Transcript Strategic commitment and pricing dynamics

Strategic commitment
and pricing dynamics
By
A.V. Vedpuriswar
Strategic Commitment
Strategic commitments are decisions that have a long term impact and are
difficult to reverse.
If firms are far sighted, when they make their commitments, they will anticipate
the effects they will have on market competition.
The degree of market rivalry can influence the commitments firms make and
the levels of commitment they choose.
Strategic commitments that seemingly limit options can actually make a firm
better off.
Inflexibility can have value because a firm’s commitments can alter its
competitors’ expectations about how it will compete.
This will prompt competitors to make decisions that benefit the already
committed firm.
A commitment by one firm will not generate the desired response from its
competitors unless it has three characteristics:
•
It must be visible
•
It must be understandable
•
It must be credible.
A key to credibility is irreversibility. To be a true
commitment, a competitive move must be hard or
costly to stop, once it is set in motion.
Competitive moves such as capacity expansion,
that require significant up-front expenditures and
create relationship-specific assets have a high
commitment value.
Contracts can also facilitate commitment.
Sometimes, public statements of intentions to act
can have commitment value.
The credibility of announcements is enhanced, if
the firm’s competitors and customers understand
that the firm and its management are putting
something at risk if they fail to match words with
actions.
When reaction functions are upward sloping, the firm’s actions are
strategic complements.
When reaction functions are strategic complements, the more of an
action one firm chooses, the more of the action the other firm will
also optimally choose.
In the Bertrand model, prices are a strategic complement because a
reduction in price is the profit maximizing response to a competitor's
price cut.
When actions are strategic substitutes, the more of the action one
firm takes, the less of the action the other firm optimally chooses.
In the Cournot model, quantities are strategic substitutes because a
quantity increase is the profit maximizing response to a competitor's
quantity reduction.
Usually, prices are strategic complements where as quantity and
capacity decisions are strategic substitutes.
Commitments have both a direct and strategic effect on a firm’s
profitability.
The direct impact of the commitment is on the present value of the
firm’s profits assuming that the firm adjusts its own tactical decisions in
light of this commitment and that its competitor’s behaviour does not
change.
The strategic effect takes into account the competitive side effects of
the commitment.
How does the commitment alter the tactical decisions of rivals and
ultimately the market equilibrium?
A tough commitment is bad for competitors .
A soft commitment is good for competitors.
When making hard-to-reverse investment decisions, managers
ought not to look at only the effects of the investments on their
own firm.
They should also try to anticipate how the decisions to invest or
not invest will affect the evolution of market competition in the
future.
A commitment that induces competitors or potential entrants to
behave less aggressively – eg., refrain from price cutting,
postpone or abandon capacity expansion plans, reduce
advertising/promotion – is likely to have a beneficial strategic
effect on the firm making the commitment.
A commitment that induces competitors or potential entrants to
behave more aggressively is likely to have a harmful strategic
effect.
The Dynamics of Pricing Rivalry

Carnot and Bertrand models are somewhat static.

These models assume that all firms simultaneously make once-and-for
all quantity or price choices.

No firm has an incentive to deviate from its equilibrium quantity given
that it expects that rivals will also choose their equilibrium quantities
and prices.

Each time the firm chooses its quantity, it does so based on what its
rivals did in the previous move.

Its reaction is the choice that maximises its current profit

An intelligent firm would take the long term view and anticipate what
its rivals would do not just what happened in the past.

Let us assume that firms would prefer prices closer to their
monopoly levels than to the levels reached in Cournot/Bertrand
equilibrium.

Consider the following situation.

MC= $0.20/lb

When MR=MC, Price, P=$0.60/lb, the monopoly price and
Demand, Q= 40 million lbs

Assume the two players divide up the market equally, they each
produce 20 million lbs.

So profit =(0.6-0.2)(20)= $ 8million for each player.

Suppose one firm raises the price to 0.6 while the other firm keeps it at 0.4.

At price=0.4, let us say demand increases pro rata to 60 million lbs.

Profit = (0.4-0.2)(60) = $ 12 million. This is completely captured by the firm
which charges the lower price.

If it had kept a price of 0.6, the profit would have been $ 8 million for each
firm and $ 16 million for the industry.

So in their collective interest, both should charge monopoly prices.

But each finds it more attractive to undercut.

The situation is also dynamic.

If the second player does not match the price increase, the first player can
cancel the earlier price increase quickly, incurring minimum loss.
Let us expand the earlier example. Exxon and Shell are the only two
oil companies in a country. The Bertrand price (Marginal cost) is
$.20/lb while the monopoly price is $.60/lb. Currently, the two players
are charging $.40/lb. The total market demand at this price is 60
million pounds.
Suppose Shell raises the price to $ 0.60. The market demand at this
price is $ 40 million pounds.
What will happen if: (a) Exxon does not follow (b) Exxon follows and
increases the price to $0.60.
Assume that prices can be revised every week and the weekly
discount rate is .2%.
When will it make sense for Exxon not to follow Shell? Assume both
players are equally powerful.
Currently, industry profit = (.40 - .20) (60) = $12 million
Each player’s profit
= 12/2 = $ 6 million
Suppose Exxon does not follow suit.
Exxon’s profit = $12 million as it will capture the entire profit.
Weekly profit = 12/52
= 3/13 = $.2308 million.
Next week, Shell will bring back its price to $40.
Then both players will each make $ 6 million or $ .1154 per week
Present value of Exxon’s profit = .2308 +
.1154 .1154

 ....
1.002 (1.002) 2
= .2308 + .1154/.002
= $ 57.93 million
If Exxon follows Shell, market will settle at monopoly price.
Market demand = 40
P = $.60, MC = $ 0.2
Industry profits = ($.6 - $.2) (40) = $16 million
Exxon’s share
= $ 8 million
Weekly profit
= 8/52 = 2/13 = .1538
.1538
.1538
Present value of profits = .1538 + 1.002  1.0022  ....
= .1538
= .1538
1
1


1



...
2
 1.002 1.002

1
1 1
1.002
= .1538 x1.002/.002
= $ 77.05 Million
2308 + .1154/r > .1538 X(1+r)/r
 This is the condition for not following suit

 0 = per period industry profit at prevailing price, P0
 m = per period industry profit at monopoly price, Pm
0
Clearly
<
m
But firms face the prisoner’s dilemma. They hope to gain a larger share
of the profit by sticking to  0
One period profit gain by not cooperating with the industry wide move
=
0 -
1
N
m
1
But profit in subsequent periods will come back to N
will retaliate.

present value of profits
 0 as other firms
+
1
1
0
0
N
N

 ...
1 r
(1  r ) 2
0 +
1 0 
1

1


...

N 1  r  1  r
0
=
=
=
0
=
0
+
+
1 0
1
N 1 r 1 1
1 r
0
Nr
If the firm had followed the move by the industry, per period profit
1
m
N
=
1
So present value of profit = N  m
=
=
1
1
m
1
(1 
)
N
1 r
 m 1 r
N
x
r
1 m 1 m
+ N 1  r  N (1  r ) 2  ....
The firm will find it makes sense to charge the monopoly price when:
 m 1 r
N
Or
Or
Or
Or
m
Nr
m
N
r>
r>
r
+
-
m
>
r<
0
0
Nr
+
1
( 0 Nr
 m)
1
N
( 0 -  m ) x
N
 m  N 0
1
( 0 -  m )
N
m
N
Or
+ Nr
>
N
0
0
0
>
0
1
( 0 -  m )
N
0 
m
N
Firms will charge monopoly price as long as
1
( m -  0 )
N
0 
Or
m
N
m
≥i
Suppose I is the interest for one year, i.e., the profit period is 1 year.
If instead, the pricing period becomes a quarter and i become i/4
1 m 0
( - )
N 4 4
≥ i/4
0 1 m

4 N 4
1
( m -  0 )
N
≥ i/4
1
0  m
N
The threshold above which it is optimal for a firm to raise its price
to the monopoly level is lower.
An increase in the speed of reaction from one year to one quarter
widens the set of circumstances in which the cooperative outcome
is sustainable.
If price cuts can be matched instantly, the effective discount rate
goes to zero and cooperative pricing will always be sustainable.
Cooperative Pricing
If a firm undercuts, it might lead to an increase in market share, it might also lead to
a long term increase in profits.
If on the other hand, rivals respond by lowering their own prices, the firm that
initiated the price reduction may end up with no increase in market share but a fall
in profits.
If each player is focused on profit maximisation, it will realise that when there are
only a few sellers, any price cut will be met with retaliation.
Since price cuts will only lead to a decrease in profits, the result is that although the
sellers are independent, the equilibrium result is as though there is a monopolistic
agreement between them.
Cooperative pricing means a firm does not undercut its rivals
Or if rivals raise prices, it also raises prices.
There are some circumstances under which cooperative pricing results.
There are other circumstances under which a firm may like to undercut its rivals or
not match the rice increases of rivals
Cooperative pricing is more likely to be an equilibrium in a
concentrated market than in a fragmented market
In a concentrated market, a typical firm’s market share is larger than
it would be in a fragmented market.
A typical firm 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 market is smaller when the market is more concentrated.
A deviator may gain from stealing business from rival firms.
But if the deviator has a large share of the market to begin with, the
business it steals is smaller in proportion to the sales it gets if it goes
along with the price than it would be if it was in a fragmented market
with small market share.
The more concentrated the market, the larger the benefits from
cooperation and the smaller the costs of cooperation.
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 reaction makes
cooperative outcome more sustainable.
If price cuts can be matched instantly, cooperative
pricing, will be more sustainable.
Quick reaction may not be possible because of:
• lags in detecting competitor’s prices
• infrequent interactions with competitors
• ambiguities in identifying which firm among a
group of firms is cutting price
• difficulties in distinguishing drops in volume due to
price cutting by rivals from drops in volume due to
unanticipated decreases in market demand.
Lumpy orders reduce the frequency of competitive interaction
between firms.
This makes price a more attractive competitive weapon for
individual firms and intensifies price competition.
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. So
price cutting to steal market share from competitors is likely to
be less attractive, enhancing the chances that cooperative
pricing can be sustained.
Some indirect forms of price cutting such as trade allowances
to retailers/favourable credit terms are less easy to detect.




Deviations from cooperative pricing are also difficult to
detect when product attributes are customised to individual
buyers.
Secret or complex transaction terms can intensify price
competition not only because price matching becomes a
less effective deterrent to price cutting behaviour but also
because misreading becomes more likely.
Firms are more likely to misinterpret a competitive move,
such as a reduction in list prices, as an aggressive attempt
to steal business, when they cannot fully observe all the
other terms competitors are offering.
When this happens, the odds of accidental price wars
breaking out rise.
Detecting deviations from cooperative pricing is easier when each firm sells to
many small buyers than when each sells to a few large buyers.
This is because a buyer who receives a price concession from one buyer has an
incentive to inform other sellers and attract more favourable concessions.
Price cutting is harder to detect when market demand conditions are volatile.
If the firm’s sales unexpectedly fall, it may begin to wonder whether it is because of
a fall in market demand or because competitors are grabbing market share.
Differences in costs/capacities/product quality can create asymmetric incentives
for firms to agree to cooperative pricing.
Small firms often have more incentive to defect from cooperative pricing than large
firms.
Larger firms benefit more from cooperative pricing as they capture a larger portion
of the gains.
Small firms may also anticipate that large firms have weak incentives to punish a
small firm that undercuts its price.
When buyers are price sensitive, a firm that undercuts rivals by even a small
amount, may be able to boost its volume significantly.
Price sensitivity tends to increase when product differentiation is minimal.
Facilitating Practices
Firms can facilitate cooperative pricing by:
-
Price leadership
-
Advance announcement of price changes
-
Most favoured customer clauses
-
Uniform delivered pricing
Price leadership : One firm announces its price changes before 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.
Advance announcement of price changes : Advance announcements
of price changes reduce the uncertainty that the firms’ rivals will
undercut them.
Most favoured customer clauses : This is a provision that promises a
buyer that it will pay the lowest price the seller charges to other
customers.
Uniform delivered prices: Transportation costs are significant in some
industries. Under uniform delivered pricing, the firm quotes a single
delivered price for all buyers and absorbs any freight charges itself.
This way it gives a better deal to far off customers without making it
very obvious.
Quality competition: Companies can charge higher prices for better
quality. But in a well functioning market, the market will force all firms
to charge the same price per unit of quality. Of course we are
assuming that consumers are able to perfectly evaluate the quality of
each seller. That is not always the case.
Quality and the market for lemons
Some consumers may have information about product quality but others may not.
There is no problem if uninformed consumers can infer quality by observing the
behaviour of informed consumers.
If there are enough well informed buyers in a market, most buyers will be
satisfied with the quality of what they buy.
But if uninformed consumers cannot guage quality by observing informed
consumers, then a lemons market can emerge.
In a lemons market, there are uninformed customers and low quality products are
cheaper to make than high quality products.
If customers start feeling vulnerable, they may insist on paying less for a product,
figuring its quality will be low.
At the same time, sellers of high quality products will find it difficult to get the
price that they think is reasonable.
So high quality sellers may decide not to offer their products in the market.
In short, the market breaks down because of the asymmetry of information.
Once a firm starts producing efficiently, there is a cost associated with
higher quality. The revenue generated by improved quality depends on:

the increase in demand caused by increase in quality

the incremental profit earned on each additional unit sold
The ability to attract more customers with improved quality depends on:

the degree of horizontal differentiation in the market

the precision with which customers observe quality.
In a horizontally differentiated market, consumers tend to be loyal to
sellers who offer a good idiosyncratic match between the product’s
differentiated attributes and the consumer’s tastes and preferences.
These loyal customers may be reluctant to switch to another seller even
if he offers a higher overall level of quality.
Even if few customers in a market are loyal to their current sellers, a
seller that boosts quality will not necessarily attract new consumers.
Consumers must be able to determine that quality is higher than it used
to be.
When consumers have difficulty in judging particular attributes of a
product, they may focus on those attributes that they can easily observe
and evaluate. The emphasis on observable attributes means that
consumers are shortchanged on the hard-to-measure attributes that
matter.
Sellers of high quality products must publicise objective quality measures
especially where quality is difficult to evaluate before the purchase.
All else being equal, the seller with the higher price cost margin will make
more money from the increase in sales and thus has a stronger incentive
to boost quality.
On the one hand, horizontal differentiation creates loyal customers which
allows sellers to boost price-cost margins, raising the gains from
attracting more customers by boosting quality.
On the other hand, loyal customers are less likely to switch sellers when
quality differences are low, implying that each seller faces fewer marginal
customers.
Summary
High market concentration facilitates cooperative pricing
-
Coordination is easier.
Firm asymmetries harm cooperative pricing
-
Disagreement over cooperative price
-
Difficulties in coordination
-
Incentives for smaller firms to deviate from
cooperative pricing
High buyer concentration harms cooperative pricing
-
Reduces the probability that a defector will be
discovered
Lumpy orders harm coop-pricing
-
Decrease the frequency of interaction between
competitors
Summary (Cont..)
Secret price terms harm coop-pricing
-
Prices of competitors are more difficult to monitor
Volatility of demand conditions harms coop-pricing
-
Increases the lag between defection and
retaliation
Price sensitive buyers harm coop-pricing
-
Increases the temptation to cut prices even if
competitors are expected to match