Avoiding the Bertrand Trap II: Cooperation

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Avoiding the Bertrand Trap II Cooperation
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How do Coke Pepsi Make Money?

• Coke and Pepsi sell essentially undifferentiated
  products
• Prices are widely known, often advertised
• There are no consumer switching costs
• No evidence of serious limits on capacity
• No evidence of cost advantages

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Coke and Pepsi Recognize Repeated Interaction

• Suppose Coke forbears cutting price today because
  it knows Pepsi will follow suit tomorrow.
• Suppose Pepsi forbears cutting price today
  because it knows Coke will follow suit tomorrow.
• Tradeoff for Coke or Pepsi is forgoing a larger
  market share today in order to avoid the Bertrand
  trap tomorrow.

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Method 6 Exploit Repeated Play

• If firms play repeatedly, then can use repeated
  play to sustain a form of cooperation on price
  known as tacit collusion
• No firm cheats (undercuts rivals) because this
  will trigger a price war in the future (e.g.,
  reversion to Bertrand competition).

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To Cheat or Not to CheatThat is the Question
Looking just at today
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
1
time
time
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To Cheat or Not to CheatThat is the Question
Now take into account the future!
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
1
time
time
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To Cheat or Not to CheatThat is the Question
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
Smaller benefits today (because split market).
But positive benefits in future.
Benefit today
But Bertrand trap forever after.
1
time
time
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To Cheat or Not to CheatMore Firms or Higher
Interest Rate
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
1
time
time
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Tacit Collusion

• Tacit collusion is easier to sustain when
• fewer firms (four or fewer if excess capacity)
• interest rate low

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To Cheat or Not to CheatDying Industry
Cheat (undercut)
Cooperate (tacitly collude)
Expected PDV of profits
Expected PDV of profits
1
time
time
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Dying Industries

• In fact, if death date known with certainty,
  then cooperation generally not sustainable at
  all.
• Backwards induction
• In last period there is no future period, so no
  punishment to deter cheating in last period.
  Hence cheating (Bertrand) in last period
• But then same is true of penultimate period and
  so on back to first period.

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General Phenomenon

• Firm going bankrupt not paid by other firms that
  owe it money.
• Management problems when boss announces shes
  leaving.
• Basically dont let others know the end is coming.

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Making Tacit Collusion Work
no
Tacit collusion not an issue
Incentive to cut price?
yes
no
Easy to detect price cuts?
Tacit collusion will fail the firms will find
themselves in the Bertrand trap
yes
no
Can serious punishments be inflicted?
yes
no
Firms willing to punish?
Tacit collusion is sustainable in equilibrium
yes
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Electronic Components Distribution Industry

• How do we assess the potential for tacit
  collusion in the electronic components
  distribution industry?

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Making Tacit Collusion WorkElectronic Components
Distribution Industry
no
Tacit collusion not an issue
Incentive to cut price?
yes
no
Easy to detect price cuts?
Tacit collusion will fail the firms will find
themselves in the Bertrand trap
yes
no
Can serious punishments be inflicted?
yes
no
Firms willing to punish?
Tacit collusion is sustainable in equilibrium
yes
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Making Tacit Collusion WorkAirline Industry
no
Tacit collusion not an issue
Incentive to cut price?
yes
no
Easy to detect price cuts?
Tacit collusion will fail the firms will find
themselves in the Bertrand trap
yes
no
Can serious punishments be inflicted?
yes
no
Firms willing to punish?
Tacit collusion is sustainable in equilibrium
yes
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The Issue with Detection
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
Detection occurs
1
2
time
time
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The Issue with DetectionStochastic Discovery
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
Detection occurs
Possibly lost to mistaken price war
1
time
time
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Exiting a Price War

• Need to signal that price war at end without
  engaging in illegal explicit collusion.
• American Airlines and the NYT
• Price leaders
• Public adoption of means for facilitating tacit
  collusion

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Facilitating Tacit CollusionImproving Detection

• Firms want to make sure that
• cheating is detected promptly
• cheating is detected accurately
• Numerous devices to make this work
• public posting of prices
• simplified pricing
• airlines per-mile pricing
• collection dissemination of prices (some
  antitrust issuesMaple Flooring Mfrs. Assn v.
  United States)

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Making Punishments Severe
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
1
time
time
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Making Punishments Severe
Cheat (undercut)
Cooperate (tacitly collude)
PDV of profits
PDV of profits
Increase the severity of the punishment
1
time
time
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How to Make Severe

• Most Favored Nation Clauses
• MFN If cut price today, give refund to past
  customers.
• Note the other guy better adopt this too!
• Also contemporaneous MFN All customers get same
  price today (makes detection of price cutting
  easier)

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How to Make Willing

• Build in doomsday devices
• Dr. Strangelove
• Meeting the Competition Clauses (MCC)
• state that will meet lowest price available
• just advertised policy
• or put into contracts (some antitrust issues)
• if rival cuts price, either honor clause (a
  reputational or contractual obligation) or suffer
  consequences.

We miss you Stanley
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Tacit Collusion on Non-Price Dimensions to Lessen
Price Competition

• When tacit collusion on price would be difficult,
  firms can tacitly collude to maintain conditions
  that lessen price competition
• Generally, these are conditions that make one of
  the assumptions of the Bertrand model fail.
• Concept of market discipline.

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Tacit Collusion on Non-Price Competition

• Raising search costs
• tacit agreements not to price advertise
• not locating outlets near each other
• Raising switching costs
• making products incompatible with rivals
• signing customers to long-term contracts
• Note As we will see, these can also serve to
  deter entry.

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Tacit Collusion on Non-price Competition

• Restrict capacity
• Firms can tacitly agree not to expand capacity
• Note can be difficult to monitor
• Cereal makers shelf space

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Product Differentiation

• Tacitly agree to split market on non-price
  dimensions
• location non-overlapping territories (usually
  invites antitrust scrutiny)
• product space e.g., split market between
  high-end and low-end

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Other Dimensions of Tacit Collusion

• RD
• (Non-price) advertising
• No poaching