1 The Dynamics of Pricing Rivalry Besanko, Dranove, Shanley, and Schaefer Chapters 8

2 Agenda Dynamic Pricing Rivalry Market Structure and Competitive Pricing Facilitating Cooperative Pricing Quality Competition

3 Dynamic Pricing Rivalry To this point, the models we have discussed have been relatively static. When competing in most markets, a firm tends to compete over time, again and again. This implies that there is a greater complexity that needs to be examine which considers short and long-run competition.

4 Issues with Cournot and Bertrand While the Cournot and Bertrand models seem dynamic, they really are looking at simultaneous moves. The reaction functions are not time based and only consider one period of time.

5 Cooperative Pricing It is a situation where firms without formal collusion can sustain prices above what would normally occur in a single-shot price/quantity setting. Question: What conditions would make this sustainable?

6 Motivation for Cooperative Pricing With intense price competition, profits can be driven to zero. If firms could push prices to monopoly levels, they could each split a positive profit. Firms tend to compete on a continuous basis. This implies that each firm must weigh the difference between short and long-run profits. The best way to do this is examining net present values.

7 Tit-for-Tat Strategy A tit-for-tat strategy says that you should try a cooperative strategy in the current round, then match the opponents choice/response in the preceding round.

8 The Folk Theorem A special version of the Folk Theorem states that with a sufficiently low discount rate, any price set between marginal cost and the monopoly price can be sustained as an equilibrium in the infinitely repeated prisoner dilemma game. This implies that cooperative pricing behavior can be possible in an oligopolistic industry.

9 Coordination Problem The coordination problem exists when there are multiple equilibria that can hinder cooperative behavior. 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.

10 Why Use Tit-for-Tat? The strategy is simple 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 Provocability Forgiveness

11 Dealing with Misreads It is possible that a firm can misread a signal in the market when cooperation is occurring. These can occur when: A firm mistakenly believes that another firm is charging one price, where it is really charging another. A firm misunderstands a competitor’s pricing decision.

12 Dealing with Misreads Cont. While tit-for-tat is robust, it can have problems with misreads. A more forgiving strategy than tit-for- tat will do better with misreads.

13 Market Structure and Cooperative Pricing The following market structural issues may facilitate or complicate the attainment of cooperative pricing: Market Concentration Structural Conditions Affecting Reaction Speeds and Detection Lags Asymmetries Among Firms

14 Market Concentration and Cooperative Pricing A concentrated market tends to facilitate cooperative pricing 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.

15 Reaction Speeds, Detection Lags, and Cooperative Pricing Cooperative pricing can be greatly affected by the speed at which firms can react to their competitors pricing moves. Why?

16 Reason For Slow Reaction Time Lags in detecting competitors prices Infrequent interaction with competitors Too many firms in the market makes it unclear who is cutting prices Difficulty discerning whether a price drop is due to a competitor or an unanticipated movement in demand

17 Structural Condition for Slow Reaction Time Lumpiness of orders This is when purchases are made infrequently in large batches. Information about sales transactions This is related to the visibility and complexity of the sales transactions in the market.

18 Structural Condition for Slow Reaction Time Cont. The number and size of buyers When there are many buyers, it is easier to detect deviations from cooperative pricing when there are many small buyers. Volatility of demand and cost conditions When demand is highly volatile, it is difficult to detect cheating.

19 Asymmetries Among Firm This is related to firms having different cost structures, vertical differentiation, or different product qualities. Asymmetries cause difficulty in sustaining cooperative pricing due to: No obvious focal point strategy Large firms may have little incentive to punish a small firm who cheats Small firms can increase long-run market share if consumers are brand loyal

20 Cooperative Pricing Facilitating Practices Price leadership This is when one firm takes the lead to set prices before any other firm. This overcomes coordination issues because it develops a focal equilibrium. Advance announcement of price changes Works much the same as price leadership except one firm is not necessarily taking the lead.

21 Cooperative Pricing Facilitating Practices Cont. Most favored customer clauses This is when a firm promises a customer a guaranteed low price. This facilitates coordination because it gives incentive to the customer to notify the firm when another firm is cheating. Uniform delivered pricing This is when a firm quotes one price and absorbs the delivery charges. This tends to work when buyers and sellers are geographically separated.

22 Quality Competition While price is one area where firms compete, quality is another area. In essence, consumers would sometimes be willing to take a higher (lower) price to obtain higher (lower) quality. Hence, competition tends to occur both on price and quality.

23 Quality Choice in Competitive Markets In a competitive market, we expect firms, due to competition, will be forced to charge the same price per unit of quality. Quality competition is heavily dependent on consumer’s information and perception of that information of a product.

24 Quality Choice of Sellers with Market Power A firm wants to set quality where the marginal cost of increasing quality is equal to the marginal benefit gained from that increase. Quality tends to increase at a decreasing rate. When contemplating a change in quality, the firm must consider the distribution and responsiveness of the marginal consumers.