Question

How does firm reaction speed and detection lag impact the sustainability of cooperative pricing? Why? Examples.

Answer 1

How does firm reaction speed and detection lag impact the sustainability of cooperative pricing? Why? Examples.

Firms’ practices to facilitate pricing cooperation Firms themselves can facilitate cooperative pricing by: • Advance announcement of price changes

• Price leadership

• Most-Favoured-Customer (MFC) Clauses

• Uniform delivered prices

• Strategic use of inventories and order backlogs

Advance announcement of price changes In some industries, firms will publicly announce the prices they intend to charge at some date in the future. Such advance announcements reduce the uncertainty that their rivals will not follow them, and it allows firms to renege on price changes that rivals refuse to follow. One firm announces its price changes before other firms: once the Sun, and then the Mirror. Happens with television advertising rates. Overcomes the problem of coordinating on a focal equilibrium: other firms cede control over pricing to a single firm.

Price leadership can break down if the price leader fails to discipline defectors, as happened in the Sydney afternoon newspaper market. Distinguish oligopolistic price leadership from “barometric” price leadership, in which the price leader’s behaviour reflects changes in market conditions: since there is no great gain to the barometric leader, the leadership role may change frequently, unlike oligopolistic price leadership. Another model of oligopolistic price leadership is the Stackelberg model. in which the Leader looks forward and reasons backwards to consider what price to charge, in the realisation that the Follower will maximise its short-run profit already knowing the Leader’s price

Cooperative Pricing

• Firms would rather have their prices at monopoly levels than what is achieved under Cournot or Bertrand competition

• Explicit collusion to maintain prices at monopoly levels is illegal in most countries

• Cooperative pricing occurs if prices persist above competitive levels without cooperative behavior from the firms When rivals expect to play for many periods, there may be incentives against price competition

• If one firm lowers the price, its market share may go up in the short run

• When the rival retaliates, the market share is back to the original level and the price is lower making both firms worse off

When there are a small number of sellers, each seller will recognize that the profit from price cutting will be short lived (Chamberlin)

• The equilibrium result is the same as if there was explicit collusion to hold the prices above competitive levels

When buyers and sellers are geographically apart and transport costs are a significant fraction of the product’s total value, the choice of pricing method can affect the nature of competitive interactions. Three kinds of pricing policies:

• with uniform FOB (Free On Board) pricing, the seller quotes a price for pickup at the seller’s loading dock, and the buyer absorbs the freight charges for shipping;

• with uniform delivered pricing, the seller quotes a single delivered price for all buyers and absorbs any freight charges itself;

• with base point pricing, the seller designates one or more base locations, and quotes FOB prices from them. A kind of intermediate case between the first two. Uniform delivered pricing facilitates cooperative pricing by allowing firms to make a more focussed response to rivals’ price cutting (at the expense of using non-uniform pricing). Under FOB pricing, retaliation requires a reduced price to all customers. By cutting the “cost” that the victim firm incurs by retaliating, retaliation is more likely, and the credibility of policies, such as Tit for Tat,

Tit-for-Tat Strategy

- Example

• Consider two firms Exxon and Shell

• Both firms currently charge $40, but monopoly price is $60

• Prices change weekly

• Exxon tells Shell “We will not be undersold”

• Book shows how both firms benefit by raising prices to $60

Tit-for-tat = each firm knows that its rival will match any price cut

• In this strategy, neither has an incentive to engage in price cutting

• When two firms compete over several periods, a tit-for-tat strategy may make cooperative pricing possible

• “We will not be undersold!” may mean higher prices through cooperative pricing

Firm cooperates if benefits outweigh costs

• Benefits of cooperating are receiving a higher price (and presumably equal market share) than in competitive market

• Cost of cooperating is the one-time gain from refusal to cooperate – Example is gain in market share from refusing to raise price

• Firms likely to choose round number price points

• Equal splits of the market likely to be durable

• Coordination is easier with fewer products that are identical

• Example: Standard cycles for adjusting prices