Stopping Price Wars with Credible Threats

During much of the Cold War, the Soviet Empire had both the desire and the ability to destroy the United States, but fear of retaliation kept the peace. The evil empire believed that attacking the U.S. with nuclear weaponry would cause America to respond in kind. A similar type of retaliation can keep firms in your market from lowering prices.

While credibly threatening to use atomic weapons against a price-cutting rival would be an effective means to limit price competition, acquiring the necessary fissionable materials could be challenging. An easier method is to threaten to match any price cut. If your rival considers cutting prices to steal your customers, then his justification for a price cut would be obliterated if he believes that you would meet any price challenge.

For retaliation to be effective it must be both swift and assured. If your rival suspects that you might not respond to a price cut, he might lower his price to see how you act. Furthermore, if he believes that it would take you a few months to respond, he might lower prices to steal some of your customers. In the time it takes you to act he could get a short-term boost in sales that might more than make up for starting a minor price war.

Threats of retaliation won’t always be enough to suppress price competition, though. When I auctioned off the twenty-dollar bill, why couldn’t my students come to an agreement not to bid against each other? One of the most challenging endeavors in life is getting a large group of friends to agree on which movie they should rent and then collectively watch. This challenge becomes an impossibility when everyone in the group has veto rights. The reason that my students could not come to an agreement to limit their bidding was because there were too many of them. After all, it would have taken just one student to break an agreement. If, for example, all but one had agreed to bid only one penny and split the profits among themselves then the student left out of the agreement could bid two cents and make herself a $19.98 profit.

When there are many firms selling the same product it can be nearly impossible for them to limit price competition. If the prevailing price is above the cost of production, each firm will have an incentive to slightly undercut its rivals to gain much of the market. Unfortunately, when everyone does this, prices are driven down to cost, and profits disappear. In a market with only two firms, each may well believe that if it cuts its price the competition will do likewise. When a market consists of 50 firms, however, then one single small firm is unlikely to believe that if it lowers prices then everyone else will immediately follow. As a result, all the firms will believe that they can get away with reducing prices without suffering massive retaliation. If all the firms believe this, of course, then all the firms will lower their prices until all the profits have dissipated. Game theory thus shows that firms should avoid entering markets where (1) there are a large number of competing firms and (2) they sell near-identical products. Internet retailing is an industry where long-term high profits probably can’t ever be maintained because these two conditions are so readily met.