1. Dynamics of Pricing Rivalry
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.

2. 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

3. 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
There exists a basic differentiation in economics between the SR and the LR. Time frame matters.

4. 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
Both are models of staged behavior where you make an assumption about the action of the rival firm, then go forward maximizing your profits in the next period. Two major problem: (1) reduces the importance of time, and (2) focuses on SR profits.
The Bertrand Model, is price-based and the competitive process - though played out in discrete one-period segments - leads to the competitive outcome of P=MC or Zero Economic Profits.
The Cournot Model, is quantity-based and the competitive process - though played out in discrete one-period segments - leads to a price between the competitive outcome and the monopoly outcome.
Thus is not to reject the models outright - they are useful in explaining a number of phenomena. They are analytically powerful and useful for framing the effects of strategic commitment and tactical maneuvering.

5. 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
Static models maximize profits in the SR. Clearly this is a weakness - firm’s should be (and are) maximizing the NPV of the flow of profits over time.
We observe price equilibria above the competitive ideal (P=MC)

6. 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

7. 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
Worse than a zero-sum game! Potentially, both end up worse off.

8. 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

9. 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
Axelrod Study - tit-for-tat won the prisoner’s dilemma.

10. Tit-for-Tat Pricing with Many Firms
Condition for sustainable cooperative pricing
Explain in next slide
N = Number of firms M = Monopoly profit for the industry
i = Discount rate 0 = Prevailing profit for the industry

11. 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
Where firms act as rivals thy must take into account the actions and potential actions of rivals. If the condition holds, the monopoly cartel price will be the result.

12. 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
In other words, the one-time gain is to sufficient to offset he flow of profits which emanate from implicit collusion.

13. 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
How do the firms coordinate their pricing? Often it is illegal to explicitly do this.
The authors refer to the compelling, rational choice as a focal point.

14. 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
Focal points are influenced by laws, institutions, evolved practices and memory (among others.) Past behaviors and practices are codified as informal rules of engagement. They are highly context and/or situation specific.
Cartels and price collusion are well-served by any “ties that bind” (e.g., religion, kinship (Daryl, Daryl and Daryl!), geographic proximity, past contact, ethnicity, etc.)
Coordination attempts are more difficult where the industry is mature. Market growth slows and rivals begin to attempt to “steal” market share.
Coordination attempts are more difficult where the industry is evolving rapidly or competitive environment is changing rapidly.

15. 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
Under “grim trigger” the threat is an infinite price war - a Slash & Burn strategy. It too will create an equilibrium but it is an overreaction.

16. 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 predominates as a strategy because it is simple, effective and reversible. According to Axelrod, tit-for-tat provides the properties of “niceness, provocability, and forgiveness.”
FIND SMITH TMS QUOTE.

17. 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

18. 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
A single misread (a cooperative move read as an uncooperative move) leads to problems.

19. 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

20. 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
We will cover each in turn.

21. 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
The LH side of the equation rises as the number of firms falls.

22. 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
Intuitively, when there are a small number of firms each firm gets a larger share of the overall industry profits. Also, when the firm is large its ability to stake market share is limited by 100% - their market share.
Lastly, it is easier to come to an implicit agreement on focal point with smaller number of firms.

23. 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
The game speeds up as rivals can react more quickly. In the limit, if the price cut can be matched instantly then cooperative pricing is easier to maintain.

24. 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.

25. 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
Frequent interaction helps to set focal points and the implicit rules of competition.
In order to react to a change in price you have to know what price is. The posted price is not always the price.
Prices can change due to increased demand for the firms product, the industries product or even due to general price level inflation. Firms need to understand why prices are going up (or down) if they are going to use this information in a strategic fashion.

26. 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

27. 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

28. 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

29. 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
The secret gets out! Think about trying to keep a secret with one friend as opposed to thirty.
More buyers means more transactions and more opportunities for that “secret price cut” to make it back to your competitors. Think of how secretive the bid price of Windows was with the big hardware assemblers (Compac, Gateway and Dell)
Where buyers are few price cuts are more difficult to detect.

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

31. 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

32. 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

33. Asymmetries in Cost
Facing the same demand, each firm has a different profit maximizing price. If costs are relatively identical then the prices charged will tend to be relatively identical.

34. 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

35. 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
Yapping Dog Effect - its annoying but not too and it can’t really hurt me (and if I turn it into a “punt” dog, people will think I’m mean!) ;-)

36. 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

37. 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

38. 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

39. 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

40. 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
How does it inhibit competition? It makes it expensive to cut prices in the future. Suppose we agree to a retroactive clause to rebate back any price differential if we charge lower prices within some future time period. The cost of lowering price for us just went up.

41. 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 means “free on board.” It is the price at the loading dock with the buyer absorbing freight charges.
Uniform Delivered Price is where the price is quoted as charged to the buyer including delivery. This type of pricing facilitates cooperative pricing. These prices will vary to customers depending upon the costs of delivering to them specifically.
If two firms are going to compete, UDP prices allow selective price cutting whereas FOB pricing means cutting price to one cuts price to all.

42. 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

43. 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

44. 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)
Depending upon the costs of collecting information, it may be rational for an individual consumer to not collect “full and complete” information about a product.
Suppose you have a market where it is difficult or costly to to judge quality. Without considerable effort and expense, people cannot judge easily. This type of market may produce a “lemon market” - those who do have information about the product will feed the “lemons” to it and hold back the high quality items. Especially problematic where the purchase represents a large proportion of the budget and is bought relatively infrequently (used cars.)
To have a “lemon market “ outside of a used product market you need
(1) a group of informed consumers facing a group of informed consumers, and (2) lower costs to produce lower quality units and higher costs to produce higher quality units.

45. 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

46. 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
In contrast to management types economists find that quality is, alas, usually not free. If you are producing inefficiently, then you can simultaneously reduce costs and increase quality but if you are already efficient, quality is likely to have a positive cost. Managerial Literature (CQI - Continuous Quality Improvement)
This also flies in the face of diminishing returns.

47. 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

48. 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
The financial benefits come from new customers and existing customers who buy more. We might call these “marginal customers” Changes in quality are directed at attracting them.
In addition, they have to be able to distinguish that there has been a change in quality. Changes in quality are, often, in the eyes of the beholder. Does it matter if the change in quality is real or perceived? No, it can be completely subjective. My dad and Jack Gibson - Whisky Tasting!
Remember that horizontal differentiation refers to differences in the quality attributes of an essentially similar productm (e.g., Boar’s Head Deli meats vs. Publix Brand.)

49. 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!)

50. 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

51. Incremental Profit per Unit from Quality Increase
All else given, a seller with a higher price-cost 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