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Economics of Strategy Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright 2010 John Wiley Sons, Inc.

Chapter 10

The Dynamics of Pricing Rivalry

Besanko, Dranove, Shanley, and Schaefer

Dynamic Price Competition

Price competition can be viewed as a dynamic process

Decisions by a firm today will affect its behavior as well as its competitors’ in the future

Dynamic competition can also occur in non-price dimensions such as quality

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Dynamic versus Static Models

Dynamic models can address questions that static models cannot (Example: What determines the intensity of price competition?

What appears as short term profits (in a static model) are often followed by long term negative effects (in a dynamic model)

Cournot and Bertrand Models

Cournot and Bertrand models are static rather than dynamic models

These models look at one time reaction to rival’s move rather than all future opportunities and future behavior of the rival

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Dynamic Model Scenarios

Static models cannot explain how firms can maintain prices above competitive levels without formal collusion

In other situations, even a small number of firms are sufficient to produce intense price competition

Dynamic models are useful in exploring such situations

Convergence to a Cournot Equilibrium

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Cooperative Pricing

Cooperative pricing occurs if prices persist above competitive (Cournot or Bertrand) levels without formal collusion among the firms

Formal collusion is illegal in most countries

Cooperative Pricing

When there are a small number of sellers, each seller will recognize that the profit from price cutting will be short lived (Chamberlin)

The equilibrium result is the same as if there was explicit collusion to hold the prices above competitive levels

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Monopoly Price and Quantity

Tit-for-Tat Pricing

When two firms compete over several periods, a tit-for-tat strategy may make cooperative pricing possible

Since each firm knows that its rival will match any price cut, neither has an incentive to engage in price cutting

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Tit-for-Tat Pricing with Many Firms

Condition for sustainable cooperative pricing

N = Number of firms M = Monopoly profit for the industry

i = Discount rate 0 = Prevailing profit for the industry

Tit-for-Tat Pricing with Many Firms

The numerator is the annuity a firm will receive by cooperating

The denominator is the one time gain by not cooperating and inviting a tit-for-tat response from the rivals

When the condition is met, the present value of the annuity exceeds the one time gain from refusal to cooperate

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The “Folk Theorem”

In an infinitely repeated prisoners’ dilemma game, any price between the marginal cost and the monopoly price can be sustained if the discount rate is sufficiently small

A small discount rate makes the present value of the annuity from cooperative pricing larger and favors a cooperative outcome

Coordination Problem

While cooperative pricing is sustainable, the folk theorem does not rule out other equilibria

Achieving a desirable equilibrium out of many possible equilibria is a coordination problem

A cooperation inducing strategy that is also a compelling choice is a focal point

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Coordination in Practice

Round number price points will help with coordination

Even splits of the market (or status quo for market shares) is likely to be durable

Coordination easier with fewer products that are identical

Coordination in Practice

Conventions and traditions make rivals’ intentions transparent and help with coordination

Examples: Standard cycles for adjusting prices, using standard price points for price quotes

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Grim Trigger and Tit-for-Tat

Grim trigger strategy is to lower price to marginal cost indefinitely in response to rival’s price cutting in one period

In tit-for-tat, the response lasts for only one period and future responses depend on future actions of the rival

Both grim trigger and tit-for-tat are capable of sustaining cooperative pricing

The Superiority of Tit-for-Tat

Tit-for-tat is easy to communicate: “We will not be undersold,” “Lowest price guaranteed”

Easy to describe and easy to understand

Combines the properties of “niceness,” “provocability,” and “forgiveness”

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Evolution of Cooperation

In his book, The Evolution of Cooperation, Robert Axelrod describes a computer tournament of repeated prisoners’ dilemma

Tit-for-tat strategy had the highest combined scores across matches even though in any one match the strategy could at best tie another strategy

Tit-for-Tat and Misreads

When it is possible to misread rival’s move tit-for-tat may not perform as well as more forgiving strategies

A firm may be able to observe rival’s list price but not the effective price

A drop in the list price may be read as a price cut when effectively it may not be

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Tit-for-Tat and Misreads

A single misread will lead the firm to alternate between cooperative and non-cooperative moves

Any additional misreads can make the pattern of moves even worse

When there is a possibility of misreads, deferred response may be better than immediate response

Market Structure & Cooperative Pricing

Achieving cooperative pricing may depend on certain market structure conditions

Some examples are:

Concentration

Conditions that affect reaction speeds and detection lags

Asymmetries among firms

Price sensitivity of buyers

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Concentration & Cooperative Pricing

Cooperative pricing is more likely to happen in concentrated markets

In concentrated markets the revenue loss from a price cut is larger

Potential gain from new customers is smaller

The benefit to cost ratio tilts in favor of higher prices

Concentration and the Benefit to Cost Ratio

As N decreases, the right hand side of the inequality increases, making it easier for cooperative pricing to sustain

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Concentration and Cooperative Pricing

In a concentrated industry, the typical firm gets a larger share of the benefits of higher prices

The deviator’s short term gain is smaller since it started with a larger market share

Thus, the more concentrated the market, the larger the benefits from cooperation and the smaller the cost of cooperation

Targeted Price Reduction & Cooperative Pricing

With targeted price reduction it may seem that customers of rivals can be stolen without revenue loss

But targeted price reduction also enables rivals to retaliate surgically

Potential discounters may be discouraged and higher prices across the board may result

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Concentration and Cooperative Pricing

The more the firms there are the more difficult it will be to coordinate a focal strategy

The relationship between concentration and the sustainability of cooperative pricing is an important consideration for antitrust policy

Reaction Speed and Cooperative Pricing

As the speed with which a firm can respond to the rival’s moves increases, cooperative pricing becomes easier to sustain

If the price cuts can be matched instantaneously, cooperative pricing can be maintained for any discount rate

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Reaction Speed and Cooperative Pricing

As the time interval for the short term gain for the deviator is reduced, the present value of benefits from cooperation is more likely to exceed this short term gain

As the time interval goes to zero, so does i.

Determinants of Reaction Speed

Lag in detecting price changes

Frequency of interactions with the rival

Ambiguity regarding which rival is cutting prices

Inability to distinguish between price cuts by rivals and lower demand as the cause of drop in sales

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Relevant Structural Conditions

Lumpiness of orders

Information availability regarding sales transaction

The number of buyers

Volatility of demand conditions

Lumpiness of Orders

When orders are lumpy, the frequency of competitive interactions in reduced

Examples: Lumpy orders in airframe manufacturing, ship building

Lag between orders makes the gain from price cutting more valuable relative to the cost imposed by rival’s retaliation

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Availability of Information about Sales Transactions

Deviations from cooperative pricing is easier to detect when the transactions are public than when they are private

Example: Transaction prices for gasoline sales are easily observable while they are not easily observable for automobile sales

Availability of Information about Sales Transactions

Deviations from cooperative pricing are harder to detect when the products are custom made individual buyers than when they are standardized

Complex transactions may make misreadings more likely compared with simple transactions

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The Number of Buyers

When firms set prices in secret, deviation from cooperative pricing is easier to detect if there are many small buyers than when there are a few large buyers

With a large number of buyers, it is harder to do secret price cuts

Volatility of Demand

Price cutting is harder to detect when demand conditions are volatile and the firm can observe only its own volume of sales

Fall in demand can be misread as competitor cutting prices

With large fixed costs, monopoly price fluctuates a lot making coordination difficult

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Asymmetries among Firms & Coordination Problems

When firms are not identical cooperative pricing becomes more difficult

Firms differ in the incentives they face for cooperative pricing due to

Different costs

Different capacities

Different product qualities

Monopoly Prices with Asymmetrical Firms

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Asymmetries in Cost

The marginal costs are different for the firms and so are the monopoly prices preferred by each of the firms

Without a single monopoly price to serve as a focal point, coordination becomes difficult

Differences in product quality can create similar obstacles to coordination

Asymmetries in Capacity

Small firms have stronger incentives to defect from cooperative pricing than their larger rivals

Larger firms get a larger share of the benefits of cooperative pricing

Larger firms may have weak incentives to punish small deviators

Small firms have a large set of potential customers to attract by price cutting

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Rule of Thumb for Price Umbrellas

PCM

α = percentage loss in volume of sales by the large firm

β = percentage price cut by the small firm

PCM = percentage contribution margin

Rule of Thumb for Price Umbrellas: Illustration

PCM = 50%

β = 5%

α < 5/50 = 10%

If the percentage contribution margin is 50%, the

large firm need not retaliate as long as the 5%

cut in prices by the small firm does not take

away more than 10% of the large firm’s business.

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Buyer’s Price Sensitivity

Temptation to cut prices is more when buyers are very price sensitive

Horizontal differentiation reduces buyers’ price sensitivity and deters price cutting

Price sensitivity can vary across market segments.

Sustainability of cooperative pricing depends on the relative size of the price insensitive segment

Practices that Facilitate Cooperative Pricing

Firms can facilitate cooperative pricing by

Price leadership

Advance announcement of price changes

Most favored customer clauses

Uniform delivered pricing

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Price Leadership

The price leader in the industry announces price changes ahead of others and others match the leader’s price

The system of price leadership can break down if the leader does not retaliate if one of the follower firms defects

Two Kinds of Price Leadership

Some times, price leadership is barometric rather than oligopolistic.

Firms follow the price leader since they face the same market conditions as the price leader

Oligopolistic price leadership system may camouflage as barometric price leadership by firms taking turns to be the leader

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Advance Announcements of Price Changes

Advance announcement reduces the uncertainty that the rival will undercut the firm

Advance announcement also allows the firms to roll back the changes if the rival deviates from cooperative pricing

Most Favored Customer Clauses

Most favored customer clause allows the buyer to pay the lowest price charged by the seller

While this clause appears to benefit the buyer (a price cut to any one customer lowers the price for the most favored customer) it also inhibits price competition

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Uniform Delivered Pricing

When transportation costs are significant, pricing could be either

Uniform FOB pricing or

Uniform delivered pricing

With uniform delivered pricing, the response to price cutting can be “surgical” and effective in deterring defection from cooperative pricing

FOB Pricing

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Delivered Pricing

Facilitating Practices and Antitrust

Make pricing decisions unilaterally

Do not over-retaliate

Handle public communications on pricing with care

Use legitimate justifications for price increases and decreases

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Facilitating Practices and Antitrust

Limit the audience. Communicate with the customer directly.

Do not lecture competitors on the need to raise prices or the consequences of lowering prices

Keep analysis of competitive reaction private

Clear pricing tactics with an attorney

Quality Competition

Competition can occur on quality dimensions such as performance and durability

Quality competition can be less destructive than price competition

Industry price elasticity should be low for industry wide price increases (to cover the cost of quality) to be tolerated

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Quality and Price

When customers can fully evaluate the quality of the products, the price per unit of quality will be the same for all products

When customers are unable to evaluate quality

there could be underinvestment in information gathering

or

a lemons market may emerge

Free Riders and Underinvestment

If uninformed customers can learn by observing informed customers, (they are free riders) low quality producers will have to lower prices

Customers who gather information about quality will not benefit relative to customers who did not

There will be underinvestment in information gathering

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Lemons Market

If there are not enough informed customers uninformed customers cannot gauge quality by observing informed customers

Low quality producers will sell at the going prices, driving out the high quality producers (lemons market)

Demand Curves Associated with Different Quality Levels

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Quality and Demand

Demand is higher when quality is higher

Demand curve gets steeper as quality increases

The vertical distance between the demand curves is the consumers’ willingness to pay for incremental quality

Is Quality Really Free?

If a firm is inefficient in its production it can boost quality and reduce costs at the same time

If a firm is already producing efficiently, quality improvements will entail additional cost

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Benefits from Improved Quality

When a firm increases the quality of its products, the benefits received depend on two factors

Increase in demand due to increase in quality

Incremental profit per unit of additional sales

Increase in Demand due to Increase in Quality

When a firm raises the quality of its product, the demand will change only if

marginal customers are available and

customers can determine that quality has changed

Horizontal differentiation will create customer loyalty and reduce the availability of marginal customers

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Increase in Demand due to Increase in Quality

When customers cannot judge quality, independent evaluators may emerge (Consumer Reports, J. D. Powers Survey)

For some products, allowing the customer to experience the product (free samples, listening booths in record stores) may be a way to convey information about quality

Increase in Demand due to Increase in Quality

Even without customer loyalty, inability of the customers to judge quality will work against an increase in demand

Sellers may rely on easily observable attributes to communicate quality (marble floors in banks, diplomas displayed in doctors’ offices)

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Incremental Profit per Unit from Quality Increase

All else given, a seller with a higher price-cost margin is likely to benefit more from increased sales

A monopolist may have a high price-cost margin but few marginal customers

Similarly, horizontal differentiation can boost price-cost margins but lead to fewer marginal customers

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