What Is the Edgeworth Price Cycle?

The Edgeworth Price Cycle is a pattern of price adjustments that results from competition between businesses offering 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.

Key Takeaways

  • 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.

How the Edgeworth Price Cycle Works

The Edgeworth Price Cycle is associated with markets where the customers are very price sensitive. In these markets, most customers are concerned principally with obtaining the lowest price possible, and will be willing to switch between companies for even a modest decrease in price. For this reason, companies in these markets will monitor each-others prices and opportunistically reduce them to gain market share.

At the same time, companies in these types of markets will often enjoy some modest amount of loyalty from their customers, which can create incentives for those customers to adopt a contrarian stance and maintain or raise their prices while others are struggling to reduce them.

Real World Example of the Edgeworth Price Cycle

For instance, in the case of gas stations customers will be sensitive to price but will also prefer buying from the gas stations nearest to them. For this reason, a gas station 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 contrarian company’s customers remain loyal, the contrarian player might make more money than if they had tried to compete by lowering prices.

This pattern of competition, in which most firms compete to lower prices while some adopt a contrarian approach and maintain or raise their prices, 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, a second 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.

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, such as in the case of gas stations.