Notes for Chapter 10: Dynamics of Pricing and Quality Rivalry This chapter deals with dynamic competition

with repeated moves and countermoves in oligopoly markets. Neither the Cournot model nor the Bertrand model can be used as a dynamic model. Assumption: Ceteris paribus, firms prefer to have prices close to monopoly price levels, to maximize . (See graph at top of p. 267.) If collusion were possible, firms would prefer to collude on price and quantity to approximate this outcome.
1.

Various types of cooperative pricing strategies to approximate the monopoly outcome (with collusion illegal in developed countries): a. Tit-for-tat pricing i. Works for any number of firms in theory as long as the rate at which the firm discounts future profits is less than this benefit-cost ratio:
= increased for the firm from charging the monopoly price extra from undercutting the prices of other firms that charge the monopoly price
(See equation 10.1 at the top of p. 271.)

Of course, with a large number of firms in an industry, the firms that may attempt to engage in this may not have enough information to accurately make this calculation. If a firm is patient enough (if its discount rate is high enough), the firm can sustain the monopoly price. Example 10.1, p. 269: GM undercutting others by offering employee pricing to the
general public in summer 2005, with Chrysler & Ford finally following with their discounts. GM may have only shifted demand forward, and/or it may have lured customers away from the other firms. Its possible that they developed customer loyalty, which provides a long-term payoff.

Example 10.2, p. 271: Philip Morris started a price war in 1993 in Costa Rica against
B.A.T., its major competitor. Philip Morris didnt expect B.A.T to respond so swiftly or decisively in undercutting its new prices. By the time the price war ended in 1994, their market shares hadnt changes and both firms had lost a considerable amount of money.

ii. Tit-for-tat has these very useful properties that make it so successful: a) Niceness - If all behave as expected, all goes well. b) Provocability - Moves away from the established discipline will provoke counter-moves. c) Forgiveness - Once discipline is restored, there is no further retaliation. b. Focal point: Coordination works well and is more sustainable if the strategy that creates cooperation is a focal point, that is, compelling enough for all other firms to adopt it. What serves as a focal point varies from industry to industry, but it is easier when products have very little horizontal differentiation. An industrys focal point could be something like: i. Round-number price points ii. Round-number percentage annual increases iii. Maintaining current market shares through pricing and other moves iv. Traditional ways of doing business/deciding prices (such as rule of thumb price mark-ups over wholesale) v. Well established time-of-year or other regular cycle for price adjustments Alleged collusion example from the timber industry in the Northwest: [In the
1970s], firms were required to use sealed bids for cutting in US government property national forests, BLM land, etc. Each major firm appears to have had been assigned a moon phase, so that the highest bid always seemed to come from each firm during a specific phase of the moon.

Counter-example 10.3: Dow Chemicals FilmTec membrane for reverse osmosis,

introduced in 1989 and whose patent protection the US government not only refused, but distributed the technology to potential rivals. A Japanese competitor aggressively competed on price, but Dows distributors did not. Dow eventually took over distribution but never made significant profits.

Counter-example: Has anyone visited the new H-E-B on Kostoryz at Gollihar?

c. Ways in which firms can facilitate cooperative pricing: i. Price leadership. A firm increases prices and others follow within days. Often only one single firm is recognized as the price leader, but in some industries this is shared. Example 10.4, p. 282: RJR and Philip Morris were recognized as the price leaders in the cigarette industry throughout the 20th century - until the 1980s: Then Liggett introduced discount cigarettes to undercut the market price, and B&W introduced their own discount brand. In the early 1990s, Liggett introduced deep-discount brands, and then all the firms followed within a few years, and then there were 3 market segments. By 1994, RJR and Philip Morris were once more recognized as the price leaders, in a much more complicated, 3-tiered pricing structure. ii. Advance announcements of price changes. This is a very public form of price leadership. iii. Most favored customer clauses. These are clauses in customer contracts that guarantee them the lowest price the firm charges. They can be stated as either contemporaneous or retroactive. They benefit the buyers, but at the same time they benefit the firms in the industry by discouraging other firms from competing by price cutting especially with retroactive clauses. iv. Uniform delivered prices: (1) Uniform free on board (FOB) pricing at the sellers dock with destination charges on top - absorbed by the buyer, is one form. The delivered price depends on the buyers location relative to the seller. (2) Uniform delivered price has the seller absorbing the delivery costs. This 2nd form allows firms to more easily respond to price cutting, because it allows firms to selectively cut prices. This section ended with a list of dos & donts for making price changes (p. 289) based on actions that have been known to trigger antitrust investigations.

2.

Various types of NON-cooperative pricing strategies Non-cooperative game: game in which it isnt possible for parties to negotiate or enforce binding contracts
a.

Nash equilibrium: Each firm does the best it can, given what its competitors are doing. (1951) The Nash equilibrium is based on noncooperative solutions, where collusion is illegal. With more than 2 firms, the interactions are a lot more complex can be worked out in dynamic computer models, but thats beyond the scope of this course. Payoff matrix: table that shows the payoff to each of two parties that results from the actions of both parties If the decision to collude is NOT enforceable, its in the best interest of each party provides the largest payoff, to select the Nash outcome; to be better off no matter what the other one does.

b. Implications of the prisoners dilemma for oligopolistic pricing Prisoners dilemma: No matter what the other prisoner does, the prisoner being questioned is better off by confessing EVEN IF SHE HASNT COMMITTED THE CRIME! This illustrates the problem faced by a firm - better off with cooperation IF ALL COOPERATE, but better off by undercutting if just one other firm were to decide to undercut the others. Firms over time can learn from observation whether they can trust the other oligopolists in their market. So the outcome need not be the same as in the Prisoners Dilemma. c. Grim trigger strategy If any firm undercuts the monopoly price, the price leader firm will immediately and forever drop price to MC (MAD strategy) threat of a price war without end Misreads It is possible that with any strategy a firm will misread, or miss altogether, the moves of a competitor. This may lead to several uncooperative moves.

3. Effect of market structure on sustainability of cooperative pricing (See Table 10.1 on p. 284 for a summary table of the effect of market structure on sustainability.) a. Market concentration: The more concentrated the industry, the higher the benefit-cost ratio. You lose more by pricing closer to MC, and youre not as likely to attract significantly more buyers. Example: Wal-Mart & Best Buy (and the few other big-box stores that sell electronics) dont engage in price competition as much as they used to: Instead, they offer price-matching to their customers. Theres no benefit from lowering prices, because customers will take in the rivals ad rather than purchase from the rival. b. Reaction speed & detection lags: The quicker the reaction time to a rivals move, the more sustainable the cooperative strategy, because the benefit from the non-cooperative move is short-lived. Slower reaction time can help the firm reducing price, because it may gain loyal customers, even after prices go back up. Several structural conditions in the industry can slow the reaction time: i. ii. Lumpiness (infrequency) of large-batch orders limits how often firms interact. Privately (secretly) negotiating orders makes it difficult to monitor rivals prices especially because list price isnt the only dimension negotiated. E.g., trade allowances, credit terms and other aspects of the sale may be hidden, so that the true price cannot be ascertained by rivals. This also makes misreads more prevalent. If the number of buyers is small, theres less chance of true price information leaking to rivals. If demand tends to be volatile, a firm cant easily tell if demand for its own goods is lower because a rival stealing its customers, or because of a downturn in demand.

iii. iv.

c. Asymmetry: Cooperative pricing is difficult whenever: i. Firms are not of similar size with larger firms having weak incentives to punish smaller firms 1) 2) Price cut relatively large, but stolen share relatively small Percentage contribution to margin (PCM) is small: margins in the industry are all small before price cut

Example: Saudi Arabia & Nigeria in OPEC Counter-example from text: Epson & Panasonic printers in South Africa Neither condition (1) nor condition (2) held. Epson overreacted by more than matching Panasonics price cut, which exacerbated the price war, with major loss-of-profit consequences. ii. iii. iv. Their products are vertically differentiated Marginal and/or fixed costs differ significantly (See graph on the top of p. 281, which depicts 2 firms with differing MCs.) Plant capacities differ

d. Price sensitivity of buyers: In markets with price-sensitive buyers, a small price cut can make a big difference in grabbing market share. A firm can be tempted even if it expects this price cut to be matched sooner or later. This is especially true under these circumstances: i. ii. Products are not highly differentiated from one another. The buyers are downstream firms, rather than consumers, though some downstream firms might prefer to buy from only one firm.

Example 105, p. 285: Heavy-duty truck engine (HDTE) industry. With buyers of
fleets being price sensitive, manufacturers of trucks are quite price sensitive. In addition to price sensitivity, ordering is lumpy, with orders placed for hundreds of engines at a time and orders are for engines that meet certain specifications, making it more difficult to unravel the price differences that depend on specs. Lumpiness and horizontal differentiation both can lead to secrecy in pricing.

4. Quality competition: Such attributes of a product as durability, after-sale service, warranty, customizability & performance can be ways of competing, without lowering , as price competition can. In fact, firms can charge more for quality improvements perceived by the customer. a. Quality choice in competitive markets: All goods are identical or have pure vertical differentiation. When vertically differentiated, consumers must be able to perceive the differences in quality. In some markets it is costly for consumers to be informed. This is especially true of markets for goods purchased infrequently and for professional services. Lemons market: a market in which consumer information is so costly that the bad products will drive out the good, because owners of the good products cant get a high enough price Counter-example 10.6, p. 291: US health insurance market has accreditors, but this has not yielded significant quality competition, except sometimes in customer service. This seems to be the only dimension that consumer information matters. So these firms continue to compete mostly in price. b. Quality choices of sellers with market power: Higher quality yields higher and less elastic demand (see graph at the top of p. 293). Yet, improving quality isnt free, after lowering inefficiencies to some acceptable level. The firm will be most profitable at the point where MC from higher quality = MB from higher quality The MB to the firm from improving quality depends on 2 factors: i. How demand increases as a result of higher quality how much the D curve shifts up and by how much it becomes more inelastic (refer again to the graph on p. 293). This depends on: (a)Horizontal differentiation (b) Consumer perceptions of quality improvements

ii. How much this increased demand results in higher profit: his depends on NEW customers (marginal consumers), not customers already loyal to the product