Competitive Strategy and Industrial Structure Price discrimination in oligopoly markets

(1)

Competitive Strategy and

Industrial Structure

Price discrimination in

oligopoly markets

(2)

Each firm has two distinct groups of consumers:

v

loyalists

v

shoppers

Stage 1: Demand analysis

1000 0

Demand Curve for Alpha in Shoppers’ Segment Price Quantity 0 500 1000 Price Quantity $3.00

Demand Curve for Alpha in loyalists’ Segment

(3)

Stage 2 Strategy Selection: Price Discrimination

v

The role of price discrimination in mature oligopoly

markets

Ø

Direct effect

Ø

Strategic effect

v

Why has is it hard for companies to give up price

(4)

Alpha meets Beta:

The incentive for a uniform price cut

(without price discrimination)

If Alpha cannot price discriminate, it must extend the same price cut to all potential customers: change in profit from cutting price = A - B - C < 0

Suppose each firm initially charges a uniform price of $2.50 to both loyalists and shoppers. Should Alpha cut its price to $2.00?

1000 $2.50

0 500

Demand Curve for Alpha in Shoppers’ Segment Price Quantity $2.00 B C A 1000 0 500 Price Quantity $3.00 $2.50 $2.00 700

(5)

Alpha meets Beta:

The incentive for a selective price cut

(i.e., price discrimination)

1000 $2.50 0 ₅₀₀ 0 1000 Price Quantity 500 Price Quantity B A

Price discrimination lets have your cake and eat it too!

Alpha gains:

A-B

from shoppers and

E=C

from loyalists

$2.50 $2.00 E $3.00 $2.50 $2.00 $3.00

(6)

Impact of price discrimination on price competition

in the shoppers’ segment

2.50 2.50 0 Beta’s Price Alpha’s Price Alpha’s Reaction

Function: no price disc

Beta’s Reaction Function

Equilibrium with price discrimination

(7)

Impact of price discrimination on price competition

in the shoppers’ segment

Alpha’s Reaction Function: price discr.

Equilibrium with price discrimination A B 1.875 Direct effect

(8)

Impact of price discrimination on price competition

in the shoppers’ segment

2.08

Alpha’s Reaction Function: price discr.

1.67

Equilibrium with price discrimination

Equilibrium

when Alpha price discriminates

A B

C

AèB direct effect of Alpha’s decision to price discriminate

BèC Strategic effect of Alpha’s decision to price discriminate

1.875

(9)

Stage 3 Strategic fit:

Implications of a

single

firm price discriminating

v

Price discrimination likely to result in increased profits to

price discriminating firm

v

Additional flexibility in pricing enables targeting each

segment better

v

Firm can charge higher price to its loyalists

Ø

This happens without significantly reducing their demand

Ø

Implies more revenue from loyalists

(10)

…but Beta will retaliate and price discriminate also

Function: no pric. discrm

Alpha’s Reaction

Function: price discrm

C

A B

(11)

…but Beta will retaliate and price discriminate also

Beta’s Reaction Function with price discrm C A B

(12)

…but Beta will retaliate and price discriminate also

1.25

equilibrium when Beta also price discriminates Beta’s Reaction Function with price discrm C D A B

(13)

…but Beta will retaliate and price discriminate also

1.25

equilibrium when Beta also price discriminates Beta’s Reaction Function with price discrm C D

CèD Combined direct and strategic effects of Beta’s decision to price discriminate

A B

(14)

Payoffs

Price discrimination can be a prisoners’ dilemma!

• Each firm has a dominant strategy to price discriminate

• But both firms would be better off if both refrained from price discrimination

$2,500, $2,500

$2609, $1739

$1739, $2609

$2,125, $2,125

Alpha

Beta

Uniform pricing Price discriminate

(15)

Stage 3 Strategic fit: Implications of

both

firms

price discriminating

v

Profits drop when both firms adopt price discrimination relative to the

case in which no one uses price discrimination

v

Price discrimination intensify price competition in contested market

Ø If contested segment is large enough, the decrease in profits resulting from

intense price competition more than offsets the gain from increasing prices for loyalists

Ø Tying prices in the contested market to prices offered to loyalists

• imposes pricing discipline in the contested market • and softens price competition

(16)

Alpha: no price discrimination (PD)

Beta: no PD

A

(17)

Alpha: no price discrimination (PD) Beta: no PD Alpha: PD A B Stage 1: Euphoria

I love to think happy thoughts! More market share and profits.. Wow, this is brilliant!

(18)

Alpha: no price discrimination (PD) Beta: no PD Alpha: PD C A B Stage 1: Euphoria

Strategic failure: A four-step program

Stage 2: Surprise I

(19)

Alpha: no price discrimination (PD) Beta: no PD Alpha: PD C D A B Stage 1: Euphoria

Beta: PD

Strategic failure: A four-step program

My competitor lowered prices!

Stage 3: Surprise II Where did they get the idea to price discr.??

(20)

Alpha: no price discrimination (PD) Beta: no PD Alpha: PD C D A B Stage 1: Euphoria

Beta: PD

Strategic failure: A four-step program

My competitor lowered prices!

Stage 3: Surprise II Where did they get the idea to price discr.??

Stage 4: Anger and the blame game Someone is responsible for

(21)

Direct vs. Strategic effects

v

For an individual oligopolist acting “in isolation” price discrimination

can be quite beneficial

Ø It allows the firm to price discriminate across market segments

Ø If competitors do not respond, price discrimination would be profit

enhancing

Ø Price discrimination has a positive direct effect

v

BUT… if competitors respond

Ø price discrimination can lead to intense price competition Ø and result in a negative strategic effect

(22)

Should I price discriminate?

v

Does my initiative grow the market or mainly targets my competitors?

Ø Grows the market: then price discriminate to reach previously unreached

segments

Ø Mainly targets competitors: This is often the initial trigger of a price

war

v

Ask the hard questions

Ø Do I have unique advantages that would offset my competitors’ likely

responses?

Ø Key issue: Is my judgment tainted by over-confidence about my