Competition in Prices and Service Level Guarantees
34 Pages Posted: 15 Oct 2007
Date Written: September 2007
In this paper we study the implications of service level guarantees (SLGs) in a model of oligopoly competition where providers compete to deliver a service to congestion-sensitive consumers. The SLG is a contractual obligation on the part of the service provider: regardless of how many customers subscribe, the firm is responsible for investing in infrastructure, capacity, or service quality so that the congestion experienced by all subscribers is equal to the SLG. First, we analyze a game where firms compete by setting prices and SLGs simultaneously. We establish that this game can be reduced to standard oligopoly models of price competition, greatly simplifying the analysis of this otherwise complex competitive scenario. Notably, we find that when costs in the original game are convex, the resulting equivalent pricing game also has convex costs. Further, for a broad class of models exhibiting constant returns to investment, the resulting pricing game is equivalent to a standard price game with constant marginal costs; many loss systems, such as those modeled by the Erlang loss formula, exhibit constant returns to investment. We then consider another commonly used contractual agreement between firms and customers: firms first set prices and investment levels simultaneously, and then consumers choose where to subscribe. In this case, firms provide the best possible service given their infrastructure, but without an explicit guarantee. Using the Nash equilibria of the games played by firms, we compare this competitive model with the model where firms set prices and SLGs, in terms of the resulting prices, service levels, firms' profits, and consumers' surplus.
Keywords: Competition, game theory, congestion, contracting, pricing
JEL Classification: D43, L13, L96, M21
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