Car dealers will tell buyers that they now have to wait three months instead of two for a new car. Restaurant owners will not raise prices on a good night but simply announce that the wait is an hour instead of 30 minutes. They may also try to set up a few extra tables or open up a part of the restaurant that is usually closed.In sum, the importance of long-term customer relationships will give firms a strong incentive to avoid responding to demand shifts with price changes. Output variations will therefore be the more common response. This tendency is further strengthened when we consider that the firm may care about its relationships with its rivals as well as with its customers.Many markets are characterized by oligopolistic structures where only a few firms account for virtually all sales. In the United States, the automobile industry, the beer industry, and the local newspaper industry are all good examples of oligopolistic structures. While our imperfect information assumption implied firms would have some short-run monopoly power, the oligopoly situation implies monopoly power even over a lengthy time interval where consumers have time to learn about prices. In such a situation, a firm cannot assume that its actions will have no market effect. Instead, the firm must judge how its actions will be evaluated by its other large rivals and how they will then respond. Unfortunately from the firm’s perspective, direct talks with its rivals are illegal. So it must rely on imperfect information to accomplish its task. This can generate considerable reluctance to change prices in response to demand shifts. Suppose for example that the firm experiences a decline in demand. If its rivals are experiencing the same shift, then a reduction in price will not increase the firm’s market share. But what if the decline is limited only to the one firm? In such a case, a price reduction would be viewed as an act of aggression on the part of the other firms. From their perspective, demand is still the same and no price change is called for. They have no reason to suspect that the price-reducing firm is doing anything but trying to increase its market share. Therefore, they will respond by lowering their price in retaliation. But this will cause the firm whose demand declined to lose more customers and induce it to lower its price still further. The process may then degenerate into a price war in which the firms in the industry are worse off. To prevent this 5 - 8
each firm must avoid even the appearance of aggression and only alter price in response to common disturbances that affect all industry members. In this respect, demand disturbances may be difficult to interpret. They could be general. But they could also be local affecting only the particular firm. Until the firm knows which is the case, it again will be reluctant to respond to demand movements with price changes and rely more on quantity fluctuations to meet such events.