Simulating Competitive Pricing

Charles Higgins, PhD Dept Finance/AIMS ne CIS Loyola Marymount University 1 LMU Dr. Los Angeles, CA 90045-8385 310 338 7344 chiggins@lmu.edu

Draft 4 August 25, 2011 Introduction In a capitalist society, a firm seeks to maximize profits determined by:
1)

= (P - V)Q F

where is profits, P is a firms price, V is variable costs, Q is quantity sold, and F is fixed costs. It is argued that the pricing of goods and services is a function of costs if there is competition and that Q will decrease when P increases and vice versa. Further, if competitive prices change, a new equilibrium will be reached in most cases. Theoretic economic examinations argue that eventually the firm will converge toward marginal revenue equaling marginal costs or: 2) R/Q = C/Q

where R is revenue and C is costs. Theory is generally configured in a calculus (and often with calculus) leading to MC equaling V and then P converging toward V. Simulation Instead of a theoretic approach, one could simulate individual customer behaviors and the price reaction behaviors of firms. Other approaches have been investigated (Amstutz [1970] and Csik [1996]. Let there be a market of N firms and M customers and a stated variable cost of V for each firm. An initial price P for each firm is set and then for each iterative market cycle, each customer randomly selects any where from 1 to N firms to choose the lowest price. The selected starting

firm for each customer is also randomized. After each market cycle, the firm with the lowest profits (and the most in need of a change in price) resets its price toward the mean price of that cycle. It is often necessary to introduce a random variation in order to perturb the system into motion which was initially set as 1 so that a random component was added anywhere from +.5 to .5. Dampening of the random variation allows a later finer gradation of subsequent price changes and is 99.9 percent of the previous variation. In each run, varying the number of firms, initial prices, variable costs, and the number firms searched resulted in a convergence of firm prices toward variable costs. The exceptions were when the customers did not search beyond only one firm (which produced the expected result of a steadily rising price) and when the firms had different variable costs (not present herefor another day). Specifically, in the simulation where there were three firms, a customer could search one, two, or three firms starting at either firm 1, 2, or 3; the simulation with two or four firms used a similar procedure. The simulation examined N at 2 then 3 then 4 firms, M at 100 customers, fixed costs F as zero (which is generally recognized as important only for a firms decision to enter or exit a market), and V as 3 then 30 dollars (or euros, yen, pounds, francs, etc.). Initial prices were set at 19 then 18 then 17 etc. (P=20-f where f is the number of the firm). For N firms, 1/Nth of the customers examined one firms price and likewise the last 1/Nth of the customers examined prices of all the firms (with exception when the simulation was set to select only one firm for each customer). Results Firms Variable Cost 3 30 3 Firms 5 10 15 20 25 30 2 3.03 30.17 P=20-f 5.03 9.99 15.06 20.03 25.01 30.01 3 3.10 30.11 P=80-20f 5.09 10.01 15.04 19.96 25.01 30.04 4 3.07 30.21 One Search 62.25 63.43 59.72 61.79 62.57 63.63

Another set of runs was performed with similar and different initial prices of 19, 18, and 17 then 60, 40, and 20. Finally find an examination where customers only examined one firm price, the prices coasted upward without an observed convergence save that of the dampening parameter limited the upward movement to a price of about 60 given a run of 2,500 simulations (producing a significance of .02 [=1/25001/2]). A run with fixed costs at 20 for each firm produced similar results. Conclusion An obvious conclusion is that a vigilant consumer is necessary to a competitive system. Note that not all customers needed to be price vigilant indeed 1/N of the customers in the simulations herein did not search beyond one firm. Some argue that the utilization of the internet by consumers has lowered prices where competition is strong (but see Grabmeier [2005]) with the observation that not all customers need the internet in order to benefit from the efficient pricing by those customers who do. References Amstutz, Arnold E., Computer Simulation of Competitive Market Response [1970], MIT Press. Csik, Balzs, Simulation of Competitive Market Situations Using Intelligent Agents [1996], Periodica Polytechnica Ser. Soc. Man. Sci. 11:1, pp. 83-93.
Jeff Grabmeier, Study Challenges Claim that the Internet Promotes Price Competition, Ohio State Research [2005], http://researchnews.osu.edu/archive/websales.htm

Computer program