Chapter 3: The Dangers of Price Competition

Overview

The trouble with the rat race is that even if you win, you’re still a rat.^[1]

Lily Tomlin

Spectators in ancient Rome most enjoyed gladiator games when the competition was fierce. The gladiators themselves, however, undoubtedly preferred days when little blood was spilled in the coliseum.

When businesses fight, they don’t spill blood but something equally as precious, profits. While businesses compete along many dimensions, their competition is never as draining as when they are fighting over price. Price competition is ferocious because low prices are both visible and desirable to consumers.

Customers perceive quality differently and inexactly. Your customers might not realize that a rival is selling a superior product. If, however, the rival charges $90 and you charge $100, then even your most dimwitted customers realize that your rival’s product costs less. A simple game I play with my students illustrates the destructive power of price competition.

I first tell my students that I’m going to conduct an auction, and that this is no mere class exercise; all sales are real and binding. The person who bids the most must buy the item I’m selling for the amount she bids. I auction a twenty-dollar bill. I start the bidding at one penny and ask how many would be willing to pay this price for my merchandise. Almost everyone raises a hand. I then slowly increase the bid amount, and as long as I’m asking for less than $20, virtually everyone offers to pay what I ask. The bidding continues until the price reaches $20. I then ask if any student is willing to pay more than $20, but none ever does. (Too bad, it would have been an easy way for someone to get an A.) After the bidding stops, I collect my $20 from the winning student and hand her the twenty-dollar bill.

After the auction I chastise my students for throwing away money. I had been willing to sell a twenty-dollar bill for a mere one penny, yet their greed cost them this profitable opportunity. Because they kept competing against each other, the bid price went up to the point where the winner took no profit from me. They were like gladiators who, competing for the emperor’s favor, fought so viciously that they all lost limbs. (OK, it wasn’t that bad, but $20 can mean a lot to some undergrads.)

Game theory, of course, doomed the students to bid the price up to $20. As long as the bid price was below $20, each student wanted to bid slightly more than the rest of her classmates. Competition raised the bids to $20. If enough of the students are self-interested, they will necessarily outbid each other and drive the price to the value of the good being sold.

Wireless companies have recently behaved like my students. Many western governments have raised astronomical sums through telephone spectrum auctions. Normally, firms dislike giving money to governments. When governments forced telecommunication companies to compete on price for limited spectrum space, however, these companies continually outbid each other, raising the amounts they eventually had to pay the government.

Competition does the most harm to companies when it forces them to set low product prices. Pretend that two firms sell identical goods. Say it costs each business $30 to produce the good, but fortunately a lot of customers are willing to pay up to $100 for the item. Since both firms sell the same product, customers will buy from the firm that offers the lowest price. In the previous example, if my students had worked together, they would have bid only one penny. If the firms in this example cooperate, they would obviously each charge $100 and split the customers. What happens, however, if the firms compete on price? If the other firm is charging $100, your firm could charge $100 and get about one-half of the customers, or charge a little less and get nearly all of them. Clearly, it would be beneficial to slightly undercut the other firm’s price if it drastically increases your firm’s sales. Alas, this same game theoretic logic applies to your competitor.

If both firms continually try to undercut each other, then prices will be driven down to cost. (Once your rival’s price equals your cost, you won’t lower prices because you would rather lose all of your customers than sell each good at a loss.) How can firms prevent destructive price competition from draining all of the profits? If antitrust laws didn’t exist, the easiest way would be for the firms to make an explicit agreement to charge the same price. Alas, under antitrust laws such an agreement could land you in prison.

^[1]Boone (1999), 114.