Original article (link) posted: 01/10/2005
Kandori (1991) "Correlated Demand Shocks and Price Wars During Booms" RES, 58
The paper extends the analysis of Rotemberg and Saloner (1986) to the case of serially correlated demand shocks and derives the same counter-cyclical movement as in their case (i.i.d. case), provided the discount factor and the number of the firms satisfy certain relationship.
The key observation in Rotemberg and Saloner (1986) was that, if the sum of future profits is unaffected by today’s demand, firms must set the price relatively low when demand is high. The premise is clearly satisfied when the demand shocks are i.i.d.. This paper shows introducing Markov demand shocks also create the same situation in the following two cases. The first case is when the discount factor delta exceeds, but is close to (N-1)/N, where N is the number of the firm. It is shown that firms maintain a constant profit (which equals to the monopoly profit in the worst state) under all demand conditions. Therefore, the extent of the correlation in demand is irrelevant.
The second case arises when delta tends to unity while (1-delta)N is held constant. In this case, firms are enormously forward-looking and total future profit is mostly determined by the stationary distribution, which is independent of today’s demand position.
The result itself is not that surprising (comparing to the other papers by Kandori at least). However, he is amazingly good at selling his work, especially in the following two points;
First, he stresses the importance of Rotemberg and Saloner (1986) and their drawbacks as well. The motivation of extension of their paper becomes very clear and the reader necessarily gets interested in HIS work.
Second, his way of illustrating results is quite lucid and rigorous. Although, the results can be more or less expected to hold, it always is difficult to prove them in rigorously.
Those techniques should be useful for us. Let’s learn them by the papers by Kandori!
Interesting Papers that cite Kandori (1991)
Bagwell (2004) "Countercyclical Pricing in Customer Markets" Economica, 71
Bo (2001) "Tacit Collusion under Interest Rate Fluctuations" Job Market Paper
Harrington (2004) "Cartel Pricing Dynamics in the Presence of an Antitrust Authority" Rand