Nonlinear pricing in an oligopoly market: The case of specialty coffee

Firms with market power and incomplete information about consumers' taste heterogeneity may use nonlinear prices to screen consumers by demand intensity. This practice of second-degree price discrimination may lead to firms to design the small (or lower quality) versions of their products to be “too small” relative to competitive benchmarks. Recent theoretical studies of nonlinear pricing have found that with sufficient competition these inefficiencies can disappear while still allowing for an oligopoly market structure and asymmetric information. This paper offers the first empirical study of these product design issues.; I conduct the empirical analysis with data from a specialty coffee market near the University of Virginia. Each coffee shop in the market employs a common form of nonlinear pricing—quantity discounting—for its coffee and espresso drinks, and the spatial dispersion of the shops permits market power through horizontal differentiation. I use data on product characteristics, sales, and consumer locations to estimate the parameters of a discrete-choice, random-coefficients structural utility model. The estimated demand model is then used with cost data to evaluate pricing and product design practices in the market. In order to test whether an observed product is significantly different from what would be offered in a competitive market, I compare consumers' marginal utilities from an increase in product size to the marginal cost of the increase.; I find that distortions in product design are close to zero in the most competitive portions of the market (the sale of regular coffee). Relatively large, positive distortions are calculated for some products over which the firms have market power. Inefficiencies generally decrease toward zero for the firms' products with the highest markups. This corresponds to the “no distortion at the top” result of the theoretical price discrimination literature. Tests of profit maximization and calculations of counterfactual price equilibria indicate that the firms' conduct in the observed market is similar to the outcome of collusion (joint profit maximization) by the firms.