The Dynamics of Pricing Rivary

1
Chapter 9

• The Dynamics of Pricing Rivary

2
Issues and questions

• What conditions influence the intensity of price
  competition in a market?
• Why do firms in some markets seem to be able to
  coordinate their pricing behavior to avoid costly
  price ways, while in other markets intense price
  competition is the norm?

3
Issues and questions

• Why do price wars erupt in previously tranquil
  markets?
• What is the value, if any, of policies under
  which the firm commits to matching the prices its
  competitors charge?
• When should a firm match its rival price, and
  when should it go its own way?

4
Purposes

• This chapter introduces a set of models and
  analytical frameworks that can help us understand
  why firms compete as they do.
• We view price competition as a dynamic process,
  which implies that a firms decisions made at one
  point in time affect how competitors and itself
  will compete in the future.

5
Purposes

• This chapter also discusses nonprice competition,
  focusing in particular on competition with
  respect to product quality.
• We explore how market structure influences a
  firms incentive to choose its product quality

6
Why the Cournot and Bertrand models are not
dynamic

• In these two models, a firm chooses its quantity
  or price based on what its rival did in its
  previous move.
• Its reaction is the choice that maximizes its
  current profit.

7
Why the Cournot and Bertrand models are not
dynamic
Cournot equilibrium
8
Why the Cournot and Bertrand models are not
dynamic

• But an intelligent firm would take the long view
  and choose its quantity or price to maximize the
  present value of profits over its entire time
  horizon.
• To do this, its must anticipate what its rival
  will do in the future, not just naively react to
  what it has done in the past.

9
Why the Cournot and Bertrand models are not
dynamic

• Neither the Cournot and Bertrand models can fully
  explain why in certain highly concentrated
  oligopolies, firms can maintain prices above
  competitive levels without formal collusion and
  why in other comparably concentrated markets,
  price competition is often fierce.

10
Dynamic pricing rivalry intuition

• Firms would prefer prices to be closer to their
  monopoly levels than to the levels reached under
  Bertrand or Cournot competition.
• In a two-firm market, by colluding the two
  competitors could charge the monopoly price,
  which is violating the antitrust laws.

11
Dynamic pricing rivalry intuition

• Cooperative pricing is referred to situations in
  which firms can sustain prices in excess of those
  that would arise in a noncooperative single-shot
  price or quantity-setting game, such as Cournot
  or Bertrand.
• Is coopertive pricing achievable when firms make
  pricing decisions noncooperatively?

12
Dynamic pricing rivalry intuition

• Are there conditions under which a firm might not
  wish to undercut its rivals, either by lowering
  its price relative to theirs or refusing to go
  along when they increase their prices?
• Under these conditions, cooperative pricing is
  feasible. Without those conditions, cooperative
  pricing is difficult to achieve.

13
Dynamic pricing rivalry intuition

• We describe the benefits and costs confronting a
  firm that contemplates undercutting the prices of
  its competitors.
• We will identify market conditions that affect
  these benefits and costs.

14
Dynamic pricing rivalry intuition

• A firm that contemplates undercutting its rivals
  confront a tradeoff.
• It stands to reap a short-run or long-run
  increase in profits if the price reduction
  translates into an increase in market share.

15
Dynamic pricing rivalry intuition

• The firms rivals might respond by lowering their
  own prices, Once they do, the firm that initiated
  the price reduction could end up with no increase
  in market share, but with lower price-cost
  margins.

16
Competitor responses and Tit-for-Tat pricing

• Suppose two firms, A and B, are currently
  charging a price somewhere between the Bertrand
  price and the monopoly price.
• Suppose firm A is considering raising its price
  to the monopoly level.
• If firm B does not follow suit, it can capture
  100 percent of the market, which increases its
  profit that is higher than that when it follows
  suit the price increase.

17
Competitor responses and Tit-for-Tat pricing

• Although it is in the collective interest of both
  firms to charge the monopoly price, firm, B is
  better off undercutting firm As price if firm A
  raises its price to the monopoly level.

18
Competitor responses and Tit-for-Tat pricing

• Now suppose that prices can be changed every
  week, so firm A can rescind its price increase
  after one week if it sees that firm B does not
  follow suit to increase its price.
• Under this situation, firm As decision to raise
  price carries little risk, since firm A at most
  sacrifices one week profit.

19
Competitor responses and Tit-for-Tat pricing

• Not only is the risk to firm A low from raising
  its price, but it would see that firm B has a
  compelling motive to follow firm As price
  increase.
• Because firm B has much to gain by matching firm
  As price, and firm A loses little if firm B does
  not match, it makes sense for firm A to raise its
  price.

20
Competitor responses and Tit-for-Tat pricing

• Total profit of firm B if it does not follow suit
  firm As price increase
• U20101010
• Total profit of firm B if it follows suit firm
  As price increase
• M15151515
• M gt U

21
Competitor responses and Tit-for-Tat pricing

• If firm B behaves rationally, then it will behave
  the way firm A expects it to behave, and firm B
  will match firm As price increase.
• The outcome corresponds to the monopoly outcome
  even though neither firm colludes with each other.

22
Competitor responses and Tit-for-Tat pricing

• By following a policy of tit-for-tat, two firms
  might have avoided the costly price war.
• The tit-for-tat strategy is akin to a commitment
  by firms to its customers that we will not be
  undersold. so there is no incentive for either
  firm deviates its price from its rivals.

23
Competitor responses and Tit-for-Tat pricing

• The tit-for-tat strategy encourages firms to
  raise prices toward the monopoly level.
• This strategy also discourages firms from cutting
  price to steal business from competitors.

24
Case study Philip Morris versus B.A.T. in Costa
Rica

• At the beginning of the 1990s, two firms
  dominated the Costa Rican cigarette market
  Philip Morris, with 30 percent of the market, and
  B.A.T., with 70 percent of the market.
• Philip Morris had the leading brands in the
  premium and mid-priced segments. B.A.T. dominated
  the value-for-money (VFM) segment.

25
Case study Philip Morris versus B.A.T. in Costa
Rica

• By 1989, industry price-cost margins exceed 50
  percent. However, in the late 1980s, the market
  began to change.
• Health concerns slowed the demand for cigarettes
  in Costa Rica, a trend that hit the premium and
  mid-priced segments much harder than it did the
  VFM segment.
• Philip Morris faced the prospect of slow demand
  growth and a declining market share.

26
Case study Philip Morris versus B.A.T. in Costa
Rica

• On Saturday, January 16, 1993, Philip Morris
  reduce the prices of Marlboro and Derby
  cigarettes by 40 percent.

27
Market structure and sustainability of
cooperative pricing

• Pricing cooperation is harder to achieve under
  some market structure than others.
• Market structure conditions systematically
  influence the benefit and cost of pricing
  decisions.

28
Market structure and sustainability of
cooperative pricing

• We discuss the following market structure
  conditions that may facilitate or complicate the
  attainment of cooperative pricing and competitive
  stability
• Market concentration
• Structural conditions that affect reaction speeds
  and detection lags
• Asymmetries among firms

29
Market concentration

• Cooperative pricing is more likely to be an
  equilibrium in a concentrated market than in a
  fragmented market.
• In a concentrated market, captures a large
  fraction of the overall benefit when
  industry-wide prices go up.
• The temporary increase in profit the firm
  forsakes by not undercutting the rest of the
  market is smaller when the market is more
  concentrated.

30
Market concentration

• The more concentrated the market, the larger the
  benefits from cooperation, and the smaller the
  costs of cooperation.
• For firms to coordinate on tit-for-tat strategy,
  competitors must think alike.
• The more competitors in the market, the more
  difficult competitors would think alike.

31
Reaction speed and detection lags

• The speed with which firms can react to their
  rivals pricing moves also affects the
  sustainability of cooperative pricing.
• An increase in the speed of firms reaction will
  make cooperative pricing easier to attain.

32
Reaction speed and detection lags

• A firm may be unable to react quickly to its
  competitors pricing moves because
• (1) lags in detection competitors prices
• (2) infrequent interactions with competitors
• (3) ambiguities in identifying which firm among a
  group of firms in a market is cutting price.
• (4) difficulties distinguishing drops in volume
  due to price cutting by rivals from drops in
  volume due to unanticipated decreases in market
  demand.

33
Reaction speed and detection lags

• All of the above factors reduce the speed with
  which firms can respond to defection from
  cooperative pricing and thus reduce the
  effectiveness of retaliatory price cuts aimed at
  punishing price-cutting firms.

34
Structural conditions, Reaction speed and
detection lags

• Several structural conditions affect the
  importance of these factors
• Lumpiness of orders
• Information about sales transactions
• The number and size of buyers
• Volatility of demand and cost conditions

35
Lumpiness of orders

• Orders are lumpy when sales occur relatively
  infrequently in large batches as opposed to being
  smoothly distributed over the year.
• Lumpy orders reduce the frequency of competitive
  interactions between firms.
• Price becomes a more attractive weapon for
  individual firms.

36
Lumpiness of orders

• When firms obtain their businesses from bidding a
  contract, they are more likely to engage in an
  intensive price competition.
• It is because the gain from undercutting its
  rivals exceeds the future cost.

37
Information about the sales transaction

• When sales transactions are public, deviations
  from cooperative pricing are easier to detect
  than when prices are secret.
• Retaliation can occur more quickly when prices
  are public, price cutting to steal business from
  competitors is likely to be less attractive,
  enhancing the chances that cooperative pricing
  can be sustained.

38
Information about the sales transaction

• Firms can cut its net price by increasing trade
  allowances to retailers or by extending more
  favorable trade credit terms.
• It is more difficult for firms to monitor these
  deals than list prices, it is more difficult to
  detect business-stealing behavior, hindering
  their ability to retaliate.

39
Information about the sales transaction

• Each firm individually prefers to use secret
  prices to steal others businesses, but the
  industry is collectively worse off when all firms
  do so.

40
Information about the sales transaction

• Deviations from cooperative pricing are also
  difficult to detect when product attributes are
  customized to individual buyers.
• Secret or complex transaction terms can intensify
  price competition not only because price mating
  becomes a less effective deterrent to
  pricing-cutting behavior, but also because
  misreadings become more likely.

41
The number of buyers

• When firms normally set prices in secret,
  detecting deviations from cooperative pricing is
  easier when each firm sells to many buyers than
  when each sells to a few large buyers.
• A buyer that receives a price concession from one
  seller will often have an incentive to report the
  price cut to other sellers in an attempt to
  receive even more favorable concessions.

42
Volatility of demand conditions

• Price cutting is harder to detect when market
  demand conditions are volatile.
• IF a firms sales unexpectedly fall, is it
  because market demand has fallen or one of its
  competitors has cut price and is taking business
  from it?
• This problem is more serious when firms can not
  observe the rivals pricing.

43
Volatility of demand conditions

• Demand volatility is an especially serious
  problem when much of a firms costs are fixed.
• Marginal costs decline rapidly at output levels
  below capacity, and fluctuations in demand will
  ordinarily cause the monopoly price to fluctuate
  too.
• It is harder to coordinate on the monopoly price
  under this condition because firms are chasing a
  moving target.

44
Volatility of demand conditions

• When costs are mainly variable, the marginal cost
  function is nearly flat, and the monopoly price
  will not change too much as demand shifts back
  and forth.
• In addition, higher fixed costs induce a dramatic
  decline in the variable cost when output is
  higher. During times of excess capacity, the
  temptation to cut price to steal business can be
  high.

45
Asymmetries among firms

• When firms are not identical, either because they
  have different costs or are vertically
  differentiated, achieving cooperative pricing
  becomes more difficult.
• When firms differ, there is no single monopoly
  price, and it becomes more difficult for firms to
  coordinate their pricing strategies toward common
  objectives.

46
Asymmetries among firms

• Differences in costs, capacities, or product
  qualities also create asymmetric incentive for
  firms to agree to cooperative pricing, even when
  all firms can agree on the cooperative price.
• Small firms often have more incentive to defect
  from cooperative pricing than large firms.

47
Asymmetries among firms

• Small firms enjoy smaller benefits from
  cooperative pricing than large firms.
• Small firms may anticipate that large firms have
  weak incentives to punish a small firm that
  undercuts its price.
• Smaller firms have an additional incentive to
  lower price on products for which buyers make
  repeat purchases.

48
Case study firm asymmetries in the U.S. airline
industry

• When firms are different from each other, the
  expectation that competitors will instantly match
  a price cut may not deter certain firms from
  cutting prices aggressively.

49
Case study firm asymmetries in the U.S. airline
industry

• Robert Gertner has argued
• Low-quality or low-market-share firms may make
  themselves better off by defecting from collusive
  prices even though they fully anticipate that
  their high-quality or high-market-share rivals
  will match their price cuts right away.

50
Case study firm asymmetries in the U.S. airline
industry

• The 1992 fare war was the most vicious price war
  to hit the U.S. airline industry since it was
  deregulated in 1978.
• It was triggered by the Northwest Airliness
  promotion Kids Fly Free.
• It deepened the record losses the airline
  industry was suffering in the wake of the
  recession in 1990.

51
Case study firm asymmetries in the U.S. airline
industry

• Why did Northwest Airlines start a price war?
• Airlines receive information about their
  competitors fares instantaneously through a
  clearinghouse computer system run by the Airline
  Tariff Publishing Company (ATP).

52
Case study firm asymmetries in the U.S. airline
industry

• The theory suggests that a price cut would not
  increase its profit when relative market shares
  would not change and smaller margins resulted.
• But when firms are asymmetric, they will have
  different views about how high the price in the
  industry ought to be.

53
Case study firm asymmetries in the U.S. airline
industry

• In the early 1990s, Norwest had a poor route
  system, an inferior frequent-flier program, and a
  reputation for poor service.
• If Northwest competitors charged the monopoly
  price along particular routes, Northwest would
  get less business than its competitors.

54
Case study firm asymmetries in the U.S. airline
industry

• Under these conditions, Northwests best hope was
  probably to move the industry down the market
  demand curve through deep price cuts for two
  reasons.

55
Case study firm asymmetries in the U.S. airline
industry

• 1. The price cuts took place in the summer, so
  much of the additional traffic that they would
  generate would consist of discretionary vacation
  travelers. Northwests competitive disadvantages
  were minimized because different service
  qualities among airlines matter less to
  discretionary traverlers.

56
Case study firm asymmetries in the U.S. airline
industry

• 2. A disproportionate share of the additional
  traffic that is generated by the price cut will
  end up flying the poorer-quality airline, such as
  Northwest, simply because at equal prices, seats
  on the higher-quality carriers will sell out more
  quickly and cause a spill of traffic that only
  the less desirable carrier can serve.

57
Case study firm asymmetries in the U.S. airline
industry

• Northwest could fill its planes only by
  stimulating market demand, its incentive was to
  do so when demand was most price elastic. This
  occurs during the summer when there are more
  price-elastic leisure travelers.

58
Pricing discipline in the U.S. cigarette industry

• Cigarettes are one of the most highly
  concentrated industries in the American economy,
  with a four-firm concentration ratio of 0.93
  percent in 1992.
• The cigarette industry displayed remarkable
  pricing cooperation. Twice a year, the dominant
  firms would announce their intention to raise the
  list prices, and within days the other firms
  followed suit.

59
Pricing discipline in the U.S. cigarette industry

• The result was one of the most profitable
  industries in the American economy, with
  operating profit margins averaging close to 40
  percent throughout the 1980s.

60
Pricing discipline in the U.S. cigarette industry

• Liggett and Myers, the smallest of the six U.S.
  cigarette companies, did not benefit much from
  the industrys success in keeping prices high.
• It had the most to gain by undercutting their
  prices.
• In 1980, it launched discount cigarettes at
  prices 30 percent below branded cigarettes.

61
Pricing discipline in the U.S. cigarette industry

• By 1984, its share of overall cigarette sales had
  tripled, largely by virtue of its success in the
  discount cigarette business.
• Liggett gambled that the discount market was a
  niche that its larger competitors would ignore.
• However it failed to anticipate how discount
  cigarettes would affect the demand for premium
  brands.

62
Pricing discipline in the U.S. cigarette industry

• Other larger cigarette companies introduced their
  own discount cigarettes and undercut Liggetts
  price.
• BY 1989, Liggetts share of the discount
  cigarette market had fallen from nearly 90
  percent to under 15 percent.

63
Pricing discipline in the U.S. cigarette industry

• In the early 1990s, Liggett introduced
  deep-discount cigarettes that sell for prices 30
  percent below those of the discount brands.
• Other manufacturers also began selling their
  deep-discount brands.
• By 1992, the domestic business could be divided
  into three clearly defined segments a premium
  segment, a discount tier, and the deep-discount
  tier.

64
Pricing discipline in the U.S. cigarette industry

• The emergence of a segmented market has
  complicated pricing coordination.
• Competitors must now coordinate an entire
  structures of prices, rather than just one.
• Low prices in the discount and deep-discount
  segments had eroded the premium market share.

65
Pricing discipline in the U.S. cigarette industry

• Philip Morris decided to cut the price of its
  flagship brand Marlboro by 20 percent on Friday,
  April 3, 1993.
• This decision was quickly matched by other
  competitors.
• In the aftermath of Marlboro Friday, pricing
  discipline seems to have returned to the
  cigarette business.

66
Facilitating practices

• Firms themselves can also facilitate cooperative
  pricing by
• Price leadership
• Advanced announcement of price changes
• Most favored customer clauses
• Uniform delivered pricing

67
Facilitating practices

• These practices either facilitate coordination
  among firms or diminish their incentive to cut
  price.

68
Price leadership

• One firm in an industry announces its price
  changes before all other firms, which then match
  the leaders price.
• Each firm gives up its pricing autonomy and cedes
  control over industry pricing to a single firm.

69
Oligopolistic price leadership vs. barometric
price leadership

• Under barometric price leadership, the price
  leader merely acts as a barometer of changes in
  market conditions by adjusting prices to shifts
  in demand or input prices.
• Under barometric price leadership, different
  firms are often price leaders, under
  oligopolistic leadership, the same firm is the
  leader for years.

70
Advance announcement of price changes

• Firms will publicly announce the prices they
  intend to charge in the future.
• Advance announcements of price changes reduce the
  uncertainty that firms rivals will undercut
  them.
• The practice also allows firms to rescind or roll
  back proposed price increases that competitors
  refuse to follow.

71
Most favored customer clauses

• A most favored customer clause is a provision in
  a sales contract that promises a buyer that it
  will pay the lowest price the seller charges.
• Two basic types contemporaneous and retroactive.

72
Contemporaneous most favored customer clauses

• If while this contract is in effect, the seller
  sells the product at a lower price to any other
  buyers, it will agree to lower the price to this
  level for a particular buyer.

73
Retroactive most favored customer clauses

• The seller agrees to pay a rebate to the current
  buyer if during a certain period after the
  contract has expired, it sells the product for a
  lower price than the current buyer paid.

74
Most favored customer clauses

• Most favored customer clauses appear to benefit
  buyers.
• It helps keep the buyers production costs in
  line with those of competitors.
• It can inhibit price competition. Retroactive
  most favored customer clauses make it expensive
  for the seller to cut prices in the future,
  either selectively or across the board.

75
Most favored customer clauses

• Contemporaneous most favored customer clauses do
  not penalize the seller for making
  across-the-board price reductions, but they
  discourage the seller from using selective price
  cutting to compete for customers with highly
  price-elastic demands.

76
Most favored customer clauses

• Thomas Cooper has shown that because adopting a
  retroactive most favored customer clause softens
  price competition in the future, oligopolists may
  have an incentive to adopt the policy
  unilaterally, even if rivals do not.

77
Uniform delivered prices

• In many industries, buyers and sellers are
  geographically separated, and transportation
  costs are a significant.
• Pricing method can affect competitive
  interactions.

78
Uniform FOB (free on board) pricing

• The FOB price is the seller quotes for loading
  the product on the delivery vehicle.
• The seller quotes a price for pickup at the
  sellers loading dock, and the buyer absorbs the
  freight charges for shipping from the sellers
  plant to the buyers plant.

79
Uniform delivered pricing

• The seller quotes a single delivered price for
  all buyers and absorbs any freight charges
  itself.
• It facilitates cooperative pricing by allowing
  sellers to make a more surgical response to price
  cutting by rivals.

80
Uniform delivered pricing

• If one firm reduces the price for one particular
  location, the rival intends to retaliate by also
  reducing its price
• For uniform FOB pricing, the rival has to reduce
  its net mill price ( the price the seller
  actually receives), which effectively reduces its
  price to all its customers.

81
Uniform delivered pricing

• Under uniform delivered pricing, the rival could
  cut its price selectively. It could cut the
  delivered price to its customers where it is
  undercut, and keep delivered prices of other
  customers at their original level.

82
Uniform delivered pricing

• By reducing the cost that the rival incurs by
  retaliating, retaliation becomes more likely, and
  enhances the credibility of policies, such as
  tit-for-tat, that can sustain cooperative pricing.

83
Quality competition

• Firms can compete on product attributes to
  attract customers. This competition is generally
  called quality competition.
• We lump all nonprice attributes into a single
  dimension called quality, any attribute that
  increases the demand for the product at a fixed
  price.

84
Quality competition

• We focus on how market structure and competition
  influence the firms choice of quality

85
Quality choice in competitive markets

• Firms may offer different levels of quality at
  different prices.
• The market will force all firms to charge the
  same price per unit of quality if the customers
  are able to perfectly evaluate the quality of
  each seller.
• If customers cannot easily evaluate the quality,
  then sellers that charge more than the going
  price per unit of quality may still have
  customers.

86
Quality choice in competitive markets

• In a market, there are some consumers that have
  information about product quality and others that
  do not.
• Uninformed consumers may be able to infer the
  quality of sellers merely by observing the
  behavior of informed consumers.

87
Quality choice in competitive markets

• If uninformed consumers cannot gauge quality by
  observing informed consumers, then a lemons
  market can emerge.
• In this market, only the low-quality products
  will be offered because consumers are only
  willing to pay low prices for products.

88
Quality choice in competitive markets

• Some consumers might spend sources gathering
  information, but if uninformed consumers can
  infer what that information is, all consumers may
  end up on an even footing.
• As a result, those who gathered the information
  may by worse off than those who did not.
• There will be underinvestment in information
  gathering.

89
Quality choices of sellers with market power

• The seller with market power should choose
  quality so that the marginal cost of the quality
  increase equals the marginal revenue that results
  when consumers demand more of the product.

90
Marginal cost of improving quality

• If a firm is producing efficiently, quality is
  costly.
• Improvements tend to be incrementally more costly
  as quality nears perfection.

91
Marginal benefit of improving quality

• When a firm improves the quality of its product,
  more consumers will want to buy it. The increase
  in revenue depends on two factors
• The increase in demand caused by the increase in
  quality
• The incremental profit earned on each additional
  unit sold

92
Marginal benefit of improving quality

• When contemplating an increase in quality, the
  firm must consider the responsiveness of its
  marginal consumers, consumers who are indifferent
  among buying from that firm and buying elsewhere.
• The financial benefits from an increase in
  quality stems from new customers.

93
Marginal benefit of improving quality

• An increase in quality will bring in more new
  customers if
• There are more marginal customers
• Marginal customers can determine that quality
  has, in fact, increased
• These two factors are determined by the degree of
  horizontal differentiation and the precision with
  which consumers observe quality.

94
Horizontal differentiation

• Horizontal differentiation creates loyalty of
  consumers to certain sellers.
• When consumers are loyal to their current
  sellers, a seller that boosts quality will not
  necessarily attract new customers.

95
The precision with which consumers observe quality

• When consumers have difficulty judging particular
  attributes of a product, they may focus on those
  attributes that they can easily observe and
  evaluate.
• Conveying quality information is especially
  critical for goods and services whose quality is
  difficult to evaluate before purchase.

96
Marginal benefit of improving quality

• All else being equal, the seller with the higher
  price-cost margin will make more money from the
  increase in sales and has a stronger incentive to
  boost quality.

97
Marginal benefit of improving quality

• Horizontal differentiation has offsetting
  implication for incentives to boost quality.
• Horizontal differentiation creates loyal
  customers, which allows sellers to boost
  price-cost margins, raising the gains from
  attracting more customers by boosting quality.

98
Marginal benefit of improving quality

• Loyal customers are less likely to switch sellers
  when quality differences are low, implying that
  each sellers faces fewer marginal customers.