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

Page 2 Pricing Rivalry: Price Wars In July 1999, Sprint announced a nighttime long distance rate of 5 cents per minute. In August 1999, MCI matched Sprint’s off-peak rate. Later that month, AT&T acknowledged that revenue from its consumer long- distance business was falling, and the company cut its long-distance rates to 7 cents per minute all day, everyday, for a monthly fee of $ AT&T stock dropped 4,7% the day of the announcement. MCI’s stock price dropped 2.5 %; Sprint’s fell 3.8%.

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 non- price dimensions such as quality

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

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

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

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

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

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

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

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”

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

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

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

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

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

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

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

Relevant Structural Conditions Lumpiness of orders Information availability regarding sales transaction The number of buyers Volatility of demand conditions

Page 33 In September 1999, customers were “unsettled” by rumors of future price reductions Ford launched the £400,000 “Price Promise” national advertising campaign Under the “Price Promise”, Ford will reimburse any reduction in the recommended retail price difference a.k.a. “Most Favored Customer Clause” The Ford Price Promise article_display.cfm?article_id=2702

Page 34 The Ford Price Promise Game between Ford and its Consumers Should consumers buy early or wait? Will Ford have much inventory at the end of the season? Should Ford lower price at the end of the season? How does the price promise changes the bargaining game between Ford and its customers?

Page 35 The Ford Price Promise Game between Ford and its Consumers Consider those consumers who want to buy a Ford before January 2000 Without the Price Promise, they wait if they believe that Ford will lower its price before January With the Price Promise, they have a dominant strategy which is to buy right away The Price Promise transforms the game between Ford and consumers as a tragedy of the commons

Page Recall Pricing Rivalry Game. NE is both firms with low price 2 - Ford makes a move that increases its costs in the event of lowering prices => same NE, Ford worse off 3 - GM understands and copies Ford move => New NE - both firms with high price!!! Conclusion - both firms make their situation worse in the event of low prices and thus are able to credibly commit to high prices The Ford Price Promise Game between Ford and Competitors

Page 37 Co-opetition Facilitating Practices Obvious examples  Advance announcement of price changes  Price leadership (GE, Philip Morris in 60’s, Kellog) Less obvious examples  Most Favored Customer Clause Guaranties any customer the best price the company gives to anyone (e.g. Ford’s “Price Promise”, Chrysler’s “Guaranteed Rebate”)  Best price guaranty John Lewis “Never knowingly undersold” Co-opetition Interactive at: 

Page 38 Commitment and Credibility Strategic Perspective “ Paradox:” Less freedom of choice may lead to more favorable outcomes (e.g. Hernan Cortes) Balance the benefits from altering competitors’ behavior with the loss in flexibility  Long warranties (Japanese entry in consumer electronics market) Credible commitments are valuable “The power to constrain an adversary may depend on the power to bind oneself” Thomas Shelling The Strategy of Confict