Dynamic Retail Price and Investment Competition

Abstract

We develop a model of retail competition in which retailers select prices and investments in cost reduction. An equilibrium is constructed in which several identical firms enter and then engage in a phase of vigorous price competition. This phase is concluded with a shakeout, as a low-price, low-cost firm comes to dominate the market. A central feature of the equilibrium is that low prices are complementary with large investments in cost reduction. Even though the dominant firm's price rises through time, and initially may be below marginal cost, we argue that an interpretation of predatory pricing may be inappropriate.