The Dynamics of Pricing Rivary

1. 1 Chapter 9 The Dynamics of Pricing Rivary

2. 2 Issues and questions What conditions influence the intensity of price competition in a market? Why do firms in some markets seem to be able to coordinate their pricing behavior to avoid costly price ways, while in other markets intense price competition is the norm?

3. 3 Issues and questions Why do price wars erupt in previously tranquil markets? What is the value, if any, of policies under which the firm commits to matching the prices its competitors charge? When should a firm match its rival price, and when should it go its own way?

4. 4 Purposes This chapter introduces a set of models and analytical frameworks that can help us understand why firms compete as they do. We view price competition as a dynamic process, which implies that a firm�s decisions made at one point in time affect how competitors and itself will compete in the future.

5. 5 Purposes This chapter also discusses nonprice competition, focusing in particular on competition with respect to product quality. We explore how market structure influences a firm�s incentive to choose its product quality

6. 6 Why the Cournot and Bertrand models are not dynamic In these two models, a firm chooses its quantity or price based on what its rival did in its previous move. Its reaction is the choice that maximizes its current profit.

7. 7 Why the Cournot and Bertrand models are not dynamic

8. 8 Why the Cournot and Bertrand models are not dynamic But an intelligent firm would take the long view and choose its quantity or price to maximize the present value of profits over its entire time horizon. To do this, its must anticipate what its rival will do in the future, not just naively react to what it has done in the past.

9. 9 Why the Cournot and Bertrand models are not dynamic Neither the Cournot and Bertrand models can fully explain why in certain highly concentrated oligopolies, firms can maintain prices above competitive levels without formal collusion and why in other comparably concentrated markets, price competition is often fierce.

10. 10 Dynamic pricing rivalry: intuition Firms would prefer prices to be closer to their monopoly levels than to the levels reached under Bertrand or Cournot competition. In a two-firm market, by colluding the two competitors could charge the monopoly price, which is violating the antitrust laws.

11. 11 Dynamic pricing rivalry: intuition Cooperative pricing is referred to situations in which firms can sustain prices in excess of those that would arise in a noncooperative single-shot price or quantity-setting game, such as Cournot or Bertrand. Is coopertive pricing achievable when firms make pricing decisions noncooperatively?

12. 12 Dynamic pricing rivalry: intuition Are there conditions under which a firm might not wish to undercut its rivals, either by lowering its price relative to theirs or refusing to go along when they increase their prices? Under these conditions, cooperative pricing is feasible. Without those conditions, cooperative pricing is difficult to achieve.

13. 13 Dynamic pricing rivalry: intuition We describe the benefits and costs confronting a firm that contemplates undercutting the prices of its competitors. We will identify market conditions that affect these benefits and costs.

14. 14 Dynamic pricing rivalry: intuition A firm that contemplates undercutting its rivals confront a tradeoff. It stands to reap a short-run or long-run increase in profits if the price reduction translates into an increase in market share.

15. 15 Dynamic pricing rivalry: intuition The firm�s rivals might respond by lowering their own prices, Once they do, the firm that initiated the price reduction could end up with no increase in market share, but with lower price-cost margins.

16. 16 Competitor responses and Tit-for-Tat pricing Suppose two firms, A and B, are currently charging a price somewhere between the Bertrand price and the monopoly price. Suppose firm A is considering raising its price to the monopoly level. If firm B does not follow suit, it can capture 100 percent of the market, which increases its profit that is higher than that when it follows suit the price increase.

17. 17 Competitor responses and Tit-for-Tat pricing Although it is in the collective interest of both firms to charge the monopoly price, firm, B is better off undercutting firm A�s price if firm A raises its price to the monopoly level.

18. 18 Competitor responses and Tit-for-Tat pricing Now suppose that prices can be changed every week, so firm A can rescind its price increase after one week if it sees that firm B does not follow suit to increase its price. Under this situation, firm A�s decision to raise price carries little risk, since firm A at most sacrifices one week profit.

19. 19 Competitor responses and Tit-for-Tat pricing Not only is the risk to firm A low from raising its price, but it would see that firm B has a compelling motive to follow firm A�s price increase. Because firm B has much to gain by matching firm A�s price, and firm A loses little if firm B does not match, it makes sense for firm A to raise its price.

20. 20 Competitor responses and Tit-for-Tat pricing Total profit of firm B if it does not follow suit firm A�s price increase U=20+10+10+10+��� Total profit of firm B if it follows suit firm A�s price increase M=15+15+15+15+��� M > U

21. 21 Competitor responses and Tit-for-Tat pricing If firm B behaves rationally, then it will behave the way firm A expects it to behave, and firm B will match firm A�s price increase. The outcome corresponds to the monopoly outcome even though neither firm colludes with each other.

22. 22 Competitor responses and Tit-for-Tat pricing By following a policy of tit-for-tat, two firms might have avoided the costly price war. The tit-for-tat strategy is akin to a commitment by firms to its customers that �we will not be undersold.� so there is no incentive for either firm deviates its price from its rival�s.

23. 23 Competitor responses and Tit-for-Tat pricing The tit-for-tat strategy encourages firms to raise prices toward the monopoly level. This strategy also discourages firms from cutting price to steal business from competitors.

24. 24 Case study: Philip Morris versus B.A.T. in Costa Rica At the beginning of the 1990s, two firms dominated the Costa Rican cigarette market: Philip Morris, with 30 percent of the market, and B.A.T., with 70 percent of the market. Philip Morris had the leading brands in the premium and mid-priced segments. B.A.T. dominated the value-for-money (VFM) segment.

25. 25 Case study: Philip Morris versus B.A.T. in Costa Rica By 1989, industry price-cost margins exceed 50 percent. However, in the late 1980s, the market began to change. Health concerns slowed the demand for cigarettes in Costa Rica, a trend that hit the premium and mid-priced segments much harder than it did the VFM segment. Philip Morris faced the prospect of slow demand growth and a declining market share.

26. 26 Case study: Philip Morris versus B.A.T. in Costa Rica On Saturday, January 16, 1993, Philip Morris reduce the prices of Marlboro and Derby cigarettes by 40 percent.

27. 27 Market structure and sustainability of cooperative pricing Pricing cooperation is harder to achieve under some market structure than others. Market structure conditions systematically influence the benefit and cost of pricing decisions.

28. 28 Market structure and sustainability of cooperative pricing We discuss the following market structure conditions that may facilitate or complicate the attainment of cooperative pricing and competitive stability Market concentration Structural conditions that affect reaction speeds and detection lags Asymmetries among firms

29. 29 Market concentration Cooperative pricing is more likely to be an equilibrium in a concentrated market than in a fragmented market. In a concentrated market, captures a large fraction of the overall benefit when industry-wide prices go up. The temporary increase in profit the firm forsakes by not undercutting the rest of the market is smaller when the market is more concentrated.

30. 30 Market concentration The more concentrated the market, the larger the benefits from cooperation, and the smaller the costs of cooperation. For firms to coordinate on tit-for-tat strategy, competitors must think alike. The more competitors in the market, the more difficult competitors would think alike.

31. 31 Reaction speed and detection lags The speed with which firms can react to their rivals� pricing moves also affects the sustainability of cooperative pricing. An increase in the speed of firms� reaction will make cooperative pricing easier to attain.

32. 32 Reaction speed and detection lags A firm may be unable to react quickly to its competitors� pricing moves because (1) lags in detection competitors� prices (2) infrequent interactions with competitors (3) ambiguities in identifying which firm among a group of firms in a market is cutting price. (4) difficulties distinguishing drops in volume due to price cutting by rivals from drops in volume due to unanticipated decreases in market demand.

33. 33 Reaction speed and detection lags All of the above factors reduce the speed with which firms can respond to defection from cooperative pricing and thus reduce the effectiveness of retaliatory price cuts aimed at punishing price-cutting firms.

34. 34 Structural conditions, Reaction speed and detection lags Several structural conditions affect the importance of these factors Lumpiness of orders Information about sales transactions The number and size of buyers Volatility of demand and cost conditions

35. 35 Lumpiness of orders Orders are lumpy when sales occur relatively infrequently in large batches as opposed to being smoothly distributed over the year. Lumpy orders reduce the frequency of competitive interactions between firms. Price becomes a more attractive weapon for individual firms.

36. 36 Lumpiness of orders When firms obtain their businesses from bidding a contract, they are more likely to engage in an intensive price competition. It is because the gain from undercutting its rivals exceeds the future cost.

37. 37 Information about the sales transaction When sales transactions are public, deviations from cooperative pricing are easier to detect than when prices are secret. Retaliation can occur more quickly when prices are public, price cutting to steal business from competitors is likely to be less attractive, enhancing the chances that cooperative pricing can be sustained.

38. 38 Information about the sales transaction Firms can cut its net price by increasing trade allowances to retailers or by extending more favorable trade credit terms. It is more difficult for firms to monitor these deals than list prices, it is more difficult to detect business-stealing behavior, hindering their ability to retaliate.

39. 39 Information about the sales transaction Each firm individually prefers to use secret prices to steal other�s businesses, but the industry is collectively worse off when all firms do so.

40. 40 Information about the sales transaction Deviations from cooperative pricing are also difficult to detect when product attributes are customized to individual buyers. Secret or complex transaction terms can intensify price competition not only because price mating becomes a less effective deterrent to pricing-cutting behavior, but also because misreadings become more likely.

41. 41 The number of buyers When firms normally set prices in secret, detecting deviations from cooperative pricing is easier when each firm sells to many buyers than when each sells to a few large buyers. A buyer that receives a price concession from one seller will often have an incentive to report the price cut to other sellers in an attempt to receive even more favorable concessions.

42. 42 Volatility of demand conditions Price cutting is harder to detect when market demand conditions are volatile. IF a firm�s sales unexpectedly fall, is it because market demand has fallen or one of its competitors has cut price and is taking business from it? This problem is more serious when firms can not observe the rivals� pricing.

43. 43 Volatility of demand conditions Demand volatility is an especially serious problem when much of a firm�s costs are fixed. Marginal costs decline rapidly at output levels below capacity, and fluctuations in demand will ordinarily cause the monopoly price to fluctuate too. It is harder to coordinate on the monopoly price under this condition because firms are chasing a moving target.

44. 44 Volatility of demand conditions When costs are mainly variable, the marginal cost function is nearly flat, and the monopoly price will not change too much as demand shifts back and forth. In addition, higher fixed costs induce a dramatic decline in the variable cost when output is higher. During times of excess capacity, the temptation to cut price to steal business can be high.

45. 45 Asymmetries among firms When firms are not identical, either because they have different costs or are vertically differentiated, achieving cooperative pricing becomes more difficult. When firms differ, there is no single monopoly price, and it becomes more difficult for firms to coordinate their pricing strategies toward common objectives.

46. 46 Asymmetries among firms Differences in costs, capacities, or product qualities also create asymmetric incentive for firms to agree to cooperative pricing, even when all firms can agree on the cooperative price. Small firms often have more incentive to defect from cooperative pricing than large firms.

47. 47 Asymmetries among firms Small firms enjoy smaller benefits from cooperative pricing than large firms. Small firms may anticipate that large firms have weak incentives to punish a small firm that undercuts its price. Smaller firms have an additional incentive to lower price on products for which buyers make repeat purchases.

48. 48 Case study: firm asymmetries in the U.S. airline industry When firms are different from each other, the expectation that competitors will instantly match a price cut may not deter certain firms from cutting prices aggressively.

49. 49 Case study: firm asymmetries in the U.S. airline industry Robert Gertner has argued Low-quality or low-market-share firms may make themselves better off by defecting from collusive prices even though they fully anticipate that their high-quality or high-market-share rivals will match their price cuts right away.

50. 50 Case study: firm asymmetries in the U.S. airline industry The 1992 fare war was the most vicious price war to hit the U.S. airline industry since it was deregulated in 1978. It was triggered by the Northwest Airlines�s promotion �Kids Fly Free�. It deepened the record losses the airline industry was suffering in the wake of the recession in 1990.

51. 51 Case study: firm asymmetries in the U.S. airline industry Why did Northwest Airlines start a price war? Airlines receive information about their competitors� fares instantaneously through a clearinghouse computer system run by the Airline Tariff Publishing Company (ATP).

52. 52 Case study: firm asymmetries in the U.S. airline industry The theory suggests that a price cut would not increase its profit when relative market shares would not change and smaller margins resulted. But when firms are asymmetric, they will have different views about how high the price in the industry ought to be.

53. 53 Case study: firm asymmetries in the U.S. airline industry In the early 1990s, Norwest had a poor route system, an inferior frequent-flier program, and a reputation for poor service. If Northwest competitors charged the monopoly price along particular routes, Northwest would get less business than its competitors.

54. 54 Case study: firm asymmetries in the U.S. airline industry Under these conditions, Northwest�s best hope was probably to move the industry down the market demand curve through deep price cuts for two reasons.

55. 55 Case study: firm asymmetries in the U.S. airline industry 1. The price cuts took place in the summer, so much of the additional traffic that they would generate would consist of discretionary vacation travelers. Northwest�s competitive disadvantages were minimized because different service qualities among airlines matter less to discretionary traverlers.

56. 56 Case study: firm asymmetries in the U.S. airline industry 2. A disproportionate share of the additional traffic that is generated by the price cut will end up flying the poorer-quality airline, such as Northwest, simply because at equal prices, seats on the higher-quality carriers will sell out more quickly and cause a spill of traffic that only the less desirable carrier can serve.

57. 57 Case study: firm asymmetries in the U.S. airline industry Northwest could fill its planes only by stimulating market demand, its incentive was to do so when demand was most price elastic. This occurs during the summer when there are more price-elastic leisure travelers.

58. 58 Pricing discipline in the U.S. cigarette industry Cigarettes are one of the most highly concentrated industries in the American economy, with a four-firm concentration ratio of 0.93 percent in 1992. The cigarette industry displayed remarkable pricing cooperation. Twice a year, the dominant firms would announce their intention to raise the list prices, and within days the other firms followed suit.

59. 59 Pricing discipline in the U.S. cigarette industry The result was one of the most profitable industries in the American economy, with operating profit margins averaging close to 40 percent throughout the 1980s.

60. 60 Pricing discipline in the U.S. cigarette industry Liggett and Myers, the smallest of the six U.S. cigarette companies, did not benefit much from the industry�s success in keeping prices high. It had the most to gain by undercutting their prices. In 1980, it launched discount cigarettes at prices 30 percent below branded cigarettes.

61. 61 Pricing discipline in the U.S. cigarette industry By 1984, its share of overall cigarette sales had tripled, largely by virtue of its success in the discount cigarette business. Liggett gambled that the discount market was a niche that its larger competitors would ignore. However it failed to anticipate how discount cigarettes would affect the demand for premium brands.

62. 62 Pricing discipline in the U.S. cigarette industry Other larger cigarette companies introduced their own discount cigarettes and undercut Liggett�s price. BY 1989, Liggett�s share of the discount cigarette market had fallen from nearly 90 percent to under 15 percent.

63. 63 Pricing discipline in the U.S. cigarette industry In the early 1990s, Liggett introduced deep-discount cigarettes that sell for prices 30 percent below those of the discount brands. Other manufacturers also began selling their deep-discount brands. By 1992, the domestic business could be divided into three clearly defined segments: a premium segment, a discount tier, and the deep-discount tier.

64. 64 Pricing discipline in the U.S. cigarette industry The emergence of a segmented market has complicated pricing coordination. Competitors must now coordinate an entire structures of prices, rather than just one. Low prices in the discount and deep-discount segments had eroded the premium market share.

65. 65 Pricing discipline in the U.S. cigarette industry Philip Morris decided to cut the price of its flagship brand Marlboro by 20 percent on Friday, April 3, 1993. This decision was quickly matched by other competitors. In the aftermath of Marlboro Friday, pricing discipline seems to have returned to the cigarette business.

66. 66 Facilitating practices Firms themselves can also facilitate cooperative pricing by Price leadership Advanced announcement of price changes Most favored customer clauses Uniform delivered pricing

67. 67 Facilitating practices These practices either facilitate coordination among firms or diminish their incentive to cut price.

68. 68 Price leadership One firm in an industry announces its price changes before all other firms, which then match the leader�s price. Each firm gives up its pricing autonomy and cedes control over industry pricing to a single firm.

69. 69 Oligopolistic price leadership vs. barometric price leadership Under barometric price leadership, the price leader merely acts as a barometer of changes in market conditions by adjusting prices to shifts in demand or input prices. Under barometric price leadership, different firms are often price leaders, under oligopolistic leadership, the same firm is the leader for years.

70. 70 Advance announcement of price changes Firms will publicly announce the prices they intend to charge in the future. Advance announcements of price changes reduce the uncertainty that firms� rivals will undercut them. The practice also allows firms to rescind or roll back proposed price increases that competitors refuse to follow.

71. 71 Most favored customer clauses A most favored customer clause is a provision in a sales contract that promises a buyer that it will pay the lowest price the seller charges. Two basic types: contemporaneous and retroactive.

72. 72 Contemporaneous most favored customer clauses If while this contract is in effect, the seller sells the product at a lower price to any other buyers, it will agree to lower the price to this level for a particular buyer.

73. 73 Retroactive most favored customer clauses The seller agrees to pay a rebate to the current buyer if during a certain period after the contract has expired, it sells the product for a lower price than the current buyer paid.

74. 74 Most favored customer clauses Most favored customer clauses appear to benefit buyers. It helps keep the buyer�s production costs in line with those of competitors. It can inhibit price competition. Retroactive most favored customer clauses make it expensive for the seller to cut prices in the future, either selectively or across the board.

75. 75 Most favored customer clauses Contemporaneous most favored customer clauses do not penalize the seller for making across-the-board price reductions, but they discourage the seller from using selective price cutting to compete for customers with highly price-elastic demands.

76. 76 Most favored customer clauses Thomas Cooper has shown that because adopting a retroactive most favored customer clause softens price competition in the future, oligopolists may have an incentive to adopt the policy unilaterally, even if rivals do not.

77. 77 Uniform delivered prices In many industries, buyers and sellers are geographically separated, and transportation costs are a significant. Pricing method can affect competitive interactions.

78. 78 Uniform FOB (free on board) pricing The FOB price is the seller quotes for loading the product on the delivery vehicle. The seller quotes a price for pickup at the seller�s loading dock, and the buyer absorbs the freight charges for shipping from the seller�s plant to the buyer�s plant.

79. 79 Uniform delivered pricing The seller quotes a single delivered price for all buyers and absorbs any freight charges itself. It facilitates cooperative pricing by allowing sellers to make a more surgical response to price cutting by rivals.

80. 80 Uniform delivered pricing If one firm reduces the price for one particular location, the rival intends to retaliate by also reducing its price For uniform FOB pricing, the rival has to reduce its net mill price ( the price the seller actually receives), which effectively reduces its price to all its customers.

81. 81 Uniform delivered pricing Under uniform delivered pricing, the rival could cut its price selectively. It could cut the delivered price to its customers where it is undercut, and keep delivered prices of other customers at their original level.

82. 82 Uniform delivered pricing By reducing the cost that the rival incurs by retaliating, retaliation becomes more likely, and enhances the credibility of policies, such as tit-for-tat, that can sustain cooperative pricing.

83. 83 Quality competition Firms can compete on product attributes to attract customers. This competition is generally called quality competition. We lump all nonprice attributes into a single dimension called quality, any attribute that increases the demand for the product at a fixed price.

84. 84 Quality competition We focus on how market structure and competition influence the firm�s choice of quality

85. 85 Quality choice in competitive markets Firms may offer different levels of quality at different prices. The market will force all firms to charge the same price per unit of quality if the customers are able to perfectly evaluate the quality of each seller. If customers cannot easily evaluate the quality, then sellers that charge more than the going price per unit of quality may still have customers.

86. 86 Quality choice in competitive markets In a market, there are some consumers that have information about product quality and others that do not. Uninformed consumers may be able to infer the quality of sellers merely by observing the behavior of informed consumers.

87. 87 Quality choice in competitive markets If uninformed consumers cannot gauge quality by observing informed consumers, then a lemons market can emerge. In this market, only the low-quality products will be offered because consumers are only willing to pay low prices for products.

88. 88 Quality choice in competitive markets Some consumers might spend sources gathering information, but if uninformed consumers can infer what that information is, all consumers may end up on an even footing. As a result, those who gathered the information may by worse off than those who did not. There will be underinvestment in information gathering.

89. 89 Quality choices of sellers with market power The seller with market power should choose quality so that the marginal cost of the quality increase equals the marginal revenue that results when consumers demand more of the product.

90. 90 Marginal cost of improving quality If a firm is producing efficiently, quality is costly. Improvements tend to be incrementally more costly as quality nears perfection.

91. 91 Marginal benefit of improving quality When a firm improves the quality of its product, more consumers will want to buy it. The increase in revenue depends on two factors The increase in demand caused by the increase in quality The incremental profit earned on each additional unit sold

92. 92 Marginal benefit of improving quality When contemplating an increase in quality, the firm must consider the responsiveness of its marginal consumers, consumers who are indifferent among buying from that firm and buying elsewhere. The financial benefits from an increase in quality stems from new customers.

93. 93 Marginal benefit of improving quality An increase in quality will bring in more new customers if There are more marginal customers Marginal customers can determine that quality has, in fact, increased These two factors are determined by the degree of horizontal differentiation and the precision with which consumers observe quality.

94. 94 Horizontal differentiation Horizontal differentiation creates loyalty of consumers to certain sellers. When consumers are loyal to their current sellers, a seller that boosts quality will not necessarily attract new customers.

95. 95 The precision with which consumers observe quality When consumers have difficulty judging particular attributes of a product, they may focus on those attributes that they can easily observe and evaluate. Conveying quality information is especially critical for goods and services whose quality is difficult to evaluate before purchase.

96. 96 Marginal benefit of improving quality All else being equal, the seller with the higher price-cost margin will make more money from the increase in sales and has a stronger incentive to boost quality.

97. 97 Marginal benefit of improving quality Horizontal differentiation has offsetting implication for incentives to boost quality. Horizontal differentiation creates loyal customers, which allows sellers to boost price-cost margins, raising the gains from attracting more customers by boosting quality.

98. 98 Marginal benefit of improving quality Loyal customers are less likely to switch sellers when quality differences are low, implying that each sellers faces fewer marginal customers.