What Is the Edgeworth Price Cycle?
The Edgeworth Price Cycle is a pattern of price adjustments that result from competition between businesses that sell the same or similar goods—generally, commodified products.
Although the competition that creates the Edgeworth Price Cycle may benefit individual companies in the short term, it is generally detrimental to those companies in the long term.
- The Edgeworth Price Cycle describes how prices can fluctuate under conditions of aggressive price competition.
- It is mainly seen among companies selling commodified products, such as gasoline.
- In these circumstances, companies face short-term incentives to compete on price, but this competition can lead to long-term declines in profit margins.
- While most firms compete to lower prices during the Edgeworth Price Cycle, some adopt a contrarian approach and maintain or raise their prices.
How the Edgeworth Price Cycle Works
The Edgeworth Price Cycle is associated with markets in which the customers are very price sensitive. These customers are concerned principally with obtaining the lowest price possible and will be willing to switch between companies for even a modest decrease in costs. For this reason, companies in these markets will monitor each other's prices and opportunistically reduce them to gain market share.
In the long term, however, this cycle can be self-defeating for the companies involved, lowering profit margins in the long term. The only permanent solution to this problem would be for companies to induce more loyalty from their customers, but this may be impossible to achieve if the product in question is highly commoditized and there is a lot of competing providers for it.
Stages of the Edgeworth Price Cycle
This pattern of competition in the Edgeworth Price Cycle generally follows three predictable stages.
In the first stage, the firms engage in a war of attrition in which they cut prices lower and lower. If this cycle continues long enough, prices will reach their marginal cost, meaning that further price cuts will lead to losses for the company.
In the second stage, some firms will abandon the price-cutting strategy and firms will begin raising their prices to somewhere near where they were before the price-cutting began.
In the third stage, another series of price cuts will commence as firms once again jostle to gain market share by cutting prices.
This cycle can repeat itself indefinitely since the products being sold are relatively undifferentiated and customers can easily switch between companies. For this reason, there will always be a short-term incentive for competitors to fall back into the pattern of the Edgeworth Price Cycle.
Edgeworth Price Cycles are the leading theory behind the price changes that appear in many retail gasoline markets around the world, particularly in North America, Australia, and Europe.
Sometimes companies in these types of Edgeworth Price Cycle-sensitive markets will often enjoy some modest amount of loyalty from their customers. That can create incentives for those companies to adopt a contrarian stance and maintain or raise their prices while others are struggling to reduce them.
For instance, in the case of gas stations, customers may well be sensitive to price but will also prefer buying from the gas stations nearest to them or highly convenient to them (near their place of work, shopping center, etc.).
For this reason, a gas station that's situated in a good area—right near an entrance to the expressway, for example—might also go against the trend of an Edgeworth Price Cycle and maintain or increase prices at a time when its competitors are cutting them. If enough of that company’s customers remain loyal, the contrarian player might make more money than if it had tried to compete by lowering prices.
History of the Edgeworth Price Cycle
When plotted on a graph, the prices in an Edgeworth Price Cycle rise and then fall in a gradually declining stair-step or saw-tooth pattern. For this reason, it is considered an asymmetrical price cycle.
The notion of a competitively driven, dynamic, asymmetric price cycle dates back to Francis Ysidro Edgeworth (1845-1926), an economist and statistician. In one of his major works, collected in Papers Relating to Political Economy (1925), he argued that when marginal costs were increasing (or firms were capacity constrained in the extreme case), prices firms would undercut one another to gain market share, until prices were low enough that one firm could profitably raise them and serve the residual demand.
However, it wasn't until 1988 that the Edgeworth Price Cycle theory was formalized—and given its name—in a paper by economists Eric Maskin and Jean Tirole, "A Theory of Dynamic Oligopoly, II: Price Competition, Kinked Demand Curves, and Edgeworth Cycles," published in Econometrica.