Search for an essay or resource:

Essay: How firms manipulate prices by adopting the Stahl-Varian model

Essay details:

  • Subject area(s):
  • Reading time: 5 minutes
  • Price: Free download
  • Published: September 29, 2021*
  • File format: Text
  • Words: 1,556 (approx)
  • Number of pages: 7 (approx)
  • How firms manipulate prices by adopting the Stahl-Varian model
    0.0 rating based on 12,345 ratings
    Overall rating: 0 out of 5 based on 0 reviews.

Text preview of this essay:

This page of the essay has 1,556 words. Download the full version above.

It is not a rare phenomenon to feel a bulging wallet in your left pocket with loyalty cards inconveniently sticking out, as you try to be savvy and maximise on savings. Paradoxically, a similar concept in service provision carries a ‘loyalty penalty’ for British consumers, who are losing out on £4bn a year (CMA, 2018). Firms exploit uninformed customers, by discriminating between them. Contrastingly, naïve consumers become complacent and blindly trust their current suppliers, whilst those that may be aware of such practises are deterred away by high search or switching costs.

In an environment where consumers are loyal, hence have an inelastic demand, or are simply uninformed, due to the presence of search costs, firms can choose to employ second and third-degree price discrimination. For example, British Gas offers a range of tariffs dependent on your needs, location etc. for electricity usage.

I illustrate how firms manipulate prices by adopting the Stahl-Varian model. We can change the assumptions from the original model so that the informed customers, I, are new customers, and the uninformed customers, M, are old customers. Thus, the uninformed customers will have a search cost, c, if they look for cheaper service providers. The other assumptions remain the same; all consumers have the same reservation price, r, and there are n symmetric firms in the market.

The number of old (uninformed) customers per firm, U, is exogenously given by:

Firms choose prices between p*, which equals to the marginal cost, and r. Informed customers have knowledge of prices provided by firms, thus, they will only buy from the cheapest firm.

The firm will sell to I with probability:

The firm will sell to M with probability:

Therefore, the firm’s expected profits are given by:

In a competitive market, firms behave in a way to maximise profits. Gamble et al., (2013), suggest firms are cognizant of customer costs; they recognise when customers are likely to switch. In this case, they will lower their price so that the price difference between theirs and rival prices is less than the search and switching costs, thereby stopping customers from switching.

The firm sets prices to maximises profits:

The derivative helps us find the profit maximisation prices:

With increasing pA1, A2 decreases. Consequently, the business model relies on setting low prices in period 1, pA1, to capture a larger market share and raise prices in pA2, to maximise profits. For instance, in the electricity retail market, a dispersion of prices exists through a range of different tariffs offered to consumers. (Giulietti, et al., 2014)

In essence, firms exploit people who are generally less tech savvy, resistant to change and less willing or able to go through the hassle of searching e.g. the elderly. Ofcom studies show ‘customers with landline and broadband service together pay on average 19% more after their discount deal has expired…94% of individuals can switch to faster broadbands but less than half choose to’ (Sweney, 2018).

Consumer and firm behaviour are together responsible for this strange phenomenon. While consumers may remain stubbornly loyal, for those that do wish to switch, firms respond by endogenously increasing switching costs. I illustrate the economics behind this behaviour using the Belleflame and Pietz model. Here, r, is the reservation price, x, is the distance from the consumer to the firm and pxy, is the price charged by firm x in period y. We assume customers are uniformly distributed along a unit line.

In the first period model, the consumer purchases from firm A if the inequality holds:

In a two-period model, customers that buy from firm A continue to do so with the switching cost, z, if:

Switching costs relaxes price competition between firms by creating a “dead area”, as long as price differences between rivals are not too large. This is because these exit fees can offset savings incurred by switching. However, there are also other important factors we can consider. Customer loyalty, f(l), is likely to ensure that a customer stays with the incumbent firm whilst search costs, s, makes it more expensive for customers to find better deals, thereby decreasing the proportion of people that will switch suppliers. Customers continue to buy from the same firm if:

Firms are also devious in creating endogenous switching costs. Companies like Vodafone are notorious for bundling their services, making it more expensive for consumers to switch or opt out of the contract (Burnett, 2014). While bundling seems cheaper, it removes transparency i.e. while some features may be desired, others are not, unnecessarily driving the price up. It is more expensive to consume the services individually, and since all firms in the market work in this manner, consumers are limited in their options. The firm has therefore created a scenario where they can generate greater revenue and make customers less likely to switch. The final model is as shown, where bundling, B, and switching costs make it harder for the customer to leave.

Challenging, expensive cancellation processes and rolled over contracts makes bundling even more effective. When customers can’t terminate contracts easily, such as with EE and Virgin Media, it prevents switching. Fining companies and passing legislation to reduce exit fees for violating the contract would make it easier for consumers to switch.

Rolled over contracts means firms automatically renew contracts without efficiently warning customers. This comes at a risk of paying a higher fee, for the same service, each successive period; ‘price jumps’ in the energy sector, ‘price walking’ in insurance and ‘legacy pricing’ in broadband (CMA, 2018).

An effective measure of stopping firms unreasonably increasing prices is through price capping. In the energy industry for example, it can be a maximum limit on what can be charged per kWH. Ofgem implemented a price cap on energy prices at the start of 2019 with savings estimated to be £76 per average household (Ofgem, 2018).

Another solution is to promote greater transparency. Citizens Advise suggested that the mortgage market should change the name of ‘standard variable rate’ to ‘expired rate’ (Citizens Advice, 2017). This alerts consumers that their discounted rate has ended, and they are now going to be charged at a higher level. Greater transparency is likely to incentivise obdurate customers to look for better deals as the asymmetry of information is mitigated.

The CMA also suggested that firms should also be held publicly accountable for their exploitative techniques (CMA, 2018). For example, Ofcom launched the ‘Boost Your Broadband’ website advising customers on the best broadband deals they can get in their area (Ofcom, 2018). The rise of price comparison websites, and campaigns to inform consumers are also useful. Ofgem’s collective switch trial saw the switching rate increase from 2.6% to 22.4% when households were notified that they were overpaying for their services (Ofgem, 2018).

The market setting in these industries moves away from a Bertrand style competition, as profit-thirsty firms inevitably look to exploit customers (Waterson, 2003). Customers, on the other hand, tend to be ignorant of this behaviour, unless it is strongly flagged. With active involvement from the CMA and industry regulators, methods such as price capping and informing customers have seen remarkable improvements in protecting consumer interests. Whilst they should continue to change guide consumer behaviour, government bodies should also impose regulations on ease of leaving contracts and transparency of firms pricing strategies. Without this combination, consumers will remain in a one-sided loyal relationship, trapped into by exploitative tactics of firms.



About Essay Sauce

Essay Sauce is the free student essay website for college and university students. We've got thousands of real essay examples for you to use as inspiration for your own work, all free to access and download.

...(download the rest of the essay above)

About this essay:

If you use part of this page in your own work, you need to provide a citation, as follows:

Essay Sauce, How firms manipulate prices by adopting the Stahl-Varian model. Available from:<> [Accessed 02-12-21].

These have been submitted to us by students in order to help you with your studies.

* This essay may have been previously published on at an earlier date.

Review this essay:

Please note that the above text is only a preview of this essay.

Review Content

Latest reviews: