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Course outline I Introduction Game theory Price setting

– monopoly– oligopoly

Quantity setting– monopoly– oligopoly

Process innovation

Homogeneous goods

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Price competition

Case study: AMXCO versus Vebco Simultaneous price competition

– Equal costs Bertrand paradox – Different costs Blockade, deterrence– Old customers, switching costs

Price cartel Minimum-price guarantees Executive summary

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Example: AMXCO versus Vebco

Cooler pads, used in air conditioning equipment, traditionally made by hand.

Around 1960 AMXCO developed a method of producing cooler pads by machine and became the leading firm in the market.

Vebco distributed pads for AMXCO. When Vebco began to distribute its own hand-made cooler pads a price war followed:

(Industrial Economics; Stephen Martin)

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Vebco AMXCO

1969 - began to distribute its own pads

- terminated Vebco as a distributor

- gradually gained market share

Jan. 1971 - charged price 9,5 % below list

- followed, not to lose market share

- cut price to 14,5 % below list

- cut price to 25 % below list

- matched AMXCO price cut

- cut price to 32,5 % below list

March 1971 - matched AMXCO price cut

March 29, 1971 - raised price to 25 % below list

1972 - offered discounts of 19 - 25 %

below list

Price war

(Industrial Economics; Stephen Martin)

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Discussion (1)

AMXCO, a dominant firm with cost advantage over fringe firms, set its price so close to list that it was profitable for Vebco to expand its output, even though Vebco had higher costs. A price war followed until Vebco “sued for peace”. AMXCO remained a dominant firm, but competition forced it to set lower prices.

(Industrial Economics; Stephen Martin)

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Discussion (2)

Vebco filed a private antitrust suit against AMXCO, alleging price discrimination in violation of the Clayton Act and attempted monopolization in violation of Sect. 2 of the Sherman Act.

A court found in favor of AMXCO. There is no injury to competiton, if the price remains above the firm’s average variable cost.

(Industrial Economics; Stephen Martin)

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Antitrust laws and enforcement, the US laws

– Sherman Act (1890)– Clayton Act (1914)– Federal Trade Commission Act (1914)

enforcement– Department of Justice– Federal Trade Commission (FTC)

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Excerpts from US Antitrust Statutes (1) Sherman Act

– Section 1. Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is hereby declared to be illegal …. Every person who shall make any contract or engage in any combination or conspiracy hereby declared to be illegal shall be deemed guilty of a felony ….

– Section 2. Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony ….

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Excerpts from US Antitrust Statutes (2) Clayton Act

– Section 2. (a) That it shall be unlawful for any person engaged in commerce … to discriminate in the price between different purchasers … where the effect of such discrimination may be substantially to lessen competition or tend to create a monopoly in any line of commerce, or to injure, destroy or prevent competition … nothing herein contained shall prevent differentials which make only due allowance for differences in the cost of manufacture, sale, or delivery ….

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Competition in prices

The Bertrand model as a simultaneous price competition:

p1

p2 2

1

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The Bertrand model

Market demand function Demand function of firm 1

Equal costs: Different costs:

ccc 21

21 cc

21

211

211

1

,0

,2

,

pp

ppepd

ppepd

x

epdpX

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Demand function of firm 1

x 1

)( 1 pX

0 p 12 p

)( 2 21 pX

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Profit function of firm 1

Mp1 2p p 1p M

12p

1st case 2nd case

3rd case

21 pp M

p 1

p 1

1

1c

21 pc

1c

Mppc 121 1

1

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Equal costs Bertrand paradox

is a Nash equilibrium in the Bertrand model with equal marginal costs.

is the only equilibrium.– – – –

Marginal cost pricing and no profits!

,c cc ,

withcc ,

cc ,

ccpp BB ,, 21

cc,

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Exercise (discrete prices)

Assume discrete prices and monetary units (1$, 2$,...) as well as equal marginal costs c=10.

Find the Bertrand-Nash equilibria.

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Ways out of the Bertrand-paradox I

Discrete prices Capacity constraints

– Assumption :– Is (c,c) an equilibrium?

Repeated play– is not an equilibrium in the one-shot

game,– but may be sustained as an equilibrium of

repeated game.

cc ,

cXcapacitycX 221

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Ways out of the Bertrand-paradox II

Cost leadership Blockade or deterrence Old customers, switching costs Price cartel Minimum-price guarantees Product differentiation

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Entry barriers

Free entry tends to drive profits down. Entry barriers allow established firms to make

profits without attracting competitors. Entry barriers

– government regulation (licences)– structural barriers (cost disadvantages)

– strategical barriers (limit price, limit quantity)

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Blockade, Deterrence, or Accomodation

Blockaded entry: There is no threat of entry even if established firms maximize profits.

Deterred entry: Established firms try to make entry unattractive to potential competitors.

Accommodated entry: Established firms do not deter entry and potential competitors become actual competitors.

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Different costs Blockade or deterrence? I Blockaded entry for both firms

Blockaded entry of firm 2:

Bertrand-Nash equilibrium:

Are there other equilibria?

)( 21 cc

ed

canded

c 21

ed

candced

cpc M

1112 2

1

21 ,ccpM

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Different costs Blockade or deterrence? II Deterrence of firm 2:

Bertrand-Nash equilibrium:

22221 ,, ccccp L

)( 21 cc

ed

candced

cpc M

1112 2

1

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Blockade, deterrence and Bertrand paradox

duopoly,Bertrandparadox

no supply

e

de

d2

c 1

c 2

firm 2 as a monopolist

deterrence

deterrenceblockade

firm 1 as a monopolist

blockadee

d

ed2

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Old costumers - switching cost

Repeat purchase switching costs Sources:

– learning processes (opportunity costs of time and direct costs)

– transaction costs– strategic design by firms (bonus program)

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Switching costs - examples

In the middle of the 1980s AT&T succeeded in becoming the supplier of digital switches (5ESS) to Bell Atlantic. From then on, all the changes in Bell Atlantic’s telephone system had to be provided by, and negotiated with, AT&T.

My tax consultant closed his office and sold his customer data to another tax consultant.

My bank closed the office I used to frequent.

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The model with switching costs

All costumers are old costumers of firm 1 Demand function of firm 1

deterrence of cost leader (firm 2) possible if:

112121 cpwcccanded

c M

wpp

wppepd

wppepd

x

21

211

211

1

,0

,2

,

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Switching costs - blockade, deterrence and Bertrand paradox

duopoly,Bertrandparadox

no supply

ed

22w

ed

c 1

c 2

deterrence

firm 1 as a monopolist

blockadewed

we

d 2 firm 2 as a

monopolistblockade

deterrence

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Worth of old costumers

at

c sw.without 1

c sw. with1

21 cc

wcXw

wcXw

wcwcxcwc

wcpxcwcp LL

2

2

22112

211121

oc with1

B1

oc with1

,

,

0

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Price cartel

For sufficiently small cost differences (Bertrand paradox or deterrence), a cartel might be established.

There are strong incentives to deviate from the cartel prices.

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The cartel, graphically

c 2no supply

firm 2 as a monopolist

c 1

firm 1 as a monopolist

cartel

ed

ed2

ed2 e

d

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Exercise (price cartel)

Consider two firms competing in prices. The demand function is given by X(p)=20-2p .

Suppose that the equal and constant unit costs are given by 6.

a) Find the optimal cartel price.

b) Assume equitable devision of profits. Calcu-late the maximum profit difference a deviating firm could achieve. 4Π b) 8 a) :S. 1 CAp

Most-Favored-Customer Clause (MFC)

A MFC guarantees a customer the best price the company gives to anyone.

MFCs are very common in business-to-business contracts.

They sound like a good deal for your customers, indeed the main effect is to shift the balance in favor of the seller.

Brandenburger/Nalebuff: Co-opetition

MFC: Example

In 1971 members of the American Congress figured that they should find a way to lower campaign expenses. Thus, the politicians voted themselves an MFC for television spots.The law didn’t quite have the desired effect. Knowing that, in an election year, politicians are going to purchase significant chunks of airtime, the networks want to get as much as they can for these spots. So with an election coming up, how will a network respond when a commercial customer comes to negotiate the rate for an ad spot? It will be very though on price. Giving a concession is extremely costly, since any discount must be extended to all the politicians buying spots. The network would likely end up losing more from the lower price paid by all politicians than it would gain from getting some extra business.One result of the law was that the networks ended up making more money than before.

Brandenburger/Nalebuff: Co-opetition

MFC: the seller’s perspectivePros

1. Makes you a thouger negotiator. (“I’d love to give you a better price, but I can’t afford to.”)

2. Reduces your customers’ incentive to bargain.(The customer is guaranteed that no one else can get a better price, even if he

does no negotiating at all.) Cons

1. Makes it easier for a rival to target one of your customers.

2. Makes it harder for you to target one of your rival’s customers.

Brandenburger/Nalebuff: Co-opetition

MFC: the customer’s perspective

Pros1. Allows you to benefit from any better deal subsequently

offered to other customers. 2. Ensures you that you’re not at a cost disadvantage relative

to rivals.3. Eliminates the risk of looking bad if other customers strike

better deals.

Cons1. When others have MFCs, it’s harder for you to get a

“special” deal.

Brandenburger/Nalebuff: Co-opetition

Meet-the-Competition Clauses (MCC)

An MCC is a contractual arrangement between company and customer that gives the company an option to retain the customer’s business by meeting any rival bids.

An MCC doesn’t force you to meet the competition. It simply rewards you, if you do so, with the assurance of the customer’s continued business.

Brandenburger/Nalebuff: Co-opetition

MCC: ExampleIn January 1994 the Miami Dolphins football team was sold for $138 million to H.W. Huizenga. A pretty good buy - almost a steal.When Dolphins owner J. Robbie died in 1990, the team was passed to his nine children. Following the death of their father, the Robbies sold Huizenga a 15 percent stake together with a right of first refusal (the buyer’s counterpart to an MCC) on any future sale. Thus, the Robbie children couldn’t sell the team without first giving Huizenga an opportunity to match the best offer.Put yourself in the shoes of a prospective bidder. You invest time, effort and money lining up financing. Will you be able to outbid Huizenga? Doubtful. If it make sense for you to acquire the team at a certain price, it will make sense for Huizenga, too. The best offer was the $138-million bid that Huizenga matched when he bought the team.

What should the Robbie children have done?Brandenburger/Nalebuff: Co-opetition

MCC: Pros and Cons

Pros1. Reduces the incentive for competitors to bid.

(You can undercut any rival bid as far as it’s a good deal.) 2. Takes the guesswork out of bidding - you know what

you have to beat.

3. Lets you decide whether to keep the customer.

Cons1. Allows competitors to bid without having to deliver.

(Your rival can make a low bid, fully expecting that you will match and lowers your profit without having to put himself on the line.)

Brandenburger/Nalebuff: Co-opetition

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Minimum-price guarantees

Minimum-price guarantees assure consu-mers the lowest price charged by any firm.

If firm 1 offers a minimum-price guarantee, its actual price will be equal to the minimum of the prices charged by the two firms:

211 ,min pppeff

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Exercise (Bauhaus)

„Sollten Sie ein identisches Produkt inner-halb von 14 Tagen ab Kaufdatum woanders noch günstiger finden, so erhalten Sie bei uns das Produkt zu einem 12% günstigeren Preis als beim Wettbewerber.“

?, 211 pppeff

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Minimum-price guarantees, graphi-cally - firm 1’s profit function

Mp 2p Mpp 2

1st case 2nd case

2ppM

p 1p 1

MMppc 2

c c

3rd case

p 1

2pc

Firm 1 offers a minimum-price guarantee.Firm 2 does not.

1M1

1

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Minimum-price guarantees, graphi-cally - firm 2’s profit function

Mp p 1

1st case 2nd case

3rd case

Mpp 1 p 2p 2

1ppM c p p M1 1 2

M2

1

cc

Mppc 1

Mpp 2

c p p M1 1 2

1pc

2

Firm 1 offers a minimum-price guarantee.Firm 2 does not.

2

2

M2

1

M2

1

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Two-stage model

1

2

minimum-price guarantee by firm 1

minimum-price guarantee by firm 2

p 1

p 2

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Four possibilities

Neither firm 1 nor firm 2 offers a minimum-price guarantee: Bertrand paradox

Only firm 1 offers a minimum-price guarantee.

Only firm 2 offers a minimum-price guarantee.

Both firms offer a minimum-price guarantee.

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Unilateral minimum-price guarantee (2nd stage) is a Nash equilibrium. is the only equilibrium.

– – – – –

Uniliteral minimum-price guarantees result in the Bertrand paradox.

c c,

cc ,,,

cc ,

withcc

withcc

,

,

cccc ,,,

c c,

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Reaction correspondence of firm 1 (2nd stage)

Mpc

c

Mp

2p

1p

21 ppR

Firm 1 offers a minimum-price guarantee.Firm 2 does not.

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Reaction correspondence of firm 2 (2nd stage)

Mpc

c

Mp

2p

1p

12 ppR

Firm 1 offers a minimum-price guarantee.Firm 2 does not.

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Bilateral minimum-price guarantee (2nd stage) is a Nash equilibrium. isn’t the only equilibrium.

– – – –

Are there any dominant strategies ?

c c,

c c,

?, Mpcwithcc

?, MM pcwithcp

?, MM pcwithcp

?, MM pp

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Reaction correspondence of firm 1 (2nd stage)

Mpc

c

Mp

2p

1p

21 ppR

Both firms offer a minimum-price guarantee.

is a dominant strategy.

21 ppR

Mp

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Mpc

c

Mp

2p

1p

12 ppR

Both firms offer a minimum-price guarantee.

12 ppR

Reaction correspondence of firm 2 (2nd stage)

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Nash equilibria (2nd stage)

Mpc

c

Mp

2p

1p

21 ppR

12 ppR

Both firms offer a minimum-price guarantee.

12 ppR

21 ppR

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Minimum-price guarantee (1st stage)Payoff matrix firm 2

with minimum-price guarantee

without minimum-price guarantee

firm 1

with minimum-price guarantee

(0, 0)

without minimum-price guarantee

(0, 0)

(0, 0)

MM

2

1,

2

1

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The game in extensive form

F1g

ngF2

g

ng

g

ng

F1F2

p1

p1

p1

p1

p2

p2

p2

p2A player’s strategy:

1. decision for or against a guarantee

2. decision on prices in all 4 possible situations

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Equilibria in extensive form games

A strategy is of the following form:

Which of these strategy combinations are equilibria?– ((g,pM,c,c,c),(g,pM,c,c,c)) ? – ((g,pM,c,c,c),(g,pM, pM ,c,c)) ?– ((ng,pM,c,c,c),(ng,pM, pM ,c,c)) ? – ((g,pM, pM,c,c),(ng,pM, pM ,c,c)) ? – ((ng,c,c,c,c),(ng,c,c,c,c)) ?

ngnggngngggg ppppngg ,,,, ,,,,/

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Executive summary I Homogeneity leads to an aggressive price war suppressing profits. In case of equal costs, zero profits (the Bertrand paradox) result.

In case of unequal costs, the cost leader will prevail. Ways out of the Bertrand paradox:

– capacity constraints,– repeated play,– cost leadership, switching costs,– price cartel,– minimum-price guarantees,– product differentiation.

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Executive summary II

reduce consumers’ uncertainty about fair prices,

make it impossible to be underbid by the rival, discourage entry, and may accomplish the monopoly outcome if

given by both firms.

Minimum-price guarantees