Sunday, May 18, 2003

Signaling and Oligopolies Price fixing is illegal in the United States and Europe, as competing companies are not allowed to form cartels to determine pricing. On the other hand, a long-term price war is an extremely dangerous policy in any industry, where all the participants can get burned badly. However, there is a third way, usually legal, that oligopolies use to stabilize price. That alternative is price signaling. Signaling is a way for members of an oligopoly to coordinate prices without having to actually talk to each other about it. It's all about setting points of equilibrium in a market by setting your own prices in keeping with those of others. In a tight oligopoly, there is less likely to be a rogue seller who will not participate in the "gentlemen's agreement" to maintain steady price ranges. Signaling is a favorite subject of role-playing experiments in economy classes, and based on game theory, mutual cooperation is the best solution for all the participants. But trusting other participants is never easy. Such trust can only be built by playing the game continually, and closely watching the behavior of the other participants. Coke and Pepsi have played the game for so long that they are comfortable that they can predict the others' behavior. Likewise the recording companies have a comfort level that one of them is not going to be selling pop music CDs at $5 or $10 less than the competition, except in a short-term sale. The gasoline companies respond very quickly to the other and downs of each other's prices, with no company trying to corner the market by risking its margins. As one writer notes, In the oligopoly model, a market equilibrium may be reached at a level above that which would prevail in a perfectly competitive situation (with pricing essentially equal to marginal cost). This is because firms in an oligopoly may decide to forgo a price cut because they assume their competitor will match the cut, thus providing little long-term benefit. Similarly, a firm in an oligopoly may take a price increase hoping its competitors will follow suit-if they do, a higher equilibrium will prevail; if they do not, the market returns to the status quo ante. This type of signaling can be viewed as an offer and acceptance even in the absence of an overt commitment: the price leader makes an "offer" to its competitors by raising its price; the competitors accept (or not) depending on whether they follow. The Internet has made the cycle of signaling ever more efficient. Vendors in any industry can see what the competition is doing immediately, and can react by adjusting their own prices. This is a far cry from the days when price books were set in type and could not be changed for months in reaction. Now most prices can be adjusted several times a day, if needed. That's a game that the airlines are particularly adept at. As consumers have more transparent access to flight costs, through online services like Orbitz and Travelocity, so the airlines are almost obligated to adjust to each other. And on routes where there is no rogue player, like Southwest Airlines or Jet Blue, they are free to adjust prices upward. As long as the members of the oligopoly with real selling power tacitly agree that a major price war is not in their interest, chances are that prices can quickly readjust themselves, keeping in mind the balance of costs and optimal prices for maintaining profitable sales levels. The FTC and its European equivalent keep looking closely at e-business signaling, and there are a variety of opinions as to when signaling is a conspiracy or simply the dynamics of the market playing themselves out. One thing is for sure, the combination of oligopolies and easy-to-adjust electronic pricing is a recipe for signaling, and it can be done perfectly in the open, without any documented collusion. 7:33:40 PM

comment []