The Dynamics of Pricing Rivalry

Strategic Management
Prof. Ernst Maug, PhD Wirtschaftswissenschaftliche Fakultt Humboldt-Universitt zu Berlin E-mail: ernst.maug@wiwi.hu-berlin.de http://www.wiwi.hu-berlin.de/konzern Tel: + 49 (030) 2093 5641

2000 Ernst Maug

Strategic Management

Overview
Competition and cooperation Why are cartels not stable? How does repetition change competitive interactions?

2002 Ernst Maug

Strategic Management: Pricing Rivalry

Remember Reaction Functions

Remember our example of Cournot dyopoly: 2 firms, Coke and Pepsi Demand: P=1000-qCoke-qPepsi Costs: constant unit costs of 40 per unit Best response functions and equilibrium:

q Coke = 480

q Coke = q Pepsi P = 1000 320 320 = 360 Coke = Pepsi = 102,400

2002 Ernst Maug Strategic Management: Pricing Rivalry

q Pepsi 2 = 320

q Pepsi = 480

q Coke 2

Remember Cournot Oligopoly

Static Price Competition qPepsi Reaction of Coke to Pepsi Reaction of Pepsi to Coke

qPepsi=320

qCoke=320
2002 Ernst Maug Strategic Management: Pricing Rivalry

qCoke
4

The Cartel Solution

Suppose the executives of Coke and Pepsi could agree on a cartel contract: Maximize joint profits. Then split it.

C +P = Q (1000 Q 40)

P = 480 q Pepsi = q Coke = Q / 2 = 240

Cartel = 240 480 = 115,200

But cartels are illegal...
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Dynamic Competition
Suppose Coke and Pepsi play this game every year ...forever Currently, they both offer the Cournot quantity q=320 and make profits of 102,400. They cannot talk to each other to negotiate an agreement to achieve the cartel solution Now Coke unilaterally announces to cut its quantity next year by 25% from 320 to 240 to obtain a higher price: Should Pepsi follow?
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Dynamic Competition
Choices for the Second Mover: Fight What should Pepsi do? 1. Use Cokes retreat, maximize this years profits: Would offer quantity:
q Pepsi = 480 qCoke = 360 2

P = 1000 240 360 = 400

Coke = 240 (400 40 ) = 86,400

Pepsi = 360 (400 40 ) = 129,600

2002 Ernst Maug

Strategic Management: Pricing Rivalry

Dynamic Competition
Choices for the Second Mover: Cooperate Pepsi could also cooperate and match Cokes move: Cut the quantity by 25% from 320 to 240 Then both would make the cartel profit: 115,200 Fighting is always better!

2002 Ernst Maug

Strategic Management: Pricing Rivalry

Static Competition
The Prisoners Dilemma Pepsi Coke,Pepsi Fight Coke Cooperate 86.4;129.6 115.2;115.2 Fight 102.4;102.4 Cooperate 129.6;86.4

What is the equilibrium of this game?

2002 Ernst Maug Strategic Management: Pricing Rivalry

Prisoners Dilemma
One Year Later

Scenario 1: Pepsi had chosen to fight and offer 360: Coke responds by going back to non-cooperative competition: Both companies offer 320, make 102,400 Scenario 2: Pepsi had chosen to cooperate and offer 240 Coke responds by continuing at the low level of production Both companies offer 240, make 115,200

2002 Ernst Maug

Strategic Management: Pricing Rivalry

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Dynamic Competition
The Long-term view Anticipating Cokes strategy, Pepsis executives now take a long-term view of all future profits They discount all future profits at 10% How do the scenarios look now? 1. Cooperate: Make 115,400 in all future periods 2. Fight: Make 129,600 today, 102,400 in all subsequent periods Which strategy should Pepsi choose?
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Dynamic Competition
Evaluate Pepsis Strategies Now compare the present values of both strategies First profit at the end of the current year
V Fight = VCooperate =
129,600 102,400 102,400 + + + ... = 1.049m 1.1 1.12 1.13 115,200 115,200 115,200 + + + ... = 1.152m 1.1 1.12 1.13

Cooperation nets 103,273! Prefer long-term profit Avoid retaliation by competitor.

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The Prisoners Dilemma Transformed Pepsi Coke,Pepsi Fight Coke

Cooperate now Fight if Pepsi did

Dynamic Competition

Fight 1024;1024 1009;1049

Cooperate now Fight if Coke did

1049;1009 1152;1152

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Strategic Management: Pricing Rivalry

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Conclusion
Cartels are unstable: Given one competitor sticks to the rules The other one benefits even more from cheating on the cartel agreement Assuming one-off interactions: prisoners dilemma Repetition generates a new outcome: Punishment strategies are now feasible Cooperation can be sustained as an equilibrium outcome.
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