Business Economics (A) Researcher training course 7-8th week Yuji Honjo Faculty of Commerce Chuo University

2 Contents  Theme The Dynamics of Pricing Rivalry  Keyword Static vs. Dynamic, Cooperative pricing, Tit-for- Tat Pricing, Fork Theorem  Discussions Explain the case when cooperative pricing occurs. What factors affect cooperative pricing?

3 Case: Australian Newspaper  Fairfax vs. News Limited Fairfax  Morning Herald (Morning) <= more affluent readership  Sun (Evening) News Limited (Rupert Murdoch)  Daily Telegraph (Morning)  Daily Miller (Evening)

4 (Continued)  Evening newspaper (market) Sun <= price leader  Price competition: The price increase was announced by the Sun, was matched within days by the Daily Mirror.  Price competition: 1975 Sun: 10 cents => 12 cents Daily Mirror: 10 cents => keep the price  Price competition: 1979 Sun: 12 cents => 10 cents

5 Dynamic Pricing Rivalry  Why the Cournot and Bertrand Models Are Not Dynamic These two models => Not dynamic but static (Figure 8.1)

6 Dynamic Pricing Rivalry  Dynamic Pricing Rivalry: Intention (Figure 8.2.) Monopoly outcome => profits: $16 million => Each profits: $8 million Bertrand outcome => Each profits: $0 =>The monopoly outcome is better for each firm.

7 Cooperative Pricing  Cooperative Pricing Cf. Price collusion => felony Situations in which firms can sustain prices in excess of those that would arise in a non- cooperative single-shot price or quantity-setting game => Is cooperative pricing achievable when firms make pricing decisions non-cooperatively?

8 (Continued)  Which If the firm lowers the price =>Short-term increase in profits =>The firm ’ s rival might respond by lowering the price. See Chamberlin (1922).

9 Competitor Responses and Tit-for- Tat Pricing  e.g. Shell vs. Exxon Mobil Bertrand price => $20 Monopoly price => $60 Shell: $20 => $60 Exxon Mobil: $20 => $40 Exxon Mobil ’ s profits: $12 million => The profits exceeds $8 million (monopoly level).

10 (Continued)  Shell ’ s Strategies 1. Raise its price to $ If Exxon Mobil sticks with the low price ($40), Shell drops its price to $ If Exxon Mobil follows Shell, both the firms earn higher profits.

11 (Continued)  Exxon Mobil ’ s Strategies (1) Sticks with the current price of $40, or (2) follow Shell and raise its price to $60. (1)Price$40$40$40$40$40 Profits(Total: $57.93 million) (2)Price$60$60$60$60$60 Profits(Total: $77.05 million)

12 (Continued)  Exxon Mobil ’ s profits (1) Profits < (2) Profits =>Exxon Mobil gain more profit by matching Shell ’ s price. Tit-for-tat strategy e.g. Fairfax & Sons vs. Daily Mirror => × Tit-for-tat strategy

13 Tit-for-Tat Pricing with Many Firms  Extension of the Shell-Exxon Mobil example π M : Industry ’ s profit when all firms charge the monopoly price. π 0 : Profit at the prevailing price (< π M ) (1) π 0 + π 0 /Ni (2) π M /N + π M /Ni Cooperative outcome (1) We obtain Equation (8.1).

14 Fork Theorem  Cooperative Outcome If the discount rate i is not too large, then the cooperative outcome will be sustainable. =>Fork theorem  Coordinating on an Equilibrium Achieving a particular equilibrium in a game with many equilibrium, some potentially are more attractive than others. => Coordination problem

15 Why Is Tit-for-Tat So Compelling?  Is Tit-for-Tat the only strategy? => No  Grim Trigger Strategy If any firm deviates from the cooperating price, the others will drop its price to marginal cost in the next period and keep it there forever.  Tit-for-Tat Strategy Niceness, provocability, and forgiveness

16 Misreads  Misread 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  Dixit and Nalebuff ’ s (1991) argument When misreads are possible, pricing strategies that are less provocable and more forgiving than tit-for-tat are desirable.

17 How Market Structure Affects the Sustainability of Cooperative Pricing  Cooperative Pricing Market concentration Structural conditions that affect reaction speeds and detection lags Asymmetries among firms Price sensitivity of buyers

18 Market Concentration and the Sustainability of Cooperative Pricing  Market Concentration The benefit-cost ratio in equation (8.1) goes up as the number of firms goes down. The more concentrated the market, the larger the benefits from cooperation. Coordinating on a particular focal strategy is likely to be easier for less firms there are compete against one another in the market.

19 Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing  Reaction Speed If price cuts can be matched instantly, cooperative pricing will always be sustainable.  A firm may be unable to react quickly to its competitors ’ pricing moves because of Lags in detecting competitors ’ price Infrequently interactions with competitors Ambiguous 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

20 (Continued)  Important factors Lumpiness of orders Information about sales transactions The number of buyers Volatility of demand and cost conditions

21 Asymmetries among Firms and the Sustainability of Cooperative Pricing  Asymmetries among Firms Firms are not identical => Firms have different costs. => No single focal price => Cooperative pricing – difficult  Two related reasons for the difficulty Large firms benefit more from the move toward cooperative pricing than does small firms. Small firms anticipate that large firms have weak incentives to punish a small firm that undercuts its price.

22 Case: Dot Matrix Printer in South Africa  Epson vs. Panasonic Epson – Leader firm Panasonic: 5% discount => Capture a fraction α of demand By allowing Panasonic to sell printers at a lower price than it charges, Epson would be extending a price umbrella.

23 Market Structure and the Sustainability of Cooperative Pricing (See Table 8.1.)

24 Facilitating Practices  Firms themselves can facilitate cooperative pricing by Price leadership Advance announcement of price charges Most favored customer clauses Uniform delivered pricing