Monopoly Pricing in Vertical Markets with Demand Uncertainty

TL;DR

This paper develops a systematic theoretical framework for analyzing and comparing monopoly prices under demand uncertainty in vertical markets, using the mean residual demand function and stochastic orders to derive new insights.

Contribution

It introduces a novel approach linking price elasticity to the mean residual demand function, enabling systematic comparison of prices across different market conditions.

Findings

Optimal prices can be ordered via stochastic dominance of MRD functions.

The framework challenges traditional views on demand variability's effect on prices.

A mild unimodality condition generalizes the IGFR condition for profit maximization.

Abstract

Pricing decisions are often made when market information is still poor. In turn, existing theoretical models often reason about the response of optimal prices to changing market characteristics without exploiting all available information about the demand distribution. Our aim is to develop a theory for the optimization and systematic comparison of prices between different instances of the same market under various forms of knowledge about the corresponding demand distributions. We revisit the classic problem of monopoly pricing under demand uncertainty in a vertical market with an upstream supplier and multiple forms of downstream competition between arbitrary symmetric retailers. In all cases, demand uncertainty falls to the supplier who acts first and sets a uniform price before the retailers observe the realized demand and place their orders. Our main methodological contribution is that we express the price elasticity of expected demand in terms of the mean residual demand (MRD) function of the demand distribution. This leads to a closed form characterization of the points of unitary elasticity that maximize the supplier's profits and the derivation of a mild unimodality condition for the supplier's objective function that generalizes the widely used increasing generalized failure rate (IGFR) condition. A direct implication is that optimal prices between different markets can be ordered if the markets can be stochastically ordered according to their MRD functions or equivalently, their elasticities. Using the above, we develop a systematic framework to compare optimal prices between different market instances via the rich theory of stochastic orders. This leads to comparative statics that challenge previously established economic insights about the effects of market size, demand transformations and demand variability on monopolistic prices.