Pricing in Imperfectly Competitive Markets

1. Pricing in Imperfectly Competitive Markets

2. Determinants of Pricing Decision • Economic analysis of pricing in imperfectly competitive markets identifies the following elements of the market environment as important to pricing decision: • number of competitors/ease of entry • similarity of competitors’ products • capacity limitations • on-going interactions • Information on past pricing decisions

3. Bertrand • Simultaneous price setting • Identical products • No capacity constraints • One time interaction Price competition results in price equal marginal cost for all firms and zero profits

4. Bertrand • Bertrand paradox (p=mc even though few firms in market) can be resolved by relaxing certain assumptions: • No Capacity Constraints • Undifferentiated Products • One-shot competition

5. Capacity Constraints • Suppose each firm has max capacity of Ki • If firm j sets a higher price than firm i, j may get the left-over demand that firm i can’t satisfy if demand exceeds i’s capacity • So setting price above MC may be worthwhile

6. Repeated Games and Collusion • Can Bertrand paradox be resolved if firms interact repeatedly? • Is it a Nash Equilibrium to set p>mc in the first period of a repeated interaction in an effort to ‘signal’ willingness to ‘cooperate’? • Depends on what we mean by repeated? -fixed number of times -infinite number of times

7. Fixed: -last period is same as one-shot game -no incentive to cooperate in any preceding period -cooperation unravels • Infinite: -no last period so cooperation is possible -influence behaviour through use of punishment strategies

8. Cooperation more likely when: -there is a high probability of future interaction -actions of rivals can be monitored -defectors can be easily punished -interest rates are low

9. Product differentiation • Can Bertrand paradox be resolved if there is a small number of firms that interact strategically? • Firms produce different varieties of a product -varieties differ according to some characteristic

10. Consumers differ as to how they value the characteristic • Consumer location on line reveals preference for characteristic • Consumer pays a ‘mismatch’ or ‘transportation’ cost t which measures their aversion to buying something other than their preferred degree of the characteristic • This cost allows firms to charge a price above marginal cost

11. Product positioning: • If price competition is intense: -firms should locate far apart (differentiate), in order to be able to drive up price • If price competition is not intense: -firms should locate close together—in the center of the spectrum

12. Switching and Search Costs • Once a consumer has experienced a product, there may be a cost associated with switching to a new product • There may also be a cost associated with finding out what products are available and at what price • In equilibrium, firms can have market power if these costs are sufficiently high

13. Vertical Differentiation • Consumers agree on what is better, but differ in their willingness to pay for quality • When firms compete in prices with given qualities, equilibrium involves the higher-quality firm charging a higher price than the lower-quality firm and earning higher profits

14. If firms first choose quality first and then price second, equlibrium involves maximum differentiation. • This is done in an effort to relax price competition. • True as long as consumers are sufficiently different in their willingness to pay for quality