Dynamic competitive retail pricing behavior with uncertainty and learning

When competing retailers lack full information about rivals' decision processes, how will dynamic pricing behavior vary from patterns observed in more traditional static or full-information models? We investigate this question in a dynamic alternating-moves duopoly model. Retailers update (linear) conjectures about rivals' future prices in a Bayesian fashion. We show that as observed and expected prices converge, a pricing equilibrium is always achieved, whether or not the conjectured and actual values of the slope of the rival's best response function are consistent. Assuming specific parameter values, we compare equilibrium prices and associated profits in our Bayesian learning model with those obtained under the assumptions of static Nash behavior, collusive behavior and dynamically optimal behavior with full information. We apply the notions of strategic substitutability and strategic complementarity to the analysis and find that when products are strategic complements, conjectures of higher rival price responsiveness lead to higher steady-state prices and profits. The reverse is true for strategic substitutes. We also find that learning about a rival's behavior proceeds more quickly, the less intensely related in demand are products. We find, in general, that equilibrium pricing patterns and profits can vary considerably from those in full-information environments, but that even with grossly wrong beliefs about rival behavior, competing retailers are still attracted to an equilibrium. The analysis suggests not only the value of investigating lessthan-full information situations but also the potential incremental value of signalling greater or less aggressiveness than truly characterizes one's behavior as a strategic option.     

The role of debt and bankruptcy statutes in facilitating tacit collusion

Using a two‐period model this paper examines the quantity decisions of leveraged duopolists that are vulnerable to bankruptcy in the first period. When the firms have symmetric costs, a bankrupt firm reorganizes under Chapter 11. If a Chapter 11 firm experiences marginal cost relief, each firm produces a collusive output in period one in order to prevent its rival's financial demise. When the firms have asymmetric costs, the less efficient firm is liquidated under Chapter 7 upon bankruptcy. A predatory equilibrium exists, whereby the inefficient firm is driven from the market. Copyright © 1999 John Wiley & Sons, Ltd.     

Upstream Foreclosure Decisions under Successive Monopoly Structure

This article models the upstream foreclosure decisions using the successive monopoly structure, whereby production requires two types of inputs, exclusive materials, and commonly available labor. An opportunity for upstream foreclosure arises when a downstream firm strategically merges with the material supplier, thereby foreclosing its rival's access to the exclusive input. The model shows that upstream foreclosure is not always optimal. A downstream firm opts for upstream foreclosure only when its relative positions in the labor‐management and material‐procurement negotiations are sufficiently strong. Copyright © 2014 John Wiley & Sons, Ltd.     

Inventory management under uncertainty: A financial theory for the transactions motive

This paper examines the effects of risk aversion and output market uncertainty on optimal inventory policy decisions for a transactions demand for inventory using the capital asset pricing theory. The paper shows that (1) the optimal order quantity of the risk-adjusted value-maximizing firm is smaller than that of the expected-profit-maximizing one and (2) the greater the firm's output market uncertainty, the smaller its optimal order quantity, where the output market uncertainty is defined as the relative volatility of the demand for the firm's output.     

Choosing the Quality of the Fit between Complementary Products

In this paper, I examine how firms should position their complementary products. I assume that there are two competing firms, each producing two complementary products. Each firm decides whether to employ strategies that enhance the quality of the fit (the degree of complementarity) between its pair of complementary products before competing in prices. The consumers have heterogeneous tastes for the four possible bundles. They are willing to pay a price premium in order to purchase a bundle from the same firm if this firm chose to make such bundle more attractive. I find that increasing the degree of complementarity between a firm's complementary products intensifies price competition and often leads to smaller profits. Only when complementarity‐enhancing strategies significantly increase the demand for a firm's matching bundle, does the firm benefit from employing them. The highest profits for both firms are obtained when both firms do not employ complementarity‐enhancing strategies. Deteriorating the quality of the fit between one's own and a rival's complementary products is never profitable.     

Supply chain decisions and coordination in the presence of an imperfect spot market

This study considers a supply chain consisting of a commodity supplier and a final product manufacturer with uncertain demand. In addition to purchasing from the supplier through a forward contract, the manufacturer can adjust their inventory by trading the commodity in an online spot market after observing the actual demand. However, the spot market is imperfect in that transactions cannot be certainly realized and come with additional transaction costs. Furthermore, the spot price is volatile such that overly relying on the spot market is unwise. To investigate how the spot market affects the decisions and coordination in a supply chain, we develop a game-theoretical model incorporating spot trading. We derive the optimal ordering decision in a centralized supply chain, as well as the supplier's and manufacturer's equilibrium pricing and ordering decisions in a decentralized supply chain. The impact of the imperfect spot market on the optimal decisions and profits is analyzed. This study also demonstrates how the supply chain can be coordinated in the presence of an imperfect spot market. Finally, a numerical analysis is performed to examine the analytical results. Our results indicate that the spot market can generally improve the performance of the centralized supply chain and benefit the manufacturer in the decentralized one. However, it can be detrimental to the supplier. The supply chain can be coordinated by a revenue-sharing contract, and both parties' profits can be improved. Our findings suggest that the manufacturer could take advantage of the spot market, and the supplier should attempt to integrate or coordinate the supply chain to share the benefits of spot trading.     

Endogenous managerial incentive contracts in a differentiated duopoly,with and without commitment

In a differentiated Cournot duopoly, we examine the contracts that firms' owners use to compensate their managers and the resulting output levels, profits and social welfare. If products are either sufficiently differentiated or sufficiently close substitutes, owners use Relative Performance contracts. For intermediate levels of product substitutability, they use Market Share contracts. When owners do not commit over the types of contracts, each type is an owner's best response to his rival's choice. Product substitutability has differential effects on output levels and profits, depending on the configuration of contracts in the industry. Finally, managerial incentive contracts are welfare enhancing if they increase consumers' surplus. Copyright © 2010 John Wiley & Sons, Ltd.     

Linear learning in changing environments

The decision maker receives signals imperfectly correlated with an unobservable state variable and must take actions whose payoffs depend on the state. The state randomly changes over time. In this environment, we examine the performance of simple linear updating rules relative to Bayesian learning. We show that a range of parameters exists for which linear learning results in exactly the same decisions as Bayesian learning, although not in the same beliefs. Outside this parameter range, we use simulations to demonstrate that the consumption level attainable under the optimal linear rule is virtually indistinguishable from the one attainable under Bayes’ rule, although the respective decisions will not always be identical. These results suggest that simple rules of thumb can have an advantage over Bayesian updating when more complex calculations are more costly to perform than less complex ones. We demonstrate the implications of such an advantage in an evolutionary model where agents “learn to learn.”     

Dividend policy and investment: Theory and evidence from US panel data

This paper examines the importance of dividend policy and liquidity constraints in the context of the firm's investment behaviour. While early financial literature has argued that dividend policy should be independent of firm investment decisions, recent studies indicate that linkages are probable in a world of imperfect capital markets. This study develops an alternative Q specification which incorporates the actual dividend payment of the firm in order to test the hypothesis of independence. Empirical results suggest that after controlling for the firm's dividend payment, liquidity constraints remain an important determinant of firm investment behavior.     

Irreversible investment and capacity choice with Bayesian learning

This paper incorporates information incompleteness into the standard capacity choice model. The firm dynamically updates its belief about the expected growth rate based on the realization of demand shocks. First, the firm’s expansion decision becomes more conservative in the dynamic updating case. Moreover, a myopic firm always overestimates the marginal value of capital but underestimates firm value. When we decompose the firm value into the value of assets in place and growth opportunities, dynamic learning significantly increases the value of growth opportunities rather than that of assets in place. Finally, the implications for the user cost of capital is also examined.     

The firm under uncertainty: real and financial decisions

This paper examines the interplay between the real and financial decisions of the competitive firm under output price uncertainty. The firm faces additional sources of uncertainty that are aggregated into a background risk. We show that the firm always chooses its optimal debt–equity ratio to minimize the weighted average cost of capital, irrespective of the risk attitude of the firm and the incidence of the underlying uncertainty. We further show that the firm’s optimal input mix depends on its optimal debt–equity ratio, thereby rendering the interdependence of the real and financial decisions of the firm. When the background risk is either additive or multiplicative, we provide reasonable restrictions on the firm’s preferences so as to ensure that the firm’s optimal output is adversely affected upon the introduction of the background risk.     

Bargaining over Managerial Contracts in Delegation Games: The Generalized Oligopolistic Case

The main purpose of this paper is to disclose the properties of the equilibrium outcomes in the differentiated‐products model with two stages: (i) owner‐shareholders negotiate managerial compensation with their managers that comprises their profits and sales (sales delegation) and (ii) they engage in their market competition. The other purpose of this paper is to study the differentiated goods model in which an owner bargains the managerial compensation with her/his manager that comprises her/his profit and her/his rival's profit (relative performance delegation). We further investigate the situation wherein the firm with sales delegation and the firm with the relative performance delegation coexist. Copyright © 2012 John Wiley & Sons, Ltd.     

Cost-based decision rules for output,quality, and price

The present paper develops a theoretical model to address the relationship between a firm's pricing policy and its cost of increasing product quality. The model expresses both firm costs and firm revenues as functions of the quantity of a firm's output and overall product quality, where quality is expressed as quantity times quality per unit. The model starts with a generic good that measures output, and models quality as priced quality enhancement for each unit of the generic good. The model leads to decision rules by which the price of quality is a mark-up over the marginal cost of increasing product quality. The relationship between the price of quality and revenues from increasing output is also determined, and is conditioned by the sign and magnitude of the elasticity of demand for quality.     

Corporate hedging and input price risk

Input price variability is an important source of risk for corporations that process raw commodities. Models of optimal input hedging are developed in this paper based on the maximization of managerial expected utility. The relationship between hedging strategies and output decisions is examined to assess the impact of the ability to set output prices on futures market participation. As a firm's ability to set output prices diminishes in the short run, input futures positions increase although the optimal hedge ratio may either increase or decrease. For a perfectly competitive firm, however, shifts in output price caused by input price changes provide a natural cash market hedge of input price risk and reduce the firm's optimal input futures position.     

Investment decisions and managerial compensation design in the presence of product market rivalry

We consider an economy where firms operate in an imperfectly competitive industry and mutually affect each others’ investment opportunities. Each firm is assumed to face a mutually exclusive choice of investing in either a short‐ or a long‐term project. For example, firm i's commitment to a short‐term project cuts into firm j's market in the short‐term but frees‐up firm j's long‐term market, and vice versa. Our results show that, even in the absence of an owner–manager conflict, the owner anticipates the product market rivalry and optimally compensates their managers with short‐ as well as long‐term compensation. Although the optimal compensation design induces myopic investment decisions, it is shown to be in the owners’ best interest. Copyright © 1999 John Wiley & Sons, Ltd.     

From market failure to organisational failure

In this paper, we argue that environmental economists who have dedicated their attention to problems of market and regulatory failure have been remiss in ignoring the potential for failure in the one institution that actually manages environmental resources - the business firm. Traditionally the firm has been modelled as a unitary, rational, optimising persona ficta. There is, however, abundant empirical and theoretical evidence to suggest that the business firm is an imperfect institution in that there are systematic deviations between the environmental objectives of the firm's leaders (principals) and the actions of the firm's employees (agents) which determine environmental performance. In the paper, we draw parallels between the causes of market failure and public policy tools to correct them on one hand and the causes of organisational failure and the management tools suited to their remedy on the other. Although much of the paper is concerned with the interrelationship between public policy that promotes sustainability and business policy to fashion a sustainable enterprise, our work is relevant irrespective of the reason why a firm's principal may want to improve environmental performance. No matter what the reason, the principal must concern him- or herself with operationalising objectives in management systems. It is consistent with the precautionary principle to assume that employees will do what the firm measures and rewards, not what its principal says is important. We build a verbal model, based on the language of principal-agent theory, to analyse how different management instruments might be employed to improve the firm's environmental performance. The model is one of three decision makers in a vertical hierarchy. Each of the first two has various instruments at its disposal to influence the behaviour of the agents subordinate to it. In the end, the goal is to ensure consistency between social, economic, and personal objectives. The specific management tools we analyse, with reference to the formal modelling which has appeared in the literature, include the compensation system, quantification and monitoring of non-financial objectives, internal pricing, horizontal task restructuring, centralisation vs. decentralisation of decision making, and corporate sanctions of agents for negligence. We conclude the paper by reiterating that the corporate policy statements to the effect that the firm should respect the environment are insufficient to ensure that result. In addition, firms' principals must operationalise that goal in the systems of measurement and control which govern the behaviour of those who really matter - the employees.     

Licensing and innovation with imperfect contract enforcement

Licensing promotes technology transfer and innovation, but enforcement of licensing contracts is often imperfect. We model contract enforcement as a game with perfect information but probabilistic enforcement and explore the implications of weak enforcement on the design of licensing contracts, the conduct of firms, and market performance. An upstream firm develops a technology that it can license to downstream firms using a fixed fee and a per‐unit royalty. Strictly positive per‐unit royalties maximize the licensor's profit if competition among licensees limits joint profits. With imperfect enforcement, the licensor lowers variable royalties to avoid cheating. Although imperfect contract enforcement reduces the profits of the licensor, weak enforcement lowers prices, increases downstream innovation, and in some circumstances can increase total economic welfare.     

The dynamic annihilation of a rational competitive fringe by a low-cost dominant firm

A low-cost dominant firm will drive all competitive fringe firms out of the market if all firms have rational expectations; however, the dominant firm will not predate (price below marginal cost). Since a dominant firm will not drive out fringe firms if they have myopic expectations, it may be in the dominant firm's best interests to inform the fringe. The effects of governmental intervention on the optimal path and welfare are presented.     

Endogenous trading in credit default swaps

We introduce a real options model in order to quantify the moral hazard impact of credit default swap (CDS) positions on the corporate default probabilities. Moral hazard is widely addressed in the insurance literature, where the insured agent may become less cautious about preventing the risk from occurring. Importantly, with CDS the moral hazard problem may be magnified since one can buy multiple protections for the same bond. To illustrate this issue, we consider a firm with the possibility of switching from an investment to another one. An investor can influence the strategic decisions of the firm and can also trade CDS written on the firm. We analyze how the decisions of the investor influence the firm value when he is allowed to trade credit default contracts on the firm’s debt. Our model involves a time-dependent optimal stopping problem, which we study analytically and numerically, using the Longstaff–Schwartz algorithm. We identify the situations where the investor exercises the switching option with a loss, and we measure the impact on the firm’s value and firm’s default probability. Contrary to the common intuition, the investors’ optimal behavior does not systematically consist in buying CDSs and increase the default probabilities. Instead, large indifference zones exist, where no arbitrage profits can be realized. As the number of the CDSs in the position increases to exceed several times the level of a complete insurance, we enter in the zone where arbitrage profits can be made. These are obtained by implementing very aggressive strategies (i.e., increasing substantially the default probability by producing losses to the firm). The profits increase sharply as we exit the indifference zone.     

Experimental Study of Firm Bounded Rationality and the Pattern of Trade

This paper describes an experiment and simulation with features of a spatially explicit trading environment. Decision makers repeatedly make decisions about firm headquarters, input demands, and export patterns. A goal of this research is to determine if subjects’ management decisions reflect profit maximization, learning, or heuristic decision making. It also considers what impact decision makers’ bounded rationality has on the aggregate pattern of trade. Results indicate that bounded rationality in the form of learning and heuristic decision making are ubiquitous features of subjects’ decisions. This manifests as under‐reaction to trade‐driver stimuli and produces Trefler's missing trade, suggesting a behavioral basis for this anomaly.