Monday, February 23, 2015

Tit-for-Tat Pricing


How Much is that Seat?

 
The smoke-filled room of lore, with big cigars and big men setting prices in their waistcoats and pocket watches drinking scotch, is over – if it ever existed at all. Instead, there is much more transparency about prices that are set and more sophisticated theories of firms and how they should act to maximize profit.
            That said, the best way to maximize profit would be to act as a price and quantity setting monopoly. Since that is not allowed, the second best option is for the market as a whole to act as if it were a single monopoly or a cartel (Besanko et al. p. 235).
            The disconnect can be solved in that pricing decisions are made all the time, based on different inputs. Every firm in a monopolistically competitive market will want to maintain the price that they would be able to get in a monopolistic market. The same firm also wants as much market share as possible to gain market share, the firm would have to drop its price. The issue with this is that if one firm drops its price, the next firm can also drop its price up to their marginal cost. A situation where all firms have dropped their prices to their marginal costs leads to much lower profits for the market as a whole, even if sales are greater. In this situation, what firms want to do is play a game of follow the leader to the point where the price is back to where it would be in a monopolistic environment. One firm can raise their price, and sacrifice market share. Once one firm has increased its price, there are two things that can happen. Either the competing firms in the market can raise their prices to the level the first firm did, or they will not. If prices are not followed, the first firm can lower its prices to the level of the other firms. If the other firms follow the first firm, all the participants in that market benefit from the increased revenues. This process can be repeated up to the point where the price level is at the monopolistic price. This is considered “tit-for-tat” pricing (Besanko et al. p. 238).
            The most common example of an industry that uses tit-for-tat pricing is the airline industry. Though they differentiate themselves on service, the large airline companies have a relatively homogeneous product. What they do is take a person from point A to point B. There are also a limited number of routes that can be flown, as most cities have only one airport and these airports have a finite number of gates. Planes are also expensive and there are regulations on the routes foreign carriers can fly in the United States, so the domestic carriers can price as if they were a monopoly fairly easily. This is helped by the fact that their pricing is not transparent (“Airlines reveal ticket pricing strategies”) and two seats on the same plane in the same section may have sold for vastly different prices. The airlines can and do monitor price changes of their competitors in order to maximize the profit from each flight. As the industry consolidates, coordination will be aided by fewer market participants and lower marginal costs as merged companies exploit back office synergies.

References

Besanko, D., Dranove, D., Shanley, M., & Schaefer, S. (2013). Economics of Strategy (6th ed.). New York: Wiley.

Sumers, B. (2013, June 30). Airlines Reveal Ticket Pricing Strategies. San Jose Mercury News. Retrieved from http://www.mercurynews.com/ci_23572144/airlines-reveal-ticket-pricing-strategies