MBA 201 a The Bertrand Trap Recap

MBA 201 a: The Bertrand Trap

Recap of the “Bertrand trap” – Even with two firms, price is driven down to the competitive price (marginal cost). • Economic profits are zero, • Accounting profits could be negative if there are sunk costs. – Note that neither higher demand nor lower costs (if both firms have the same cost) increase profits. – Examples: fiber-optic cable, railroad grain rates. – First piece of advice: Avoid this game if you can! Professor Wolfram MBA 201 a - Fall 2009 Page 1

Avoiding the Bertrand trap Option 1: Be the cost leader. P 1 MC 2 45° BR 2 BR 1 P* = c 2 - ε MC 1 P 2 Remember: cost advantage must be sustainable. Professor Wolfram MBA 201 a - Fall 2009 Page 2

Additional ways to avoid the Bertrand trap – Option 2: Limit capacity • In the example we did on the board, imagine that the two firms each had maximum capacity of 20. – Option 3: Product differentiation and branding (moderates impact of price competition) • Create switching costs – Option 4: Collude • This is illegal in the U. S. and many other countries, more on that later. Professor Wolfram MBA 201 a - Fall 2009 Page 3

Option 5: leverage repeated interactions – If firms interact repeatedly, they can use the future as source of leverage: threaten to punish rival if it behaves noncooperatively. – Topsy-turvy principle: if price wars lead to a really bad situation, it is easier to deter non-cooperative behavior! – This is called tacit collusion. Professor Wolfram MBA 201 a - Fall 2009 Page 4

The repeated Bertrand price game – In the Bertrand price game, we contrasted • The “cooperative” outcome: set the monopoly price, split the market, and make M/2 (M = monopoly profits). • The Nash equilibrium: price at MC, make zero. – Claim: in the repeated game, the cooperative outcome (set the monopoly price) can be a Nash equilibrium. – Equilibrium strategies: • If all firms have set the monopoly price in the past, stick to it. • If one firm ever sets price different from monopoly price, revert to pricing at marginal cost forever. (This “punishment” is what supports the equilibrium. ) Professor Wolfram MBA 201 a - Fall 2009 Page 5

How is cooperation an equilibrium? – If firm sets monopoly price, expected payoff is M/2 + V, where V is discounted future profit along the monopoly pricing path. – If firm undercuts rival, then expected payoff is approximately M + 0. (This assumes firm sets price just below rival and takes all of the market—for one period. ) – If follows that monopoly pricing is an equilibrium if M/2 + V > M + 0, or simply V > M/2. Profits from cooperating Professor Wolfram Profits from cheating MBA 201 a - Fall 2009 Page 6

Tacit collusion in words In words, “if the future is sufficiently important, then cooperation is an equilibrium. ” • Temptation: deviate and capture all the monopoly profits right now. • Carrot: if you don’t deviate, you get the monopoly profits in the future. • Stick: if you do deviate, you get 0 profits in the future, forever… Professor Wolfram MBA 201 a - Fall 2009 Page 7

When is cooperation easier? – Market growth (firms care more about the future) – Likelihood of survival (ditto) – Speed of response (future is close) – Market structure (numbers and symmetry) – Multimarket contact (harsh punishments) – Probability of detection Professor Wolfram MBA 201 a - Fall 2009 Page 8

Comments – Punishment/retaliation is a disciplinary device that supports “cooperation. ” – Along the “equilibrium path, ” price wars do not actually take place, only the threat. – Explicit price-fixing is illegal, but an understanding of repeated games may produce a similar outcome legally. Professor Wolfram MBA 201 a - Fall 2009 Page 9

Price wars are supposed to be “off the equilibrium path, ” but they happen in many industries on occasion. Why? – High demand – Low demand imperfectly observable strategies – Financial distress – Signalling strength Professor Wolfram MBA 201 a - Fall 2009 Page 10

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The fine print Retail Store Price Match Guarantee If you find a lower advertised price on the same available brand model prior to your purchase or during the exchange and return period, we will match that price. Simply bring in the ad of the local retail competitor or Best Buy, while the lower price is in effect and receive your price match. The guarantee does not apply to our competitors' website pricing and the guarantee does not apply to our or our competitors': • Offers that include financing, bundling of items, free items, pricing errors and mail-in offers • Items that are limited-quantity, out of stock, open-box, clearance, Outlet Center, refurbished/used items and items for sale Thanksgiving day through the Saturday after Thanksgiving Professor Wolfram MBA 201 a - Fall 2009 Page 12

Other “facilitating practices” – Most-favored customer clauses • GE and Westinghouse • Medicaid reimbursement rules Professor Wolfram MBA 201 a - Fall 2009 Page 13

U. S. antitrust laws The Department of Justice (DOJ) and the Federal Trade Commission (FTC) have missions to “promote and protect the competitive process. ” Laws concerning: – Price-fixing (Sherman Act of 1890, Section 1). – Monopolization (Sherman Act of 1890, Section 2). – Mergers. – Price discrimination, exclusive dealing, tying. Some things are per se illegal. In other cases, the courts apply a rule of reason. Enforcement involves: – Both private party and government initiated proceedings. – Civil and criminal cases. Professor Wolfram MBA 201 a - Fall 2009 Page 14

Competition policy outside the U. S. All 30 OECD countries have some antitrust authority: – European Union laws very similar to U. S. . – Member countries have their own competition commissions. – Japan Fair Trade Commission. As do a number of non-OECD countries: – For example, Argentina, Brazil, and India. Professor Wolfram MBA 201 a - Fall 2009 Page 15

Antitrust and price discrimination US law* forbids “discriminat[ing] in price between different purchasers” where the effect “may be substantially to lessen competition” unless: – price differences are based on costs, or – price differences were needed to “meet the competition. ” Two categories of cases: – “Primary line discrimination”: seller practicing discrimination harms its rivals. – “Secondary line discrimination”: injury to competition takes place in the buyers’ market. “One often hears of the baseball player who, although a weak hitter, was also a poor fielder. Robinson-Patman is a little like that. Although it does not prevent much price discrimination, at least it has stifled a great deal of competition. ” - Robert Bork * The Robinson-Patman Act. Professor Wolfram MBA 201 a - Fall 2009 Page 16

Takeaways – Price competition can be severe, even with a small number of firms. – Avoid hazards of price competition by • Having lower costs • Limiting capacity • Differentiating your product – Repeated interaction provides firms with strategic leverage over each other that may encourage cooperation. Professor Wolfram MBA 201 a - Fall 2009 Page 17