The dynamics of price competition

Price wars Nash equilibrium is the only price at which either of you cannot individually improve his

own situation by reducing price When the two companies are trying to decide at which price to sell their product

without having the rival take control of the price Price reaction

When two substitute company are competing and company A lowers his price, company B shouldn’t lower his price: lower profits

Example was the two gas station in town, they should charge full monopoly price not the competitive price

Industry conditions that affect the degree of price completion The number of companies in an industry Co-operative pricing becomes more difficult as

the number of companies increases. Co-operative becomes more complex and less likely.

o Example: OPEC Differences among the companies in an industry. Unlike the two gas station example, no

companies are exactly like their rivals. o As the number of company’s increases, the differences among them are also

likely to proliferate. Example OPEC where many countries are members, but those companies are not same; they each have different cost structure, extraction costs, level of reserves and so on.

The sort-run gain from cutting prices: to the extent that the benefit of undercutting high prices is small, the temptation to ‘cheat’ on an implicit high prices agreement by lowering prices is also small.

o Two main factors may reduce the gains from short run price cuts: high capacity utilization and high product differentiation.

Price Transparency: In order to respond effectively to a rival’s price cut, one must know that a price cut occurred.

o Loss of sale, when rivals’ price aggressively To sum up, industries in which there are few companies, transparent prices and stable demand

conditions, some easy way to implement tacit co-ordination and high product differentiation, are most likely to be conducive to high price outcome

The short run gain from the price cuts depends on the degree of product differentiation in the market.

The prisoner’s dilemma: tit-for-tat strategy

The individual incentive of each player to defect (reduce price) leads both players to a situation that leaves them collectively worse off.

Four strategy:

o Successful strategy should be nice: confronted with a co-operative player, it should reciprocate

o It should be pro-vocable: faced with an uncalled defection, it should respondo It should be forgiving: after responding to a defection, it should go back to co-

operation.o It should be easy to understand: other players should be able to anticipate the

consequences of their actions.

Most Favored Customer clauses and price competition

it promises each customer to give him or her the best price that the firm gives to anyone. This clause decrease price competition by making it very costly for firms to give discount

to their customer Example: a firm is negotiating a price with a large customer. MFC is not practiced which means

that the firm may be tempted to reduce prices in order to gain this additional business. Now MFC is practiced, this means that if the firm is giving discount to one person it will

have to give it everyone. This can get costly because if the firm reduces prices for one it will have to reduce it for

everyone and therefore decreasing their margin on all of the units sold