an experiment on strategic capacity reduction mikhael shor vanderbilt university may 2008
DESCRIPTION
3 Shelf-Space Models & Slotting Allowances Theoretical concerns have mostly focused on supplier market power, not buyer market power Competitor foreclosure through slotting allowances Yet, slotting allowances usually buyer-initiated (Arquit 1991) Slotting allowances can be pro-competitive Align retailer-manufacturer incentives (Klein and Wright 2007) Decrease consumer search costs (Sullivan, 1997) Traditional equilibrium bargaining models show little incentive to limit capacity But may rest on behaviorally untenable assumptionsTRANSCRIPT
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An Experiment onStrategic Capacity Reduction
Mikhael ShorVanderbilt University
May 2008
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Motivation
Health insurers restrict the number of drugs on their formulary
Pharmaceutical benefit managers restrict the number of drug stores in their retail networks
Private airports artificially limit the availability of gates or runways
Grocery stores limit available shelf space for competing products
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Shelf-Space Models & Slotting Allowances Theoretical concerns have mostly focused on
supplier market power, not buyer market power Competitor foreclosure through slotting allowances Yet, slotting allowances usually buyer-initiated (Arquit 1991)
Slotting allowances can be pro-competitive Align retailer-manufacturer incentives (Klein and Wright 2007) Decrease consumer search costs (Sullivan, 1997)
Traditional equilibrium bargaining models show little incentive to limit capacity
But may rest on behaviorally untenable assumptions
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Thought Experiment
You are the director of a commercial-free music video channelPerhaps jazz, pop, polka, or classic rock?
Cable companies pay you a fixed fee to carry your content
You make a take-it-or-leave-it price request to each cable company
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Thought Experiment
MarketThere are a total of 20 (homogeneous) suppliers
Cable CompaniesEach music channel adds $10M to profitCable companies have varying capacities (k)Cable companies select the k lowest offers
Market 1: k = 30 (unlimited capacity) Market 2: k = 12 (constrained capacity)
How much do you ask for in each market?
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Research Question
How does a firm’s capacity impact the allocation of bargaining power between it and its suppliers?
What happens to a firm’s revenue if it commits to insufficient capacity to deal with all suppliers?
Outline: Experiment Theory for our thought experiment Results Subject behavior
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Experiment
Identical to thought experiment
A market consists of N = 20 suppliers (subjects) Each market has a capacity level k {4,6,…,18,20} Each supplier contributes $10 to monopolist profits Subjects make simultaneous proposals.
A proposal of p implies, if accepted, the subject receives p and the monopolist receives $10-p.
The lowest k proposals are accepted and paid; remaining subjects are paid $0.
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Theoretical Predictions
If k ≥ N Suppliers should request the whole $10 (or a bit less) Buyer is left with zero profits
If k < N Unique equilibrium: each requests $0 Buyer captures entire surplus ( 10k million)
Equilibrium in weakly dominated strategiesOnly strategy that guarantees zero profit
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Equilibrium Requests
Monopolist captures entire surplus whenever k<N
-202468
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2 4 6 8 10 12 14 16 18 20
Pric
e R
eque
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Capacity
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Equilibrium Revenue
04080
120160200
2 4 6 8 10 12 14 16 18 20
Rev
enue
Capacity
There is incentive to exclude at most one supplier
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Market Games
Nine proposers for a single prizeRoth, Vesna, Okuno-Fujiwara, and Zamir, 1991Prasnikar and Roth, 1992
Two to four proposers for a single prizeDufwenberg and Gneezy, 2000Dufwenberg, Gneezy, and Rustichini, 2005
Three sequential proposals for a single prizeAbbink, et al, 2001
In all of these, only one bargain may be consummated
How does altering the number of accepted offers change subjects’ bids?
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Experiment
Subjects: 60 MBA students
Each subject bid in three different capacity conditions
180 bids total, 20 at each capacity level
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Results: Price Requests
Bids increase with available capacity and do not correspond to theoretical predictions
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Pric
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Capacity
Price RequestsMean
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Winning bids increase with available capacity and do not correspond to theoretical predictions
Results: Accepted Price Requests
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Pric
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Capacity
Accepted RequestsRejected RequestsMean Accepted
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55% profit increase19% profit increase
Results: Buyer’s Profit
0
10
20
30
40
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60
70
80
2 4 6 8 10 12 14 16 18 20Capacity
Prof
it
Experiment:
Firm has incentive to decrease capacity by 30%
606% profit increase
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Subject Pool Executives at two manufacturing firms yield similar results
Executive Subject Price Requests
0
2
4
6
8
10
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Relative Capacity (k/N)
ExecutivesMBAs
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Robustness
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Repeated Experiment Price Requests (k=12)
Subject Pool Executives at two manufacturing firms yield similar results
Learning Introducing multiple rounds does not lead to equilibrium
convergence
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Robustness
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0 5 10 15 20Round
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Explaining Subject Behavior
An executive subject:
““ This game is simplistic but still similar to what we face every day. In our business, we compete against other suppliers in what is, essentially, a commodity business. Our only differentiation is price.
” ”
Equilibrium fails to describe behavior Bounded rationality (QRE) fails, too
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Explaining Subject Behavior
An executive subject:
““ The idea is to treat everyone fairly, while still securing a sufficient profit for ourselves.
” ”
Consider behavior in the classic ultimatum game:Equity norm (even split)
+ Strategic considerations
In the present context, some modifications
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Surveys
What is an equitable payment to a supplier (considering that some suppliers will earn nothing)?
What is a fair profit for one of k accepted suppliers? 100 respondents, 20 for each k{4,8,12,16,20}
Strategic considerations: what is a reasonable profit share for the cable company to maintain position?
What percentage of profits need an accepted supplier share with the buyer to secure his position? 50 respondents, 10 for each k{4,8,12,16,20}
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Results: Both Surveys
Start with a “fair profit,” adjust for strategic concerns Fairness norms tempered with strategic concerns
accurately describe subject behavior
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Survey
Experiment
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Conclusions
Experiments In a competitive ultimatum / market game setting,
subjects react to capacity constraints
Implications for firms Reducing capacity is inefficient, but profitable Efficiency loss of at least 30%
Behavior Weakly dominated strategies are not rational Strategic concerns tempered by fairness predict data