Pricing

Abhijit Sharma
Economics of Industry: Lecture 8
MAN0201M

Lecture overview
This lecture will cover:
Dynamic price competition and dynamic models "
Industry rivalry and intensity of price competition"
Co-operative pricing"
Retaliation"
(I) Market concentration (ii) structural conditions affecting
reaction speeds and detection lags (iii) asymmetries
among firms and (iv) multi-market contact "
Co-ordination problem and firm responses"
Non-price competition including quality competition"
"
Reference: Besanko et al., Ch 9."
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Dynamic price competition

Price competition can be viewed as a
dynamic process.
The firm s decisions today affect its own
behavior as well as that of its competitors
in the future.
Dynamic competition can also occur in
non-price dimensions such as quality.
Dynamic models capture aspects of real
world competition that static models
cannot.
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Dynamic model scenarios

Static models do not explain how firms can
maintain prices above competitive levels
without formal collusion.
In some cases, a small number of firms are
sufficient to produce intense price competition.
Dynamic models can explore such situations.
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.

Co-operative pricing
Collusion to maintain prices at monopoly levels is
illegal (in most countries).
Co-operative pricing occurs if prices persist above
competitive levels, without co-operative behaviour
from the firms.
Long-term considerations: When rivals expect
to play for many periods, there may be
incentives against price competition.
If one firm lowers the price, its market share may
go up in the short run.
When the rival retaliates, the market share is back
to the original level and the price is lower making
both firms worse off. E.g. photocopier industry.
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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.
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.
The Superiority of Tit-for-Tat
Tit-for-tat is easy to communicate: E.g. We will not be
undersold, Lowest price guaranteed etc.
Easy to describe and easy to understand
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Supermarket price wars break out again

THE GUARDIAN, JUNE 15 2008

Supermarket price wars broke out again today as the two

biggest grocers - Asda and Tesco - announced tit-for-tat
price cuts totalling more than 500m across thousands of
products.
Asda moved first, cutting the prices of 10,000 products. The
chain, part Wal-Mart, said it was investing 250m in the price
cuts and the reductions were just "the first salvo" in a new
price war.
Andy Bond, Asda CEO, said UK grocers had been too
focused on the environmental concerns of some shoppers
and had taken their eye off the ball of offering lower prices:
"We have been too attentive on a small part of the
population. There is a vocal minority for whom price is less
important, but there are a huge set of people out there for
whom price is still very important".
However, within hours Tesco responded, promising 270m
of price cuts on 3,000 products.

Market structure and cooperative pricing

The ease of achieving co-operative pricing
may depend on certain aspects of market
structure.
Some such aspects are
Concentration
Conditions that affect reaction speeds and
detection lags
Asymmetries among firms
Price sensitivity of buyers
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Concentration and co-operative

pricing
Co-operative pricing is more likely in a
concentrated market than in a fragmented
market.
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 co-operation
and the smaller the cost of co-operation.
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Targeted price reduction and

co-operative pricing
With targeted price reduction customers of rivals
can be stolen without revenue loss.
Rivals can retaliate strategically.
Higher prices across the board may result.
Reaction Speed and Co-operative Pricing
As the speed with which a firm can respond to the
rivals moves increases, co-operative pricing
becomes easier to sustain.
If the price cuts can be matched instantaneously,
co-operative pricing can be maintained for any
discount rate.
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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
Aggregation in order placement.
Information availability regarding sales transaction.
The number of buyers.
Volatility of demand and cost conditions.
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Asymmetries among firms and

co-ordination problems
When firms are not identical co-operative
pricing becomes more difficult.
Temptation to cut prices is more when
buyers are very price sensitive.
Firms differ in the incentives they face for
cooperative pricing due to
Different costs
Different capacities
Different product qualities
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Asymmetries in cost
Marginal costs differ across firms as do preferred
monopoly prices for each firm.
No single monopoly price serving as a focal point: coordination becomes difficult.
Differences in product quality can create similar obstacles
to co-ordination.
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.
Small firms have a large set of potential customers to
attract by price cutting.
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Practices that facilitate

co-operative pricing
Firms can facilitate co-operative pricing by
Price leadership
Advance announcement of price changes
Most favoured customer clauses

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Price leadership
The price leader in the industry announces
price changes first and others 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 as
a barometer of market conditions.
Even without oligopolistic conditions, firms
follow the price leader because they face the
same changes in market conditions.
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Quality Competition
Competition can occur on quality
dimensions such as
performance and
durability.

Quality competition can be less destructive

than price competition.
Industry price elasticity should be low for
industry wide price increases to be
tolerated (to cover the cost of enhanced
quality).
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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 market for lemons may emerge [see
Akerlof].
Free rider problem may lead to
underinvestment in information gathering.
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Demand Curves Associated with Different Quality

Levels

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
(markets for lemons e.g. used cars and insurance).
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.
There will be underinvestment in information
gathering.
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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.
Benefits from improved quality
When a firm increases the quality of its products, the
benefits received depend on two factors
Increase in demand
Incremental profit per unit
All else given, a seller with a higher price-cost margin is
likely to benefit more from increased sales.
Similarly, horizontal differentiation can boost price-cost
margins but lead to fewer marginal customers.
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Lecture summary
We have considered:
The dynamics of price competition
Factors influencing industry rivalry and price competition"
Characteristics and determinants of co-operative pricing"
Co-ordination problem and firm responses"
Quality competition and non-price competition
Inter-firm behaviour in a dynamic framework
The next lecture will consider firm entry and exit.

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