Strategic commitment and pricing dynamics

1. Strategic commitment and pricing dynamics By A.V. Vedpuriswar

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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

8. 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.

9. 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.

10. 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.

11. 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 + = .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

12. Present value of profits = .1538 + = .1538 = .1538 = .1538 x1.002/.002 = $ 77.05 Million

13. 2308 + .1154/r > .1538 X(1+r)/r • This is the condition for not following suit

14. = per period industry profit at prevailing price, P0 = per period industry profit at monopoly price, Pm Clearly < But firms face the prisoner’s dilemma. They hope to gain a larger share of the profit by sticking to One period profit gain by not cooperating with the industry wide move = - But profit in subsequent periods will come back to as other firms will retaliate. present value of profits

15. + = = + = + = + If the firm had followed the move by the industry, per period profit = So present value of profit = + = =

16. The firm will find it makes sense to charge the monopoly price when: > + + > + Or Or - > - ) - Or r > ) x Or r > Or r <

17. Firms will charge monopoly price as long as ≥ 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 ≥ i/4 ≥ i/4 Or

18. 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.

19. 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

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. 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.

29. 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.

30. 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

31. 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