Time Varying Competition

Normative models typically suggest that prices rise in periods of high demand and cost. Yet in many markets, prices fall when demand or costs rise. This inconsistency occurs because the normative models assume that competitive intensity does not change with demand and cost conditions over time. We therefore introduce the notion of time varying competition by suggesting that it is important to not account for the direct effect of demand and cost on prices (e.g., higher demand means higher prices), but also the indirect effect of demand and cost changes on competition (e.g., higher demand could cause more competition and hence lower prices). We develop a general, unified framework to empirically model the direct and indirect effects of demand and cost shifts on pricing in differentiated product markets. Our approach allows us to measure the indirect effect of multiple demand and cost drivers on competitive intensity and test predictions from alternative theories of repeated games. The empirical application is to the U.S. photographic film industry where there are two main players, Kodak and Fuji. We find that the indirect effects are highly significant and comparable in magnitude to the direct effects. Competitive intensity is greater in periods of high demand and lower cost and is moderated by whether demand or costs are expected to grow or decline. Interestingly, we find asymmetries in the competitive responses of Kodak and Fuji. While Kodak is sensitive to demand factors, Fuji is sensitive to costs. Our results suggest that market characteristics such as observability of competitor prices can be an important determinant of how competitive intensity is affected by demand and cost conditions