Competitive Oligopolistic Pricing

Transcription

1 Competitive Oligopolistic Pricing ROBERT L. KNOX Do oligopolistic industries evolve a pricing pattern which is inimical to consumer welfare? In this article, pricing policies in a major American industry are examined in the light of orthodox analysis. The results shed some light on the relevance of oligopolistic pricing theory in judging the competitiveness of certain industrial markets. /7*o' of. Marketing, VoL 30 (July, 1966), pp ~. A N oligopolistic industry, one in which several large and power- -^*- ful firms dominate the market, is usually characterized by parallel behavior. This could be against the best interests of the consumer, however, especially in the area of pricing. For example, if a few large manufacturers, responsible for the entire output of an essential product, were able to agree on prices, the public interest would not be served. Such collusion, either overt or tacit, appears relatively easy to organize in oligopoly. But in reality, pricing is not that simple, as can be seen in the domestic rubber-tire industry, whose market structure is clearly oligopolistic. Although 15 firms currently produce automotive tires, from 75 to 80% of industry output is controlled by 5 large firms, 4 of them located in the same city. Since 1925, the story of the tire industry has been one of exit, not entry. From a high in that year of 71 producers, the market has dwindled to just 15 firms. No new firm has been established since 1938, and 6 firms have left the industry since The rubber tire does not compete with other products in the functional sense; consequently, there is no inter-industry competition through cross-elasticities of demand. Since the demand for tires is derived from the need to use the automobile, buyers cannot be induced to buy more or less of the product in any significant sense through price changes. Moreover, rising levels of national income do not normally lead buyers to stock up on tires; and so total market demand is relatively price and income inelastic. Within the total market, however, there are varying degrees of price elasticity in the various market segments, a fact which makes for considerable differences among sellers with respect to their overall commitment to tire production for all markets. The recognized submarkets include: (1) the Original Equipment market, for which tires are supplied to vehicle manufacturers as components; (2) the Replacement market, which is broken down into markets for factory brands, subsidiary brands, and distributor brands; and (3) the Government market, including federal, state, and local purchasing. Cross-elasticity of demand among the large firms in these submarkets is quite high, particularly in the original equipment and government markets. The market position of the smaller sellers is. somewhat differentiated from that of the major producers, but among themselves they face relatively elastic demand curves. Tire production and distribution require a scale of plant in which fixed costs are moderately heavy, at least great enough to necessitate volume selling. 47

2 48 Journal of Marketing, July, 1966 However, the most efficient scale of plant can be achieved at a rate of output which accounts for only 2 to 3% of the total market for tires.^ Barriers to entry are relatively high, buttressed principally by a long-established system of dealer relationships, company stores, and technology. Inasmuch as tires must be placed before the consumer in volume, a strong and heterogeneous system of distribution is the foundation of market success. These characteristics bring up the possibility of little or no price competition. The dominant firms should be able to raise price above the competitive level, with concomitant problems of consumer exploitation, profiteering, and other manifestations of market power. Moreover, as in most oligopolies, they should have little to fear, competition-wise, from the remaining smaller firms. In short, the market structure of the tire industry portends a situation tailor-made for parallel behavior at the expense of efficiency and growth. Yet an examination of industry pricing policies reveals that powerful market forces are constantly operating to prevent this type of parallel behavior. Absence of antitrust activity suggests that overt or tacit collusion on price, the latter enforced through price leadership, have not emerged in any significant degree for years. Also, the basic heterogeneity of the tire producers themselves based principally on the fact that they differ as to the extent to which tires constitute their major profit plus the fact that they differ on the extent to which they participate in the three submarkets, tend to produce competitive price behavior. How Prices Are Determined Many years ago a noted economist stated that "the theory of oligopoly is a ticket of admission to institutional economics."^ Liberally interpreted, this meant that students of the oligopoly problem must always be ready to support their theoretical generalizations and predictions with extensive investigation of actual industry behavior. In recent years this has resulted in the need to obtain first-hand information from individuals closely connected with the decision-making process within the firms of the industry. Armed with a knowledge of pricing theory, the researcher knows what questions to ask and how to evaluate the responses. In the present study of pricing in the rubber-tire industry, interviews were with executives in several large tire companies with authority in the pricing decision. Similar talks were held with executives in a medium-size and small tire company. 1 Joe S. Bain, Barriers to New Competition (Cambridge: Harvard University Press, 1957), p Edward S. Mason, "Price and Production Policies of Large-scale Enterprise," Am.erican Economic Review, Vol. 29 supplement (March, 1939), pp , at p. 65. The large firms were well diversified; the smaller firms were almost wholly committed to tire production for their sales revenue. Also, talks were held with economists and lawyers in the federal antitrust agencies. Finally, the tire industry's pricing practices were discussed with several academicians concerned with the problem. General Pricing Decision Total industry demand is derived from the demand for automotive vehicles, both new and used. However, the bulk of industry demand comes from buyers who wish to replace tires that are worn out due to prolonged use of the vehicle. New vehicle production plus the number of vehicles in use establishes the basis for price determination in the various market segments. A firm's historical market share is applied to total demand, and some percentage over that is set as a goal. A price and discount structure based on costs of production is established to reflect this target market share. Because of the emphasis on volume, prices are initially set or reviewed annually to yield a return on investment which is thought to he realistic in terms of the contemplated market share. This realism is largely a product of judging the real and imagined pricing strategies of major competitors. If at any time throughout the sales year realized market share falls short of contemplated market share by as much as one-fourth, serious consideration is given to making changes in the formal price structure, either by altering the discount structure to dealers or by making concessions to large buyers. If these concessions are handled adroitly and are not excessive, a firm can often obtain additional volume without precipitating countermoves by rivals. Discount Structure The tire industry is characterized by an intricate system of quoted prices and discounts which reflect attempts at product differentiation and also reflect the many types and sizes of buyers and buying organizations. Each tire firm calculates and announces a formal price structure which provides for geographically uniform retail price lists to various distributive levels. The formal list is then subjected to a set ABOUT THE AUTHOR. Robert L Knox is Associate Professor of Economics, College of Business Administration, Arizona State University. He has also taught at the College of William and Mary. A graduate of Oklahoma State University, the author received his Ph.D. in Economies from the University of North Carolina.

3 Competitive Oligopolistic Pricing of discounts.3 This formal price structure represents the maximum price plan of the producer, and consists of a retail price list and a series of quantity, cumulative volume, service, and cash discounts. Since the hulk of replacement market output is marketed through dealers, most of whom are small and hence exert little or no countervailing buying power, tire producers are able to make unilateral changes in the discount structure for replacement market tires. This means that retail prices are not meaningful evidence of price behavior; manufacturers' prices are the important ones for study. The manufacturer's price is designed to cover factory costs of production, certain assigned selling and administrative costs, and yield a profit margin which can be looked upon as a "reasonable" return on standard costs, taking into consideration the multiplicity of discounts that are built into the formal price structure. Because of the plethora of brands, sizes, and quality levels of tires, there is a wide variety of manufacturers' prices; but all are subject to the same type of discount structure, including quantity, cumulative volume, service, and cash discounts. By altering the discount structure, any tire manufacturer can match or cut below a competitor's wholesale price for any given size and quality level. Therefore, the discount structure is designed to refiect the overall competitive position of the firm, and there is likely to he considerable difference between the maximum announced list price and what the manufacturer actually receives after discounting. Firms whose products have poor brand positions are forced into a much more liberal discount structure in order to secure favorable distributive outlets. The narrowing of the margin between actual realizations and costs accruing to the smaller tire producers, coupled with their almost total commitment to the production and sale of tires and their weaker distribution systems, places many of them at a disadvantage in the replacement market for factory-branded tires. Consequently, they have moved aggressively into private label production. Full-cost Pricing Because of the nature of discounting, the theory of full-cost pricing is not relevant to the tire industry.-* Full-cost pricing includes some allowance or markup over standard cost to provide for profit. However, the utilization of a rigid full-cost pricing formula requires certain necessary conditions. For an example, see U. S. Congress, Senate, Select Committee on Small Business, "Dual Distribution in the Automotive Tire Industry 1959," Hearings, Part I (Washington, D.C.: U. S. Government Printing Office, 1959), p. 20. * A discussion of this theory and other cost-price concepts can be found in Alfred R. Oxenfeldt, Pricing for Marketing Executives (San Francisco: Wadsworth Publishing Co., 1961), Chapter 2. First, raw materials prices must be relatively stable. Although vertical integration, coupled with the growing importance of synthetic rubber, has mitigated this problem, short-term fluctuations in the price of natural rubber create some instability in the realized price structure. Second, the level of operations must be fairly predictable. The largest tire firms, which might be expected to exert a dominant influence on pricing, are heavily involved in original equipment sales. This derived demand is dependent upon the level of general economic activity and therefore complicates the leveling out of operations on a cyclical basis. Finally, idle capacity must not crop up regularly. This might force producers into price-cutting and secret concessions to obtain additional orders. The problem of idle capacity has been especially troublesome to the tire industry and has been the major factor precluding a rigid, full-cost pricing approach. This is not to say that tire producers do not price at standard cost. So long as the possibility of changes in realizations due to changes in the level of demand is present, a modified form of full-cost pricing is possible. A flexible system of full-cost pricing explicitly recognizes the elasticity of demand, and realizations depend upon market conditions. Price Discrimination The presence of large and powerful buyers in the original-equipment and private-label markets present the possibility of discriminatory pricing between these markets and the replacement market for factory brands. Conventional price theory would treat price discrimination imposed on these markets as an attempt by sellers to equate the incremental revenue obtained from each market with the incremental cost of the total output in all markets." However, this profit-maximizing price is not determinate in practice. Only certain limits can be approximated. Original Equipment Market In the original equipment market the upper limit, in the long run, would be set by the price at which it would be cheaper for the automobile manufacturer to produce its own tires or to subsidize plant expansion by one of the smaller tire firms to produce the automobile company's private label. Theoretically, the lower limit would be governed by the maximizing conditions stated above, as long as variable costs were being covered. How are original equipment prices actually determined? After carefully estimating the possible quantities that will be taken by their automobile company customers, original equipment suppliers adopt an arbitrary procedure of cost allocation, based on the assumption that average total costs 5 Richard H. Leftwich, The Price System and Resource Allocation (New York: Holt, Rinehart and Winston, third edition, 1966), pp

4 50 Journal of Marketing, July, !? 'Z~ decrease as total output increases up to the point of capacity. They treat original equipment sales as a means of spreading the overhead and will accept prices on these sales down to the point where variable costs are barely covered. In fact, they might even supply at a price below variable costs to retain a large contract which might otherwise go to a competitor who could then lower his average costs of production for his total output in all markets. Lack of recognized interdependence among original equipment suppliers would set the price floor in the short run. Private-label Market In the private-label market manufacturers attempt to earn a small margin over manufacturing cost, which includes factory cost, administrative and selling expenses related to obtaining the contracts, warehouse and shipping expenses, and cost of adjustments on defective tires. The profit margin is usually between 5 and 7%. However, most private label contracts provide for price adjustments to refiect any change in direct costs. Therefore, these prices respond rather quickly to cost changes. Price discrimination in the private-label market is not a unilateral profit-maximizing decision on the part of the tire manufacturers. It must be remembered that manufacturers' factory brands are in competition with private-label brands at the retail level. This means that tire firms supplying large private label buyers are not anxious to contribute to a widening spread between their own brands and those of private label competitors at retail. Prices are largely determined by the bargaining strength of large buyers who are relatively immune to the factory brand preference built up over the years by selling outlays of the larger tire producers. Even if prices to private label sellers are lower than the manufacturers' factory brands of identical quality by more than the actual differences in full costs, the fact that the recipients of this favorable price compete directly with the grantor effectively impedes the attempt by the tire manufacturers to enforce higher prices for their factory brands. Moreover, the fact that all large buyers generally receive the same terms of sale from a variety of tire suppliers means that in the absence of collusion they face competition among themselves at announced selling prices, even if they are below prices of factory brands. The retail price differential between private-label and factory-brand tires is about 10 to 20%, with the lesser-known private labels such as those of department stores carrying the largest spread. However, the prices actually obtained at retail for leading private-label brands are very close to those prices obtained by brands of the smaller producers of tires. Price Leadership Formally announced list prices of tires of identical quality and enjoying comparable sales positions are virtually identical. Actually there is a zone within which these tires are priced, and no manufacturer will permit his comparable product to be priced outside this zone. The differences are so slight, however, that the replacement market buyer acts as if the prices were the same. Furthermore, tire prices move in parallel fashion. Is price leadership, therefore, a method of imposing a non-competitive price on individual consumers in the replacement market? The heterogeneous nature of the tire industry, illustrated by the differentiated commitment to tires by different producers, plus different sales programs, precludes the emergence of a "dominant firm" form of price leadership. In theory, the dominant firm establishes an administered price and permits all other sellers to dispose of their entire output at that price, covering the remainder of market demand itself.e In practice, however, no one single firm is willing to provide the "umbrella" under which competition could grow, permitting smaller firms to capture an increasing share of the market. What about the possibility of a form of "barometric price leadership" where the leader has the responsibility of recognizing changes in cost and demand conditions and translating them into price changes, but with no real power to enforce monopoly prices? Once again, basic firm heterogeneity, augmented by lack of any appreciable growth in the replacement market for tires, has prevented any one firm from assuming this role. Price Leader's Decision The orientation of any price leader's decision not only is lateral but also vertical, in the sense that he must consider possible reactions from his competitors and also possible actions of individual large buyers in particular submarkets. An illustration would be the price of the 100-leveI tire, the basis of sales to automobile manufacturers and hence the foundation of the entire price structure. Original equipment tire suppliers could not raise the price of this tire to dealers without a corresponding increase in the price to Detroit, assuming the price increase were made for some rise in average costs. Not to do so would subject them to a charge of economic price discrimination and a possible Robinson-Patman Act violation. Correspondingly, for the same reason they could not lower prices to dealers without an equivalent cut to automobile manufacturers. Moreover, ag- ^ The original formulation is found in George J. Stigler, "The Kinky Oligopoly Demand Curve and Rigid Prices," Journal of Political Economy, Vol. 55 (October, 1947), pp , at pp

5 Competitive Oligopolistic Pricing gressive buying from Detroit would undoubtedly uncover any price differences. Therefore, the largest producers are reluctant to change the price of their 100-level tires, and this quality level has always served as the basis of the formal price structure. An alteration in its price would necessitate a complete remaking of the formal price structure at all levels. In an oligopolistic market, conventional wisdom suggests that a firm should not test the market discipline too often by making frequent and haphazard price changes. Changes should occur only at a customary time and be based on clearly recognizable factors which will insure that all firms will accept the move. Formal price changes in the tire industry follow this wisdom, and when made overtly are an industry matter, although in recent years price leads have not always been followed. Despite the fact that most price changes are made by the four largest producers, is this price leadership in the real sense? For a given level of aggregate demand, a move by one of the smaller producers to lower prices for some reason not explainable by cost factors would be interpreted by the industry as an aggressive act designed to increase market share. Hence, the cuts would surely be matched by the larger firms, with the possibility of undercutting. But if market demand were growing rapidly, the smaller firms might take a larger share of the business through price competition without provoking retaliation from more powerful rivals whose markets are also expanding. Conversely, a price increase by a smaller firm would run the risk of not being followed, and the result would be a drastic loss of market position, particularly if the small firm's factory brand did not have widespread acceptance. Market maneuvering in the tire industry is based on a fundamental criterion: if an initial pricing move by one firm is neutralized by the countermoves of rivals, further pricing maneuvers can still be made. Therefore, a price cut, unless supported by some external factor common to the entire industry, is a poor maneuver. The same is true of a price increase, although financially it is always easier to retreat from a higher price, since distributors are g'lad to receive a rebate on their inventory. What conditions offer the appropriate environment for a price cut to be followed? The basic criterion is a drop in variable costs, particularly in the price of new materials. This is refiected almost immediately on the lower-priced elements in the tire market, namely the private-label buyers who purchase tires on a cost-plus contract. The private-label buyers who receive the bulk of their tires from smaller producers who have short Inventory positions in natural rubber will almost immediately begin receiving tires at lower prices. Consequently, they are in a position to lower their ovni retail prices. Smaller producers will also grant price concessions to distributors in order to remain competitive with the mass distributing organizations. In the absence of collusion, the larger producers will finally be forced to participate in the price cutting. Initially they may act by way of the price concession route to their distributors, who will be feeling the pressure of the private label suppliers and the smaller producers. Eventually they will announce a formal price cut, which merely recognizes a situation already existing in the market. The firm that finally initiates the formal price change can hardly be called a price leader. Positions are reversed with respect to a price increase. Rising direct costs fall more heavily on smaller producers and private label buyers. Therefore, they are always ready for a price increase. However, because of the historical price differential between well - advertised and lesser - known brands, these firms cannot lead the increase. They must wait for the larger producers. Because of the recognized interdependence in firm decision-making, confidence is built that a price increase will be followed. Once the announcement is made, distributors will begin to step up orders to obtain inventory at lower prices. Consequently, other firms will generally follow a price increase quickly to avoid being saddled with large orders at the old and lower price. Implications Despite the clearly oligopolistic character of the rubber tire industry, price behavior does not refiect the monopolistic connotation usually associated with competition among the few. The intricate system of discounts and concessions enables and even forces the tire producers to make a finer adaptation to demand than would be the case if a rigid pricing policy enforced by tacit collusion were adopted. In general, tire firms set prices which refiect competitive conditions. The market power of the larger producers is effectively blunted in major submarkets by the countervailing force of large buyers, including automobile manufacturers, private label buyers, and other mass-distributing organizations. There is little evidence of purposive price discrimination on the part of the tire producers. When contemplating a price change, the individual firm must take into account a number of both horizontal and vertical forces in the several submarkets, thus precluding the possibility of any enforced understanding among the tire oligopolists. Market forces have not permitted an abdication of price competition in the tire industry. In other words, pricing policy does not completely reflect the results anticipated under models of perfect competition; but apparently it does yield a type of behavior not adverse to consumer interest. 51

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