Economics of Strategy

Economics of Strategy Besanko, Dranove and Shanley Chapter 9 Dynamics of Pricing Rivalry Slide show prepared by Richard PonArul California State University  John Wiley  Sons, Inc.

Dynamic Price Competition • Price competition should be viewed as a dynamic process where decisions by a firm today will affect • competitor behavior in the future • constraints and opportunities faced by the firm itself • 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 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

Cooperative Pricing • Firms would rather have their prices at monopoly levels relative to prices under Cournot, Bertrand, or pure competition • In most countries explicit collusion to maintain prices at monopoly levels is illegal • Cooperative pricing occurs if prices persist above competitive levels without explicit 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, their market share may go up in the short run but... • 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 • 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 • “We will not be undersold!” may mean higher prices through cooperative pricing

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

The “Folk Theorem” • In an infinitely repeated prisoners’ dilemma game, any price at or above marginal cost and at or below monopoly price can be sustained if the discount rate is sufficiently small • Small discount rate makes the present value of the annuity from cooperative pricing larger and favors a cooperative outcome

Coordination Problem • While Folk Theorem says that cooperative pricing is sustainable it 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

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

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”

Evolution of Cooperation • Robert Axelrod’s book “Evolution of Cooperation” 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

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 • Ease in achieving cooperative pricing may depend on certain aspects of market structure • e.g., • Concentration • Conditions that affect reaction speeds and detection lags • Asymmetries among firms

Market Concentration and Cooperative Pricing • Cooperative pricing is more likely to happen in a concentrated market than in a fragmented market • In the condition for sustainable cooperative pricing, as N decreases, the left-hand side of the inequality increases, making it easier for the condition to hold

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

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

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 • In the condition as the time interval goes to zero, so does i.

Determinants of Reaction Speed • Frequency of interactions with the rival • Availability of information about a rival’s price cut • Difficulty in distinguishing changes in volume of sales due to changes in demand as opposed to changes in rival’s price

Frequency of Interactions • When orders are lumpy, the frequency of competitive interactions in reduced • e.g.,: 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 • Increased frequency also tends to provide more information to all firms

Availability of Information about Rival’s Pricing • Deviations from cooperative pricing are easier to detect when the transactions are public • e.g.,: Transaction prices for gasoline sales are easily observable while they are not easily observable for automobile sales

Availability of Information about Rival’s Pricing • Deviations from cooperative pricing are harder to detect when the products are custom made for individual buyers than when they are standardized • Complex transactions make misreadings more likely relative to simple transactions

Availability of Information about Rival’s Pricing • When firms set prices in secret, deviation from cooperative pricing is easier to detect if there exist many small buyers • With a large number of buyers, it is harder to carry out secret price cuts

Volatility of Demand • Price cutting is harder to detect when demand conditions are volatile

Demand Volatility with Large Fixed Costs • When fixed costs are large, marginal cost decline more steeply and over a wider range of output. • This causes demand movements to have an exaggerated effect on price. • Hence, with large fixed costs cooperative pricing involves chasing a moving target

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

Asymmetries in Cost

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 (yapping dog effect) • Small firms have a large set of potential customers to attract by 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 they 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, the price leader may simply act a barometer of market conditions • Even without oligopolistic conditions, firms follow the price leader because they face the same changes in market conditions • Oligopolistic price leadership system may camouflage as barometric price leadership by firms taking turns being the leader

Advance Announcements of Price Changes • Advance announcement reduces the uncertainty that the rival will undercut the firm • Advance announcement also gives the firm the opportunity to roll back the changes if the rival does not match

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 “surgical” and effective in deterring defection from cooperative pricing

Quality Competition • Competition need not be in the price dimension alone • “Quality” can be a term that encapsulates all the non-price variables that increase the demand for the product at any given price

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

Market with Some Uninformed Customers • Some customers are informed and others are not • Uninformed customers cannot gauge quality by observing informed customers • Some low quality producers can sell at the going prices, driving out the high quality producers (lemons market)

Free Riders and Underinvestment • If uninformed customers can learn by observing informed customers, they are free riders • Customers who invest in information gathering will find that they are no better than those who did not make that investment • Leads 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 - quality is not free

Benefits from Improved Quality • When a firm increases the quality of its products, the benefits actually received depend on two factors • the increase in demand • the incremental profit per unit

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

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, clothes make the man (or woman!)

Increase in Demand due to Increase in Quality • When customers cannot judge quality, independent evaluators may emerge (Consumer Reports, J. D. Powers Survey, Moody’s Bond Ratings) • 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

Economics of Strategy