Dynamic and Production Inefficiencies of Price-Match

Guarantees
Mishal Ahmed∗ Byung-Cheol Kim†

August 15, 2018

Abstract

In this paper we consider duopoly price competition à la Hotelling model between

an online firm with a cost advantage and a brick-and-mortar firm in which the latter
may decide to price-match its online rival. We show two new effects of price-match
guarantees. First, price-matching may decrease both firms’ incentives to invest in
cost-reduction technologies. This result has an important policy implication – price-
match guarantees may involve not only static inefficiency but also dynamic inefficiency.
Second, when the low-cost firm has a quality superiority over the high-cost firm, price-
matching can aggravate the standard problem of production inefficiency in that the
cost-efficient firm may not cover enough of the market relative to the social optimum.
(JEL codes: D4, L13, L4, M2)

Key words: price-match guarantees, duopoly competition, cost asymmetry, online vs

offline shopping, investment incentives

∗
School of Economics, Georgia Institute of Technology. 221 Bobby Dodd Way, Atlanta, GA 30332.
E-mail: mishal.ahmed@gatech.edu
†
Corresponding author. Department of Economics, Finance & Legal Studies. University of Alabama.
265 Alston Hall, Tuscaloosa, AL 35487. Email: byung-cheol.kim@ua.edu
1 Introduction

Price-match guarantees have been used by firms for a while now.1 Recent data show 12% of
the top 500 retailers selling electronics and computers price-match while 50% of hardware
and home improvement stores and 100% of office supplies stores commit to such policies
(Jiang et al., 2016).2 Price-matching typically involves a firm advertising to its buyers that
it will lower its price to that of another seller in the event that a buyer finds such a lower
price elsewhere.3 While this may appear to be beneficial for consumers, economists have
debated over whether such price-matching policies are pro or anti-competitive. Even the
media which used to believe in the benefits of price-matching have started to cast doubt.4
Not surprisingly economists have studied price-matching behavior and its effects on
prices, profits and welfare in a variety of settings, from variation in timing of firms’ de-
cisions to offer a price-match guarantee and choice of prices, to variations in cost structures
between firms. In this paper we study a standard Hotelling-type model of duopoly between
a low-cost online firm and a high-cost brick-and-mortar firm with consumers being heteroge-
neous in terms of their relative preference toward online versus offline shopping. Our novel
findings in this context are two-fold.
First, we study how a price-match guarantee would affect the motivation of the high-cost
firm to invest in reducing the cost disadvantage against the low-cost firm and the motivation
of the low-cost firm to increase the cost advantage. We find that investment incentives for
both firms can be adversely affected due to price-match guarantees. The intuition for this
result is as follows. The low-cost online firm can invest in cost reduction and benefit from
an increase in its markup irrespective of price-matching. But while it can also gain market
share through cost reduction, price-matching by the high-cost firm prevents similar gains in
market share by the low-cost firm. Hence the total benefit to the low-cost firm from cost
reduction is higher in the no-price-match regime.

1
Edlin & Emch (1999) show the earliest usage dating back to 1947.
2
See their Table 1 for more details. To obtain the sample of firms, they use the “Top 500 List” by
Internet Retailer which is a list of online firms only. However, many of the firms are actually portals of
brick-and-mortar stores.
3
For example, the US’s biggest consumer electronics Best Buy has adopted a price match
guarantee, “At the time of sale, we [Best Buy] price match all local retail competitors (in-
cluding their online prices) and we price match products shipped from and sold by these
major online retailers: Amazon.com, Bhphotovideo.com, Crutchfield.com, Dell.com, HP.com,
Newegg.com, and TigerDirect.com.” Retrieved from https://www.bestbuy.com/site/help-topics/
best-buy-price-match-guarantee/pcmcat297300050000.c?id=pcmcat297300050000 (Accessed on April
2, 2018.)
4
See for example “Guaranteed profits: Price-match guarantees prevent rather than provoke price wars,”
The Economist 12 Feb. 2015.

2
 In the case of the high-cost firm, it can gain market share by reducing the cost disadvan-
tage when it’s not price-matching. Given that the high-cost firm already has half the market
using a price-match, it can gain no further share through cost reductions. Furthermore, the
tacit collusion generated by price-matching backfires. To see this, note that firms can pass
off cost increases one-for-one to the consumer through price hikes. But the reverse is true
also. Price-matching necessitates firms to pass on cost reductions to consumers one-for-one,
unlike in the case of no price-matching. Thus the high-cost firm investing in cost reductions
enjoys a positive increase in markup with no price-match but none with a price-match.
Hence both firms will be less incentivized to reduce its production cost in the presence of
price-matching. Hence, our result implies that price-matching may generate not only static
inefficiency by lowering social welfare but also dynamic inefficiency by decreasing innovation
efforts.
Our second novel finding is based on the well-known result that in a standard Hotelling
model with asymmetric quality, the firm with higher quality sells too few units relative to
the social optimum. We ask whether a price-match policy would aggravate or mitigate this
distortion. We find that the answer crucially depends on the relative superiority/inferiority
in quality. If the online firm offers quality that is superior to that of the brick-and-mortar
firm by a large enough margin, price-matching can mitigate this distortion. Otherwise, price-
matching will in fact amplify the distortion compared to no price-matching. The intuition
for this result is simple. A quality superiority for the low-cost firm would mean a greater
profit compared to when such product superiority did not exist. However, note that the firm
with a quality superiority cannot fully extract all rent associated with the quality advantage
in a product-differentiated duopoly model. Because the price-match by the other firm has an
effect of “diluting” the benefit of the superiority in quality, i.e. price-matching can aggravate
the production inefficiency problem of the high-quality good firm’s market share to be lower
than the social optimum.

1.1 Related literature

The early literature on price-matching emphasized the anti-competitive aspect. One plau-
sible reason why a firm adopts a price-match policy is that it sends a message to its rivals
that they will not be able to increase sales by cutting price because the former will match
that price and prevent buyers from switching. As long as a firm can make such a promise
credible, for instance by putting up a written notice in its store or website, it ties itself to
matching lower prices even in cases where it is harmful to the firm. Given the credibility
of the threat, firms move towards an outcome of tacit collusion where they charge a price
higher than they could have in a non-cooperative outcome. In short, price-match policies

3
can be anti-competitive. This idea was first put forward by Hay (1982) and Salop (1986)
although Cooper (1986)5 had earlier pointed out a similar effect of most-favored-customer
clauses.6 Our paper is similar to this early strand in that firms price-match in equilibrium
by having equal posted prices, obviating the need for consumers to invoke the price-match
clause in equilibrium.
In contrast to the anti-competitive argument, it is easy to see why price-match policies
may benefit consumers. For example, if a buyer can get the lowest price at the store closest
to him by showing proof of a lower price at a store farther out from his home, this saves
him the trouble of a longer trip. Similarly, if he finds something cheaper online but does not
want to wait for the item to arrive, he can immediately go to the local brick-and-mortar store
that price-matches and get the item at the lower online price. In addition, it is known that
price-matching policies can be pro-competitive if firms can adopt price-matching guarantees
and price-beating guarantees. There are no a priori reasons to preclude this given the lack
of legal barriers against either practice. This may allow a firm to post a price higher than
those of rivals and then offer to beat the rivals’ lower price by a certain amount. As long as
the rivals are price-matching posted prices, consumers cannot invoke the price-match with
rivals since the posted price of the firm with the price-beating policy is higher. Meanwhile,
the price-beating firm lures customers away from the rivals by cutting actual prices below
its rivals. This will lead to the rivals adopting the same price-beating policy which in turn
leads to non-collusive Bertrand price competition (Corts (1997); Hviid & Shaffer (1994)).
However, Edlin (1997), Kaplan (2000) and Arbatskaya et al. (2004) argue that tacit collusion
is restored when firms match both advertised and effective selling prices. Arbatskaya et al.
(2006) provide data to show that in some cases firms do price-match actual prices on top of
advertised prices. As a result we do not gain additional insight from explicitly incorporating
price-beating policies into the strategy space of firms and hence leave it out in our model.
While tacit collusion has been the dominant theme to explain price-matching, more recent
literature has emphasized a different reason why firms price-match. Moorthy & Winter
(2006) and Moorthy & Zhang (2006) argue that in a duopoly with asymmetric costs, the
low-cost firm uses a price-match guarantee to “signal” to uninformed consumers its low-price
advantage over the high-cost rival. They go on to show why the high-cost rival will not find
it in its interest to also adopt a price-match guarantee. This lack of incentive ensures only

5
The working paper version of Cooper’s paper is from 1981.
6
Most-favored-customer clauses promise customers a refund of the price difference in case a firm lowers
price after the buyer purchases the item. In essence, the firm matches its own future price rather than that
of rivals. It has very similar potential implications for facilitating collusion. We contrast our results with
that of models on most-favored-customer clauses in Section 6.2.

4
the low-cost firm price-matches and the signaling mechanism works in equilibrium to aid
buyers identify the low-cost from the high-cost firm. The issue with this narrative is the fact
that high-cost brick-and-mortar firms are increasingly adopting price-match policies that
specifically match prices of low-cost online firms. Because our model does not depend on
consumers to be informed about lower prices to benefit from the price-match guarantee since
it is the firm that takes up that burden, the need for signaling is moot. Hence we show that
it is the high-cost firm that adopts price-matching and not the low-cost firm. The intuition
is that the high-cost firm is more in need of inducing a collusive outcome with higher prices
to be able to cover its higher costs in contrast to the low-cost firm.
The empirical literature on price-matching provides evidence both for and against such
guarantees facilitating collusion. Grether & Plott (1984) find experiment evidence that
prices are significantly higher with adoption of most-favored-nation clauses, which as we have
mentioned earlier, potentially impact the incentives for tacit collusion in a way similar to
price-matching. Hess & Gerstner (1991) finds evidence specifically for price-matching. More
recent work include that of Arbatskaya et al. (2000), Arbatskaya (2001) and Arbatskaya
et al. (2006) which provide mixed results regarding tacit collusion. Mañez (2006) finds
that supermarkets used price-matching to signal low prices, favoring the theory of Moorthy
& Winter (2006) and against collusion. Jain & Srivastava (2000) and Srivastava & Lurie
(2001) find similar results in experiments in favor of price-matching as low-price-signals. The
paper that most closely addresses the context we follow is by Zhuo (2017). Using prices on
Amazon before and after the announcements by Walmart, Target etc. targeting specifically
Amazon, she finds that Amazon prices rise after such announcements.
Our paper is related to Edlin & Emch (1999) in that they show welfare losses arising not
just due to higher prices as a result of price-matching, but over time these higher prices induce
excessive entry by firms which generate further welfare losses. Our work is complementary
to theirs. Instead of looking at firm entry and exit, we attempt to uncover unintended effects
of price-matching practices on investments and production efficiency.
In terms of a theoretical framework, our model is similar to that of Logan & Lutter
(1989) who considered differentiated product duopoly markets with asymmetric costs. They
find that the ability of price-match policies to sustain collusive prices depends on whether
the high-cost firm chooses to price-match. If the firms’ costs are very different, the high-cost
does not price-match and pricing is competitive. On the other hand, if the firms’ costs are
similar, the high-cost firm price-matches and pricing is above the competitive level. While
we uses a similar model to Logan & Lutter (1989), we address very different questions to
uncover new effects of price-matches.
The rest of the paper is as follows. In Section 2 we describe our model and identify

5
conditions for price-matching to occur. Then in Section 3 we examine the effects of price-
match guarantees on firms, consumers and total welfare and highlight the static inefficiency
that has been documented in the past literature. Our main results then follow. Section 4
examines the dynamic inefficiency that arises due to price-match policies, while Section 5 is
on price-matching aggravating the inefficiency of the low-quality firm producing more than
the social optimum. In Section 6 we discuss several issues related to price-match guarantees
such as show-rooming, hassle costs and most-favored customer clauses, and then provide
our conclusion. We briefly show in the Appendix how price-matching does not arise in the
simultaneous-pricing case and hence why we do not study it elsewhere in the paper.

2 Equilbrium analysis of price-match guarantees

2.1 Model

We consider the standard Hotelling model of duopoly. A continuum of consumers, whose

mass is one, are uniformly distributed over the linear city [0, 1]. Each consumer has a
unit demand. A brick-and-mortar seller, firm B, at the left corner (x = 0) and an online
seller, firm O, at the right corner (x = 1) compete in prices. A consumer closer to firm B
has stronger preference toward offline shopping relative to online shopping. Heterogeneous
preferences regarding online vs. offline shopping may be attributed to differing patience
levels in waiting for an item to arrive from the online seller, or to variation in valuation of
advantages of shopping online (e.g. saving of time, less compulsive spending, no crowds)
relative to the inconvenience associated with it, e.g. inability to physically examine before
purchasing items, concerns about online scams and online privacy or security. The typical
transport cost parameter t measures the degree of the consumers’ relative preference intensity
regarding the two different modes of shopping.
Firm B’s cost of serving one consumer is c ∈ R+ whereas firm O’s is normalized to zero.7
We motivate the assumption of asymmetric costs by using the example of online vs. brick-
and-mortar firms. It is generally true that online firms locate warehouses in remote areas
with lower costs which allows for carrying much greater inventory and for greater economies
of scale. The need to bring in customers constrains brick-and-mortar retail stores to locate in
high-traffic areas and hence they face a cost disadvantage. Moreover, often online retailers
operate marketplaces allowing them to offer goods through third-party sellers and which

7
We do this to avoid dealing with two cost parameters. This will simplify our analysis of the unintended
impact of price-matching on investment in cost reduction in Section 4.

6
further reduces costs by eliminating the need to carry inventory.8 A particular trend since
online shopping became mainstream has been the closure of brick-and-mortar firms, big and
small, as they failed to compete with online firms with a cost advantage such as Amazon.9
We assume that the market is fully covered and thus each firm is not a local monopoly.10
The timing of the game between the two firms is as follows. At the initial node firm B
decides whether to price-match or not. We assume the decision to price-match or not is
irrevocable. The sequence of deciding first to price-match or not and then choosing prices is
reasonable, since firms change prices frequently whereas they tend to stick to price-matching
(or not) for a longer time period. This also justifies our assumption of irrevocability as
long as the duration of the game we study is shorter or equal to the time period during
which a firm does not change its price-matching policy. In the subgame in which firm B
does not choose to price-match, we consider the sequential-move game in which firm O acts
as the price leader and firm B the follower. In the subgame following firm B deciding to
price-match, firm B’s choice of price following firm O’s choice is automatic and trivial. The
analysis proceeds backward from the two subgames following the brick-and-mortar firm’s
commitment decision. The equilibrium concept is subgame-perfect Nash Equilibrium.

2.2 No price-match subgame

Consider the subgame ensuing from firm B’s choice not to price-match. We characterize the
−pB
demand for each firm by identifying the indifferent consumer’s location x = 12 + pO 2t , which
gives the demand for B, QB (pB , pO ) = x, and for O, QO (pB , pO ) = 1 − x. The notation is
self-explanatory: pB and pO are respectively B’s price and O’s price and QB and QO are
demands. As usual, we start from B’s profit maximization problem: max πB = (pB − c)QB
pB
1
which renders the following best response function of pB (pO ) = 2
(t + pO + c).
From firm O’s
viewpoint, firm B’s best-response plays the role of a constraint for its optimization problem:
 
1 pB − pO 1
max pO + s.t. pB = (t + pO + c).
pO 2 2t 2

8
While throughout the paper we use the online vs. offline example, our results naturally extend to cases
where there is cost asymmetry between firms due to factors other than those that differentiate online and
brick-and-mortar firms. The implications of cost asymmetry is important for our results, but the reason for
the asymmetry is not.
9
See for example Evangelista, Benny. “How ‘Amazon factor’ killed retailers like Bor-
ders, Circuity City,” SFGATE July 14, 2015. https://www.sfgate.com/business/article/
How-Amazon-factor-killed-retailers-like-6378619.php
10
Specific conditions are given later in the relevant analyses.

7
 Figure 1: Best-response and isoprofit functions with and without price-match

Solving this problem, we derive the prices in this sequential-move game as follows:

3t + c 5t + 3c
p∗O = and p∗B = (1)
2 4

which yields the location of the marginal consumer x∗ = 58 − 8tc .

In theory, there are two different cases depending on the primitive parameters c and t. If
c ≤ t, then firm B’s price is lower than firm O’s, p∗O ≥ p∗B , where the equality holds for c = t.
In this case consumers find no need to claim the price-match—even if firm B committed to
such a policy—as they find the online price is higher than the offline price. In contrast, if
the offline firm’s cost disadvantage is large enough such that c > t, then p∗O < p∗B . Let us
assume c > t for subsequent analyses to ensure that the offline’s marginal cost is not so low
that its price-match becomes irrelevant for subsequent price competition.
In the absence of firm B’s price-match, the pair of prices in (1) constitute the equilibrium
prices. Each firm’s profit is computed as

(5t − c)2 (3t + c)2

πB∗ = x∗ (p∗B − c) = ∗
and πO = (1 − x∗ ) p∗O = (2)
32t 16t

For firm B to gain a positive market share (i.e. x∗ > 0), we need c < 5t. Additionally, the
full market coverage requires v − tx∗ − p∗B ≥ 0, which is simplified as v ≥ 15
8
t + 85 c. This
outcome would occur at point E in Figure 1.

8
2.3 Price-match subgame

In the presence of the price-match commitment, the online seller’s price choice is bounded
by a convex set composed of a 45-degree line from the origin to point M and then follows
BRB beyond point M; the relevant edges are shaded. Firm O obtains its highest profit when
its iso-profit curve passes through point M. Hence, the equilibrium prices are determined at
the intersection of pO = pB and pB = 12 (t + pO + c), which gives

pm m
B = pO = t + c (3)

where the subscript m again indicates the price-match in consideration. At equal prices,
each firm’s profit is computed as

t t+c
πBm = xm (pm
B − c) = ;
m
πO = (1 − xm ) pm
O = (4)
2 2

where xm = 21 . The sufficient condition for full market coverage is v − txm − pm ≥ 0, which
is simplified as v ≥ 32 t + c and which subsumes v ≥ 158
t + 85 c for c > t.
But note that we need to check when both firms do not deviate from the given price,
pm = t + c. Suppose that the online firm attempts to monopolize the market by deviating to
pdO = c − t so that the least interested consumer at x = 0 would prefer buying from firm O to
buying from firm B even if firm B follows and sets its most competitive price, c. Then, firm
O’s deviation payoff would be πO d
= c−t. Thus, no deviation requires πO d m
≤ πO ⇔ c−t ≤ t+c
2
,
we have c ≤ 3t.

2.4 Price-match or not

For the price-match decision, throughout this paper we consider the following set of param-
eters:

Assumption 1 v > 23 t + c and c ∈ (t, 3t)

Since firm B’s price-match decision depends on the relative size of the continuation payoffs
πB∗ and πBm , we can say that the price-match will be chosen if

t (5t − c)2 (c − t) (9t − c)

πBm − πB∗ = − = >0 (5)
2 32t 32t

which is satisfied for any c ∈ (t, 3t). Graphically, it is clear from Figure 1 that firm B’s
isoprofit curve passing through point M is above the one passing through point E.

9
 In summary, under Assumption 1, the subgame perfect Nash equilibrium of the sequential
pricing is characterized by the path on the price-match. The equilibrium prices and payoffs
are given by (3) and (4).

3 Static inefficiency of price-matching

Having characterized the equilibrium in which a brick-and-mortar firm with a cost disadvan-
tage finds it better to adopt the price-match guarantees, we now analyze how the adopted
policy affects the online rival, consumers and social welfare.

3.1 Effect on online rival

How would the price-match guarantee adopted by the offline seller affect its online rival?
Clearly the impact on firm O can be examined by studying how firm O’s payoff changes
with the price-match compared to that without it. First of all, let us recall the standard
result, which is obtained in our model as well, that a price-match commitment can soften
price competition.
Consider the sequential pricing model with Assumption 1. The price-match increases the
equilibrium prices relative to no price-match prices:

∗ 3t + c 1
pm
O − pO = t + c − = (c − t) > 0;
2 2
∗ 5t + 3c 1
pm
B − pB = t + c − = (c − t) > 0.
4 4

However, the higher prices do not necessarily imply that the online seller also benefits
from weakened competition owing to the price-match. The comparison between firm O’s
payoff with the price-match and without it can be decomposed into two opposing forces:

∗
m
πO − πO = (pm − p∗ ) Qm + p∗O (Qm ∗
O − QO )
| O {zO O} | {z }
mark-up effect (+) market-share effect (−)

(c − t) (c + 3t) (c − t) (c − t)2
= − =− <0
4 16t 16t

On the one hand, firm B’s price-match weakens price competition, which makes firm O
enjoy a higher per-unit markup on existing sales. More precisely, the markup increases by
∗ 1 1 1 (c−t)
pm
O − pO = 2 (c − t) > 0 and the overall mark-up effect measures up to 2 (c − t) × 2 = 4
. On
∗
the other hand, firm O loses market share due to the price-match policy by QO −QO = − c−t
m
8t
.
∗ 3t+c (c+3t)(c−t)
Since pO = 2 , the overall loss from the decrease in market share is equal to − 16t .
We find that the price-match makes the online seller earn less profit because the (negative)

10
market-share effect outweighs the (positive) mark-up effect. Graphically, it is clear from
Figure 1 that firm B’s isoprofit curve passing through point M is to the left of the one
passing through point E.

3.2 Effect on consumers

Antitrust concerns are usually focused more on the impact on consumers than on rivals.
In the sequential pricing game, we already confirmed that equilibrium prices increase due
to price-matching. Does this necessarily imply that all consumers will be worse off? To
answer this question, let us start by noticing that there are three groups of consumers who
are affected by a price-match guarantee differently based on their location. First, the
consumers located in x ∈ [0, 58 − 8tc ) who buy from firm B regardless of the price-match
∗ 1
are worse off because pmB > pB . Similarly, the consumers located in x ∈ [ 2 , 1] always buy
∗
from the online seller and they also get worse off because pm O − pO > 0. In contrast, the
consumers with x ∈ [ 58 − 8tc , 12 ) would have bought from firm O without the price-match but
switch to firm B in the presence of the price-match. Hence, the net surplus of a consumer
x in this group is computed as V ∗ (p∗O , x) = v − t(1 − x) − 3t+c


2
under no price-match
and V m (pm
B , x) = v − tx − (t + c) under the price-match guarantee. The net change of the
consumer surplus denoted by ∆V (x) is given by

∗ ∗ 1
∆V (x) ≡ V m (pm
B , x) − V (pO , x) = − (c − t) + t(1 − 2x) (6)
| 2 {z } preference
| {z }
effect (+)
price effect (-)

A consumer switching due to the price-match ends up paying the higher price pm B = t+c
∗ 3t+c
compared to pO = 2 without the price-match. The first term in (6) captures this negative
price effect. However, this switching consumer now saves on “travel costs” by choosing
a more preferred mode of shopping given equal prices by both firms. The second term
measures this positive preference effect. Note that ∆V (x) decreases with x because the price
effect is independent of x but the preference effect decreases with x. The largest preference
effect occurs for the consumer located at x∗ = 58 − 8tc (and there is no preference effect for
x = 1/2). But we can verify that even this consumer finds the price-match undesirable,
i.e. ∆V 58 − 8tc = − 14 (c − t) < 0 which ensures ∆V (x) < 0 for every switching consumer.

That is, ∆V (x) < 0 for ∀x ∈ [ 85 − 8tc , 12 ).

The total consumer surplus denoted by S is computed from aggregating all consumers’

11
net surplus.11 With the price-match, it is given by
Z 1/2 Z 1
m 5
S = (v − tx − pm
B )dx + (v − t(1 − x) − pm
O )dx = v − t − c.
0 1/2 4

Without the price-match, the aggregate consumer surplus is

x∗ 1
c2
Z Z
∗ 103 21
S = (v − tx − p∗B )dx + (v − t(1 − x) − p∗O )dx = v − t− c+
0 x∗ 64 32 64t

where x∗ = 58 − 8tc . The difference in aggregate consumer surplus due to the price-match is
easily computed as
(c − t) (c + 23t)
∆S = S m − S ∗ = − <0
64t
which verifies that in the sequential model, price-matching leads to a decrease in consumer
surplus as every consumer is worse off from the higher prices due to the price-match policy
and she is not sufficiently compensated for the loss by a positive preference effect.

3.3 Effect on social welfare

Since total welfare is the sum of firm profits and consumer surplus, the welfare effects of price-
matching are consistent with what we have described regarding firm profits and consumer
surplus. One notable point is how the change in firm B’s profit due to the price-match is
substantial relative to the impact on its rival and consumers.
Using prior results, we can obtain the welfare with and without price-match as follows:
W m = πBm + πO m
+ CS m and W ∗ = πB∗ + πO ∗
+ CS ∗ from which the net change in welfare is
given by
(c − t) (7c + t)
∆W ≡ W m − W ∗ = − . (7)
64t
As is clearly seen from (7), ∆W < 0. Simply put, the offline seller’s gain is not enough to
offset the loss to consumers and the decrease in online rival’s profits. We summarize the
effects of the price match as follows.

Proposition 1 Under Assumption 1, the price-match guarantees have the effects such that
(compared to the no price-match benchmark)

(a) the online firm is worse off,

(b) each consumer receives smaller net surplus, and

11
Note that we use S for consumer surplus and later use W for social welfare.

12
 (c) social welfare decreases.

4 Dynamic inefficiency of price-matching

In this section and the next, we examine two extensions of the baseline model to discuss
unintended effects of price-match guarantees. First, we analyze how a price-match policy
can affect incentives of the firms to invest in cost-reduction. Second, we extend our model
to allow for an asymmetry in (vertical) quality offered by the two firms to examine whether
a price-match guarantee mitigate or aggravate the usual market distortion of the low-cost
firm producing less than the socially desirable level.
How would price-matching affect the incentive of the brick-and-mortar seller to reduce its
marginal cost, equivalently its cost disadvantage c? What about the incentive of the online
seller to widen the cost advantage? To address these intriguing questions, let us add a new
stage to the timing of the game. Let firm B invest in cost reduction or firm O invest in
increasing the cost gap, after firm B’s decision to offer a price-match guarantee but before
price competition. We could explicitly model investment cost functions, but our analysis does
not make it imperative. This is because essentially we end up comparing the marginal benefit
of such investments with the price-match and without it, which means the marginal cost of
investment is not crucial for analysis, unless if we were specifically interested in the optimal
choice of investment level. Instead we assume a one-time fixed cost F of investing in such
cost-reduction technology that is incurred by whichever firm makes such an investment, O or
B. We also assume that the size of F does not depend on whether a price-match guarantee
is offered or not.
Consider the investment incentive for Firm B. Using the equilibrium payoffs we had
t
earlier derived and after subtracting fixed cost F we have πBm = xm (pm B − c) − F = 2 − F
2 dπ m
and πB∗ = x∗ (p∗B − c) − F = (5t−c) 32t
− F . The derivatives w.r.t. to c are dcB = 0 and
dπOm

dc
= − 5t−c
16t
but we will decompose the derivatives into the mark-up effect and market-
share effect to aid intuition in the ensuing discussion. In the presence of price-matching, the
marginal change in firm B’s profit in response to a marginal change in its cost is given by

dπBm
 m
∂xm

m ∂pB
=x − 1 + (pm B − c) (8)
dc ∂c ∂c
1
= (1 − 1) + (t + c − c)(0) = 0
2

The first term in (8) measures the effect of a change in mark-up for each unit of existing
sales. An increase in marginal cost reduces the profit but at the same time the price also
∂pm
increases by ∂cB . Recalling pm
B = t + c, the two effects are exactly offset for the uniform

13
distribution though in theory the intensive margin effect may go either way. The second
term in (8) measures the change in profit due to a change in market share, which is zero
with the price-match.
Similarly, we can analyze the investment incentive for firm B without the price-match:

dπB∗
 ∗
∂x∗

∗ ∂pB
=x − 1 + (p∗B − c) (9)
dc ∂c ∂c
     
5 c 3 5t + 3c 1 5t − c
= − −1 + −c − =− <0
8 8t 4 4 8t 16t

This time, both the markup and market effects are negative, i.e. cost reduction boosts profit
through both channels. The market-share effect is negative because Firm B has room to
gain market share using cost reduction in the no-price regime whereas it can gain no further
market share beyond half of the market with a price-match. The markup effect is negative
because price does not change one-for-one
 m  with  cost but rather less than that, unlike in the
 dπB   dπB∗ 
price-match case. It follows that  dc  <  dc . Investment in cost reduction is lower with
the price-match relative to that without it.
We apply an analogous analysis for the online firm’s investment to expand its cost advan-
tage. The online firm’s investment to enlarge its cost advantage can be captured by firm O’s
1
incentive to raise c.12 Firm O’s equilibrium payoffs are πO m
= (1 − xm )pm
O − F = (1 − 2 )(t +
∗
c)−F = t+c = (1 − x∗ ) p∗O −F = 1 − 85 − 8tc 3t+c



2
−F under the price-match and πO 2
−F =
(3t+c)2
16t
− F under no price-match. With the price-match, firm O’s investment incentive is
from the mark-up effect only, which is given by
m
 m  m
dπO m ∂pO m ∂x
= (1 − x ) − pO (10)
dc ∂c ∂c
 
1 1
= 1− (1) − (t + c)(0) =
2 2

and with no price-match:

∗
dπO ∂p∗ ∂x∗
= (1 − x∗ ) O − p∗O (11)
dc  ∂c  ∂c  
3 c 1 3t + c 1 3t + c
= + − − =
8 8t 2 2 8t 8t

In the absence of a price-match guarantee, the greater cost advantage increases Firm O’s

12
Recall that for simplicity in analysis, we opted to include the single cost parameter c to reflect the
asymmetry in cost between the two firms instead of two separate cost parameters. In that sense, firm O
raising c is equivalent to firm O investing in its own cost reduction.

14
profit through a higher mark-up for a given demand, which is captured by the first term,
∂p∗
(1 − x∗ ) ∂cO But this markup effect is smaller than that with the price match (( 38 + 8tc ) 12 > 12
only if c > 5t which is ruled out by Assumption 1). However, the larger cost advantage also
allows firm O to steal some market share from firm B, which is captured by the second term,
∗ ∂x∗
−p∗O ∂c > 0. Recall that the market share effect is 0 with price-match. One can check that
 dπO   dπOm 
 dc  >  dc  for any c > t, which is satisfied under Assumption 1. Therefore, we can say
that the online firm’s investment incentive is higher without the price-match compared to
that with it and it is due to the fact that price-matching by Firm B prevents Firm O from
gaining market share by investing in cost reduction.

Proposition 2 Both the brick-and-mortar firm and the online firm have weakened incentives
to reduce their own costs under the price-matching guarantees.

These results have an important policy implication in the sense that price-matching guar-
antees may involve not only static inefficiency (Proposition 1) but also dynamic inefficiency
as we demonstrate in Proposition 2.

5 Production inefficiency of price-matching

Belleflame & Peitz (2015)13 demonstrate in a differentiated-product Hotelling setup that the
low-cost firm sells less than the socially optimal quantity and the high-cost firm sells more
than the social optimum. We obtain the same result here. The social optimum requires
marginal-cost pricing and hence p̃O = 0 and p̃B = c in our context. This leads to Firm B’s
market share x̃ = 12 + 0−c2t
= t−c
2t
. Recall that Firm B’s market share in the no price-match
5t−c
case was 8t . The socially optimal market share for Firm B is less than Firm B’s market
share in duopoly competition with no price-match when:

t−c 5t − c
<
2t 8t
3c > −t

which is always true for c, t > 0. Now recall that Firm B’s market share with the price-match
was xm = 21 . The socially optimal market share for Firm B is less than Firm B’s market

13
See Lesson 3.4 on pg. 54 of Belleflame & Peitz (2015).

15
share in duopoly competition with a price-match when:

t−c 1
<
2t 2
−2c < 0

which is again always true for c > 0, i.e. price-matching does not fix the problem of the
high-cost firm selling too much. Indeed price-matching makes things worse. Firm B’s market
share under price-match is greater than its share with no price-match:

1 5t − c
>
2 8t
c>t

which is true under Assumption 1.

So far our analyses have rested on the assumption of symmetric values vB = vO = v to
the consumer for buying from either firm. But firms may differ in their other features such
as better warranties or faster shipping options. For instance, brick-and-mortar stores may
try to enhance in-store services by hiring more staff and offering pick-up services after online
orders. So, we relax this assumption and let α = vO − vB denote the online firm’s quality
superiority if α > 0 or inferiority for α < 0. Then, the equilibrium analysis in Section 3 and
the preceding discussion in this section are special cases of α = 0.
With this change, firm B’s best-response is changed to pB (pO ) = 12 (t + pO + c) − α2 and
the derived prices are
3t + c − α 5t + 3c − α
pαO = ; pαB = .
2 4
where pαO = p∗O and pαB = p∗B are verified for α = 0. Since the derivation procedures are
similar to those in the basic model, we quickly get to the results. With no price-match, the
marginal consumer’s location is given by

1 pαO − pαB α 5t − c − 5α
x∗ (pαO , pαB ) = + − = (12)
2 2t 2t 8t

and the social planner’s social optimum is

t−c−α
x̃(c, 0) = (13)
2t

Using (12) and (13), the no price-match market share for Firm B is again more than the
socially desirable market share unless α > t+3c which implies Firm O’s superiority in quality
would have to be sufficiently high to cancel out the distortion of Firm B selling too much.

16
 Price-matching does not eliminate this problem as is seen from

t−α t−c−α
xm (pm m
B , pO ) = > x̃(c, 0) = .
2t 2t

But for α < t + 3c, does price-matching mitigate this distortion or aggravate it? To
answer this question, we compare firm B’s sales with and without the price match. Adopting
price-match guarantees aggravates the distortion if

∗ α
xm (pm m α
B , pO ) > x (pO , pB )
t−α 5t − c − 5α
>
2t 8t
α>t−c

Because α need not be positive to make t − c < α (since c > t by Assumption 1), price-
matching can exacerbate this distortion even if α < 0. On the other hand, price-matching
will lessen the distortion if α < t − c which requires firm B’s quality to be superior to firm
O’s quality by a sufficiently large margin.

Proposition 3 Under Assumption 1, we obtain the following results:

(a) In equilibrium the high cost firm produces and sells too much relative to the social
welfare maximizing perspective, regardless of the quality difference.

(b) With symmetric quality and asymmetric cost, price-matching always aggravates this
distortion.

(c) With asymmetric quality and asymmetric cost, price-match guarantees aggravate this
distortion if t − c < α < t + 3c. This will be the case if the high cost firm’s quality is
inferior to or not sufficiently superior to the low-cost firm’s quality. For α > t + 3c,
price-matching generates this distortion whereas it is absent without price-matching.

Thus here we uncover another unintended effect of adopting a price-match policy. It

may generate a production inefficiency as the low-cost firm sells fewer units under the price-
matching guarantee compared to the case without it.
Note that we have purposefully excluded from our discussion any adverse socio-economic
effects that potentially arise from dominance of online sellers. For example, some have as-
serted that online shopping has killed offline local shopping malls and abandoned malls have

17
become a hotbed of crime.14 Even without relying on such arguments, we show that appar-
ently pro-competitive price matching practices may have some hidden aspects to deteriorate
the societal outcome.

6 Discussion and Conclusion

6.1 Show-rooming and hassle costs

The scope of our paper is such that we do not consider certain other issues related to
price-matching. First, we ignore the possibility of brick-and-mortars using price-matching to
prevent the practice of “show-rooming”. Wu et al. (2015) and Mehra et al. (2017) address
this issue. Second, we do not attempt to explain cases where price dispersion is observed and
where customers do actually invoke price-match clauses. How variation in timing of pricing
may affect such a scenario may be an avenue for further research. Third, the online firm
may price-match also. Since only a few online-only sellers such as eBay and NewEgg offer
price-match guarantees, we opted to study the case of the brick-and-mortar firm adopting a
price-match, which has become far more common lately.
An additional issue which may not make price-matching pro-competitive but at least
limits the anti-competitive aspect of such policies is the existence of “hassle costs”. If the
burden of proving the existence of lower prices elsewhere falls on the buyer, this usually
entails him a) searching for a lower price, b) bringing proof in the form of a flyer, printout
or display of ad on smartphone etc., c) potentially filling out paperwork (some stores require
registration) d) waiting for store employee to process the claim and so on. Even after incur-
ring such costs, the buyer may not always get the price-match due to failing to comply with
all the conditions or due to inconsistent implementation of such policies by store employees.
Hviid & Shaffer (1999) show that the presence of even small hassle costs can diminish, if not
eliminate, the collusive implications of price-match policies.
The caveat of the argument for hassle costs is that it holds when the burden of price-
matching is mostly on the customer. If however firms undertake the responsibility of match-
ing their rivals’ prices, and keep their posted prices equal to those of rivals, consumers face
no hassle costs. This justifies our choice of modeling in which firms post equal prices in
equilibrium and hence the need for consumers to invoke a price-match does not arise, thus
avoiding the hassle.
But this in turn implies two things: we should not observe price dispersion in posted

14
For examples of media coverage, see Worstall “The shopping malls really are being killed by online
shopping” Forbes (Jan 4, 2015) and Lutz, Ashley and Mary Hanbury “Haunting photos of an Ohio mall that
became a hotbed of crime before it was demolished” Business Insider (Feb 8, 2018).

18
prices and also not observe buyers invoking price-match guarantees. The reality is that
we do observe both price dispersion and buyers bringing in rivals’ advertisements to get
price-matches and this is the criticism by Corts (1997) of non-hassle-costs based models of
price-matching. However, there are cases where we do not observe price dispersion. Also,
a recent trend has been for firms to attempt to transfer to themselves the hassle of price-
matching and away from consumers, perhaps because they are aware of hassle costs limiting
the effectiveness of price-match guarantees. In 2014, Walmart announced a smartphone
app that will search for lower prices elsewhere and issue refunds automatically as long as
customers upload their Walmart receipts on to the app.15 This is more prevalent in the U.K.
where Asda, Tesco and Sainsbury’s offer similar price-match guarantees in which the burden
of finding lower prices and refunding the buyer falls on the seller.
Price-matching as a price discrimination device is an alternative argument that seeks
to explain why firms price-match (see Png & Hirshleifer (1987) and Corts (1997) among
others). When a price-matching firm does have posted prices higher than those of rivals, a
very small percentage of customers actually tend to invoke price-match guarantees. This is
not surprising if hassle costs are high and the burden on obtaining the price-match is on the
buyer. But this has the advantage (to the firm) of separating buyers into two types; high-
types who do not bother price-matching and low-types who do. Hence the firm manages to
charge the regular high price to the high-type and the discounted price after price-matching
to the low-type. Our paper does not attempt to explain price discrimination since posted
prices in our model are always equal with a price-match guarantee. Price discrimination is
useful with considerable heterogeneity in consumer valuation for the good in question. Hence
our model is more suited to cases where such heterogeneity is low.

6.2 Most-favored-customer clauses

A literature on most-favored-customer (MFC) clauses16 as a collusion-facilitating device runs

parallel to the one on price-matching and price-beating guarantees.17 In a two-period duopoly
in which the firms choose prices simultaneously in each period, Cooper (1986) shows that
a firm has an unilateral incentive to offer a MFC clause to its customers. By combining a
MFC clause with a higher than Bertrand-Nash non-cooperative price in the first period, it

15
Source: “Walmart To Competitors: Catch Our Savings If You Can.”
Retrieved from https://corporate.walmart.com/_news_/news-archive/2014/06/05/
walmart-to-competitors-catch-our-savings-if-you-can
16
Footnote 6 in Section 1.1 explains how most-favored-customer clauses are implemented.
17
See Hviid & Shaffer (2010) for references. There are also some papers that consider both most-favored-
customer and price-match clauses together, including Hviid & Shaffer (2010) and Holt & Scheffman (1987).

19
commits itself to that price in the second period. It acts like a price-leader since its first
period price influences its rival’s price in the second period.
Pricing in both periods is required in a MFC model for the buyers to observe whether
the firm offering MFC protection do cut prices in the second period, and then invoke (or not
invoke) the MFC clause based on their observation. By contrast, as we model, pricing in one
period is sufficient to analyze a price-match guarantee since the firm offering the guarantee
is matching its rival’s price and not its own. Thus, adopting a price-match guarantee in the
first period does not result in price-leadership, unlike with the MFC clause.
Rather, a different mechanism leads to the price-match to induce the rival to charge a
high price. The rival firm knows that it cannot obtain a market share greater than half by
cutting prices below that of the firm offering the price-match. Hence, as long as it cannot
tip the market in its favor, instead of charging the non-cooperative price the rival will charge
a higher price so as to maximize rent extraction from the marginal consumer indifferent
between the two firms. The magnitude of rent extraction in turn depends on the buyers’
valuation of the product.
Cooper (1986) and later Tirole (1988) consider price-leadership due to a MFC clause
to be effectively Stackelberg leadership. However, Neilson & Winter (1992) show that the
firm offering a MFC clause will not commit to the Stackelberg price in the first period. The
gain from lowering price below the Stackelberg price (albeit still charging above the Bertrand
price) in the first period is greater than the loss from committing to a lower cooperative price
in the second period. This is because the other firm not offering MFC protection responds
to any price above the non-cooperative price in the first period with Bertrand prices and
takes away market share from the firm offering MFC. In the sequential-pricing case that we
analyze on the other hand, the higher prices due to a price-match guarantee are even higher
than Stackelberg prices. This is because in our case, Stackelberg pricing arises by default
in the no-price-match case and hence a price-match in equilibrium will be adopted only if
prices are higher than in the Stackelberg case. Note that the price-matching firm transfers
price-leadership to the other firm, opposite to what occurs in the MFC case.

6.3 Conclusion

In this paper we focus on illustrating two unintended effects of price-matching by a high-cost

firm in a standard product differentiated duopoly market. Economists have studied various
incentives for and effects of price-matching guarantees and similar business practices, but
to our knowledge, dynamic inefficiency associated with price-matching has not been given
sufficient attention, and we try to fill the gap in this paper. Also, we illustrate how price-
matching can aggravate the distortion of the offline firm meeting a larger-than-socially-

20
optimal demand.
Our model is stylized and simple, but we think the implications of our findings are
important. While it is an empirical matter to measure the effects of a particular price-
matching practice in a specific industry or market, it is worth understanding all possible
channels through which price-matching has impact.

21
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Appendix: The simultaneous pricing game

Suppose that firm B did not choose to price-match. Then, generally we can think of an
alternative version of price competition that the two firms compete with their simultaneous
price choices. For this simultaneous pricing game, we use the hat symbol (ˆ) for each variable
to make them distinct from the variables in the sequential pricing game where we do not use
the hat symbol.
The analysis when there was no price-match by firm B is straightforward. As usual, the
analysis starts with characterizing the demand for each firm by identifying the indifferent
−p̂B
consumer’s location x̂ = 21 + p̂O 2t , which gives the demand for B, Q̂B (p̂B , p̂O ) = x̂, and
for O, Q̂O (p̂B , p̂O ) = 1 − x̂. Then, we set up each firm’s profit maximization problem. For
firm B, it is set up as max π̂B = (p̂B − c)Q̂B and for firm O as max π̂O = p̂O Q̂O . Deriving
p̂B p̂O
the first-order necessary conditions for their prices, we obtain following two best responses:
p̂B (p̂O ) = 21 (t + p̂O + c) and p̂O (p̂B ) = 12 (t + p̂B ). Solving these two equations as a system,
the prices in Nash equilibrium are derived as

2 1
p̂∗B = t + c; p̂∗O = t + c. (14)
3 3

where the asterisk at the subscript (∗) signifies that we are considering the standard price
competition without a price-match. Substituting (14) into x̂(p̂B , p̂O ), the demands in equi-
librium are derived as

1 c 1 c
Q̂B = x̂∗ = − ; Q̂O = 1 − x̂∗ = + . (15)
2 6t 2 6t

As firm B’s marginal cost is higher than that of firm O, the demand for firm B is smaller
than that of firm O. The demand gap 3tc increases with c, but decreases with t. Using the

24
derived prices and demands, the equilibrium profits are equal to

(3t − c)2 ∗ (3t + c)2

π̂B∗ = (p̂∗B ∗
− c) x̂ = ∗ ∗
; π̂O = p̂O (1 − x̂ ) = . (16)
18t 18t

For an interior solution x̂∗ ∈ (0, 1), we need c < 3t without which the market equilibrium
is characterized by the so-called tipping equilibrium such that the online seller monopolizes
the market. Intuitively, this corner solution arises when the cost disadvantage c is sufficiently
large that firm B cannot survive as an effective competitor vis-à-vis the more efficient online
rival. Aforementioned, we assume a full market coverage. The net surplus of the indifferent
consumer must be non-negative, i.e. v − tx̂∗ − p̂∗B ≥ 0 where v denotes the intrinsic value of
a product. This condition leads to v ≥ 23 t + 12 c. Intuitively, the market will be fully covered
once the intrinsic value is large enough.
Now consider the other subgame ensuing from the brick-and-mortar firm’s price-match
commitment. Under the price-match announcement, one candidate for the equilibrium would
be that the market will be evenly split as long as both firms are active and they charge the
same price. In this case the marginal consumer is located at x̂∗ = 1/2 and both firms charge
the price such that they extract the entire surplus from the marginal consumer:

t
p̂m m
O = p̂B = v − . (17)
2

where the superscript m indicates that currently we consider the price-match. The non-
negative price constraint requires v ≥ t/2. With this equal price, both firms earn the profits
of
m 1 t 1 t
π̂O = (v − ); π̂Bm = (v − − c) (18)
2 2 2 2
where firm B will be active only if v ≥ t/2 + c. Both of the constraints on price and
no-exclusion of firm B at the matched price are subsumed by the full coverage assumption
v ≥ 32 t + 12 c.
However, before we can assert that (18) represent the price-match subgame payoffs, we
t
need to check whether p̂m m
O = p̂B = v − 2 is sustained as an equilibrium pricing strategy. In
fact, this is not an equilibrium. To see this point, consider firm B’s deviation to p̂dB = v − t.
Then, consumers see no need to claim the price match because now p̂dO = v − 2t > p̂m B = v − t.
d
Firm B’s new payoff is π̂B = v − t − c and this deviation strategy is profitable if

1 t
v − t − c > (v − − c),
2 2

that is, v > c + 3t2 . This condition has no conflict with any restriction to the equilibrium and

25
basically it boils down to v being sufficiently high, which is consistent with the full coverage
assumption. This implies that there will be no equilibrium with simultaneous pricing such
that both firms have a positive market share with the full market covered.

26