Short-Run Constraints and Price Wars

Abstract

Price wars have been explained as occurring because of breakdown of cartels, or as necessary deterrent measures to sustain collusion, or due to imperfect information about demand conditions and/or moves of other firms; and combinations of the above. The above literature, however, fails to explain the repeated episodes of price wars in an industry with instantaneous transmission of information, for example, the U.S. domestic airlines industry. This paper studies different market models with linear and twice differentiable market demand and identical linear costs without capacity constraints, and with almost perfect homogeneity of competitors' products, to demonstrate that, in the presence of short-run constraints (such as insolvency) of firms and of intertemporal substitution of demand (such as with vacation travel or durables), a price war occurs if one or more firm(s) have sufficiently low net asset level(s) --- such price wars occur in equilibrium and as part of cooperation. Explicit expressions for prices under survival and predatory price wars are provided along with characterizations of conditions for each variant of price wars.