Chapter 8 The Dynamics of Pricing Rivalry

Chapter Contents 1) Introduction 2) Dynamic Pricing Rivalry Why the Cournot and Bertrand Models Are Not Dynamic Intuition Example 8.1: The General Motors Employee Discount Price War Competitor Responses and Tit-for-Tat Pricing Tit-for-Tat Pricing with Many Firms Example 8.2: What Happens When a Firm Retaliates Quickly to a Price Cut: Philip Morris versus B.A.T in Costa Rica The Folk Theorem Coordination Why is Tit-for-Tat so Compelling? Misreads Example 8.3: Forgiveness and Provocability: Dow Chemicals and the Market for Reverse Osmosis Membrane 3) How Market Structure Affects the Sustainability of Cooperative Pricing Market Concentration and the Sustainability of Cooperative Pricing Reaction Speed, Detection Lags, and the Sustainability of Cooperative Pricing Asymmetries Among Firms and the Sustainability of Cooperative Prices Example 8.4: Pricing Discipline in the U.S. Cigarette Industry Example 8.5: Profitability in the Heavy-Duty Truck Engine Industry Market Structure and the Sustainability of Cooperative Pricing: Summary 4) Facilitating Practices Price Leadership Advance Announcement of Price Changes Most Favored Customer Clauses Uniform Delivered Prices Facilitating Practices and Antitrust 5) Quality Competition Example 8.6: Quality Competition among U. S. Health Plans Quality Choice in Competitive Markets Quality Choices of Sellers with Market Power

6) Chapter Summary 7) Questions

Chapter Summary Through examples and theory, Chapter 8 further explores industry rivalry and examines what conditions affect the intensity of price competition in an industry. Why are some firms able to coordinate their pricing behavior to avoid costly price wars while other firms engage in vicious price wars? This chapter introduces a set of models and analytical frameworks that help explain why firms compete as they do. These models build on the ideas introduced in Chapter 6. However, unlike Chapter 6, these models are dynamic; that is they assume firms engage in repeated interactions with each other. This chapter introduces a theory of rivalry to explain how firms act when they meet repeatedly over timea dynamic that is not fully encompassed in the Cournot or Bertrand oligopoly models. The first section describes a scenario where two firms - competing in the same industry with the exact same product and cost structure could charge monopoly prices and reap monopoly profits without meeting or engaging in price collusion. This dynamic pricing rivalry theory supports this intuition and further suggests that any price between the monopoly price P and marginal cost C can be sustained as an equilibrium. The chapter uses the term cooperative pricing to refer to these situations in which firms are able to sustain higher profits than would be predicted by the Cournot and Bertrand model. This example and theorem prove that cooperative pricing is possible, but not guaranteed. There are strategies that a firm can adopt to increase the likelihood that cooperative pricing will occur in their market. The chapter focuses on the pros and cons of the tit-for-tat strategy, a strategy that is appealing in its simplicity and its power. The chapter goes on to discuss four market structure conditions and whether they help or hinder firms from achieving cooperative pricing and competitive stability: market concentration, structural conditions that affect reaction speeds and detection lags, asymmetries among firms, and multi-market contact. Although market structure strongly affects a firms ability to sustain cooperative pricing, this chapter discusses four ways in which firms can facilitate cooperative pricing: though price leadership, advance announcements of price changes, most favored customer clauses, and uniform delivered pricing. The chapter discusses each of these methods in turn. The last section of this chapter addresses non-price competition, such as competition with respect to product quality. This part of the chapter explores how market structure influences a firms decision to choose its level of product quality. It also examines the role that consumer information plays in shaping the nature of competition with respect to quality. Specifically, if consumers do not have perfect information about product quality or if a consumer cannot gauge quality, a lemons market can emerge (i.e., cars, health insurance). When sellers have market power, the quality they provide depends on the marginal cost and marginal benefit of increasing quality. The marginal benefit of increasing quality depends on the increase in demand brought on by the increase in quality and the incremental profit earned on each additional unit sold. This implies that a firms price-cost margin is an important determinant of its incentives to raise quality.

Approaches to Teaching this Chapter Chapters 8 and 9 have the most difficult microeconomics content and students with weaker microeconomic backgrounds will find these chapters especially challenging. In teaching this chapter, one could begin by talking about the notion of price cooperation, which is the ability of firms within an industry to collectively avoid the prisoners' dilemma outcome of pricing, that is, to do better than they would do in a static Bertrand or Cournot equilibrium. The first section of Chapter 8 develops a theoretical framework (based on a repeated prisoners dilemma game model) for looking at firms' incentives to deviate from cooperative outcomes. This framework has very powerful implications for how market structure conditions impact the likelihood of firms to achieve pricing cooperation. Equation 8.1 sets forth a condition for the cooperative pricing outcome to bean equilibrium in a noncooperative game of price setting. This condition can then be used to develop insights about how market structure affects the intensity of pricing rivalry. The next section develops this point in detail. This section is the heart of the chapter. The instructor should cover carefully how market concentration, asymmetries among firms, multimarket contact, reaction speeds and detection lags affect the sustainability of cooperative pricing. It is then natural to follow up this material with a coverage of facilitating practices: price leadership, advance announcement of price changes, most favored customer clauses, uniform delivered pricing and strategic use of inventories and order backlogs. The Quality Competition section of the chapter discusses the other dimensions besides price along which competition can take place. This section does not follow directly the earlier parts of the chapter, and can easily be dropped.

Suggested Harvard Case Study

Caterpillar HBS 9-385-276 (see earlier chapters) De Beers Consolidated Mines, HBS 9-391-076 (see earlier chapters) Nucor at a Crossroads HBS 9-793-039 (see earlier chapters)
Philips Compact Disc Introduction, HBS 9-792-035 (see earlier chapters)

Extra Readings The sources below provide additional resources concerning the theories and examples of the chapter. Axelrod, R., The Evolution of Cooperation, New York: Basic Books, 1984. Bernheim, B.D. and M. Whinston, Multimarket Contact and Collusive Behavior, RAND Journal of Economics, 21, Spring 1990: 1-26. Chamberlin, E.H., Monopolistic Competition, Cambridge, MA: Harvard University Press, 1933, p. 48 Dixit, A. and B. Nalebuff, Thinking Strategically.- The Competitive Edge in Business, Politics and Everyday Life, New York: Norton, 1991. Dranove, D. and M. Satterthwaite, Monopolistic Competition When Price and Quality are Not Perfectly Observable, RAND Journal of Economics, Winter 1992: 518-534. Kreps, D.M., A Course in Microeconomic Theory, Princeton, NJ: Princeton University Press, 1990, pp. 392-393. Merrilees, W., Anatomy of a Price Leadership Challenge: An Evaluation of Pricing Strategies in the Australian Newspaper Industry, Journal of Industrial Economics, XXXI, March 1983:291-311. Schelling,Thomas. The Strategy of Conflict, Cambridge, MA: Harvard, 1960. Scherer, F.M. and D. Ross, Industrial Market Structure and Economic Performance, New York: Houghton Mifflin, 1991. Spence, A.M., Monopoly, Quality, and Regulation, Bell Journal of Economics, 1975: 417429. Stigler, George J., A Theory of Oligopoly, Journal of Political Economy, 72 (1), February 1964:44-61.

Answers to End of Chapter Questions 1. Explain why Cournot and Bertrand models are not dynamic. In the Cournot and Betrand models of duopoly each firm decides on the price and quantity choice once. In a dynamic model there will be multiple periods and these choices will have to be made repeatedly in each period. Each periods decision will have to maximize the present value of future cash flows. This means in a dynamic model a firm has to anticipate 2. An article on price wars by two McKinsey consultants makes the following argument. That the (tit-for-tat) strategy is fraught with risk cannot be overemphasized. Your competitor may take an inordinately long time to realize that its actions can do it nothing but harm; rivalry across the entire industry may escalate precipitously; and as the tit-fortat game plays itself out, all of a price wars detrimental effects on customers will make themselves felt. As the argument in the McKinsey article points out, there are risks involved in adopting the tit-for-tat strategy. Misreading pricing moves made by competitors can lead to alternating cooperative and uncooperative responses or all uncooperative responses. When the possibility of misreads exists, it may be beneficial for a firm to adopt a more forgiving strategy to reduce the likelihood of detrimental responses to a competitors price deviations. However, adopting the tit-for-tat strategy before a price war ensues can serve as a powerful deterrent sustaining monopoly pricing at a non-cooperative equilibrium. 3. How does revenue destruction effect (see Chapter 6) affect the ability of firms to coordinate on a pricing equilibrium? If a small firm cuts prices to get new customers and expand revenue, the additional revenue from new customers can more than offset the loss of revenue from existing customers. Since its market share is small the impact of the revenue destruction effect on the firm will be small. If the market is concentrated, the loss of revenue is likely to be larger than the revenue gain from new customers. There is no incentive for the firms with significant market shares to engage in price cutting. 4. Why do misreads encourage firms to lower prices? Consider what might happen when two firms are playing tit-for-tat, and there is a chance that a cooperative move is misread an uncooperative one. The firm that misreads the cooperative move as an uncooperative one responds by making an uncooperative move in the next period. The firm lowers price in order to enforce the tit-for-tat strategy. It is possible that a firm mistakes the actions of its rival as aggressive and so reacts with a price cut in order to protect volume. 5. Firms operating at or near capacity are unlikely to instigate price wars. Briefly explain. Firms who lower price earn less on every unit they sell up to the quantity they sold before the price reduction. However, this loss can be offset by an increase in units sold due to the now lower price. If a firm is at or near capacity, its ability to expand quantity sold is

constrained and hence the firm cannot recover the forgone profits from selling each unit at a lower margin. The capacity constrained firm has little incentive to initiate a price reduction. Firms are more likely to instigate price wars when excess capacity exists. For example, if a firm is experiencing excess capacity, and a new firm enters the market, the new entry will induce even greater excess capacity on the part of the incumbent. If there are economies of scale in production, the costs of idle capacity may rise with the degree of idleness. This suggests that the incumbent will fight harder to retain market share under excess capacity conditions, prices are likely to drop with entry. The firm with excess capacity may lower its price in order to retain or steal market share. 6. Pricing cooperation is more likely to emerge in markets where, if one firm raises a price and competitors follow suit, market shares remain unchanged. It is less likely to work well in markets where price matching may not leave market shares constant. Evaluate this statement. Can you think of circumstances under which price matching behavior could alter market share?

The relative levels of profitability from cooperating and defecting in the collusive pricing game are what will ultimately determine the stability of price cooperation. Market share is only important in so far as it is often a good proxy for profitability. Price-matching behavior will not necessarily leave market shares unchanged. For example, if products are differentiated, the relative abilities of products to support their level of benefits in the market may vary as prices change. In addition, changes in market share may also occur if movements in price allow one firm to develop a more favorable brand image or reputation, or if network externalities are at work. For example, imagine that two firms, Firm A and Firm B, share a market equally. If Firm A cuts its price, then it will steal market share from Firm B until Firm B lowers its price to the same level. Once Firm B matches Firm A, both firms are worse off than they were before Firm A lowered price. If Firm A knows it cannot increase its market share, Firm A has little incentive to initiate a price reduction. However, if Firm A is able to keep a larger market share even after Firm B matches the price cut, the deterrent effect of the tit-for-tat strategy would be reduced. If Firm A could, for example, build in some switching costs for its new users, it can retain much of its increased market share. 7. Suppose that you were an industry analyst trying to determine if the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game. What real world data would you want to examine? What would you consider to be evidence of tit-for-tat pricing? Circumstantial evidence of tit-for-tat pricing is relatively easy to find. Public pricing behavior like the advance announcement of price changes and the use of commitments to meet the lowest available price support price coordination and stability, as does simplified pricing behavior such as having annual pricing reviews. However, hard evidence of tit-fortat pricing is much harder to come by, unless firms are foolish enough to put a collusive agreement in writing. You would want detailed data on historical prices and firm profits in an attempt to discern pricing patterns that support above-average industry profitability. One such telltale pattern is a punishment strategy, where all firms lower price to punish a renegade firm that reduces its price unilaterally. Then, after a period, all firms raise their

price back to the previous, higher level. However, firms can always argue that external circumstances are responsible for the price moves. Furthermore, if collusion is extremely effective, you would not observe punishment behavior at all. 8. Studies of pricing in the airline industry show that carriers that dominate hub airports (Delta in Atlanta, USAir in Pittsburgh, American in Dallas) tend to charge higher fares, on average, for flights in and out of the hub airport than other, nondominate, carriers flying in and out of the hub. What might explain this pattern of prices? There are several reasons why dominant hub airlines can charge higher prices than nondominant carriers flying in and out of the hub. First, the convenience that a hub airline provides creates a differentiated product for which the airline can charge a premium. Second, the frequency that hub airlines provide reduces the number of substitute flights available for consumers. This shifts the demand for the hub airline out, reducing the price elasticity for the hub airlines flights. And finally, smaller airlines may reduce prices below the hub airline prices because the dominant airline has little incentive to retaliate with a price war. 9. It is often argued that price wars may be more likely to occur during low demand periods than during high demand periods. (This chapter makes that argument.) Are there factors that might reverse this implication? That is, can you think of reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high demand) than during busts (low demand)? Deviation from cooperative pricing can occur during economic booms. During periods of high demand, gaining the dominant market share position will capture a higher percentage of industry profits. Also, recognizing the inevitable downturn in their market following a boom period, a firm may be tempted to capture profits to serve as a cushion during an economic downturn. Gaining a dominant market share is more profitable during a boom than during a downturn. Furthermore, if the firm can retain some of it increased share after the boom (through reputational effects, switching costs, etc.) it will be in a better position during the downturn. These factors may tempt a firm to deviate from cooperative pricing during a boom. 10. Consider a duopoly consisting of two firms, Amalgamated Electric (AE) and Carnegie-Manheim (C-M), that sell products that are somewhat differentiated. Each firm sells to customers with different price elasticities of demand, and, as a result, occasionally discounts below list price for the most price-elastic customers. Suppose, now, that AE adopts a contemporaneous most favored customer policy, but C-M does not. What will happen to AEs average equilibrium price? What will happen to CMs average equilibrium price? By adopting a contemporaneous most favored customer clause (MFCC), AE precludes itself from discriminating between price-elastic and price-inelastic customers. Whereas before it was price discriminating, now it will charge all customers the same price. Margins on inelastic customers will fall and margins on elastic customers will rise. The common price for AE will most likely be higher than the average price without the MFCC. Presumably AE adopted the MFCC to increase its profit. This implies that the

margin increase on elastic customers will be greater than the margin decrease on inelastic customers. Now that AE will charge a higher price to the elastic customers, CM does not have to discount as aggressively in order to compete for these customers. Its profit-maximizing price to elastic customers will increase, though not as much as AEs. As a result, CMs average equilibrium price will increase as well. 11. Firms often complain that their competitors are setting prices that are too low. Can you give any recommendations to the firm regarding how they should handle such public complaints? Anti competitive below cost pricing is illegal under the antitrust law in the U. S. and elsewhere. One possibe counter to the complaints from the competitors is to make public the fact that these products in question are profit makers for the company.

12. How might an increase in the number of competitors in a market affect overall product quality? Under what circumstances might a high quality firm prosper by entering a competitive market? When there are a large number of competitors, the marginal benefit of increasing quality is high due to the abundance of marginal consumers. On the other hand, in a competitive market, the price cost margin is likely to be too small to allow quality improvements. High quality firms cannot prosper in a market where the customers cannot ascertain the quality. We end up with a lemons market.