Pricing in Imperfectly Competitive Markets

Determinants of Pricing Decision Economic analysis of pricing in imperfectly competitive markets identifies the following elements of the market environment as important to pricing decision: –number of competitors/ease of entry –similarity of competitors’ products –capacity limitations –on-going interactions –Information on past pricing decisions

Bertrand Simultaneous price setting Identical products No capacity constraints One time interaction Price competition results in price equal marginal cost for all firms and zero profits

Bertrand Bertrand paradox (p=mc even though few firms in market) can be resolved by relaxing certain assumptions: No Capacity Constraints Undifferentiated Products One-shot competition

Capacity Constraints Suppose each firm has max capacity of Ki If firm j sets a higher price than firm i, j may get the left-over demand that firm i can’t satisfy if demand exceeds i’s capacity So setting price above MC may be worthwhile

Repeated Games and Collusion Can Bertrand paradox be resolved if firms interact repeatedly? Is it a Nash Equilibrium to set p>mc in the first period of a repeated interaction in an effort to ‘signal’ willingness to ‘cooperate’? Depends on what we mean by repeated? -fixed number of times -infinite number of times

Fixed: -last period is same as one-shot game -no incentive to cooperate in any preceding period -cooperation unravels Infinite: -no last period so cooperation is possible -influence behaviour through use of punishment strategies

Cooperation more likely when: -there is a high probability of future interaction -actions of rivals can be monitored -defectors can be easily punished -interest rates are low

Product differentiation Can Bertrand paradox be resolved if there is a small number of firms that interact strategically? Firms produce different varieties of a product -varieties differ according to some characteristic

Consumers differ as to how they value the characteristic Consumer location on line reveals preference for characteristic Consumer pays a ‘mismatch’ or ‘transportation’ cost t which measures their aversion to buying something other than their preferred degree of the characteristic This cost allows firms to charge a price above marginal cost

Product positioning: If price competition is intense: -firms should locate far apart (differentiate), in order to be able to drive up price If price competition is not intense: -firms should locate close together—in the center of the spectrum

Switching and Search Costs Once a consumer has experienced a product, there may be a cost associated with switching to a new product There may also be a cost associated with finding out what products are available and at what price In equilibrium, firms can have market power if these costs are sufficiently high

Vertical Differentiation Consumers agree on what is better, but differ in their willingness to pay for quality When firms compete in prices with given qualities, equilibrium involves the higher- quality firm charging a higher price than the lower-quality firm and earning higher profits

If firms first choose quality first and then price second, equlibrium involves maximum differentiation. This is done in an effort to relax price competition. True as long as consumers are sufficiently different in their willingness to pay for quality