Strategy Case

3/20) Why do price misreads (or more generally the inability to observe prices with precision) encourage firms to lower prices? [Note: assume all prices are subject to misreads.]

When companies have less precision in what regards price observation, their knowledge about other companies’ behavior is shorter. Blind about cooperativeness or uncooperativeness of competitors, companies which could probably cooperate with each other might end up competing on prices. This may deviate themselves from their best possible outcome which could be achieved through collusion.

For instances, if two firms (A &B) are playing tit-for-tat and firm A makes a cooperative move which is misunderstood by firm B, firm B will react differently than it would if had well understood firm A. Believing that firm A is not cooperating, firm B will respond by making an uncooperative move. B will decide to charge lower prices, enforcing the tit-for-tat strategy. These, in turn, may lead the misunderstood firm A to respond to such action by also punishing, or in other words by cutting down prices too, starting a pattern of sequential uncooperative moves by lowering prices (price war).

It is also possible that a company decides to change its behavior not exactly because they have misread other’s moves but simply because they can’t clearly observe what price strategy competitors are about to follow. Afraid of being unable to respond fast enough to an uncooperative move, a company may want to move first. Before other companies decide to lower prices, which could lead to a loss of market share on our side, we might adopt a self-defensive behavior and anticipate others, protecting our volume/market share.

2. (4/20) It is often argued that price wars may be more likely to occur during low-demand periods than high-demand periods. Are there factors that might reverse this implication? That is, can you think of reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high-demand) than during busts (low-demand)?

A firm will always deviate whenever the reward of doing it (normally short-termed accounted) compensates the punishment that may appear (normally long-term accounted). Having this in mind, it is so, possible, that a price war arises during periods of high demand (or booms), due to different factors, such as:

In periods of high demand, it is more profitable for a company to gain a dominant market share position than in periods of low demand. A company may, so, capture a bigger percentage of industry profit.

Also, knowing that after a period of high-demand, a market will inevitably face a downturn, one company may want to make and reserve some profits today in order to better survive in the future. Besides this, after the boom and due to its possible reputation and/or commodity of consumers, a company may be able to retain its increased market share and be better