qA ) the monopolist maximizes

A = (D qA qB ) qB cqB

Similarily, given the outcome of the negotiations with B the monopolist max-
imizes

B = (D qA qB ) qA cqA
However, simultaneously maximizing these two pro…t ‡ows makes the mo-
nopolist acting as a cournot duopolist in the market. Formally, maximizing
A w.r.t. qA given qB , and maximizing B w.r.t. qB given qA , is mathemat-
ically equivalent to the cournot dupopoly problem. Hence, given that the
monopolist has all bargaining power, the best it can do is to extract the sum
of dupopoly pro…t which is something less than the monopoly pro…t.
The problem is that the monopolist cannot credibly commit not to rene-
gotiate the contract with either …rm. Hence negotiating with …rm A, the two
parties A and the monopolist have incentives to expand production at the
cost of …rm B.

93
 The fact that the contracts are commercial and secret is essential. If
contract terms were public, the monopolist could write a set of general access
conditions into the agreements, and such that the two …rms total production
sum up to the monopoly quantity, and …nally extract using the transfers T.
How can the monopolist deal with the problem? One option is to o¤er
an exclusive contract, hence writing into the contract that the retailer has
exclusivity. Hence the monopolist will not sell through any other retailer.
If the two retailers are identical (as in the illustration above), there is no
e¢ ciency loss associated with using only one of them.
Exclusive contracts are, however, met with considerable skepticism from
competition authorities. In particular in EU due to their potentially adverse
e¤ects on internal trade. Seemingly a ban on exclusive contract may improve
e¢ ciency as the consumer price declines, due to the contract externality.
However, a ban may induce the monopolist to integrate downstream and see
only through its internal retailer.
Final comment: the contract externality problem is a potential source of
distortions. To illustrate this, suppose the two retailers are di¤erentiated,
each with a speci…c competitive advantage. Hence, maximizing total value
requires that the monopolist sign contracts with both. However due to the
contract externality problem, the monopolist is forced to o¤er one them ex-
clusivity, and hence the other retailer’s competitive advantage is not realized.

8.4 Access price regulation

The "optimal outsourcing" argument is essential: a monopolist has incentives
to sign an e¢ cient contract if independent …rms are superior in some tasks.
It reveals the fundamental di¤erence between exerting market power in the
…nal goods market, which yields distortions due to monopoly pricing and
controlling a monopoly segment in the vertical chain. In the latter case, the
monopolist has per se no incentive to implement a price scheme which is
distortive.
Hence the justi…cation of access price regulation must be that there
are some other challenges, e.g., analogous to those discussed in the section
"Chicago school arguments - modi…cations." However any reason the reg-
ulator must have, the regulatory scheme must be assessed in light of the
potential regulatory costs. Some of them will be discussed below.
In principle, a properly designed access price regulation is compatible
with e¢ ciency. The price minus principle illustrates this.

94
8.4.1 "Price-minus" principle
Suppose an integrated network, I, faces an independent service provider,
S. To make the illustration more realistic, assume the sercive provider is
a small …rm, with a limited capacity, qS , to serve customers. The service
provider’s marginal cost is cS whereas the integrated network’s retail cost is
cI . Consider the prospects for a pro…table business contract.
The pro…t functions are:

I = (P (Q) cI c) (Q qS ) + (r c) qS
S = (P (Q) cS r) qS

The service provider’s optimal production is:

qS = qS if P (Q) cS r 0
qS = 0 otherwize (foreclosure)

The integrated network’s pro…t is:

I = (P (Q) cI c) Q + [r (P (Q) cI )] qS

Providing access to the service provider is pro…table to the network owner if

r (P (Q) cI ) 0

The service provider produces if

P (Q) cS r 0

Both constraints must be satis…ed for an equilbrium with active participation

from both …rms. This requires that

P (Q) cS r P (Q) cI (18)

that is
cI cS :
The integrated network has an incentive to sign a contract with the service
provider, if and only if cI cS . This is also the situation where the contract
is socially e¢ cient.

95
 Suppose now the regulator introduces an access price regulation, known
as a "margin squeese test", which is the current regulation regime in Norway.
A margin squeeze test compares the retail price of a dominant undertaking
P (q) with its wholesale price r and retail costs cI . The idea is that an equally
e¢ cient service provider (equally e¢ cient as the integrated network’s own
service division) obtains a positive pro…t, hence it must be that

r P (Q) cI

Logically, for e¢ ciency, a less e¢ cient service provider should have a negative
margin (ine¢ cient entry is not warranted), hence this narrows down the test
to
r = P (Q) cI
Note that r = P (Q) cI satis…es the constraint (18). With a perfectly
designed margin squeese test, the integrated network obtains the same pro…t
from providing access, as it obtains from running the retail activitities in-
house. Hence the independent service provider extracts the entire pro…t from
any superior e¢ ency.
Obviously, a perfectly designed margin squeeze regulation is e¢ cient. The
challenge is that there are regulatory costs which are not accounted for.
Furthermore, the model is stylized and there are other characteristics of the
market situation which a business contract takes into account, and which is
impossible to internalize in a regulatory regime. The next sections discusses
this.

8.4.2 Partly crowding out

In the model above we assumed that any customer the independent service
provider gains, is a customer the integrated network loses. That is, there is
full crowding out.
Think now about an innovative service provider - a service provider who
builds up a new market, perhaps based on a more innovative bundling of
services. Say that the service provider gets 100 new customers, but only 70
of them would have been customers in the integrated network’s customer
base. In this example there is partly crowding out, with crowding out factor
equal to = 0:7.
The …rms’pro…t functions will be:

96
 I = (P (Q) cI c) (Q qS ) + (r c) qS
S = (P (Q) cS r) qS

where 1 market crowding out factor.

As above, the service provider’s optimal production is:

qS = qS if P (Q) cS r 0
qS = 0 otherwize (foreclosure)

The integrated network’s pro…t is

I = (P (Q) cI c) Q + [r [(1 )c + (P (Q) cI )]] qS

Providing access to the service provider is pro…table if

r [(1 )c + (P (Q) cI )] 0

Production is pro…table for the service provider if

P (Q) cS r 0

If = 1, we are in the orginal model, in which case a business contract

requires an wholesale price in the interval

P (Q) cS r P (Q) cI

which exists if
cS < cI
If < 1 the interval for r is larger (everything else equal):

P (Q) cS r [(1 )c + (P (Q) cI )]

Note that the right hand side is the weighted average of marginal cost in the
network, c, and the retail price net of the integrated networks retail cost cS .
In the extreme case, if = 0, which is no crowding out, providing access is
pro…table if
r c 0

97
 Obviously, regulating access terms is challenging if the crowding out factor
di¤er between …rms. A business contract is pro…table, and socially e¢ cient,
at a low access price if the crowding out factor is small. Di¤erentiation of
access prices would be possible as part of voluntary contract arrangements.
However, the information required to adjust the contract terms as part of a
regulatory regime, is not available to the government.
Furthermore, any uniform access price is ine¢ cient, as it may foreclose
innovative service providers, which builds up new markets at a higher cost,
and induce ine¢ cient entry from service providers for which the crowding
out factor is close to one.

8.5 Access price regulation based on average margin

Another sourve of ine¢ ciency relates to the complex structure of market
segments. Customers di¤er in many dimensions: the business market has
di¤erent characteristics from the household market. Most likely, business
segments for small and large …rm have di¤erent characteristics, customers
demanding high speed data tra¢ c are di¤erent from customers that are sat-
is…ed with low speed etc. Furthermore, as we know from the chapter on
Ramsey pricing, prices should be di¤erentiated accoding to demand charac-
terstics, with a larger price in inelastic segments.
Furthermore, the price minus principle requires that the regulation is
more detailed than what would be feasible. As an illustration, consider two
market segment A and B.
There are gains from trade in both segments if:

cIA cSA
cIB cSB

that is if the independent service providers are more e¢ cient that the inte-
grated network.
It follows that e¢ ciency requires segment speci…c access prices. Take the
"price minus" rule as derived above:

rA = PA (Q) cIA
rB = PA (Q) cIB

Suppose the regulation is based on the average mark up. The …gure below
illustrates that this may lead to ine¢ ciencies.

98
 We see that service provider B has an incentive to enter market segment
2, despite the fact that it is less e¢ cient than the network owner is. On the
other hand, the more e¢ cient service provider A, is foreclosed from market
segment 1 because of the non-discrimination rule.

8.6 Competition between integrated networks

The section is brief - the main purpose is to describe an important linkage be-
tween access price regulation and competition between integrated networks.
The Norwegian government’s goal is to achieve competition between three
integrated networks. Currently, Telenor and Telia dominate the market, but
there is one newcomer, Ice, with the prospect of building up a network with
complete national coverage.
Ice’s investments are risky. Network investments are sunk, and it is ex-
tremely expensive to cover the entire country. Furthermore the company
will compete with two dominant networks, both with commercial activitities
worldwide.
A new comer can grow in di¤erent segments. Expansion in the household
market is a slow process. The business market provides better opportunities
in that a single contract can represent a large bundle of customers. Thus
to win a large business contract is particularly attractive to the …rm which
is in the process of building up the network. The classic story is from the
air industry in Norway. After Norwegian entered the market in 2002, the
Norwegian government signed a contract with the newcomer which made it
the exclusive provider of domestic travels for public employees - a contract
which substantially reduced the company’s risk and stimulated its growth.
The purpose of the contract was explicitly to stimulate the newcomer.

99
 In the telecommunication market, independent service providers are po-
tential business customers for Ice. The access regulation of Telenor harms
Ice in that it will be harder for Ice to compete for business customers. To
illustrate the e¤ects suppose the telecomunication market consist of business
market B and the retail market C.
Ice’pro…t is

I = RCI (Q I qIS (rI ; rT )) + RBI (qIS (rI ; rT )) FI

where I is the crowding out factor.
Suppose rT is regulated down. The impact on Ice’pro…t will be:
d I 0 0 dqIS (rI ; rT )
= [RB (qS (rI ; rT )) I RC (Q qS (rI ; rT ))]
drT drT
Since Ice is a small newcomer to the market, I would expect that

1. Iis small. A reasonable …rst guess is tthat I re‡ects the company’s

market share in the household market, which obviously is much larger
for Telenor and Telia. Business customers are therefor particularly
valuable to a small newcomer.
dqIS (rI ;rT )
2. drT
is large in absolute value. Demand tend to be less elastic
for companies with a known brand and strong position in the market.
Newcomers and unknown brands is more dependent on a favorable
price. Hence, more …erce price competition harms newcomers more.
0
3. RB (qS (rI ; rT )) is large compared to RC0 (Q qS (rI ; rT )). Generally,
margins are larger in business segments than in the household sector
of the market.

thus, the access regulation is particularly harmful to the newcomer.

9 Pricing in the transport sector

I refer to the slides regarding the Hurtigruten vs Bodø Havn case –Appeal
court. Here is a brief description: Hurtigruten described the current pricing
practice as follows:
"The price for using the port (the quay fee) is calculated on the basis of
the gross tonnage of the ship, and each ship is charged for 24 hours regardless

100
of how long it is actually using the quay. The Hurtigruten has two ships which
arrive daily, with a total length of time at the quayside of 4.25 hours per 24 h.
The ship is then charged two quay teams per 24 h. The practice is surprising
when ships arriving several times a day have accumulated time at the dock
that is longer, only paying one quay fee"
Hurtigruten’s claimed that the correct pricing principle is a fee per "meter
hour": the length of the ship multiplied with the time it occupies the quay.
Note that harbour costs have the following characteristics:

Large …xed (sunk costs) - approximately 90 % of total costs are …xed

Some variable costs related to loading/unloading etc - those costs are

covered by a seperate set of fees.

Variable cost components attributed to the quay as such:

– Maintenance costs
– Congestion costs

Pricing principles - some theory elements:

First best prices - price equal to marginal cost

– Congestion costs are part of marginal costs

– If demand exceeds port capacity, the revenue from properly set
congestion fees can be substantional (see "peak-load pricing" later).
– Capacity utilization rate at Bodø Havn is about 15 percent.

With no congestion costs, total costs are substantially larger than vari-
able costs

– First best prices yields a de…cit.

– Bodø port is supposed to break even.

Second best pricing models

Maximize social surplus conditional on a …nancial constraint

– The Harbour revenues should cover total costs

101
 The inverse elasticity rule: higher mark ups in segments with inelastic
demand

Is meter-hour as pricing principle in accordance with the Ramsey rule?

– If congestion, yes de…nitely (important in busy harbours as Hong

Kong, Singarpore etc)
– If not, problematic due to its impact on incentives:

1. incentives to speed up loading and unloading processes

2. induces frequent movements of ships in and out of the port (lay
on anchor is free)
3. frequent movements of big ships increase maintenance costs

9.1 Theory - pricing models in transport sector

Complex cost and demand structure

– Large …xed costs (as in most infrastructure sectors)

First best pricing yields a de…cit.
– We explore the following problems:

1. Demand varies over time - "peak-load"

2. Demand for priority

9.2 Peak load pricing –congestion pricing

Simple model with two periods, load period (1) and peak period (2)

Fixed cost F

Marginal costs c1 ; c2

Fixed capacity q

102
 The planner maximizes social surplus W , subject to i) a …nancial con-
straint, ii) a capacity constraint. Hence the planner’s problem is:
Z q1 Z q2
max W = p1 (z)dz c1 q1 + p2 (z)dz c2 q2
0 0
s:t: p1 q1 c1 q 1 + p 2 q 2 c2 q 2 F 0
q2 q

The Lagrangian of the problem is

Z q1 Z q2
L= p1 (z)dz c1 q 1 + p2 (z)dz c2 q 2
0 0
+ (p1 q1 c1 q1 + p2 q2 c2 q 2 F)
(q2 q)

Recall the interpretation of (from the envelope theorem)

@L dW
= =
@q dq
is the social value of capacity on the margin and yields a measure of
the gross return of capacity investments.
The problem generalizes the Ramsey problem (see part 1) to include
capacity constraints. The …rst order conditions are
dp1
p1 (q1 ) c1 + p1 + q1 c1 = 0
dq1
dp2
p2 (q2 ) c2 + p2 + q2 c2 = 0
dq2

In addition we have the following to conditions (socalled complementary

slackness)

(p1 q1 c1 q 1 + p 2 q 2 c2 q 2 F ) = 0
(q2 q) = 0

Note that the latter condition says that either = 0 or q2 = q. In words:

if the capacity does not bind, q2 < q, the associated lagrange parameter

103
is zero. Recall the economic interpretation of as the value of increasing
capacity. It is clear that investing in a larger capacity has no value if the
port is never crowded. If however the capacity binds in peak periods, delays
occur, and a higher capacity would have been valuable: hence is a positive
number.
Thus we have four equations and four endogenous variables: q1 ; q2 , and
. Consider …rst the situation where capacity does not bind.

9.2.1 If capacity does not bind

We have now: q2 < q =) = 0. This yields the standard Ramsey pricing
problem (inverse elasticity rule)

p1 (q1 ) c1 1
=
p1 (q1 ) "1 1 +
p2 (q2 ) c2 1
=
p2 (q2 ) "2 1 +
p1 q1 c1 q 1 + p 2 q 2 c2 q 2 F = 0
q2 < q

9.2.2 If capacity binds

This is the situation where q2 = q =) > 0.

p1 (q1 ) c1 1
=
p1 (q1 ) "1 1 +
p2 (q2 ) c2 1
= +
p2 (q2 ) "2 p2 (q2 ) 1+
p1 q1 c1 q 1 + p 2 q 2 c2 q 2 F = 0
q2 = q

Note the following. Everything else equal, a higher increses the price
in peak periods, p2 . But remember that is endogenous - hence we cannot
draw a too simplistic conclusion.
Still, we can, by reasoning, …gure out how is impacted by q. To put it
into a story, say a section of the port is closed due to maintenance, which
means lower capacity. The immediate e¤ect is that capacity binds in peak
periods. An e¢ cient port will then raise the price such that the market is

104
cleared: this is the simple principle of using the price to allocate a scarce
resource across buyers, illustrated by the following …gure:

Suppose the initial capacity is q2old , which as illustrated is so high that the
capacity does not bind even in peak periods, q2 (P ) < q2old . Then the capacity
jumps down to q2 , at a level at which demand exceeds supply at the original
Ramsey price. Hence the quay fee has to be raised in order to clear the
market.
Obviously, the higher price in peak periods raises the port’s revenue, thus
improves the …nancial situation. Unless the port reduces the price in load
periods, total revenue will exceed total cost (since revenue in peak period has
increased), and hence the …nancial constraint will not bind. This cannot be
optimal. The better …nancial situation means that declines, and so does
p1 .

Is …rst best achievable? Yes, if net revenues during peak periods are suf-
…cient to cover total costs. Then we have = 0 and the optimum conditions
are:

p1 (q1 ) c1
= 0 ) p1 (q1 ) = c1
p1 (q1 )
p2 (q2 ) c2 =
p 2 q 2 c2 q 2 F > 0
q2 = q

105
 Actually, given the constraint q2 = q, the allocation is e¢ cient, as it
corresponds exactly to the solution of a pricing problem with the …nancial
constraint removed.
However is positive, thus increasing the ports’ capacity is valuable.
As mentioned above, if exceeds the marginal cost of providing capacity,
increasing the capacity is socially optimal.

Are bottlenecks socially valuable? Arti…cial bottlenecs cannot be valu-

able, in that if the capacity is there, it is always valueble to use it as long as
it creates value. However the bottleneck q is a scarce resource –and as any
scarce resource, yields an economic rent.
This has the following implication: if we add a …nancial constraint to the
port problem, investment in higher capacity is not necessarily optimal, even
if the investment is optimal without the …ncancial constraint.
Consider the …gure below

Note that, due to the …nancial constraint, the Ramsey price is so high
that the capacity does not bind. Hence = 0. This means investing in more
capacity is a pure waste. However if we remove the …nancial constraint, the
price will drop to P (q2 ) and will be positive. This illustrates a general
point: unless we are in …rst best, optimal allocation of resources in one
market segment cannot not be derived indepently of the distortions in other
segments. Public economics is di¢ cult.

106
9.3 Priority pricing
A related topic is priority pricing. Consider the follwoing example: Hur-
tigruten follows a strict time schedule, wheras as a cargo is more ‡exible. In
situations were there will be delays, e.g. because of bad weather, a market
for priority can be created - re‡ecting the di¤erences in delay costs. If a …rm
has priority, it will not experience any delay.
Take the following simple illustration: the value of using Bodø port for
Hurtigruten and the cargo is
On time Risk of delay
Hurtigruten 100 60
Cargo 60 60
and suppose bad weather occurs with probability 0.5. The port has
di¤erent alternatives. It can charge both companies a price 60, and in case
of bad weather either of them may experience delays.
An alternative scheme would be to o¤er priority contracts. Note that
the cargo has no willingness to pay for priority, hence the most the port
can extract from the cargo, is 60. Hurtigruten is willing to pay more, up to
100, if it is given priority. However, if the price for priority is set too high,
Hurtigruten would be better o¤ choosing a standard contract at 60. If so,
it experiences delays with probability 1/2. Hence the expected value of the
standard contract would be
1 1
100 + 60 = 80
2 2
Hence the port can charge Hurtigruten at most 80 for a priority contract,
if the price exceeds 80, Hurtigruten is better o¤ with the standard contract
(this constraint corresponds to the incentive constraint in contract theory).
In equilibrium the port charges Hurtigruten access with priority at a price
80, whereas the Cargo pays 60.
Obviously the market is e¢ cient. Priority, which means that the delay
is avoided, is allocated to the …rm with the highest willingness to pay. Any
other rationing mechanism would yield ine¢ ciencies.
Note that the market mechanism resembles price discrimination of second
degree except for the fact that there are no ine¢ ciencies associated with the
marginal customers contract: the delay is real.
A price discrimination story could be as follows. There are no risk of
delays from the beginning. However, as the the two customers marginal
rates of substitution between price and delay di¤er, the seller (the port) can

107
use delays to extract rent from Hurtigruten - thus using arti…cial delays as
an instrument.

9.3.1 Exercises transport pricing

Peak load pricing

Part 1 of the exercise consider’s the benchmark case, with no capacity
constraints. In part 2 we introduced the capacity constraints which is binding
in peak periods.
Part 1
We consider a port which has discretion to choose its own price model,
however under the constraint that market revenue should be su¢ cient to
cover total costs (but nothing more).
Total cost consist of a …xed cost F and constant marginal cost c. Demand
‡uctuates between day (peak) and night, and we let the demand functions
be specied by

qN = pN"
qD = pD"

where > 1 is a shift parameter. Note that the demand elasiticity, Elp q =
", is the same in the two periods.
Suppose service capacity does not bind.

1. Formulate the Lagrange problem, and show that in a social optimum,

the port should not di¤erentiate prices between night and day.

2. Suppose increases. Explain how this impacts the optimal price level
and the Lagrangian multiplier. Provide intuition to the e¤ect has on
the Lagrangian multiplier in optimum.

Solution
We have the Lagrangian
Z qN Z qD
pN (z)dz cN qN + pD (z)dz cD qD + (( pN c) qN + (pD c) qD F)
0 0

108
Since the demand elasticity does not change over the 24 hours, the optimal
mark up is constant
p c 1
= (19)
p "1+
where
p = pN = p D
hence from the demand functions

qN = p "
qD = p "

Inserting qN and qD in the constraint yields

( pN c) qN + (pD c) qD F
= ( p c) p " + (p c) p " F
= (1 + ) ( p c) p " F = 0

that is
" F
(p c) p = (20)
1+
Note that (19) and (20) are two equations that determine and p as
functions of the exogenous variables, F , , " and c. Note also the recursive
structure: (20) determines p and then (19) determines .
Consider an increase in . Since c, F and " are given, it follows from (20)
that p declines (note that the left hand side is strictly increasing in p). From
(19) it is clear that declines (the left hand side is monotonically increasing
in p and the right hand side is increasing in .)
Economically, a higher (which represents a positive shift in demand)
makes it possible for the port to cover the …xed cost with a smaller markup,
which is bene…cial as it makes the distortions associated with pricing above
marginal cost less severe.
Note the interpretation of :
@L dW
= =
@F dF
where W is social surplus. A lower , due to higher demand, re‡ects that the
distortions associated with a price which exceeds marginal is, on the margin,

109
smaller. Recall that the deadweight loss increases at the rate of the square
of the mark up, not linearly in the mark up.

Part 2:
Suppose maximum port capacity is q, and assume the capacity is binding
in day time.

1. Derive the optimal price structure.

2. Discuss how impacts prices and the two Lagrange multipliers. Ex-
plain the result. I suggest that you simplify the model as follows: as-
sume demand is iso-elastic (that is " = 1). With this simpli…cation you
solve explicitly for and . Note that the assumption " = 1 is incom-
patible with pro…t maximization (since the monopoly price approaches
in…nity), but compatible with welfare maximization.

Solutions:
We have the Lagrangian
Z qN Z qD
pN (z)dz cN q N + pD (z)dz cD q D
0 0
+ (( pN c) qN + (pD c) qD F)
(qD q)

Maximize with respect to pN and pD . Given that the capacity constraint

binds (if it doesn’t we are back in the previous exercise) we get the following
four conditions:

pN c 1
= (21)
pN "1+
pD c 1
= + (22)
pD " 1+
(pN c) pN" + (pD c) q F = 0 (23)
q = pD" (24)

We have four endogenous variables, pN ; pD ; and , and the exogenous

variables "; F; c and q. Note that (24) is one equation which determines pD

110
as function of the capacity q and the shift parameter . The interpretation
is the following: pD has the role of rationing demand such that total demand
is compatible with the limited capacity. If demand shifts outwards (higher
), then pD must increase, and increase more, the less elastic deman is. We
…nd that:
1
El pD =
"
Inserting pD in (23) yields one equation which determines pN . Since an
increase in yields a higher pD , then pN declines (ref 23), and thus declines
(from 21).
Finally you can use (22) to calculate . It is a bit messy to calculate how
impacts - to simplify, consider iso-elastic demand. With " = 1 we have
the following four conditions:

pN c
=
pN 1+
pD c 1
= ( + )
pD 1+
pN c
+ (pD c) q F = 0
pN
pD =
q
with solutions:
F + cq
=
1 (F + cq )
1 cq
= 1
1 (F + cq )
c
pN =
1 (F + cq )
pD =
q
which shows that an increase in yields a lower pN , a higher pD , a lower
and a higher .
Priority pricing
We take the example from the slides dated February 14. The story is:

111
 Hurtigruten follows a strict time schedule

A cargo is more ‡exible

In bad weather there will be delays

Yields a market for priority

Suppose valuations are as follows

On time Delayed
Hurtigruten 100 80
Cargo 60 60

Bad weather occurs with probability 0.5

Question 1: Derive equilibrium prices

Solution: Suppose the port does not o¤er a contract with priority. Then
the best it can do is to charge 60 and serve both ships, which yields a revenue
of 120.
O¤ering

Question 2: Suppose Hurtigruten invests in new and faster ships, which

lower the costs associated with delays. How will the investment impact 1)
the port’s prices, and 2) social surplus.

10 Damage compensation
How can we compute the damage from an illegally high price? Suppose a
cartel or a dominant …rm abuses market power, and charges an illegally high
price. Their customers are harmed. If the illegal action is detected, those who
are responsible will be punished. In addtion, anyone who is harmed by the
overcharge may claim compensation. According to the law, the compensation
should re‡ect the actual harm.
To estimate the harm, you have to evaluate the competitive structure in
the market and apply economic theory
We will brie‡y discuss:

Harm associated with a small overcharge

112
 Harm due to a larger overcharge (why this di¤erence?)
Does competitive structure matter (e.g. does it matter if the …rm
seeking compensation is a monopoly or competes …ercly)?
Does it matter if only one …rm in the market pays the overcharge or
all …rms do?
Are there other strategic e¤ects?

10.1 Compute the harm associated with a small over-

charge
Consider the following simpli…ed setting:
A downstream …rm produces a good q using two inputs, v1 and v2
The …rm’s production function is
q = F (v1 ; v2 )

The …rm’s (gross) revenue is

R(q)

1. Competition: R(q) = pq Marginal revenue: R0 (q) = p

2. Monopoly: R(q) = p(q)q Marginal revenue: R0 (q) = p0 (q)q + p

Input prices are w1 and w2

Suppose input 1 is overcharged with a small amount dw1 , in case of
competition, we assume that the …rm we consider is the only …rm which
su¤er from the overcharge. This is important, since if all …rms in
a competitive market pays the overcharge, the market price will be
impacted (see below).
Small overcharge
Downstream …rm’s net revenue
(v1 ; v2 ) = R(q) w1 v1 w2 v2
where q = F (v1 ; v2 )

113
 First order condition:

R0 (q)F1 w1 = 0
R0 (q)F2 w2 = 0
=) v1 (w1 ; w2 ); v2 (w1 ; w2 )

with interpretation: value of the marginal product equal to input price.

Impact of a small overcharge (envelope theorem)

d (v1 ; v2 )
= v1
dw1

With a small overcharge the harm is the direct, the number of units of
the overpriced input.

Note that this does not depend on whether the …rm competes in a
market, or has monopoly power

10.2 Compute the harm –…nite overcharge

Suppose w1 increases by w1
Consider the following …gure (read p as the input price and x as the input)

The input price increases with the amount t. We can then decompose
the harm in two parts. With the high price the …rm purchases the amount

114
x1 . The overcharge is t, hence there is a direct cost equal to tx1 : that is, the
…rm pays to much for its actual volume. The second part has the following
explanation. Because of the overcharge, the …rm buys less than what it would
have bought in the contrafactual situation, that is the situation without the
overcharge. If the price had been p , the …rm would have bought the volume
x0 . The triangle B is known as the indirect loss.
Note the di¤erence between a small and a large overcharge. If you let t
be small, the triangle B converges to zero, and the loss is represented by the
direct loss xt only.
So far we have considered situations where there is one …rm that is
harmed. Let us now consider oligopolistic markets, and where all …rms pay
the overcharge.

10.3 Market e¤ects - duopoly competition downstream

Consider competition between two …rms downstream
Consumer price: p(q1 ; q2 )
Gross revenue: R1 (q1 ; q2 ) = p(q1 ; q2 )q1
Marginal cost c
Small overcharge dc - both downstream …rms pay the overcharge
Net revenue: 1 = R1 (q1 ; q2 ) cq1
First order condition:
dR1 (q1 ; q2 )
c = 0 =) q1 (c; q2 )
dq1

The e¤ect of overcharge:

d 1 dR1 (q1 ; q2 ) dq2
= q1
dc dq2 dc
d 1 dR1 (q1 ;q2 ) dq2
dc
> q1 if dq2 dc
> 0, which is reasonable
Interpretation: the overcharge creates a strategic e¤ect which reduces the
harm. Note that there is a negative relationship between cost and production
level.

115
10.4 Perfect competition and complete pass-on
If there is perfect competition downstream, the e¤ect described in the previ-
ous section eliminates the hart.

Perfect competition and constant marginal cost

Suppose now that all …rms in the market pay the overcharge

Hence the marginal cost in the market shifts upwards with dc, and so
does the equilibrium price.

dp = dc

10.5 Market strategic e¤ects

In the Telenor-TDC case:

– Telenor knew about the overcharge

– In constrast to the typical situation in markets (…rms A does not
know that opponent B pays an overcharge)
– Does it matter for the calculation of the damage?

Generally yes

– If Bertrand competition - the loss is slightly smaller

– If Cournot competition - slightly higher

Take Bertrand competition as example in which case prices are strategic

complements. By this we mean the following: suppose one of the …rm charges
a higher price (e.g. due to higher cost), the opponent …rm’s best response is
to raise its own price.
Graphically this means that the response curve are increasing. You can
try to draw the responsecurves in a price diagram e.g. based on the following
standard speci…cation of demand functions:

q1 = D p1 + ap2
q2 = D p2 + ap1

116
where a > 0.
If …rm A pays an overcharge, B sets a higher price if it knows about the
overcharge than if it is unaware of it. Hence from A’s point of view, the fact
that B is informed is an advantage.

11 Bookmarket - RPM contracts

We focus on the rationale behind …xed price contracts, the most controversial
part of the book agreement.

RPM - resale price maintanence (…xed price contract)

The book price is set by the publisher and is …xed for a given period
of time.

– In Norway until May 1. the year after the book was published

Hence book sellers cannot compete on price

The principle is embodied in a (vertical) contract between the Nor-

wegian Publishers Association and the Norwegian Booksellers Associa-
tion. Also an exemption from the competition act section 10 is granted.

ESA (Efta’s surveillance authority) submitted a request for information

about the regulation in December 2017. They consider the aggreement
as potentially in con‡ict with Article 53 of the EEA Agreement (cor-
responds to section 10 of the Norwegian act)

– the Norwegian government cannot grant exemption to Article 53

Norwegian book market - the complexity of the market structure

117
11.1 How is competition impacted by RPM?
Resale price maintanence means that the publisher (the upstream …rm)
sets the price

Eliminates price competition between book sellers ("intrabrand com-

petition")

Still publishing houses compete in prices ("interbrand competition")

Questions:

– Is intrabrand competition important for e¢ ciency?

– Does RPM facilitate collusion?
– Does RPM impact the incentives to invest in quality?

11.2 Cost structure and incentives

Production costs in the book market are too a large extent …xed and sunk:

Variable costs: printing, distribution, marketing (about 10 percent of

total costs)

Fixed costs: author’s work, the publishing house’s contribution (process-

ing the manuscript etc)

118
 Hence the net value of increased sale for the vertical chain: 90 percent
of book price

Information good (you don’t buy the same book twize)

Essential for value creation:

– Which factors impact the buying decision?

We consider here one aspect of this - the book seller’s incentives to

exert sales e¤ort with and without RPM

11.3 Investment in quality - no vertical restraints

Consider two book sellers, 1 and 2, competing in prices p1 and p2 and
sales e¤ort s1 and s2 .

Think about sales e¤ort as providing information, promoting new and

unknown authors etc.

Pro…t functions

1 = (p1 r) q1 (p1 ; p2 ; s1 ; s2 ) (s1 )

2 = (p2 r) q2 (p2 ; p1 ; s2 ; s1 ) (s2 )

q1 (p1 ; p2 ; s1 ; s2 ) is decreasing in p1 , increasing in p2 (products are sub-

stitutes), increasing in s1 and increasing in s2 (sales e¤orts, as described
above, are complements). r is the whole sale price

Note the following:

– what one book seller does has an impact on competitors’ pro…t

(externalities)
– price setting is associated with negative externalities
– sales e¤ort with positive externalities (information as public good)

119
11.4 Equilibrium sales e¤ort

1 = (p1 r) q1 (p1 ; p2 ; s1 ; s2 ) (s1 )

2 = (p2 r) q2 (p2 ; p1 ; s2 ; s1 ) (s2 )

First order conditions (book seller 1)

d 1 dq1 (p1 ; p2 ; s1 ; s2 ) 0
= (p1 r) (s1 ) = 0
ds1 ds1

Two problems:

1. The margin, p1 r, is below the vertical chain’s marginal value

(which is p1 c where c is the marginal cost)
2. The public good aspect of sales e¤ort (positive externality imposed
on book seller 2)

Compare this with the optimal sales e¤ort of an integrated monopoly.

Joint pro…t (the publisher and the two book stores)

= (p1 c) q1 (p1 ; p2 ; s1 ; s2 ) (s1 ) + (p2 c) q2 (p2 ; p1 ; s2 ; s1 ) (s2 )

with …rst order condition

d dq1 (p1 ; p2 ; s1 ; s2 ) 0 dq2 (p1 ; p2 ; s1 ; s2 )
= (p1 c) (s1 ) + (p2 c) =0
ds1 ds1 ds1
which identi…es the two important externalites:

1. The integrated monopoly’s margin, p1 c, in outlet 1 exceeds the out-

let’s own margin p1 r. Hence the return from quality investments
is substantially larger for the integrated monopoly than for the book
store.

2. Quality in store 1 impacts sale in store 2. If quality takes the form

of information and promotion, it tends to stimulate demand for the
releases more generally (public good aspect of information).

120
11.5 Optimal price response
Let’s think about the quality dimension in a slightly more dynamic setting.
Suppose store 1 invests a lot in quality, stimulates reading and build up the
market for new releases. Given store 1’s quality choice, what is store 2’s
optimal choice of price level? You can think about store 2 as just across the
street of store 1.

2 = (p2 r) q2 (p2 ; p1 ; s2 ; s1 ) (s2 )

Book seller 2’s optimal price:
d 2 dq2 (p1 ; p2 ; s1 ; s2 )
= (p2 r) + q2 (p2 ; p1 ; s2 ; s1 ) = 0
dp2 dp2
There is a strong incentive to undercut to capture the customers targeted
by book seller 1’s sales e¤ort:
dq2 (p1 ;p2 ;s1 ;s2 )
dp2
can be large in absolute value (business stealing)
Hence the value added associated with store 1’s quality choice is almost
entirely extracted by store 2. This kind of cannibalism may have a very
averse impact on the quality level generally

11.6 The impact of RPM

RPM can be used as an instrument to avoid business stealing

1 = (p r) q1 (p; p; s1 ; s2 ) (s1 )
2 = (p r) q2 (p; p; s2 ; s1 ) (s2 )
First order condition for choice of sales e¤ort:
d 1 dq1 (p; p; s1 ; s2 ) 0
= (p r) (s1 ) = 0
ds1 ds1
In addition, RPM impacts the content of sales e¤ort/ promotions

– Since price cannot be used to make the store attractive to buyers,

book sellers have to use other means to attract customers (in which
incentives are more aligned with the vertical chain’s interest)
– If publishing houses compete - the authorities should not be con-
cerned about p (but what if they don’t compete?)

121
12 Appendix A
12.1 Dependence in demand
The most intuitive way to capture the idea of social welfare with two goods
is the following procedure. Suppose …rst that the second good does not exist
(or that it exists but o¤ered at a price that no one is willing to pay). In this
situation, social welfare is Z q1
p1 (z)dz
0
What is the additional gain of introducing good 2? Now we have to take
into account that good 1 is there, o¤ered at a price p1 . The additional value
of good 2 is Z q2
p2 (z; p1 )dz
0
Let us just illustrate the e¤ects, we will draw on this insight later, but we
will not go deep into this. There are dependencies in demand if the marginal
willingness to pay for one good depends on the price of the other good. Let
the marginal willingness to pay for good 1 be written:

p1 (q1 ; p2 )

Traditionally, we think about goods that are complements and goods

that are substitutes. The goods are complements if a higher p2 reduces the
willingness to pay for good 1: that is, p1 (q1 ; p2 ) is decreasing in p2 . The
goods are substitutes if p1 (q1 ; p2 ) is increasing in p2 .
Comment (not relevant for the exam): It can be shown that the precise
mathematical expression for the consumer surplus in the two markets is
Z q1 Z q2
p1 (z; 1)dz + p2 (z; p1 )dz
0 0
Rq
which has a simple intuition. The …rst term 0 1 p1 (z; 1)dz is the consumer
surplus associated with good 1, in the hypothetical situation were consumers
do not have access to good 2 (in that good 2 is supplied at a price equal
to in…nity). You can think about
R q2 this …rst term as the "stand alone" value
of good 1. The second term, 0 p2 (z; p1 )dz, is the additional value good 2
represents.

122
 As an illustration, think about two goods that are almost perfect sub-
stitutes. The second term is almost zero, and the total consumer surplus
is captured from the …rst term. The other extreme would be good that are
almost perfect complements, in which case the …rst term is almost zero.

123