1. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Chapter 10 Strategic Price Setting

2. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Introduction An oligopoly refers to a market where there are only a few sellers of standardized goods.  5 firms control 80% of the beef processed in the US: The beef processing sector can be described as an oligopoly. Product differentiation allows a firm to possess market power and charge higher prices.  Markets where product differentiation exists, but where the individual brands are still in competition with one another, are referred to as monopolistic competition.

3. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Purpose of the Chapter 1. Introduce the basic concept of game theory 2. Use game theory to discuss price-setting strategies when demand for a firm’s product depends on prices set by other firms 3. Discuss settings and strategies when a firm can engage in tacit price collusion 4. Describe price-setting strategies to limit competition by other firms

4. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Game Theory Game Theory: The study of how interdependent firms behave when they are aware that their actions affect each other.

5. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. The One-Shot Price-Setting Game Behavior of firms in an oligopoly are best studied using game theory  Profits realized by each firm depend on the prices set by other firms and vice versa.  i.e. Two firms in a duopoly: ADM (Archer Daniels Midland) and Ajinomoto Both make lysine-corn feed additive to improve animal growth

6. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Figure 10.1. Price-Setting Game (profits in millions of dollars) If both firms charge high prices, they split the market and both make large profits. If they both engage in price war and both charge low prices (again splitting the market), both make low profits. If one firm charges a high price and the other charges a lower price, the low-price firm gets all the market and makes the largest profits possible, while the high-price firm receives the lowest profits possible.

7. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Game Theory continued… This is a “one-shot game,” meaning it is only played once.  Firms can set their strategies without worrying about how their actions will affect future interactions. Technical Details of a “game”:  Players  Actions  Information  Strategies

8. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Technical Details Players: in this game their are 2 firms Actions: in this game each firm can charge high or low prices Information: describes how much each firm knows, in this game we have common knowledge. Strategies: describe the actions taken by each player  Payoffs: show the outcome realized by each player contingent upon the players’ strategies.

9. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Strategies Dominate Strategy: a strategy that yields the highest payoff regardless of the other player’s actions.  In this game: ADM would be better off charging a low price. No matter what action Ajinomoto takes, ADM will be better off. Profit More Profit the Same

10. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. The Repeating Price-Setting Game In a real market the price-setting game is played repeatedly.  Firms set their prices, observe prices set by other firms, observe the outcome, and change their price-setting strategy accordingly.

11. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Dominant Strategy in an Infinitely Repeating Price-Setting Game Experts were asked to submit a programmed strategy, meaning a set of rules dictating which action—”cooperate” or “defect”—would be chosen in any given round.  Cooperate = to choose high price  Defect = to choose low price

12. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Dominant Strategy in an Infinitely Repeating Price-Setting Game Strategies submitted:  Unforgiving: “cooperate” was chosen in the first period but if the opponent ever defected, the player would always choose “defect.” Otherwise, the unforgiving would always be “cooperate.”  Tit-For-Tat: “cooperate” is chosen in the first period. In the second period, the player would choose the strategy that his opponent chose in the previous period and will continue to mimic the opponent’s action the previous action.  Defect: where the player always chooses “defect” regardless of what happened in previous periods.

13. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. “Scoring” the Game The strategies were run against each other in a computer simulation. This was used to calculate the “score of the game.”  If an unforgiving strategy was paired with a defect strategy, from the second period forward both players would choose “defect” and both would receive a low score.  A tit-for-tat matched with defect would also score low.  A tit-for-tat matched with unforgiving would perform well because both players would cooperate in all periods.

14. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Strategy that Dominated the Population of Strategy-Pairs Tit-For-Tat  If tit-for-tat encounters an opponent willing to cooperate, both firms charge high prices and receive high profits.  If tit-for-tat encounters an opponent that likes to defect, it does not allow that strategy to profit at its expense.

15. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Trigger Pricing Trigger Pricing: Set high price if competitors set high price; low price if competitors set low price.  Firms too have been observed to display the tit- for-tat strategy, which more formally is called trigger pricing.

16. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Figure 10.2. Trigger Pricing If a firms announces this trigger-pricing strategy, it eliminates two possibilities from the game. With the trigger-pricing strategy in place, cooperate now becomes a dominant strategy and the firm’s joint profits are maximized. In reality, firms in an oligopoly collude and decide on a designated price to maximize profits.

17. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Low-Price Guarantees Low Price Guarantee: a promise made to consumers that the firm will meet or beat a competitor’s price for the same product.  i.e. Staples, OfficeMax, and Office Depot lowering prices and giving a low price guarantee.  Can promote competition and lower prices or promote collusion and raise prices.

18. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Tacit Collusion Tacit collusion: collusion of prices without a spoken word, businesses seeing what other businesses are doing with their prices and following suit. Folk Theorem: mathematical proof that shows if the players are rational, in repeated games players will develop cooperative strategies, even if they are ultimately competitors.

19. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Nash Equilibrium A Nash Equilibrium exists when all players are following their best strategy, given the strategies pursued by the other players.  Cooperate/Cooperate is not a Nash Equilibrium  Defect/Defect is a Nash Equilibrium Nash Equilibrium allows us to develop a universal market model, one that encompasses both perfect competition and monopoly and everything in between (assuming all firms produce the same good).  This model is commonly referred to as the Cournot Model.

20. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. The Cournot Model of Imperfect Competition The price in the Cournot Model is somewhere between the price in a monopoly and the price in perfect competition.  If a monopoly would charge $100, but a competitive market would produce a price of $10, then in a duopoly, the price would be closer to $100, say $80. With 3 firms, it be lower than $80, and with 4 firms even lower. As the number of firms becomes very large, eventually equal $10, the perfectly competitive price.

21. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Beating the Cournot Model The Cournot model provides a good indicator of the price and profits one should expect in an oligopoly. Firms do not make economic profit in the Cournot model. Nash Outcome: the price, quantity, and profits predicted by the Cournot model.  Remember the solution to the Cournot model assumes a Nash Equilibrium.

22. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Beating the Cournot Model continued… Collusive outcome: firms collude through the use of tacit collusion, trigger pricing, low-price guarantees, or illegal means to set prices high and receive high profits. Rivalistic outcome: each firm produces a large amount and charges low prices, hoping their firm’s profits will be low enough to drive the competitor out of business.

23. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Figure 10.6. Three Outcomes of Oligopolistic Competition

24. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Collusive Outcome through Tacit Collusion Four features that increase the probability of a collusive outcome through tacit collusion: 1. Stable competitors Facilitate Tacit Collusion 2. Pre-Play Communication Facilitates Tacit Collusion 3. Experience Facilitates Tacit collusion 4. Firm Homogeneity Facilitates Tacit Collusion

25. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Stable Competitors Facilitate Tacit Collusion Tacit collusion only works when all firms have a mutual understanding that all firms will set a high price. Firms want to play the price-setting-game with the same opponent.  If you play against the same person over and over again, you are playing the repeating price-setting game, which according to the Folk Theorem tends to lead to the collusive outcome.  The collusive outcome is more likely when there are stable trading partners in an oligopoly.

26. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Pre-Play Communication Facilitates Tacit Collusion When firms communicate before the game begins they are more likely to collude.  A sense of trust is built and they tend to feel more guilty defecting against someone they know. Price-Fixing is ILLEGAL. Low-Price Guarantees is pre-play communication.  This can lead firms to collude and charge higher prices. Price Leader: the one firm in the industry that changes its prices first.

27. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Experience Facilitates Tacit Collusion The more experience one has in the games like the price-setting game, the greater the likelihood of a collusive outcome. Firms should involve experienced employees for help with price determination.  Employees with years of experience with the company and price setting have learned how competitors react and are more likely to produce a collusive outcome.

28. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Firm Homogeneity Facilitates Tacit Collusion Homogenous firms are firms that are alike. The more homogenous firms are, the easier it is for them to tacitly collude.  If firms produce the same product, then consumers can substitute between each firm’s output. By tacitly colluding, the firms can stop consumers from seeking lower prices.  If firms prices are identical, there is less incentive for one firm to try and drive other firms out of business.

29. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Pricing To Eliminate Rivals Limit Pricing: Charging a low price to deter potential competitors from entering the market.  Used to discourage firms from entering the market Predatory Pricing: lowering price when competitors enter the market in an attempt to drive then out of the market.  Firms wait for the competitor to enter the market then drop their price to put them out of business.  i.e. J. D. Rockefeller and Standard Oil Company

30. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Figure 10.7. Predatory Pricing Game (incumbent profits, competitor profits) A strong monopolist is one who, in the presence of a competitor, can change a price low enough to drive the competitor out while still making profits itself. A weak monopolist loses money when it employees predatory pricing.

31. Norwood and Lusk: Agricultural Marketing & Price Analysis © 2008 Pearson Education, Upper Saddle River, NJ 07458. All Rights Reserved. Conditions for a Weak Monopolist There are conditions when a weak monopolist should also use predatory pricing.  The condition requires asymmetric information. Asymmetric information: Where the two firms possess different information.  The other condition that could be requires asymmetric costs. Asymmetric costs: When there are asymmetric costs—one firm can produce at lower costs than others.