STR 421

1. STR 421 Economics of Competitive Strategy Michael Raith Spring 2007

2. Course structure Part I: Obtaining and Sustaining a Competitive Advantage Part II: Strategic Interaction • Dynamics of price competition • Strategic commitments • Technological competition

3. Today’s class • Dynamics of price competition 4.1 Shrimp game wrap-up 4.2 Logic of cooperative pricing 4.3 Factors hindering and facilitating coordination (next class)

4. Shrimp game: example of a Cournot market • Price (Bertrand) competition: firms set prices, quantities sold are functions of prices • Quantity (Cournot) competition: firms choose how much to produce, market price is set so that demand = supply • Applications: • (Oligopolistic) commodities markets: oil (OPEC), aluminum • Long-run competition: think of quantities as capacities

5. Monopoly solution = perfect collusion • Demand: P = 45 ‑.2 QTotal • MR = 45 ‑.4 QTotal, set equal to MC=5 • Optimal QTotal = 100, so QA = QB = QC = 33.33 • Price is 25 • Profit is 666.7 for each firm = 2000 for industry

6. Independent decisions: look for Nash equilibrium • First: find best response for each player • Find quantity that maximizes my profit given what I think my rivals are doing • Demand: P = 45 ‑.2 (QA + QB + QC) • Arnold’s MR, taking QB and QC as given: MR = 45 ‑.2 (QB + QC) - .4QA • Set equal to MC = 5, solve for QA: QA = 100 – (QB + QC)/2

7. The more the others produce, the less you want to produce:

8. Static Nash equilibrium • Nash equilibrium: each player chooses best response to other players’ quantities • Solution: QA = QB = QC = 50 • Corresponding price is 15 • Profit is 500 for each firm = 1500 for industry, less than with perfect collusion • At Nash equilibrium, no firm has incentive to change its quantity • But with repeated interaction, strategic interaction gets very complicated:

9. Example of prices in shrimp game:

10. Some worlds did better than static Nash equilibrium, others worse • Failed attempts to cooperate: incentive to be mean greatest when others are nice: • Trying to beat others in industry?

11. Moral: competitive mindset can be very destructive • Least profitable firm in nicest world almost always has higher profit than most profitable firm in meanest world • Avoiding price wars more important than outperforming competitors • With repeated interaction, competitors can and will react to your attempts to steal business from them • How do firms manage to cooperate?

12. Today’s class • Dynamics of price competition 4.1 Shrimp game wrap-up 4.2 Logic of cooperative pricing 4.3 Factors hindering and facilitating coordination

13. Cooperation in the shrimp game • Suppose: • Firms expect to play this game forever, choose quantities weekly • Future profits are discounted by 20% annually ≈ 0.35% weekly • Possible strategy for the repeated game: • If no one has deviated so far, produce 33 and get profit of 667 • If someone deviates and it is observed by others, switch to static Nash equilibrium (Q=50) forever, and get profit of 500 • Suppose deviations are observed with ¼ probability

14. Key to coordination is a long horizon of interactions ahead • Equilibrium? • Payoff from cooperating: $667/0.0035 = $190,571 • Payoff from cheating: 889 (this week) + 0.998 * (discount from next week) (3/4 * 667/0.0035 + (deviation is not detected) 1/4 * 500/0.0035) (deviation is detected) = 179,175 < 190,571 • No incentive to deviate! • In our game, last round mostly uncooperative • In rounds right before last, when cooperation worked, you didn’t know that game would end very soon • Airlines that are on the verge of bankruptcy cut prices. Why?

15. Tit-for-tat pricing • Problem with “trigger” strategy above: threat of price war forever is very costly if followed through • Alternative: “tit-for-tat” pricing = Match price that rival charged in previous period • Axelrod (1981): experimentally, best strategy to induce cooperation • Why does it work? Axelrod argues: Tit for tat is • nice: never the first to start price war • provokable: immediately matches a price cut • forgiving: return to cooperative pricing if rival does • easy to understand (“We will match our competitors’ prices”) • Problem (see BDSS): misperceptions can lead to large losses • Possible solution: “forgiving” TFT = Wait until it is clear that defection taking place

16. An Example: Airlines in 1998

17. Remark: Collusion and product differentiation are conceptually different • Both lead to P > MC, lower internal rivalry, but: • Product differentiation: At Nash equilibrium, cutting price not profitable even if rivals don’t respond • Collusion: At cooperative price, cutting price not profitable because others are expected to retaliate • Cutting price is profitable in short run, i.e. before rivals can respond

18. Antitrust restrictions • Goal of antitrust laws is to promote efficiency • Price-fixing agreements are per se illegal in U.S. • Recent international cases: Lysine cartel, vitamin cartel (late 90s), Sotheby’s and Christie’s (2001), Samsung in DRAMs (2005), L’Oreal, Chanel and 11 others in perfumes • Parallel behavior in oligopolies not sufficient for antitrust violation; evidence of explicit agreement is required • Tacit collusion is currently not considered illegal in U.S. • E.g. Jewel’s and Dominick’s high milk prices in Chicago in late 90s: lack of evidence of conspiracy

19. Today’s class • Dynamics of price competition 4.1 Shrimp game wrap-up 4.2 Logic of cooperative pricing 4.3 Factors hindering or facilitating coordination

20. What determines ability to coordinate prices? • How easy is it for firms to tacitly agree on prices? • How effectively can deviations from an agreement be deterred? Need, for each firm, Profit under continued cooperation > Gain from deviating today + Probability of detection * Profit in a price war Effectiveness of retaliation

21. 1. Can firms agree on a price? • Finding a (tacit) agreement more difficult • the more firms there are • Main reason why we care about concentration in 5 forces: collusion in aluminum, infant formula industries? • the more products there are, and the more heterogeneous the products • If there are cost asymmetries

22. So what can firms do about it? • Price leadership: if one firm is accepted by all as price leader, then it’s easier for all to coordinate prices • Pricing rules to price large number of products • E.g. per-pound price rule for electrical equipment used by GE and Westinghouse in 1960s • Information exchange, e.g. through trade association • about costs and demand • about which products are substitutes

23. 2. Are there strong incentives to deviate? • Gain from deviating is larger…. • the more firms there are • if orders are lumpy • Commercial aircraft: Boeing vs. Airbus • Industries with large business customers: e.g. CCS • if firms have excess capacity

24. How can firms reduce the incentive to cut price? • Advance announcement of price raises: if rivals don’t match, just rescind • Exclusive territories for retailers • Most-favored customer clauses • “If I sell to any other buyer at a lower price, I will also charge you the lower price (or pay you a rebate)” • Reduces the own temptation to cut price! • Meet-the-competition clauses • “If any other seller offers you a better price, I will match it” • Makes it unprofitable for rivals to cut price

25. 3. How effective is retaliation against deviating firms? • Factors making retaliation more difficult • Lack of price transparency • Retail gasoline, vs. corporate discounts in express mail industry • Demand fluctuations: were your sales low because of low demand or because someone stole your customers? • Product differentiation between firms • Multi-market contact actually facilitates collusion, since cutting price in one market may trigger price war in all markets • Argument against merger of Union Pacific and Southern Pacific Railroads in mid-90s: multi-market contact with large rival

26. How can firms make retaliation more effective? • Sometimes excess capacity can help: punishing deviations requires some unused capacity • Saudi-Arabia’s capacity to flood market as way to discipline OPEC members • Increase market transparency • Through information exchange • By standardizing products • Through pricing formulas

27. The “topsy-turvy principle” of collusion • “Factors/practices that lead to intense competition if firms don’t cooperate often actually facilitate coordination.” • Examples: • High market transparency • Low degree of product differentiation

28. Antitrust restrictions II • Warning: many/most of the practices mentioned raise suspicions with antitrust authorities • Many practices facilitate collusion, but also increase market efficiency among non-colluding firms • e.g. information exchange • In evaluating facilitating practices, courts weigh pro- and anti-competitive effects