THE DINAMICS OF PRICING REVALRY ECONOMICS OF STRATEGY CHAPTER 8 Presented by: Agus Hermanto Ganggas Cahyono (MM UGM Jakarta - AP14)

CONTENT: DINAMIC PRICING RIVALRY Why the Cournot and Bertrand Models Are Not Dynamic Dynamic Pricing Rivalry: Intuition Competitor Responses and Tit-for-Tat Pricing Tit-for-Tat Pricing with Many Firms The “Folk Theorem” Coordination Why is Tit-for-Tat So Compelling? Misreads HOW MARKET STRUCTURE AFFECTS THE SUSTAINABILITY OF COOPERATIVE PRICING Market Concentration and the Sustainability of Cooperative Pricing Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing Asymmetries among Firms and the Sustainability of Cooperative Prices Market Structure and the Sustainability of Cooperative Pricing: Summary

CONTENT (continuation): FACILITATING PRACTICES Price Leadership Advance Announcement of Price Changes Most Favored Customer Clauses Uniform Delivered Prices Facilitating Practices and Antitust QUALITY COMPETITION Quality Choice in Competitive Markets Quality Choices of Sellers with Market Power

DYNAMIC PRICING RIVALRY Firms that compete with one another do so repeatedly, again and again. Competitive moves by firm might have short-run benefit, but in the longer run can hurt the firm if the competitor makes countermoves.  Why the Cournot and Bertrand Models Are Not Dynamic Cournot & Bertrand models are static, they are looking at simultaneously moves. In these models, all firms simultaneously make once-and-for all quantity or price choices. The reaction functions are not time based and only consider one period of time. These models reduce a complicated phenomenon in industry rivalry. R1 R2 Cournot equilibrium q2q2 q1q1 q1q1 0 q1q1 1 q1q1 * q2q2 1 q2q2 2 q2q2 * q1q1 2 Figure 1: Convergence to a Cournot Equilibrium

 Dynamic Pricing Rivalry: Intuition Intense price competition, profits can be driven to zero. The firms would prefer prices to be closer to their monopoly price level.  It can be achieved if there is a “cooperative pricing” in which neither firms will undercut its rival. A firm that contemplates undercutting its rivals confronts a tradeoff.  In short time, it will increase a market share and the firm has higher profit  But, if rivals also respond to lowering their own prices there will be no more increase in market share, and on the other hand will result lower price-cost margin.

 Competitor Responses and Tit-for-Tat Pricing A tit-for-tat strategy says that the firm should try a cooperative pricing strategy in the current round, then match the opponents response in the preceding round. Example:  Shell vs. Exxon Mobil  The current oil price $40 per hundred pounds.  Monopoly price is $60 and Bertrand (oligopoly) price is $20  Shell increases their price from $40 (current price) to $60 (monopoly price): If Exxon Mobil does not follow to increase price, Shell will drop their price back down after 1 week. Exxon Mobil will get “bump” profit in a week from $ million to $ million and will be back to $ million if Shell drop their price down back to $40. Exxon Mobil discounted present value weekly profit would be $57.93 million. If Exxon Mobil follows to increase price, both firms will earn annual profit $8 million or weekly profit $ million. The discounted value of Exxon Mobil weekly profit would be $77.05 million.

 Tit-for-Tat Pricing with Many Firms The firm will get larger profit if it sticks on prevailing price (P 0 ) and all competitors use monopoly price (P M ). The firm undercutting its competitors and capturing the entire market. A firm’s one period profit gain from refusing to cooperate with industrywide move to monopoly prices is π 0 – (1/N) π M If each firm believe that competitor will raise the price from P 0 to P M in the current period and thereafter will follow tit-for-tat strategy, then each firm will find it in its self-interest to charge the monopoly price as long as: 1/N( π M – π 0 ) > i π 0 – (1/N) π M Where: π 0 : per period industry’s profit at the prevailing price P 0 π M : per period industry’s profit when all firms charge the monopoly price P M i : discount rate per period

 The “Folk Theorem” The “Folk Theorem” says that for sufficiently low discount rates, any price between monopoly price and marginal cost can be sustained as an equilibrium in the infinitely repeated prisoners’ dilemma game.  Implies that cooperative pricing behaviour is a possible outcome in an oligopolistic industry even if all firms act unilaterally.  Coordination To attain the cooperative outcome, firms in the industry must coordinate on a strategy, such as tit-for-tat, that makes it in each firm’s self-interest to refrain from aggressive price cutting. The coordination problem can be overcome if there exists a focal point strategy.  A focal point strategy is a strategy that is so compelling that a firm expects all other firms to adopt it.

 Why Is Tit-for-Tat So Compelling? Another strategy results in the monopoly price for sufficiently low discount rates is the “grim trigger” strategy:  Starting this period, we will charge the monopoly price (P M ). In each subsequent period, if any firm deviates from P M we will drop our price to marginal cost in the next period and keep it there forever.  The threat of an infinite price war to keep firms from undercutting their competitor’s price. Tit-for-tat strategy is simple and easy to describe and easy to understand. Tit-for-tat does well against many strategies in the long-run. The tit-for-tat strategy embodies the following properties:  Niceness : it is never the first to defect from the cooperative outcome.  Provocability : it immediately punishes a rival that defects from the cooperative outcome by matching the rival’s defection in the next period.  Forgiveness : the rival returns to the cooperative strategy.

 Misreads It is possible that a firm can misread a signal in the market when cooperation is occurring.  A firm mistakenly believes a competitor is charging one price when it is really charging another  A firm misunderstands the reasons for a competitor’s pricing decision. A single misread leads to a pattern in which firms alternate between cooperative and uncooperative moves. If another move is misread as uncooperative one, the result pattern become even worse. Firm should carefully ascertain the details of the competitive initiative and figure out the competitor’s move before responding.

Pricing cooperation is harder to achieve under some market structures. The following market structural issues may complicate the attainment of cooperative pricing: o Market concentration o Structural conditions that affect reaction speeds and detection lags o Asymmetries among firm o Price sensitivity of buyers HOW MARKET STRUCTURE AFFECTS THE SUSTAINABILITY OF COOPERATIVE PRICING  Market Concentration and Sustainability of Cooperative Pricing The benefit-cost ratio goes up as the number of firms goes down. Cooperative pricing is more likely to be achieved in concentrated market (few firms) than in a fragmented market (many firms), because:  There is less to gain from cheating due to each firm already having a considerable share of the market.  It is more likely that a few firms can more quickly discover a focal point strategy.

 Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing The speed with which firms can react to their rivals’ pricing moves also affects the sustainability of cooperative pricing. A firm maybe unable to react quickly to its competitors’ pricing move, because:  Lags in detecting competitors’ prices.  Infrequent interactions with competitors (e.g., a few times a year)  Ambiguities in identifying which firm among a group of firms in a market is cutting price  Difficulties distinguishing drops in volume due to price cutting by rivals from drops in volume due to unanticipated decreases in market demand. The above factors reduce the speed with which firms can respond to defections from cooperative pricing. Several structural conditions affect the importance of these factors: a. Lumpiness of orders b. Information about sales transactions c. The numbers of buyers d. Volatility of demand and cost conditions

Lumpiness of Orders This occurs relatively infrequently in large batches as opposed to being smoothly distributed over the years. Lumpy orders reduce the frequency of competitive interactions between firms. This makes price a more attractive competitive weapon for individual firms and intensifies price competition throughout the industry. Information about the Sales Transaction This is related to the visibility and complexity of the sales transaction in the market. When sales transactions are “public”, deviations from cooperative pricing are easier to detect than when prices are secret. Deviations from cooperative pricing are also difficult to detect when product attributes are customized to individual buyers. With secret and complex sales terms, forgiving strategy may not work in environments where misreading can occur.

The Number of Buyer When firm normally set prices in secret, it is easier to detect deviations from cooperative pricing when each firm sells to many small buyers than when each sells to a few large buyers. Illustration:  Probability detection of 300 small buyers : 1 – (0.99) 300 =  Probability detection of 10 large buyers : 1 – (0.99) 10 = Volatility of Demand Conditions Price cutting is harder to detect when market demand conditions are volatile. If a firm’s sales unexpectedly fall, is it because market demand has fallen or because one of its competitors has cut price and is taking business from it? During times of excess capacity, the temptation to cut price to steal business can be high.

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 o different costs o different capacities o different product qualities

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 o Larger firms get a larger share of the benefits of cooperative pricing o Larger firms may have weak incentives to punish small deviators o Small firms have a large set of potential customers to attract by price cutting

Price Sensitivity of Buyers When buyer are price sensitive, a firm that undercuts its rivals price by even a small amount may be able to achieve a significant boost in its volume. A key factor shaping buyers price sensitivity is the extent to which competing firms product are horizontally different.

Practices that Facilitate Cooperative Pricing Firms can facilitate cooperative pricing by: Price leadership Advance announcement of price changes Most favored customer clauses Uniform delivered pricing

Price Leadership The price leader in the industry announces price changes ahead of others and they match the leader’s price The system of price leadership can break down if the leader does not retaliate if one of the follower firms defects Situation in which a market leader sets the price of a product or service, and competitors feel compelled to match that price. (Investorworld.com)

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

Most Favored Customer Clauses Most favored customer clause allows the buyer to pay the lowest price charged by the seller While this clause appears to benefit the buyer (a price cut to any one customer lowers the price for the most favored customer) it also inhibits price competition

Uniform Delivered Pricing When transportation costs are significant, pricing could be either ◦ uniform FOB pricing or ◦ uniform delivered pricing With uniform delivered pricing, the response to price cutting can be “surgical” and effective in deterring defection from cooperative pricing

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

Quality and Price When customers are fully informed and are able to evaluate the quality of the products, the price per unit of quality will be the same If customers are unable to evaluate quality ◦ a lemons market may emerge ◦ free rider problem may lead to underinvestment in information gathering

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

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

Is Quality Really Free? If a firm is inefficient in its production it can boost quality and reduce costs at the same time If a firm is already producing efficiently, quality improvements will entail additional cost - quality is not free

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

Increase in Demand due to Increase in Quality 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!)

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

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