Strategic Pricing in Volatile Markets

Abstract

We study dynamic signaling in a game of stochastically evolving stakes. Our motivating example is dynamic limit pricing in markets with persistent demand shocks. An incumbent is privately informed about its costs, high or low, and can deter a potential entrant by setting prices strategically. The incumbent builds a reputation by maintaining low prices whenever the market reaches new lows and entry becomes a distant threat; equilibrium strategies thus exhibit path dependence, being functions of both the market's current size and its historical minimum. The model provides an explanation for rising prices in falling markets, which may have implications for antitrust policy. Variations of the model apply to predatory pricing and sovereign debt.