Durable good monopoly and the Coase conjecture

22 November 2008

1 Introduction
• Consider a standard monopoly pricing problem. The monopoly faces a down-
ward sloping demand curve D1 (p). Say the marginal cost is constant at some
number c. The monopoly picks a price to maximize profit:

π = max
p
(p − c) D1 (p) .

The condition for profit maximization is the usual marginal revenue equal to
marginal cost condition: ∙ ¸
1
p 1+ = c,
ε1
where ε1 denotes the elasticity of demand associated with demand curve D1 .

• Implicit in this analysis is that the market opens just one time and then is
closed once and for all. We call such analyzes static models. Indeed, almost all
the economic analyzes you have been exposed to up to now are static models,
in which the interactions stipulated in the analyzes are assumed to take place
just once.

• Most real world markets operate over time, however. With such an apparently
important disparity between models and reality, how can we trust that the
conclusions we derive from static models are valid for the dynamic markets of
the real world?

• In most cases, static models can be defended on the grounds that dynamic
considerations are not important, and so their abstractions should do no harm to
the validity of the analysis. That is, even if we allow for the market interactions
to go on over time in the analysis, the same conclusions derived from the static
model will still apply.

1
 Figure 1: Monopoly pricing

• Is this true for the standard monopoly pricing model? Suppose that in each
period of time, where a period can be a month, a day, or whatever, the demand
side of the market is represented by the same demand curve D1 (p) . Then during
each period of time when the market opens, the same analysis as summarized
by fig.1 obviously remains valid. In this way, our good old monopoly pricing
model does appear to apply to the dynamic markets of the real world.

• But what if the demand side of the market can not be accurately described
by a time—stationary demand curve? In particular, suppose we have a market
for a certain durable good. Once bought, the good will offer the consumer a
continuous stream of services over time. In such markets, once a consumer buys
in the current period, she is out of the picture, so much so that her demand
drops to 0 in all subsequent periods. An immediate implication is that if the
monopoly sells more in one period, it may only be able to sell less in other
periods. To analyze how the monopoly prices in such markets, there is clearly
no acceptable alternative to a full-fetched dynamic analysis.

• To conclude then, the standard monopoly pricing analysis is only valid for non-
durable goods or services, the demand for which is independent over time.

2 Intertemporal price discrimination

• We begin the analysis assuming that no one has yet bought the good. Faced
with the demand curve D1 (p), suppose the monopoly in the first period sells q1

2
 Figure 2: Monopoly pricing in period 2

units at price p1 to maximize the profit that can be earned in the period.
• In the second period when the market opens again, those who bought in the
first period drops out. The residual demand is given by
D2 (p) = D1 (p) − q1 .

To maximize profit in period 2, the monopoly sells q2 units at price p2 , as shown

in figure 2.

• With D2 (p) < D1 (p), the profit maximizing price in the second period p2 falls
below the profit maximizing price in the first period p1 .
• Then in period 3, the residual demand drops to
D3 (p) = D2 (p) − q2 .

To maximize profit in the period, the monopoly sells q3 units at p3 , as shown

in figure 3.

• Quite obviously, p3 < p2 . And it is clear that p4 < p3 , p5 < p4 , etc.

• When would the monopoly stop selling the good? So long as there is positive
demand at a price above the marginal cost of production, there are profits to
be made by continuously selling. Therefore, in the very last period that the
monopoly chooses to offer the good for sale, we have p = c. See figure 4.

3
Figure 3: Monopoly pricing in period 3

Figure 4: Monopoly pricing; P = mc

4
 • That means that the total quantity sold over all periods is equal to q ∗ in figure
1, the competitive output level.

• The careful student should recognize that the pricing scheme over time is essen-
tially a strategy of third—degree price discrimination, where the monopoly sells
to each submarket at a different price to maximize profit. In the first period,
the monopoly sells at a high price, attracting businesses from the high demand
buyers only. In the second period, it lowers price to sell to buyers with lower
demand. In the third period, it sells at a still lower price to buyers with still
lower demand and so on and so forth. In the very last period, the monopoly
sells to the remaining consumers with valuations just equal to the marginal cost
of production. After that, no more profitable sales remain.

• The important point is that the monopoly will eventually sell up to where the
original demand curve cuts the marginal cost curve, just as what a perfectly
price discriminating monopoly will do.

• Does the pricing scheme described above help the monopoly earn the maximum
profit?

• In the above analysis, the length of a period denotes the time elapsed between
successive batches are offered for sale. Since the profits that may be earned
from the future batches are discounted more heavily the further in the future
the batches are sold, the monopoly benefits from selling the successive batches
as soon as possible. Indeed, the monopoly earns the maximum discounted profit
by selling the successive batches one right after another, with the length of time
between periods arbitrarily small.

• If that is the case, the monopoly should only sell one unit in each batch, at
the maximum price that the current highest demand buyer is willing to pay.
That is, to earn the maximum profit, the monopoly should practice first-degree
price discrimination intertemporally, where the monopoly sells each unit at the
maximum price consumers are willing to pay for that unit.

3 The Coase conjecture

• This analysis is mistaken to the extent that we have not considered how con-
sumers may react to the monopoly’s pricing scheme. Instead, we have implicitly
assumed that each consumer buys as long as the price at the current moment
is not above her reservation price.

• Are such behaviours rational? If the price will fall continuously over time, it is
surely not rational for the marginal consumers in each period to buy. They will
enjoy greater surplus by waiting for the price to fall before purchasing.

5
 • Furthermore, if the length of time between successive batches are offered for
sale is arbitrarily small, the price will fall to the marginal cost almost instan-
taneously. In this case, all consumers should wait until the price falls to the
marginal cost of production before purchasing.

• This rather surprising conclusion was first reached by Ronald Coase, and has
since been termed the Coase conjecture.1 Under the Coase conjecture, a monopoly
selling a durable good is tempted to change his price as quickly as possible. If
the firm is in fact able to change his price very quickly, he will take advantage
of the flexibility. But in doing so, the monopoly will lose her monopoly power
completely!!! In equilibrium, consumers expect her to charge prices close to the
marginal cost at any future instant. And, as they can wait for the next offer
without much delay cost, they cannot be induced to accept higher prices. Thus,
the monopoly ends up charging prices close to the marginal cost, vindicating
the consumers’ beliefs.

• The irony is that the monopoly is worse off when it attempts to price discrim-
inate. If it can commit not to lower price from the simple monopoly price in
figure 1 in all periods, the profit is, rather paradoxically, higher.

• The monopoly suffers from the consumers’ rational belief that it will flood the
market, which it will in fact do so.

• Can the monopoly simply in the first period make an announcement that it
would not lower price, hoping that the high demand buyers would be induced
to buy in the first period at high price?

• Should consumers believe the monopoly’s promise?

• In the second period, the residual demand curve is as depicted in figure 2. Hence
come second period, the monopoly, as before, would ex post wish to drop the
price below p1 in the second period. But, if these were possible, some consumers
would refrain from buying in the first period. Thus, ex ante, the monopoly is
actually hurt by his ex post flexibility. The monopoly must be able to credibly
commit to charge p1 in all periods for high demand consumers to expect that
prices would not fall and buy in period 1 at the high price.

• The result is actually much more general: An economic agent can always do as
well when he can commit himself as when he cannot. This is because, under
commitment, he can always duplicate what he does under no commitment. For
instance, in this case the monopoly could announce, at date 1, the the prices
1
Coase, Ronald H., “Durability and Monopoly,” Journal of Law and Economics, 1972, 15, 143-
149. For a more rigorous proof of the Coase conjecture, see Tirole, Jean, The theory of Industrial
Organization, 1988, pp.91-92.

6
 to be charged in each period to follow under no commitment. The consumer’s
behaviour would be unaffected. This simple paradox — that one generally gains
by imposing self-constraints — is an important phenomenon in industrial eco-
nomics.

4 Evading the Coase conjecture

• The credibility issue drives the durable good monopoly’s profit to zero in the
Coase conjecture. Although this problem is a serious one for the monopoly,
there are many reasons why a durable good monopoly can in practice make
some hefty profit.

4.1 Leasing
• Leasing allows the monopoly to keep clear of the Coase problem altogether.
When the goods are returned to the monopoly at the end of each period, the
monopoly will be putting pressure on the price of its own good, but not on
units owned by consumers, if it ever attempts to flood the market. This makes
not lowering price and increasing production a credible strategy. The monopoly
thus realizes the simple monopoly profit under leasing.

• Leasing, however, may create some serious hazards on its own. If consumers’
consumption mode (maintenance, care, etc) matters, the monopoly must be
able to monitor at the end of each period the exact condition of the good. Such
a monitoring technology, however, may be extremely costly for many products,
and leasing may lose its virtues. For instance, automobiles are seldom leased
on a long term basis.

4.2 Reputation
• The monopoly’s reputation can enter into consideration when the relationship
between producers and consumers is long-lived. For example, DeBeers, the
diamond monopoly, has the reputation of refusing to allow prices to fall.

4.3 Demolishing the productive capacity

• To commit itself not to add to the existing stock of the good tomorrow, the
monopoly may destroy its factory after today’s production.

• In less extreme forms, the monopoly may offer a limited edition of the product in
the first period, whose design and packaging is slightly different from subsequent
versions of the same product.

7
4.4 Increasing production cost
• The existence of increasing marginal production costs (decreasing returns to
scale) prevents the monopoly from flooding the market too fast. Thus increasing
costs allow the monopoly to commit itself not to cut prices in a Coasian fashion.

4.5 Money-back guarantee

• The monopoly can offer a money-back guarantee if it lets the price of the good
fall. Then the monopoly is, de facto, able to commit itself not to lower the
market price, and is thus able to realize the simple monopoly profit.

• The intuition is that the monopoly reimburses the consumers for any capital loss
its opportunistic second and subsequent periods behaviour would inflict relative
to the promised (commitment) behaviour. In this way, it totally internalizes
the consumers’ concern about price reductions.

4.6 In-flow of new customers

• The inflow of new customers also helps the monopoly to commit to not lowering
price.

• Over time, when high valuation consumers bought and left the market, the
monopoly is tempted to lower the price. The inflow of new customers at each
instant reimburses the market with high valuation consumers. This reduces the
monopoly’s propensity to cut prices and relieve it from the Coase problem to
some extent.

• In an interesting paper, Conlisk, Gerstner, and Sobel (1984)2 show that the
constant inflow of new buyers leads to “price cycle”: The monopoly, from time
to time, offers a sale to cater to the existing stock of low valuation buyers. For a
few periods, it charges high prices so as to extract the surplus of high valuation
buyers, until the proportion of low valuation buyers in the sample of unserved
consumers becomes so high that it cannot resist selling to these customers at a
low price. This sale temporarily reduces the proportion of low valuation buyers
among potential customers, and the monopoly starts charging high prices again.

4.7 Planned obsolescence

• Other things equal, a more durable product is worth more to consumers. Yet,
the monopoly may wish to deliberately sell a less durable product to help alle-
viate itself from the Coase problem.
2
Conlisk, J., Gerstner, E. and Sobel, J., “Cycle pricing by a durable goods monopolist,” Quarterly
Journal of Economics, 1984, 55, 489-509.

8
• When the good breaks down more often, there will be a greater inflow of buy-
ers and thus a greater inflow of high valuation buyers at each instant. This
lowers the monopoly’s temptation to lower prices. By decreasing durability,
the monopoly reduces the quantity of the good carried over to the next period,
increases the next period’s residual demand curve, and therefore increases the
next period’s price.

• Reducing durability is a way of committing oneself not to lower price tomorrow,

which induces consumers to buy today.

• Frequent design changes, a strategy pursued by many mobile phone manufac-

turers, perhaps is motivated by the same consideration to a certain extent.

• Another bias in technological choices concerns investment. Suppose, for in-

stance, that the durable good monopoly chooses between not investing today
and facing a high marginal cost in all future periods, and investing so as to face
a lower marginal cost. The monopoly may choose not to invest in the absence
of commitment, whereas it would invest if it could commit. Choosing a high
marginal cost technology makes possible a certain commitment not to flood the
market in the future and may thus be profitable.

• Notice that this presents a peculiar instance where to maximize profit, the
monopoly should not minimize cost.