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Competitive Oligopolistic Pricing
ROBERT L. KNOX
Do oligopolistic industries
evolve a pricing pattern
which is inimical to consumer welfare?
In this article, pricing policies in a major American industry are examined in the
light of orthodox analysis.
The results shed some light
on the relevance of oligopolistic pricing theory in
judging the competitiveness
of certain industrial markets.
/ 7 * o ' of. Marketing,
1966), pp. 47-61.
VoL 30
~ .
(July,
A N oligopolistic industry, one in which several large and power-^*- ful firms dominate the market, is usually characterized by
parallel behavior. This could be against the best interests of the
consumer, however, especially in the area of pricing.
For example, if a few large manufacturers, responsible for the
entire output of an essential product, were able to agree on prices,
the public interest would not be served. Such collusion, either
overt or tacit, appears relatively easy to organize in oligopoly.
But in reality, pricing is not that simple, as can be seen in the
domestic rubber-tire industry, whose market structure is clearly
oligopolistic. Although 15 firms currently produce automotive
tires, from 75 to 80% of industry output is controlled by 5 large
firms, 4 of them located in the same city.
Since 1925, the story of the tire industry has been one of exit,
not entry. From a high in that year of 71 producers, the market
has dwindled to just 15 firms. No new firm has been established
since 1938, and 6 firms have left the industry since 1945.
The rubber tire does not compete with other products in the
functional sense; consequently, there is no inter-industry competition through cross-elasticities of demand. Since the demand for
tires is derived from the need to use the automobile, buyers cannot be induced to buy more or less of the product in any significant
sense through price changes.
Moreover, rising levels of national income do not normally lead
buyers to stock up on tires; and so total market demand is
relatively price and income inelastic.
Within the total market, however, there are varying degrees of
price elasticity in the various market segments, a fact which
makes for considerable differences among sellers with respect to
their overall commitment to tire production for all markets. The
recognized submarkets include: (1) the Original Equipment market, for which tires are supplied to vehicle manufacturers as components; (2) the Replacement market, which is broken down into
markets for factory brands, subsidiary brands, and distributor
brands; and (3) the Government market, including federal, state,
and local purchasing.
Cross-elasticity of demand among the large firms in these submarkets is quite high, particularly in the original equipment and
government markets. The market position of the smaller sellers
is. somewhat differentiated from that of the major producers, but
among themselves they face relatively elastic demand curves. Tire
production and distribution require a scale of plant in which fixed
costs are moderately heavy, at least great enough to necessitate
volume selling.
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However, the most efficient scale of plant can be
achieved at a rate of output which accounts for only
2 to 3% of the total market for tires.^
Barriers to entry are relatively high, buttressed
principally by a long-established system of dealer
relationships, company stores, and technology. Inasmuch as tires must be placed before the consumer
in volume, a strong and heterogeneous system of
distribution is the foundation of market success.
These characteristics bring up the possibility of
little or no price competition. The dominant firms
should be able to raise price above the competitive
level, with concomitant problems of consumer exploitation, profiteering, and other manifestations of
market power. Moreover, as in most oligopolies,
they should have little to fear, competition-wise,
from the remaining smaller firms. In short, the
market structure of the tire industry portends a
situation tailor-made for parallel behavior at the
expense of efficiency and growth.
Yet an examination of industry pricing policies
reveals that powerful market forces are constantly
operating to prevent this type of parallel behavior.
Absence of antitrust activity suggests that overt
or tacit collusion on price, the latter enforced
through price leadership, have not emerged in any
significant degree for years.
Also, the basic heterogeneity of the tire producers
themselves—based principally on the fact that they
difFer as to the extent to which tires constitute their
major profit—plus the fact that they differ on
the extent to which they participate in the three
submarkets, tend to produce competitive price
behavior.
How Prices Are Determined
Many years ago a noted economist stated that "the
theory of oligopoly is a ticket of admission to institutional economics."^ Liberally interpreted, this
meant that students of the oligopoly problem must
always be ready to support their theoretical generalizations and predictions with extensive investigation of actual industry behavior.
In recent years this has resulted in the need to
obtain first-hand information from individuals closely connected with the decision-making process
within the firms of the industry. Armed with a
knowledge of pricing theory, the researcher knows
what questions to ask and how to evaluate the
responses.
In the present study of pricing in the rubber-tire
industry, interviews were with executives in several
large tire companies with authority in the pricing
decision. Similar talks were held with executives
in a medium-size and small tire company.
1 Joe S. Bain, Barriers to New Competition (Cambridge: Harvard University Press, 1957), p. 72.
2 Edward S. Mason, "Price and Production Policies of
Large-scale Enterprise," Am.erican Economic Review,
Vol. 29 supplement (March, 1939), pp. 61-74, at p. 65.
Journal of Marketing, July, 1966
The large firms were well diversified; the smaller
firms were almost wholly committed to tire production for their sales revenue. Also, talks were held
with economists and lawyers in the federal antitrust agencies. Finally, the tire industry's pricing
practices were discussed with several academicians
concerned with the problem.
General Pricing Decision
Total industry demand is derived from the demand for automotive vehicles, both new and used.
However, the bulk of industry demand comes from
buyers who wish to replace tires that are worn out
due to prolonged use of the vehicle. New vehicle
production plus the number of vehicles in use establishes the basis for price determination in the
various market segments.
A firm's historical market share is applied to total
demand, and some percentage over that is set as a
goal. A price and discount structure based on costs
of production is established to reflect this target
market share. Because of the emphasis on volume,
prices are initially set or reviewed annually to yield
a return on investment which is thought to he
realistic in terms of the contemplated market share.
This realism is largely a product of judging the real
and imagined pricing strategies of major competitors.
If at any time throughout the sales year realized
market share falls short of contemplated market
share by as much as one-fourth, serious consideration is given to making changes in the formal price
structure, either by altering the discount structure
to dealers or by making concessions to large
buyers. If these concessions are handled adroitly
and are not excessive, a firm can often obtain
additional volume without precipitating countermoves by rivals.
Discount Structure
The tire industry is characterized by an intricate
system of quoted prices and discounts which reflect
attempts at product differentiation and also reflect
the many types and sizes of buyers and buying
organizations.
Each tire firm calculates and announces a formal
price structure which provides for geographically
uniform retail price lists to various distributive
levels. The formal list is then subjected to a set
• ABOUT THE AUTHOR. Robert L Knox
is Associate Professor of Economics, College of Business Administration, Arizona
State University. He has also taught at
the College of William and Mary.
A graduate of Oklahoma State University, the author received his Ph.D. in Economies from the University of North
Carolina.
Competitive Oligopolistic Pricing
of discounts.3 This formal price structure represents
the maximum price plan of the producer, and consists of a retail price list and a series of quantity,
cumulative volume, service, and cash discounts.
Since the hulk of replacement market output is
marketed through dealers, most of whom are small
and hence exert little or no countervailing buying
power, tire producers are able to make unilateral
changes in the discount structure for replacement
market tires. This means that retail prices are not
meaningful evidence of price behavior; manufacturers' prices are the important ones for study.
The manufacturer's price is designed to cover
factory costs of production, certain assigned selling and administrative costs, and yield a profit
margin which can be looked upon as a "reasonable"
return on standard costs, taking into consideration
the multiplicity of discounts that are built into the
formal price structure.
Because of the plethora of brands, sizes, and
quality levels of tires, there is a wide variety of
manufacturers' prices; but all are subject to the
same type of discount structure, including quantity,
cumulative volume, service, and cash discounts. By
altering the discount structure, any tire manufacturer can match or cut below a competitor's
wholesale price for any given size and quality level.
Therefore, the discount structure is designed to refiect the overall competitive position of the firm, and
there is likely to he considerable difference between
the maximum announced list price and what the
manufacturer actually receives after discounting.
Firms whose products have poor brand positions
are forced into a much more liberal discount structure in order to secure favorable distributive outlets. The narrowing of the margin between actual
realizations and costs accruing to the smaller tire
producers, coupled with their almost total commitment to the production and sale of tires and their
weaker distribution systems, places many of them at
a disadvantage in the replacement market for factory-branded tires. Consequently, they have moved
aggressively into private label production.
Full-cost Pricing
Because of the nature of discounting, the theory
of full-cost pricing is not relevant to the tire industry.-* Full-cost pricing includes some allowance or
markup over standard cost to provide for profit.
However, the utilization of a rigid full-cost pricing formula requires certain necessary conditions.
For an example, see U. S. Congress, Senate, Select
Committee on Small Business, "Dual Distribution in
the Automotive Tire Industry—1959," Hearings,
Part I (Washington, D.C.: U. S. Government Printing Office, 1959), p. 20.
•* A discussion of this theory and other cost-price concepts can be found in Alfred R. Oxenfeldt, Pricing
for Marketing Executives (San Francisco: Wadsworth Publishing Co., 1961), Chapter 2.
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First, raw materials prices must be relatively stable.
Although vertical integration, coupled with the
growing importance of synthetic rubber, has mitigated this problem, short-term fluctuations in the
price of natural rubber create some instability in
the realized price structure.
Second, the level of operations must be fairly
predictable. The largest tire firms, which might be
expected to exert a dominant influence on pricing,
are heavily involved in original equipment sales.
This derived demand is dependent upon the level of
general economic activity and therefore complicates
the leveling out of operations on a cyclical basis.
Finally, idle capacity must not crop up regularly.
This might force producers into price-cutting and
secret concessions to obtain additional orders. The
problem of idle capacity has been especially troublesome to the tire industry and has been the major
factor precluding a rigid, full-cost pricing approach.
This is not to say that tire producers do not price
at standard cost. So long as the possibility of
changes in realizations due to changes in the level
of demand is present, a modified form of full-cost
pricing is possible. A flexible system of full-cost pricing explicitly recognizes the elasticity of demand,
and realizations depend upon market conditions.
Price Discrimination
The presence of large and powerful buyers in the
original-equipment and private-label markets present the possibility of discriminatory pricing between these markets and the replacement market
for factory brands. Conventional price theory would
treat price discrimination imposed on these markets
as an attempt by sellers to equate the incremental
revenue obtained from each market with the incremental cost of the total output in all markets."
However, this profit-maximizing price is not
determinate in practice. Only certain limits can
be approximated.
Original Equipment Market
In the original equipment market the upper limit,
in the long run, would be set by the price at which
it would be cheaper for the automobile manufacturer
to produce its own tires or to subsidize plant expansion by one of the smaller tire firms to produce
the automobile company's private label.
Theoretically, the lower limit would be governed
by the maximizing conditions stated above, as long
as variable costs were being covered.
How are original equipment prices actually determined? After carefully estimating the possible
quantities that will be taken by their automobile
company customers, original equipment suppliers
adopt an arbitrary procedure of cost allocation,
based on the assumption that average total costs
5 Richard H. Leftwich, The Price System and Resource
Allocation (New York: Holt, Rinehart and Winston,
third edition, 1966), pp. 197-200.
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decrease as total output increases up to the point of
capacity. They treat original equipment sales as
a means of spreading the overhead and will accept
prices on these sales down to the point where variable costs are barely covered.
In fact, they might even supply at a price below
variable costs to retain a large contract which might
otherwise go to a competitor who could then lower
his average costs of production for his total output
in all markets. Lack of recognized interdependence
among original equipment suppliers would set the
price floor in the short run.
2!?
'Z~
Private-label Market
In the private-label market manufacturers attempt to earn a small margin over manufacturing
cost, which includes factory cost, administrative and
selling expenses related to obtaining the contracts,
warehouse and shipping expenses, and cost of adjustments on defective tires.
The profit margin is usually between 5 and 7%.
However, most private label contracts provide for
price adjustments to refiect any change in direct
costs. Therefore, these prices respond rather quickly
to cost changes.
Price discrimination in the private-label market
is not a unilateral profit-maximizing decision on the
part of the tire manufacturers. It must be remembered that manufacturers' factory brands are in
competition with private-label brands at the retail
level.
This means that tire firms supplying large private label buyers are not anxious to contribute to
a widening spread between their own brands and
those of private label competitors at retail. Prices
are largely determined by the bargaining strength
of large buyers who are relatively immune to the
factory brand preference built up over the years
by selling outlays of the larger tire producers.
Even if prices to private label sellers are lower
than the manufacturers' factory brands of identical
quality by more than the actual differences in full
costs, the fact that the recipients of this favorable
price compete directly with the grantor effectively
impedes the attempt by the tire manufacturers to
enforce higher prices for their factory brands.
Moreover, the fact that all large buyers generally
receive the same terms of sale from a variety of
tire suppliers means that in the absence of collusion they face competition among themselves at
announced selling prices, even if they are below
prices of factory brands.
The retail price differential between private-label
and factory-brand tires is about 10 to 20%, with
the lesser-known private labels such as those of
department stores carrying the largest spread. However, the prices actually obtained at retail for leading private-label brands are very close to those
prices obtained by brands of the smaller producers
of tires.
Journal of Marketing, July, 1966
Price Leadership
Formally announced list prices of tires of identical quality and enjoying comparable sales positions
are virtually identical. Actually there is a zone
within which these tires are priced, and no manufacturer will permit his comparable product to be
priced outside this zone. The differences are so
slight, however, that the replacement market buyer
acts as if the prices were the same.
Furthermore, tire prices move in parallel fashion.
Is price leadership, therefore, a method of imposing
a non-competitive price on individual consumers in
the replacement market?
The heterogeneous nature of the tire industry,
illustrated by the differentiated commitment to tires
by different producers, plus different sales programs,
precludes the emergence of a "dominant firm" form
of price leadership. In theory, the dominant firm
establishes an administered price and permits all
other sellers to dispose of their entire output at that
price, covering the remainder of market demand
itself.e
In practice, however, no one single firm is willing
to provide the "umbrella" under which competition
could grow, permitting smaller firms to capture an
increasing share of the market. What about the
possibility of a form of "barometric price leadership" where the leader has the responsibility of
recognizing changes in cost and demand conditions
and translating them into price changes, but with
no real power to enforce monopoly prices? Once
again, basic firm heterogeneity, augmented by lack
of any appreciable growth in the replacement market for tires, has prevented any one firm from
assuming this role.
Price Leader's Decision
The orientation of any price leader's decision
not only is lateral but also vertical, in the sense
that he must consider possible reactions from his
competitors and also possible actions of individual
large buyers in particular submarkets.
An illustration would be the price of the 100-leveI
tire, the basis of sales to automobile manufacturers
and hence the foundation of the entire price structure. Original equipment tire suppliers could not
raise the price of this tire to dealers without a corresponding increase in the price to Detroit, assuming the price increase were made for some rise in
average costs. Not to do so would subject them to a
charge of economic price discrimination and a possible Robinson-Patman Act violation.
Correspondingly, for the same reason they could
not lower prices to dealers without an equivalent
cut to automobile manufacturers. Moreover, ag^ The original formulation is found in George J. Stigler, "The Kinky Oligopoly Demand Curve and Rigid
Prices," Journal of Political Economy, Vol. 55 (October, 1947), pp. 432-449, at pp. 444-445.
Competitive Oligopolistic Pricing
gressive buying from Detroit would undoubtedly
uncover any price differences.
Therefore, the largest producers are reluctant to
change the price of their 100-level tires, and this
quality level has always served as the basis of the
formal price structure. An alteration in its price
would necessitate a complete remaking of the formal
price structure at all levels.
In an oligopolistic market, conventional wisdom
suggests that a firm should not test the market
discipline too often by making frequent and haphazard price changes. Changes should occur only at a
customary time and be based on clearly recognizable
factors which will insure that all firms will accept
the move. Formal price changes in the tire industry
follow this wisdom, and when made overtly are an
industry matter, although in recent years price leads
have not always been followed.
Despite the fact that most price changes are made
by the four largest producers, is this price leadership in the real sense? For a given level of aggregate demand, a move by one of the smaller
producers to lower prices for some reason not
explainable by cost factors would be interpreted by
the industry as an aggressive act designed to increase market share. Hence, the cuts would surely
be matched by the larger firms, with the possibility
of undercutting.
But if market demand were growing rapidly,
the smaller firms might take a larger share of the
business through price competition without provoking retaliation from more powerful rivals whose
markets are also expanding.
Conversely, a price increase by a smaller firm
would run the risk of not being followed, and the
result would be a drastic loss of market position,
particularly if the small firm's factory brand did not
have widespread acceptance.
Market maneuvering in the tire industry is based
on a fundamental criterion: if an initial pricing
move by one firm is neutralized by the countermoves
of rivals, further pricing maneuvers can still be
made.
Therefore, a price cut, unless supported by some
external factor common to the entire industry, is a
poor maneuver. The same is true of a price increase, although financially it is always easier to
retreat from a higher price, since distributors are
g'lad to receive a rebate on their inventory.
What conditions offer the appropriate environment for a price cut to be followed? The basic
criterion is a drop in variable costs, particularly in
the price of new materials. This is refiected almost
immediately on the lower-priced elements in the
tire market, namely the private-label buyers who
purchase tires on a cost-plus contract.
The private-label buyers who receive the bulk
of their tires from smaller producers who have
short Inventory positions in natural rubber will
almost immediately begin receiving tires at lower
51
prices. Consequently, they are in a position to
•lower their ovni retail prices.
Smaller producers will also grant price concessions to distributors in order to remain competitive
with the mass distributing organizations. In the
absence of collusion, the larger producers will finally
be forced to participate in the price cutting. Initially they may act by way of the price concession route
to their distributors, who will be feeling the pressure of the private label suppliers and the smaller
producers. Eventually they will announce a formal
price cut, which merely recognizes a situation already existing in the market. The firm that finally
initiates the formal price change can hardly be
called a price leader.
Positions are reversed with respect to a price
increase. Rising direct costs fall more heavily on
smaller producers and private label buyers. Therefore, they are always ready for a price increase.
However, because of the historical price differential between well - advertised and lesser - known
brands, these firms cannot lead the increase. They
must wait for the larger producers. Because of the
recognized interdependence in firm decision-making,
confidence is built that a price increase will be
followed. Once the announcement is made, distributors will begin to step up orders to obtain inventory
at lower prices. Consequently, other firms will generally follow a price increase quickly to avoid being
saddled with large orders at the old and lower price.
Implications
Despite the clearly oligopolistic character of the
rubber tire industry, price behavior does not refiect
the monopolistic connotation usually associated with
competition among the few. The intricate system
of discounts and concessions enables and even forces
the tire producers to make a finer adaptation to
demand than would be the case if a rigid pricing
policy enforced by tacit collusion were adopted.
In general, tire firms set prices which refiect
competitive conditions. The market power of the
larger producers is effectively blunted in major submarkets by the countervailing force of large buyers,
including automobile manufacturers, private label
buyers, and other mass-distributing organizations.
There is little evidence of purposive price discrimination on the part of the tire producers.
When contemplating a price change, the individual firm must take into account a number of both
horizontal and vertical forces in the several submarkets, thus precluding the possibility of any enforced understanding among the tire oligopolists.
Market forces have not permitted an abdication
of price competition in the tire industry. In other
words, pricing policy does not completely reflect the
results anticipated under models of perfect competition; but apparently it does yield a type of behavior not adverse to consumer interest.