Economics of Strategy
Fifth Edition
Besanko, Dranove, Shanley, and Schaefer
Chapter 10
The Dynamics of Pricing Rivalry
Slides by: Richard Ponarul, California State University, Chico
Copyright  2010 John Wiley  Sons, Inc.
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 longdistance business was falling, and the company cut its long-distance
rates to 7 cents per minute all day, everyday, for a monthly fee of $
5.95.
 AT&T stock dropped 4,7% the day of the announcement.
 MCI’s stock price dropped 2.5 %; Sprint’s fell 3.8%.
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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 nonprice 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 noncooperative 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
The Ford Price
Promise




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”
http://www.media.ford.com/
article_display.cfm?article_id=2702
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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?
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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
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The Ford Price Promise
Game between Ford and Competitors
1 - 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
Competitor Price
Competitor Price
Low
Low
High
5
Low
5
7
7
6
5.5
7
6
High
High
3
6
3
Low
3.5
Ford
Price
High
3.5
3
Low
Low
Ford
Price
Competitor Price
High
5
3
3 - GM understands and
copies Ford move =>
New NE - both firms with
high price!!!
3
6
3.5
Ford
Price
5.5
5.5
6
High
3
6
Conclusion - both firms make their situation worse in the event
of low prices and thus are able to credibly commit to high prices
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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:
 http://mayet.som.yale.edu/~nalebuff/
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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
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