In lieu of an abstract, here is a brief excerpt of the content:

CHAPTER 9 Strategic Pricing in Markets with Increasing Returns W Brian Arthur and Andrzej Ruszczynski Several of the papers in this book show that where products or technologies experience increasing returns to market share, markets can become unstable, so that in the long run one product or technology can come to dominate and drive out the others. But these assume the absence of strategic manipulation. Thus the question arises: If firms that lose market share (and hence the increasing returns advantage that accrues to market share) can offset this by strategically lowering their prices, are increasing-returns markets still unstable ? Does the possibility of strategic pricing mitigate positive feedback effects and stabilize such markets? In this paper, Andrzej Ruszczynski and I examine the problem by setting up a stochastic duopoly game between two competing firms that can strategically price products that experience positive feedback to market share. We show that whether pricing mitigates the natural instability of the market or enhances it depends on the rate of time preference of the firms. If firms have high discount rates, firms that achieve a large market share tend to quickly lose it by pricing high to exploit it for near-term profit, and so the market stabilizes. If, on the other hand, firms have low discount rates, they price in an effort to lock in and hold onto a dominant position, so that pricing further destabilizes the market. The paper appeared under the title "Dynamic Equilibria in Markets with a Conformity Effect" in Archives of Control Sciences, 37 (1992):7-31. For this version I have rewritten the title, the introduction, and some of the expository parts of the article. Andrzej Ruszczynski is with the Institute of Automatic Control, Warsaw University of Technology, Poland. 1. Introduction In many markets, competing products are subject to increasing returns in the sense that their natural usefulness or perceived attractiveness or potential profitability increase with their share of the market. For example, in hightechnology markets for competing computer software applications, or 159 160 Increasing Returns and Path Dependence in the Economy computer operating systems, or telecommunication systems, network externalities lend advantage to products that gain a lead in user-base. In markets for luxury cars or designer clothing, fashion or conformity effects bestow brand advantage with increases in market share. In the airline industry, the ability to operate efficient hub-and-spoke systems depends greatly on passenger-mile volume and hence market share of the market. In all these markets, we might ask whether such positive-feedback or increasing-returns mechanisms tend to destabilize the market and lead to the eventual domination of one or a small number of monopolizing firms. Most of the studies of competition under increasing returns to date assume the absence of strategic manipulation. (For a survey see Arthur, chap. 7 in this book.) And so we know little about the effects of pricing or other forms of strategic action in markets with self-reinforcement. The possibility of pricing may give firms that lose market share and its positive-feedback advantage a means to respond by lowering their prices, which would mitigate the effects of positive feedback and possibly stabilize the market. Or, it may give producers a means to further exploit a positive-feedback advantage, which would suggest that the market may be more prone to monopoly and destabilization. A priori it is not obvious that in the presence of strategic pricing, positive feedback will still imply instability of the market. The few studies that explore market structure in the presence of strategic action and self-reinforcement do show indications in the direction of instability and multiple equilibria. Flaherty [8] explores the case where firms strategically invest to reduce their costs. Multiple, open-loop, noncooperative equilibria result. Fudenberg and Tirole [10] use learning effects as a source of reinforcement and investigate closed-loop perfect equilibria. Again they find multiple equilibria. Spence [14] shows in ad hoc fashion that the order in which firms enter a market matters, with different orders of entry giving different market-share trajectories. But none of these studies demonstrates precise conditions under which mUltiple equilibria rather than a single equilibrium might occur. Further, the equilibria derived in these studies are deterministic trajectories. There is no indication of how one trajectory from the multiplicity of candidate trajectories might come to be selected. In this paper, we explore strategic pricing under increasing returns to market share, and carefully analyze conditions under which the market is stable or unstable. And...

Share