A Simple Model of Pricing, Markups and Market Power Under Demand Fluctuations

This paper formulates and analyzes a relatively simple model of duopoly pricing under conditions of fluctuating demand. Price-setting firms produce a homogenous product subject to increasing marginal cost of production. We focus on static Nash equilibria in price choices and examine the impact of varying the level of demand on equilibrium price levels, markups of price over marginal cost, and price variability. Price variability can arise because equilibria may involve mixed strategies in prices. For a particular class of demand and cost conditions, we find the following impact of increasing the level of demand: 1) The average level of prices rises, 2) Average markups of price over marginal cost may rise or fall, and 3) Price variability falls. The class of demand and cost conditions for which these results apply is a special class. But we believe that it is not so special that it could not capture the essential demand and technology conditions that drive pricing decisions in a variety of different industries. Our main point is that models much simpler than optimal collusion models are capable of explaining interesting patterns of pricing and markups as demand fluctuates.