Department of Economics University of Louisville Seal
Yong Chao
 Assistant Professor
Research Interests
  Applied Microeconomics Theory, Industrial Organization, Behavioral Economics, Antitrust and Regulatory Policies
Current Research Topics
  Nonlinear Pricing Contracts, Two-Sided Markets, Behavior-Based Pricing Strategy
  Strategic Effects of Three-Part Tariffs under Oligopoly. International Economic Review 54 (3): 977-1015.
  A three-part tariff refers to a pricing scheme consisting of a fixed fee, a free allowance of units up to which the marginal price is zero, and a positive per-unit price for additional demand beyond that allowance. The three-part tariff and its variations are commonly used in both final-goods and intermediate-goods markets. Recently, the offering of three-part tariffs and the like by dominant firms has become a prominent antitrust issue (e.g., U.S. v. Microsoft Corp. and AMD v. Intel). Existing studies have focused on monopoly models, interpreting the three-part tariff as a price discrimination device. In this paper, I investigate strategic effects of three-part tariffs in a sequential-move game and offer an equilibrium theory of three-part tariffs in a competitive context. I show that, compared with linear pricing equilibrium and two-part tariff equilibrium, a three-part tariff always strictly increases the dominant firm¡¯s (the leader¡¯s) profit when competing against a rival (the follower) with substitute products, in the absence of usual price discrimination motive. To explore the effects of a three-part tariff on welfare, I further perform comparative statics analysis using general differentiated linear demand system. I show that the competitive effect of a three-part tariff in contrast to linear pricing depends on the degree of substitutability between products: Competition is intensified when two products are more differentiated, yet softened when two products are more substitutable. This is in stark contrast with the competitive scenario posed by a two-part tariff: A two-part tariff always enhances competition and gives the highest total surplus of these three pricing schemes. Moreover, the rival firm always gets hurt in both profit and quantity sale when the dominant firm switches from linear pricing to a two-part tariff, yet it enjoys higher profit when the dominant firm moves from a two-part tariff to the more ornate three-part tariff, despite the fact that its quantity and market share are decreased even further. My findings offer a new perspective on three-part tariffs, a perspective which could help antitrust enforcement agencies distinguish the exclusionary three-part tariff from the pro-competitive one.
  We extend the traditional literature on bundling and the burgeoning literature on two-sided markets by presenting a theoretical monopoly model of mixed bundling in the context of the portable video game console market¡ªa prototypical two-sided market. We show that the monopoly platform¡¯s dominant strategy is to offer a mixed bundle rather than pure bundle or no bundle. Deviating from both traditional bundling literature and standard two-sided markets literature, we find that, under mixed bundling, both the standalone console price on the consumer side and the royalty rate on the game developer side are lower than their counterparts under independent pricing equilibrium. In our setting, mixed bundling acts as a price discrimination tool segmenting the market more efficiently as well as functions as a coordination device helping solve ¡°the chicken or the egg¡± problem in two-sided markets. After theoretically evaluating the impact mixed bundling has on prices and welfare, we further test the model predictions with new data from the portable video game console market in the early to middle 2000s, during which Nintendo was a monopolist. We employ a reduced form approach, and find empirical support for all theoretical predictions.
  Pay-What-You-Want Pricing: Can It Be Profitable? with Jose Fernandez and Babu Nahata Journal of Behavioral and Experimental Economics 57: 176-185.
    Using a game theoretic framework, we show that not only can pay-what-you-want (PWYW) pricing generate positive profits, but it can also be more profitable than charging a fixed price to all consumers. Further, whenever it is more profitable, it is also Pareto-improving. We derive conditions in terms of two cost parameters, namely the marginal cost of production and the psychological cost of the consumer for paying too little compared to her reference price.
     The paper makes the following contributions to the existing literature. First, we endogenize the choice of pricing strategies—PWYW vs. fixed price. Thus rather than solely focusing on the profitability of PWYW pricing, we evaluate its profitability vis-a-vis uniform pricing. To the best of our knowledge this has not been done so far theoretically. Second, we specify consumer utility to account for both economic and behavioral considerations. We show that when marginal cost is low and behavioral considerations are strong, then PWYW pricing can exploit the deadweight loss present under the uniform price to gain additional profit at the cost of serving some free riders. Therefore, PWYW pricing can be more profitable than charging a fixed price especially when the marginal cost is low and the deadweight loss is high. Third, we demonstrate PWYW pricing is more attractive when the cost of price setting is considerable or the market size is small.
  We consider second-degree price discrimination for two types of consumers. When the net-of-cost valuation functions cross at least once at some positive quantity, it is always optimal to serve both types of consumers. Moreover, the type with the higher valuation peak always gets the socially efficient quantity. The sufficient and necessary condition for the overall efficiency is the peak of each type's net-of-cost valuation is above the other type's net-of-cost valuation at that peak quantity. For two general linear demands, we quantify the degree of efficiency, upward and downward distortions.
Research Papers
  All-Units Discounts as a Partial Foreclosure Device. with Guofu Tan (Revise and Resubmit at The RAND Journal of Economics)
  All-units discounts (AUD) are pricing schemes that lower a buyer’s marginal price on every unit purchased when the buyer’s purchase exceeds or is equal to a pre-specified threshold. The AUD and related conditional rebates are commonly used in both final-goods and intermediate-goods markets. Although the existing literature has thus far focused on interpreting the AUD as a price discrimination tool, investment incentive program, or rent-shifting instrument, the antitrust concerns on the AUD and related conditional rebates are often their plausible exclusionary effects.
    In this article, we investigate strategic effects of volume-threshold based AUD used by a dominant firm in the presence of a capacity-constrained rival. We find that the AUD always increase the dominant firm’s profits, sales volume and market share over linear pricing or two-part tariff. At the same time, the AUD adopted by a dominant firm lead to “partial foreclosure” of an equally or more efficient rival, in the sense that the rival’s profit, sales volume and market share are strictly reduced, as compared to linear pricing. The buyer’s surplus and total surplus could be either lower or higher under AUD, depending on the rival's capacity level relative to the demand size. The intuition for our findings is that, due to the limited capacity of the rival, the dominant firm, that has a “captive” portion of the buyer’s demand in the context of a single product, is able to use the AUD to leverage its market power on the “captive” to “competitive” portion of the demand, much like the tied-in selling strategy in the context of multiple products. Our analysis applies to other similar settings in which the dominant firm has some “captive” market when it offers “must-carry” brands or a wider range of products.
    We propose a theoretical model to explain two salient features of the U.S. stock exchange industry: (i) sizable dispersion and frequent changes in stock exchange fees; and (ii) the proliferation of stock exchanges offering identical transaction services, highlighting the role of discrete pricing. Exchange operators in the United States compete for order flow by setting “make” fees for limit orders (“makers”) and “take” fees for market orders (“takers”). When traders can quote continuous prices, the manner in which operators divide the total fee between makers and takers is irrelevant because traders can choose prices that perfectly counteract any fee division. If such is the case, order flow consolidates on the exchange with the lowest total fee. The one-cent minimum tick size imposed by the U.S. Securities and Exchange Commission’s Rule 612(c) of Regulation National Market Systems for traders prevents perfect neutralization and eliminates mutually agreeable trades at price levels within a tick. These frictions (i) create both scope and incentive for an operator to establish multiple exchanges that differ in fee structure in order to engage in second-degree price discrimination; and (ii) lead to mixed-strategy equilibria with positive profits for competing operators, rather than to zero-fee, zero-profit Bertrand equilibrium. Policy proposals that require exchanges to charge one side only or to divide the total fee equally between the two sides would lead to zero make and take fees, but the welfare effects of these two proposals are mixed under tick size constraints.
    This paper studies probabilistic selling with vertically differentiated products when firms compete and consumers anticipate the potential post-purchase regret raised by possibly obtaining the inferior products. Intuitively, anticipated regret hurts the attractiveness of probabilistic selling. However, we find that probabilistic selling can be more profitable, and more likely to arise with anticipated regret than without it. Anticipated regret depends on consumers¡¯ decision-making processes, which can be categorized into two types: (1) choose whether and what to buy concurrently (simultaneous process); (2) decide whether to buy before selecting a product (sequential process). When consumers anticipate regret in a simultaneous process, probabilistic selling does not lower the profit, and emerges when the product differentiation is intermediate. Moreover, it yields higher profits and arises more often in a sequential process with anticipated regret. That is due to the ¡°reverse quality discrimination¡± (perceived quality of the random product becomes non-increasing in consumer type), which increases the perceived differentiation at the competition margin, and maintains sufficient attractiveness of the random product for infra-marginal consumers. Meanwhile, it may hurt the competitor.
  Market Foreclosure and Welfare Under Monopolistic Second-Degree Price Discrimination. with Babu Nahata (Under Review)
  Compared to uniform pricing, second-degree price discrimination not only can result in a market foreclosure, but also such foreclosure can increase the total surplus. On the contrary, when all markets are served under second-degree price discrimination and at least one market will always be served with socially efficient quantity, the total surplus can still be lower.
  Pay-What-You-Want Pricing and Competition: Breaking the Bertrand the Bertrand Trap. with Jose Fernandez and Babu Nahata
    Under pay-what-you-want (PWYW) pricing, each consumer has total control over the price she wants to pay, which could potentially result in negative profits for the firm. In the standard Bertrand competition, two identical firms earn zero profits when they both charge the uniform price. We show that when one firm deviates and uses PWYW pricing, both firms could earn positive profits in equilibrium, breaking the so-called Bertrand trap. Although behavioral concerns are the driving factors for voluntary payments under PWYW, they may not always help the viability of PWYW pricing in the presence of competition.
  Nonlinear Pricing with Asymmetric Competition. with Guofu Tan and Adam Chi Leung Wong
  All-Units Discounts, Captive Demand, Foreclosure, and Inefficiency. with Guofu Tan