Economics of Strategy Fifth Edition. The Dynamics of Pricing Rivalry

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1 Economics of Strategy Fifth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 10 The Dynamics of Pricing Rivalry Slides by: Richard Ponarul, California State University, Chico Copyright 2010 John Wiley Sons, Inc. 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 nonprice dimensions such as quality 1

2 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 2

3 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 3

4 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 4

5 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 5

6 Tit-for-Tat Pricing with Many Firms Condition for sustainable cooperative pricing N = Number of firms i = Discount rate M = Monopoly profit for the industry 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 6

7 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 7

8 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 8

9 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 9

10 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 10

11 Tit-for-Tat and Misreads A single misread will lead the firm to alternate between cooperative and noncooperative 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 11

12 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 12

13 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 13

14 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 14

15 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 15

16 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 16

17 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 17

18 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 18

19 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 19

20 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 20

21 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. 21

22 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 22

23 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 23

24 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 24

25 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 25

26 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 26

27 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 27

28 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 28

29 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 29

30 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 30

31 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 31

32 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) 32

33 Incremental Profit per Unit from Quality Increase All else given, a seller with a higher pricecost 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 Copyright 2010 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the1976 United States Copyright Act without express permission from the copyright owner is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. 33