Week 8 - Dynamic Games: Pricing and Competition Flashcards
What is behaviour-based price discrimination (BBPD)?
This is a type of dynamic pricing strategy. The goal of BBPD is to achieve first-degree price discrimination.
This is more easily achievable thanks to rapid progress in information technology (Big Data, AI, and Machine Learning), online companies, banks, airlines and grocery stores commonly collect individual information, track consumers’ purchase histories, and use this information to identify consumers and offer personalized prices and products to them.
Examples of BBPD:
- “Smart shelves” – already common in European supermarkets and coming to the UK
o Digital price displays – it is a dynamic by non-personalised pricing strategy. - Airlines
o US department of Transportation approved a system allowing airlines and travel companies to collect passengers’ data to present them with “personalised offerings” based on their address, their marital status, their birthday and their travel history.
What features of market structure affect the attainment of cooperative pricing and competitive stability?
- The misread problem
- The patience of firms
- Market concentration
- Structural conditions that affect reaction speeds and detection lags
- Asymmetries among firms
- Price symmetries of buyers
Features that affect the attainment of cooperative and competitive stability: the misread problem
Tit-for-tat strategy assumes that firms can perfectly observe each other’s actions. But rivals will sometimes “misread” their rivals:
- A firm mistakenly believes a competitor is charging one price when it is really charging another price, or
- A firm misunderstands the reasons for a competitor’s pricing decision or its own change in market share
Due to either of the above, a firm might mistakenly believe that its competitor has lowered prices in an attempt to break the “collusive agreement”. If the firms are playing tit-for-tat, then rounds of price cutting may ensue, merely because of a misunderstanding.
Features that affect the attainment of cooperative and competitive stability: the patience of firms
If each firm is reasonably patient, i.e., if the discount rate i is not too large, then the cooperative pricing will be sustainable.
Features that affect the attainment of cooperative and competitive stability: market concentration
Cooperative pricing is more likely to be achieved in a concentrated market (few firms) than in a fragmented market (many firms). The reason is that the benefit-cost ratio goes up as the number of firms goes down.
- To be more specific, in a concentrated market, a typical firm’s market share is larger than it would be in a fragmented market.
- A price-cutting firm must lose significant revenue on its existing customers but could only gain a relatively small pool of new customers. Hence, high concentration facilitates cooperative pricing.
Features that affect the attainment of cooperative and competitive stability: structural conditions that affect reaction speeds and detection lags
An increase in the speed of reaction or a shorter detection lag makes cooperative pricing more sustainable. The intuition is that a price-cutting firm benefits only as long as its rivals do not match. If
rivals react swiftly, the benefits of price reductions are smaller. So firms have no incentive to
undercut its rivals’ prices.
Structural conditions include the following:
- Volatility of demand and cost conditions: Pricing cutting is harder to verify when market demand conditions are volatile and a .rm can observe only its own volume and not that of its rivals
- Secret price terms
- Lumpy orders: Lumpy orders reduce the frequency of competitive interactions between firms, lengthen the time required for competitors to react to price reductions, and thereby make price cutting more attractive
- High buyer concentration
Features that affect the attainment of cooperative and competitive stability: asymmetries among firms
When firms are asymmetric, either because they have different costs or are vertically differentiated, it becomes more difficult for firms to coordinate their pricing strategies.
- When firms differ, there is no single focal price, and it thus becomes more difficult for firms to coordinate their pricing strategies toward common objectives.
- Even when all firms can agree on the cooperative price, differences in costs, capacities, or product qualities may affect their incentives to abide by the agreement.
- Small firms within a given industry often have more incentive to defect from cooperative pricing than larger firms, as they gain more in new business relative to the loss due to the revenue destruction effect.
Features that affect the attainment of cooperative and competitive stability: price symmetries of buyers
When buyers are price sensitive, a firm that undercuts its rivals’ prices by even a small amount may be able to achieve a significant boost in its volume. Therefore, a firm may be tempted to cut price even if it expects that competitors will eventually match the cut price.
How can facilitate cooperative pricing?
- Price leadership
- Advance announcement of price changes
- Most favoured customer clauses
- Uniform delivered prices
Facilitating cooperative pricing: Price leadership
Price leadership is a way to overcome the problem of coordinating on a focal equilibrium. Each firm gives up its pricing autonomy and cedes control over industry pricing to a single firm.
- Examples include Kellogg in breakfast cereals, Philip Morris in tobacco, and (until the mid-1960s) U.S. Steel in steel.
Facilitating cooperative pricing: Advances announcement of price changes
In chemicals markets firms often announce their intention to raise prices 30 or 60 days before the price change is to take effect.
Facilitating cooperative pricing: Most favoured customer clauses
A most favoured customer clause is a provision in a sales contract that promises a buyer that it will pay the lowest price the seller charges. Most favoured customer clauses appear to benefit buyers.
- However, most favoured customer clauses can inhibit price competition by discouraging firms from cutting prices to other customers who do not have these clauses.
Facilitating cooperative pricing: Uniform delivered prices
In many industries, such as cement, steel, or soybean products, buyers and sellers are geographically separated, and transportation costs are significant. In such contexts, the pricing method can affect competitive interactions. There are two types of pricing policies.
- Under uniform FOB pricing, the seller quotes a price for pick up at the seller’s loading dock, and the buyer absorbs the freight charges for shipping from the seller’s plant to the buyer’s plant.
- Under uniform delivered pricing, the firm quotes a single delivered price for all buyers and absorbs any freight charges itself. Uniform delivered pricing facilitates cooperative pricing by allowing firms to make a more surgical response to price cutting by rivals.
- Like targeted couponing, uniform delivered pricing reduces the cost that the “victim” incurs by retaliating. This makes retaliation more likely and enhances the credibility of policies, such as tit-for-tat, that can sustain cooperative pricing.
