BAO-IDANG, CHAERMALYN D.

A.Kinked demand curve

-A kinked demand curve occurs when the demand curve is not a straight line but has a different
elasticity for higher and lower prices.
-One example of a kinked demand curve is the model for an oligopoly. This model of oligopoly suggests
that prices are rigid and that firms will face different effects for both increasing price or decreasing price.
The kink in the demand curve occurs because rival firms will behave differently to price cuts and price
increases.
Diagram of kinked demand curve

kinked-demand-curve
The logic of the kinked demand curve is based on
* A few firms dominate the industry
* Firms wish to maximize profits
Impact of price rise
If a firm increases the price, then it becomes more expensive than rivals and therefore, consumers will
switch to its rivals.
Therefore, for a price rise, there is likely to be a significant fall in demand. Demand is, therefore, price
elastic.
In this case, of increasing price firms will lose revenue because the percentage fall in demand is greater
than the percentage rise in price.
Impact of price cut
If a firm cut its price, it is likely to lead to a different effect. In the short term, if a firm cuts price it would
cause a big increase in demand and therefore would lead to a rise in revenue. The firm would gain
market share.
However, other firms will not want to see this fall in market share and so they will respond by also
cutting price to follow the first firm. The net effect is that if all firms cut price – the individual firm will
only see a small increase in demand.
Because there is a ‘price war’ demand for a firm is price inelastic – there is a smaller percentage rise in
demand.
If demand is inelastic and price falls, then revenue will fall.
Prices stable
If the kinked demand curve is true, the firm has no incentive to raise price or to cut price.

B. GAME THEORY
Game theory was introduced in the previous chapter to better understand oligopoly. Recall the
definition of game theory.
Game Theory = A framework to study strategic interactions between players, firms, or nations.
Game theory is the study of strategic interactions between players. The key to understanding strategic
decision making is to understand your opponent’s point of view, and to deduce his or her likely
responses to your actions.
A game is defined as:
Game = A situation in which firms make strategic decisions that take into account each other’s’ actions
and responses.
A payoff is the outcome of a game that depends of the selected strategies of the players.
Payoff = The value associated with a possible outcome of a game.
Strategy = A rule or plan of action for playing a game.
An optimal strategy is one that provides the best payoff for a player in a game.
Optimal Strategy = A strategy that maximizes a player’s expected payoff.
Games are of two types: cooperative and noncooperative games.
Cooperative Game = A game in which participants can negotiate binding contracts that allow them to
plan joint strategies.
Noncooperative Game = A game in which negotiation and enforcement of binding contracts are not
possible.
In noncooperative games, individual players take actions, and the outcome of the game is described by
the action taken by each player, along with the payoff that each player achieves. Cooperative games are
different. The outcome of a cooperative game will be specified by which group of players become a
cooperative group, and the joint action that the group takes. The groups of players are called,
“coalitions.” Examples of noncooperative games include checkers, the prisoner’s dilemma, and most
business situations where there is competition for a payoff. An example of a cooperative game is a joint
venture of several companies who band together to form a group (collusion).
The discussion of the prisoner’s dilemma led to one solution to games: the equilibrium in dominant
strategies. There are several different strategies and solutions for games, including:
(1) Dominant strategy
(2) Nash equilibrium
(3) Maximin strategy (safety first, or secure strategy)
(4) Cooperative strategy (collusion).

6.1.1 Equilibrium in Dominant Strategies

The dominant strategy was introduced in the previous chapter.
Dominant Strategy = A strategy that results in the highest payoff to a player regardless of the
opponent’s action.
Equilibrium in Dominant Strategies = An outcome of a game in which each firm is doing the best that it
can regardless of what its competitor is doing
Recall the prisoner’s dilemma from Chapter Five.

C. PREDATORY PRICING
A predatory pricing strategy, a term commonly used in marketing, refers to a pricing strategy in which
goods or services are offered at a very low price point, with the intention of driving out competition and
creating barriers to entry. In contrast to loss leader pricing, predatory pricing is aimed toward setting
prices low for an extended period of time, long enough to, hopefully, drive the competition out of the
market.
Predatory Pricing
Understanding the Rationale Behind Predatory Pricing
Predatory pricing typically takes place during a price war. The ultimate goal behind this pricing strategy
is to establish a strong market position and to drive out competitors. Predatory pricing may require a
firm to sustain losses for a certain period of time and, thus, is typically only undertaken by large,
established firms capable of absorbing short-term losses. The strategy is considered successful if the
firm is able to recoup its short-term losses with much higher prices (and thus, higher profits) in the long
term.

Effects of Predatory Pricing on an Industry

Short-Term Effects
Predatory pricing in the short-term benefits customers but harms all companies in the industry. In the
short term, predatory pricing creates a buyer’s market, where customers are able to “shop around” and
usually obtain goods at a lower price.
For companies, profitability declines as competitors actively try to undercut each other’s prices and
divert traffic to their own business. The company that survives the price war and remains in the market
is able to reap long-term rewards of increased market share, although it is not likely that it will be able
to establish a monopoly in the industry.
Long-Term Effects
After competitors are driven out, the remaining firm is able to raise prices and recover lost profits. As a
customer’s willingness to pay declines as prices increase, the price appreciation works most effectively
on inelastic goods. In the long term, customers suffer from higher prices and the now near-monopoly
company is able to reap the profits of price appreciation.
The Legality of Predatory Pricing
Predatory pricing is deemed illegal and anti-competitive in many countries. For example, in Canada,
those that engage in predatory pricing face a monetary penalty. Allegations of wrongdoing are often
hard to prove, as firms can claim they were merely trying to be competitive with their pricing, rather
than deliberately acting to drive out their competition.
Allegations of Predatory Pricing: Air Canada
In 2001, Air Canada faced allegations of predatory pricing against two smaller competitors (WestJet and
CanJet) by Canada’s Commissioner of Competition. Air Canada introduced special fares to match
competitor’s prices of $89 to $99 for one-way travel from Halifax to St. John’s, Montreal, or Ottawa. In
the past, the airline had priced such flights at more than $600.
Other airlines filed complaints regarding Air Canada’s anti-competitive behavior, and a representative of
the company’s corporate development and strategy department came out and stated: “We are not
aware of any precedent anywhere where an airline has been prevented from matching pricing.”
Previously, Air Canada faced a cease-and-desist order from the Competition Bureau and was forced to
withdraw a set of low fares.
As previously noted, proving predatory pricing can be very difficult, as companies can deem it as price
competition. In this specific case, Air Canada explained that they were matching prices and were not
engaged in predatory pricing.
Example of Predatory Pricing
Fresh Foods Ltd. is a local mom-and-pop grocery store that’s been serving its community for many years.
Recently, an internationally renowned grocery store company decided to locate one of its stores in the
same community. Fresh Foods then faced significant pricing pressure from the new store as the
competitor started lowering prices over the past couple of weeks. To remain competitive, Fresh Foods
began reducing its prices to match its competitor.
After months of pricing pressure, the local mom-and-pop grocery store decided to close up, as it could
no longer sustain such low prices. With Fresh Foods eliminated, the now monopoly grocery store
company decided to raise its prices significantly. With nowhere else to shop for groceries, customers
were forced to accept the new, higher prices.
This example provides a good illustration of how predatory pricing can have a long-term negative impact
on consumers.

D. MARKET EFFICIENCY
What Is the Efficient Market Hypothesis (EMH)?
The efficient market hypothesis (EMH), alternatively known as the efficient market theory, is a
hypothesis that states that share prices reflect all information and consistent alpha generation is
impossible
According to the EMH, stocks always trade at their fair value on exchanges, making it impossible for
investors to purchase undervalued stocks or sell stocks for inflated prices. Therefore, it should be
impossible to outperform the overall market through expert stock selection or market timing, and the
only way an investor can obtain higher returns is by purchasing riskier investments.
Understanding the Efficient Market Hypothesis
Although it is a cornerstone of modern financial theory, the EMH is highly controversial and often
disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict trends in the
market through either fundamental or technical analysis.
Theoretically, neither technical nor fundamental analysis can produce risk-adjusted excess returns
(alpha) consistently, and only inside information can result in outsized risk-adjusted returns.
$342,850
The January 10, 2020 shared price of the most expensive stock in the world: Berkshire Hathaway Inc.
Class A (BRK.A).
While academics point to a large body of evidence in support of EMH, an equal amount of dissension
also exists. For example, investors such as Warren Buffett have consistently beaten the market over long
periods, which by definition is impossible according to the EMH.
Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones
Industrial Average (DJIA) fell by over 20 percent in a single day, and asset bubbles as evidence that stock
prices can seriously deviate from their fair values.
The assumption that markets are efficient is a cornerstone of modern financial economics—one that
has come under question in practice.
Special Considerations
Proponents of the Efficient Market Hypothesis conclude that, because of the randomness of the market,
investors could do better by investing in a low-cost, passive portfolio.
Data compiled by Morningstar Inc., in its June 2019 Active/Passive Barometer study, supports the EMH.
Morningstar compared active managers’ returns in all categories against a composite made of related
index funds and exchange-traded funds (ETFs). The study found that over a 10 year period beginning
June 2009, only 23% of active managers were able to outperform their passive peers. Better success
rates were found in foreign equity funds and bond funds. Lower success rates were found in US large-
cap funds. In general, investors have fared better by investing in low-cost index funds or ETFs.
While a percentage of active managers do outperform passive funds at some point, the challenge for
investors is being able to identify which ones will do so over the long term. Less than 25 percent of the
top-performing active managers can consistently outperform their passive manager counterparts over
time.

What does it mean for markets to be efficient?

Market efficiency refers to how well prices reflect all available information. The efficient markets
hypothesis (EMH) argues that markets are efficient, leaving no room to make excess profits by investing
since everything is already fairly and accurately priced. This implies that there is little hope of beating
the market, although you can match market returns through passive index investing.
But people do make excess returns trading and investing...
The validity of the EMH has been questioned on both theoretical and empirical grounds. There are
investors who have beaten the market, such as Warren Buffett, whose investment strategy focused on
undervalued stocks made billions and set an example for numerous followers. There are portfolio
managers who have better track records than others, and there are investment houses with more
renowned research analysis than others. EMH proponents, however, argue that those who outperform
the market do so not out of skill but out of luck, due to the laws of probability: at any given time in a
market with a large number of actors, some will outperform the mean, while others will underperform.
Can markets be inefficient?
There are certainly some markets that are less efficient than others. An inefficient market is one in
which an asset's prices do not accurately reflect its true value, which may occur for several reasons.
Market inefficiencies may exist due to information asymmetries, a lack of buyers and sellers (i.e. low
liquidity), high transaction costs or delays, market psychology, and human emotion, among other
reasons. Inefficiencies often lead to deadweight losses. In reality, most markets do display some level of
inefficiencies, and in the extreme case an inefficient market can be an example of a market failure.
Accepting the EMH in its purest (strong) form may be difficult as it states that all information in a
market, whether public or private, is accounted for in a stock's price. However, modifications of EMH
exist to reflect the degree to which it can be applied to markets:
Semi-strong efficiency - This form of EMH implies all public (but not non-public) information is calculated
into a stock's current share price. Neither fundamental nor technical analysis can be used to achieve
superior gains.
Weak efficiency - This type of EMH claims that all past prices of a stock are reflected in today's stock
price. Therefore, technical analysis cannot be used to predict and beat the market.
What can make a market more efficient?
The more participants are engaged in a market, the more efficient it will become as more people
compete and bring more and different types of information to bear on the price. As markets become
more active and liquid, arbitrageurs will also emerge, profiting by correcting small inefficiencies
whenever they might arise and quickly.

REFERENCES:
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