Chapter 10 – Dynamics of Pricing Rivalry

Prof. Jepsen

ECO 610

Lecture 6

December 11, 2012

John Wiley and Sons

Outline

• Dynamic Pricing Rivalry

• How Market Structure Affects Sustainability of Coordinating Prices

• Facilitating Practices

Dynamic Price Competition

• Dynamic = over time (long run)

• Static = at a point in time (short run)

• Price competition can be viewed as a dynamic process

• Firm’s decisions today will affect its future behavior as well as its competitors’

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

Dynamic versus Static Models

• Dynamic models can capture aspects of real world competition that the static models cannot

• It is possible to incur short-term costs that are more than offset by long-term benefits (not captured in static models)

• It is also possible to see short-term profits (in a static model) followed by long-term negative effects

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

Dynamic Model Scenarios

• Static models do not 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

Cooperative Pricing

• Firms would rather have their prices at monopoly levels than what is achieved under Cournot or Bertrand competition

• Explicit collusion to maintain prices at monopoly levels is illegal in most countries

• Cooperative pricing occurs if prices persist above competitive levels without cooperative behavior from the firms

Cooperative Pricing

• When rivals expect to play for many periods, there may be incentives against price competition

• If one firm lowers the price, its market share may go up in the short run

• When the rival retaliates, the market share is back to the original level and the price is lower making both firms worse off

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

Tit-for-Tat Strategy - Example

• Consider two firms Exxon and Shell

• Both firms currently charge $40, but monopoly price is $60

• Prices change weekly

• Exxon tells Shell “We will not be undersold”

• Book shows how both firms benefit by raising prices to $60

Tit-for-Tat Strategy

• Tit-for-tat = each firm knows that its rival will match any price cut

• In this strategy, neither has an incentive to engage in price cutting

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

• “We will not be undersold!” may mean higher prices through cooperative pricing

Tit-for-Tat Pricing with Many Firms

• Firm cooperates if benefits outweigh costs

• Benefits of cooperating are receiving a higher price (and presumably equal market share) than in competitive market

• Cost of cooperating is the one-time gain from refusal to cooperate

– Example is gain in market share from refusing to raise price

Coordination in Practice

• Firms likely to choose round number price points

• Equal splits of the market likely to be durable

• Coordination is easier with fewer products that are identical

• Example: Standard cycles for adjusting prices

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”

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

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 and Cooperative Pricing

• Market structure aspects that may affect how easy it is to achieve cooperative pricing: – Concentration

– Conditions that affect reaction speeds and detection lags

– Relative structural conditions

– Asymmetries among firms

– Price sensitivity of buyers

Concentration and Cooperative Pricing

• Cooperative pricing is more likely to happen in a concentrated market than in a fragmented market

• Recall that as number of firms decreases, cooperative pricing is more likely to hold

• However, this logic fails when firms can target price reductions

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 costs of cooperation

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 more easily

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

Relevant Structural Conditions

• Lumpiness of orders

• Information availability regarding sales transaction

• The number of buyers

• Volatility of demand and cost conditions

Lumpiness of Orders

• When orders are lumpy, the frequency of competitive interactions is 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

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: gasoline (petrol) sales

• Such deviations are harder to detect when the products are custom made for individual buyers than when they are standardized – Example: automobile sales

• Complex transactions may make misreadings more likely compared with simple transactions

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

– Hard to keep all price cuts secret

Volatility of Demand

• Price cutting is harder to detect when demand conditions are volatile – Is change in market due to change in demand or

change in competitor’s behavior?

• When fixed costs are large, marginal cost declines rapidly with reduced output and monopoly price fluctuates a lot

• With large fixed costs, cooperative pricing is difficult

Asymmetries Among Firms and 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

Effect of Buyer’s Price Sensitivity

• Greater temptation to cut prices when buyers are very price sensitive

• Horizontal differentiation reduces buyers’ price sensitivity and deters price cutting

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

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

Advance Announcements of Price Changes

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

• Advance announcement also gives the firms time 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

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 targeted to customers in particular locations

– Deters defection from cooperative pricing

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

Quality and Price

• When customers are fully informed and are able to evaluate the quality of the products, the price per unit of quality will be the same for all products

• If customers are unable to evaluate quality

– A lemons market may emerge

– Free rider problem may lead to underinvestment in information gathering

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