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In recent decades, economists have employed the applied mathematical tools of game theoryApplied mathematical tools that are used to describe strategic behavior in oligopolies. to try to capture the dynamics of oligopoly markets. The initial research papers are generally abstract and very technical, but the acquired insights of some of this research have been presented in textbooks geared to nontechnical readers.A text that applies game theory to management is Brandenburger and Nalebuff (1996). Game theory is outside the scope of this text, but we will consider some of the insights gained from the application of game theory in discussions about strategy in this and the following sections.
In this section, we will consider the economics underlying some of pricing strategies used by firms in monopolies and tight oligopolies.
Yield managementA pricing strategy in which a firm changes prices frequently in order to extract higher prices from customers and make it more difficult for other firms to compete on price.. Another method for taking advantage of the power to set prices is yield management, where the firm abandons the practice of setting a fixed price and instead changes prices frequently. One goal is to try to extract higher prices from customers who are willing to pay more for a product or service. Normally, with a fixed announced price, customers who would have been willing to pay a significantly higher price get the consumer surplus. Even if the firm employs third-degree price discrimination and charges different prices to different market segments, some customers realize a surplus from a price well below the maximum they would pay. Using sophisticated software to continuously readjust prices, it is possible to capture higher prices from some of these customers. Yield management can also make it more difficult for other firms to compete on the basis of price since it does not have a known, fixed price to work against.
A good example of yield management is the airline industry. Airlines have long employed price discrimination in forms of different classes of customers, different rates for flyers traveling over a weekend, and frequent flyer programs. However, in recent years, the price to buy a ticket can change daily, depending on the amount of time until the flight occurs and the degree to which the flight has already filled seats.
However, economists have pointed out that customers may sense this strategy, and if patient, the customer can wait and pay a much lower price than the perceived value of the item. Even if the firm has little competition from other firms, a firm may find itself in the interesting situation of competing with itself in other production periods. In theoretical analyses of monopolies that sold durable goods, it has been demonstrated that when durable goods last a long time and customers are patient, even a monopolist can be driven to price items at marginal cost.The durable goods problem is discussed in Kreps (2004).
One response to the durable goods dilemma is to sell goods with shorter product lives so that customers will need to return sooner to make a purchase. U.S. car manufacturers endeavored to do this in the middle of the 20th century but discovered that this opened the door for new entrants who sold cars that were designed to last longer.
Another response is to rent the use of the durable good rather than sell the good outright. This turns the good into a service that is sold for a specified period of time rather than a long-lived asset that is sold once to the customer (for at least a long time) and allows more standard oligopoly pricing that is applied for consumable goods and services. This arrangement is common with office equipment like copiers.