The goal of this chapter is to convey the main principles of pricing in competitive environments. We approach them through a series of of thought experiments. The advantage of these experiments is that every variable within them can be controlled. This allows one to precisely isolate how each aspect of the competitive environment affects prices. The result will be a clearer and deeper understanding of pricing in competitive environments than any collection of anecdotes or string of ‘just so’ stories is able to deliver. To apply the lessons of this chapter, one must know some basic facts about the industry one is in – specifically, entry costs, exit costs, structure of demand, number, concentration and the distribution of rivals' sizes.

The Pricing Dilemma

Imagine two firms selling identical widgets to a market of 100 individuals. Each buyer is interested in purchasing at most one widget, and the RP of each buyer is $3. Each buyer will buy from the seller that offers them the largest surplus. Because the products are identical (in the eyes of each buyer), each buyer will purchase from the lowest-priced seller. In the event that both firms set equal prices (and so yield the same surplus to all buyers), the buyers divide equally between the two firms.

The production cost for each firm is $1 a widget. Production is instantaneous and defect-free, so neither firm needs to worry about inventory, returns, and the other complications of real life. Production capacity is unlimited for both firms.