THE DINAMICS OF PRICING
REVALRY
ECONOMICS OF STRATEGY
CHAPTER 8
Presented by:
Agus Hermanto
Ganggas Cahyono
(MM UGM Jakarta - AP14)
CONTENT:
DINAMIC PRICING RIVALRY
• Why the Cournot and Bertrand Models Are Not Dynamic
• Dynamic Pricing Rivalry: Intuition
• Competitor Responses and Tit-for-Tat Pricing
• Tit-for-Tat Pricing with Many Firms
• The “Folk Theorem”
• Coordination
• Why is Tit-for-Tat So Compelling?
• Misreads
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
• Market Structure and the Sustainability of Cooperative Pricing: Summary
CONTENT (continuation):
FACILITATING PRACTICES
• Price Leadership
• Advance Announcement of Price Changes
• Most Favored Customer Clauses
• Uniform Delivered Prices
• Facilitating Practices and Antitust
QUALITY COMPETITION
• Quality Choice in Competitive Markets
• Quality Choices of Sellers with Market Power
DYNAMIC PRICING RIVALRY
Firms that compete with one another do so repeatedly, again and again.
Competitive moves by firm might have short-run benefit, but in the longer run
can hurt the firm if the competitor makes countermoves.
 Why the Cournot and Bertrand Models Are Not Dynamic
q2
Figure 1: Convergence to a
Cournot Equilibrium
Cournot & Bertrand models are
static, they are looking at
simultaneously moves.
In these models, all firms
simultaneously make once-and-for all
quantity or price choices. The reaction
functions are not time based and only
consider one period of time.
These models reduce a complicated
phenomenon in industry rivalry.
Cournot equilibrium
q2 1
q2 2
q2 *
R2
R1
0
q1
1 2 *
q1 q1 q1
q1
 Dynamic Pricing Rivalry: Intuition
Intense price competition, profits can be driven to zero.
The firms would prefer prices to be closer to their monopoly price level.
 It can be achieved if there is a “cooperative pricing” in which neither
firms will undercut its rival.
A firm that contemplates undercutting its rivals confronts a tradeoff.
 In short time, it will increase a market share and the firm has higher
profit
 But, if rivals also respond to lowering their own prices there will be no
more increase in market share, and on the other hand will result lower
price-cost margin.
 Competitor Responses and Tit-for-Tat Pricing
A tit-for-tat strategy says that the firm should try a cooperative pricing
strategy in the current round, then match the opponents response in the
preceding round.
Example:
 Shell vs. Exxon Mobil
 The current oil price $40 per hundred pounds.
 Monopoly price is $60 and Bertrand (oligopoly) price is $20
 Shell increases their price from $40 (current price) to $60 (monopoly
price):
 If Exxon Mobil does not follow to increase price, Shell will drop their
price back down after 1 week. Exxon Mobil will get “bump” profit in
a week from $0.1154 million to $0.2307 million and will be
back to $0.1154 million if Shell drop their price down back to $40.
Exxon Mobil discounted present value weekly profit would
be $57.93 million.
 If Exxon Mobil follows to increase price, both firms will earn annual
profit $8 million or weekly profit $0.1538 million. The discounted
value of Exxon Mobil weekly profit would be $77.05 million.
 Tit-for-Tat Pricing with Many Firms
The firm will get larger profit if it sticks on prevailing price (P0) and all
competitors use monopoly price (PM). The firm undercutting its competitors and
capturing the entire market.
A firm’s one period profit gain from refusing to cooperate with industrywide
move to monopoly prices is π0 – (1/N) πM
If each firm believe that competitor will raise the price from P0 to PM in the
current period and thereafter will follow tit-for-tat strategy, then each firm will
find it in its self-interest to charge the monopoly price as long as:
1/N(πM – π0)
----------------- > i
π0 – (1/N) πM
Where:
π0
: per period industry’s profit at the prevailing price P0
πM
: per period industry’s profit when all firms charge the monopoly
price PM
i
: discount rate per period
 The “Folk Theorem”
The “Folk Theorem” says that for sufficiently low discount rates, any price
between monopoly price and marginal cost can be sustained as an equilibrium in
the infinitely repeated prisoners’ dilemma game.
 Implies that cooperative pricing behaviour is a possible outcome in an
oligopolistic industry even if all firms act unilaterally.
 Coordination
To attain the cooperative outcome, firms in the industry must coordinate on a
strategy, such as tit-for-tat, that makes it in each firm’s self-interest to refrain from
aggressive price cutting.
The coordination problem can be overcome if there exists a focal point strategy.
 A focal point strategy is a strategy that is so compelling that a firm
expects all other firms to adopt it.
 Why Is Tit-for-Tat So Compelling?
Another strategy results in the monopoly price for sufficiently low discount rates
is the “grim trigger” strategy:
 Starting this period, we will charge the monopoly price (PM). In each
subsequent period, if any firm deviates from PM we will drop our price
to marginal cost in the next period and keep it there forever.
 The threat of an infinite price war to keep firms from undercutting their
competitor’s price.
Tit-for-tat strategy is simple and easy to describe and easy to understand.
Tit-for-tat does well against many strategies in the long-run.
The tit-for-tat strategy embodies the following properties:
 Niceness : it is never the first to defect from the cooperative outcome.
 Provocability : it immediately punishes a rival that defects from the
cooperative outcome by matching the rival’s defection in the next
period.
 Forgiveness : the rival returns to the cooperative strategy.
 Misreads
It is possible that a firm can misread a signal in the market when cooperation is
occurring.
 A firm mistakenly believes a competitor is charging one price when it is
really charging another
 A firm misunderstands the reasons for a competitor’s pricing decision.
A single misread leads to a pattern in which firms alternate between cooperative
and uncooperative moves. If another move is misread as uncooperative one, the
result pattern become even worse.
Firm should carefully ascertain the details of the competitive initiative and figure
out the competitor’s move before responding.
HOW MARKET STRUCTURE AFFECTS THE SUSTAINABILITY OF
COOPERATIVE PRICING
Pricing cooperation is harder to achieve under some market structures.
The following market structural issues may complicate the attainment of
cooperative pricing:
o Market concentration
o Structural conditions that affect reaction speeds and detection lags
o Asymmetries among firm
o Price sensitivity of buyers
 Market Concentration and Sustainability of Cooperative Pricing
The benefit-cost ratio goes up as the number of firms goes down.
Cooperative pricing is more likely to be achieved in concentrated market (few
firms) than in a fragmented market (many firms), because:
 There is less to gain from cheating due to each firm already having a
considerable share of the market.
 It is more likely that a few firms can more quickly discover a focal point
strategy.
 Reaction Speed, Detection Lags, and the Sustainability of
Cooperative Pricing
The speed with which firms can react to their rivals’ pricing moves also affects the
sustainability of cooperative pricing.
A firm maybe unable to react quickly to its competitors’ pricing move, because:
 Lags in detecting competitors’ prices.
 Infrequent interactions with competitors (e.g., a few times a year)
 Ambiguities in identifying which firm among a group of firms in a market
is cutting price
 Difficulties distinguishing drops in volume due to price cutting by rivals
from drops in volume due to unanticipated decreases in market demand.
The above factors reduce the speed with which firms can respond to defections
from cooperative pricing.
Several structural conditions affect the importance of these factors:
a. Lumpiness of orders
b. Information about sales transactions
c. The numbers of buyers
d. Volatility of demand and cost conditions
• Lumpiness of Orders
This occurs relatively infrequently in large batches as opposed to being smoothly
distributed over the years.
Lumpy orders reduce the frequency of competitive interactions between firms.
This makes price a more attractive competitive weapon for individual firms and
intensifies price competition throughout the industry.
• Information about the Sales Transaction
This is related to the visibility and complexity of the sales transaction in the
market.
When sales transactions are “public”, deviations from cooperative pricing are
easier to detect than when prices are secret.
Deviations from cooperative pricing are also difficult to detect when product
attributes are customized to individual buyers.
With secret and complex sales terms, forgiving strategy may not work in
environments where misreading can occur.
• The Number of Buyer
When firm normally set prices in secret, it is easier to detect deviations from
cooperative pricing when each firm sells to many small buyers than when each
sells to a few large buyers.
Illustration:
 Probability detection of 300 small buyers : 1 – (0.99)300 = 0.951
 Probability detection of 10 large buyers : 1 – (0.99)10 = 0.096
• 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
because one of its competitors has cut price and is taking business from it?
During times of excess capacity, the temptation to cut price to steal business can
be high.
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

o different costs
o different capacities
o 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
o Larger firms get a larger share of the benefits
of cooperative pricing
o Larger firms may have weak incentives to
punish small deviators
o Small firms have a large set of potential
customers to attract by price cutting
Price Sensitivity of Buyers
When buyer are price sensitive, a firm
that undercuts its rivals price by even a
small amount may be able to achieve a
significant boost in its volume.
 A key factor shaping buyers price
sensitivity is the extent to which
competing firms product are horizontally
different.

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
Situation in which a market leader sets the
price of a product or service, and competitors
feel compelled to match that price.
(Investorworld.com)
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

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
 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
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!)

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

Thank You