7.6 Competing in Tight Oligopolies: Pricing Strategies

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.

1. Deep discountingA strategy in which a firm sets its price below the average cost of a competitor in order to drive out existing competition.. One exercise of seller power is to try to drive out existing competition. Deep discounting attempts to achieve this by setting the firm’s price below cost, or at least below the average cost of a competitor. The intent is to attract customers from the competitor so that the competitor faces a dilemma of losses from either lost sales or being forced to follow suit and also set its price below cost. The firm initiating the deep discounting hopes that the competitor will decide that the best reaction is to exit the market. In a market with economies of scale, a large firm can better handle the lower price, and the technique may be especially effective in driving away a small competitor with a higher average cost. If and when the competitor is driven out of the market, the initiating firm will have a greater market share and increased market power that it can exploit in the form of higher prices and greater profits than before.
2. Limit pricingA strategy for warding off competition in which an existing firm sets a low price that is just enough for it to make a small profit but that will cause a new entrant to lose money.. A related technique for keeping out new firms is the technique of limit pricing. Again, the basic idea is to use a low price, but this time to ward off a new entrant rather than scare away an existing competitor. Existing firms typically have lower costs than a new entrant will initially, particularly if there are economies of scale and high volume needed for minimum efficient scale. A limit price is enough for the existing firm to make a small profit, but a new entrant that needs to match the price to compete in the market will lose money. Again, when the new entrant is no longer a threat, the existing firm can reassert its seller power and raise prices for a sustained period well above average cost. As a game of strategy, the new entrant may reason that if it is willing to enter anyway and incur an initial loss, once its presence is in the market is established, the existing firm will realize their use of limit pricing did not work and decide it would be better to let prices go higher so that profits will increase, even if that allows the new entrant to be able to remain in the market.

3. 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.

4. Durable goodsA strategy in which a firm sets the price very high at first and drops the price progressively over time in order to attract most customers at a price close to the maximum they would be willing to pay.. When firms in monopolies and oligopolies sell long-lived durable goods like cars and televisions, they have the option to sell to customers at different times and can attempt to do something similar to first-degree price discrimination by setting the price very high at first. When the subset of customers who are willing to pay the most have made their purchase, the firms can drop the price somewhat and attract another tier of customers who are willing to pay slightly less than the first group. Progressively, the price will be dropped over time to attract most customers at a price close to the maximum they would be willing to pay.

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.