Economics of Strategy
Besanko, Dranove and Shanley
Chapter 9
Dynamics of Pricing Rivalry
Slide show prepared by
Richard PonArul
California State University
 John Wiley  Sons, Inc.
Dynamic Price Competition
• Price competition should be viewed as a
dynamic process where decisions by a firm
today will affect
– competitor behavior in the future
– constraints and opportunities faced by the firm
itself
• Dynamic competition can also occur in nonprice dimensions such as quality
Dynamic versus Static Models
• Dynamic models can capture aspects of real
world competition that the static models
cannot
• It is possible to incur short term costs that
are more than offset by long term benefits
(not captured in static models)
• It is also possible to see short term profits
(in a static model) followed by long term
negative effects
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
Cooperative Pricing
• Firms would rather have their prices at
monopoly levels relative to prices under
Cournot, Bertrand, or pure competition
• In most countries explicit collusion to
maintain prices at monopoly levels is illegal
• Cooperative pricing occurs if prices persist
above competitive levels without explicit
cooperative behavior from the firms
Cooperative Pricing
• When rivals expect to play for many
periods, there may be incentives against
price competition
• If one firm lowers the price, their market
share may go up in the short run but...
• When the rival retaliates, the market share
is back to the original level and the price is
lower making both firms worse off
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
Tit-for-Tat Strategy
• 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
• “We will not be undersold!” may mean
higher prices through cooperative pricing
Tit-for-Tat Pricing with Many
Firms
Condition for sustainable cooperative pricing
i
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 at or above marginal cost
and at or below monopoly price can be
sustained if the discount rate is sufficiently
small
• Small discount rate makes the present value
of the annuity from cooperative pricing
larger and favors a cooperative outcome
Coordination Problem
• While Folk Theorem says that cooperative
pricing is sustainable it 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
• 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
• Robert Axelrod’s book “Evolution of
Cooperation” 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 and
Cooperative Pricing
• Ease in achieving cooperative pricing may
depend on certain aspects of market
structure
• e.g.,
– Concentration
– Conditions that affect reaction speeds and
detection lags
– Asymmetries among firms
Market Concentration and
Cooperative Pricing
• Cooperative pricing is more likely to
happen in a concentrated market than in a
fragmented market
• In the condition for sustainable cooperative
pricing,
as N decreases, the left-hand side of the
inequality increases, making it easier for
the condition to hold
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
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
• In the condition
as the time
interval goes to zero, so does i.
Determinants of Reaction Speed
• Frequency of interactions with the rival
• Availability of information about a rival’s
price cut
• Difficulty in distinguishing changes in
volume of sales due to changes in demand
as opposed to changes in rival’s price
Frequency of Interactions
• When orders are lumpy, the frequency of
competitive interactions in reduced
– e.g.,: Lumpy orders in airframe manufacturing,
ship building
• Lag between orders makes the gain from
price cutting more valuable relative to the
cost imposed by rival’s retaliation
• Increased frequency also tends to provide
more information to all firms
Availability of Information about
Rival’s Pricing
• Deviations from cooperative pricing are
easier to detect when the transactions are
public
– e.g.,: Transaction prices for gasoline sales are
easily observable while they are not easily
observable for automobile sales
Availability of Information about
Rival’s Pricing
• Deviations from cooperative pricing are
harder to detect when the products are
custom made for individual buyers than
when they are standardized
• Complex transactions make misreadings
more likely relative to simple transactions
Availability of Information about
Rival’s Pricing
• When firms set prices in secret, deviation
from cooperative pricing is easier to detect
if there exist many small buyers
• With a large number of buyers, it is harder
to carry out secret price cuts
Volatility of Demand
• Price cutting is harder to detect when
demand conditions are volatile
Demand Volatility with Large
Fixed Costs
• When fixed costs are large, marginal cost
decline more steeply and over a wider range
of output.
• This causes demand movements to have an
exaggerated effect on price.
• Hence, with large fixed costs cooperative
pricing involves chasing a moving target
Asymmetries Among Firms and
Coordination Problems
• When firms are not identical cooperative
pricing becomes more difficult
• Firms differ in the incentives they face for
cooperative pricing due to
– different costs
– different capacities
– different product qualities
Asymmetries in Cost
Asymmetries in Cost
• The marginal costs are different for the
firms and so are the monopoly prices
preferred by each of the firms
• Without a single monopoly price to serve as
a focal point, coordination becomes difficult
• Differences in product quality can create
similar obstacles to coordination
Asymmetries in Capacity
• Small firms have stronger incentives to
defect from cooperative pricing than their
larger rivals
– Larger firms get a larger share of the benefits of
cooperative pricing
– Larger firms may have weak incentives to
punish small deviators (yapping dog effect)
– Small firms have a large set of potential
customers to attract by price cutting
Practices that Facilitate
Cooperative Pricing
Firms can facilitate cooperative pricing by
• Price leadership
• Advance announcement of price changes
• Most favored customer clauses
• Uniform delivered pricing
Price Leadership
• The price leader in the industry announces
price changes ahead of others and they
match the leader’s price
• The system of price leadership can break
down if the leader does not retaliate if one
of the follower firms defects
Two Kinds of Price Leadership
• Some times, the price leader may simply act
a barometer of market conditions
• Even without oligopolistic conditions, firms
follow the price leader because they face the
same changes in market conditions
• Oligopolistic price leadership system may
camouflage as barometric price leadership
by firms taking turns being the leader
Advance Announcements of
Price Changes
• Advance announcement reduces the
uncertainty that the rival will undercut the
firm
• Advance announcement also gives the firm
the opportunity to roll back the changes if
the rival does not match
Most Favored Customer Clauses
• Most favored customer clause allows the
buyer to pay the lowest price charged by the
seller
• While this clause appears to benefit the
buyer (a price cut to any one customer
lowers the price for the most favored
customer) it also inhibits price competition
Uniform Delivered Pricing
• When transportation costs are significant,
pricing could be either
– uniform FOB pricing or
– uniform delivered pricing
• With uniform delivered pricing, the
response to price cutting can be “surgical”
and effective in deterring defection from
cooperative pricing
Quality Competition
• Competition need not be in the price
dimension alone
• “Quality” can be a term that encapsulates all
the non-price variables that increase the
demand for the product at any given price
Quality and Price
• When customers are fully informed and are
able to evaluate the quality of the products,
the price per unit of quality will be the same
for all products
• If customers are unable to evaluate quality
– a lemons market may emerge
– free rider problem may lead to underinvestment
in information gathering
Market with Some Uninformed
Customers
• Some customers are informed and others
are not
• Uninformed customers cannot gauge quality
by observing informed customers
• Some low quality producers can sell at the
going prices, driving out the high quality
producers (lemons market)
Free Riders and Underinvestment
• If uninformed customers can learn by
observing informed customers, they are free
riders
• Customers who invest in information
gathering will find that they are no better
than those who did not make that
investment
• Leads to underinvestment in information
gathering
Is Quality Really Free?
• If a firm is inefficient in its production it
can boost quality and reduce costs at the
same time
• If a firm is already producing efficiently,
quality improvements will entail additional
cost - quality is not free
Benefits from Improved Quality
• When a firm increases the quality of its
products, the benefits actually received
depend on two factors
– the increase in demand
– the incremental profit per unit
Increase in Demand due to
Increase in Quality
• When a firm raises the quality of its
product, the demand will change only if
– marginal customers are available and
– customers can determine that quality has
changed
• Horizontal differentiation will create
customer loyalty and reduce the availability
of marginal customers
Increase in Demand due to
Increase in Quality
• Even without customer loyalty, inability of
the customers to judge quality will work
against an increase in demand
• Sellers may rely on easily observable
attributes to communicate quality (marble
floors in banks, diplomas displayed, clothes
make the man (or woman!)
Increase in Demand due to
Increase in Quality
• When customers cannot judge quality,
independent evaluators may emerge
(Consumer Reports, J. D. Powers Survey,
Moody’s Bond Ratings)
• For some products, allowing the customer
to experience the product (free samples,
listening booths in record stores) may be a
way to convey information about quality
Incremental Profit per Unit from
Quality Increase
• All else given, a seller with a higher pricecost margin is likely to benefit more from
increased sales
• A monopolist may have a high price-cost
margin but few marginal customers
• Similarly, horizontal differentiation can
boost price-cost margins but lead to fewer
marginal customers