UGBA 10 Module 5

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UGBA 10 Module 5

• Lecture 4 November 26, 2008
• Avoiding the Bertrand Trap

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• Recall the models assumptions
• firms produce a homogeneous product
• firms have unlimited capacity
• firms play once (alternatively, myopically)
• customers know prices.
• customers face no switching costs
• firms have the same, constant unit cost

The Bertrand Trap
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Avoiding the Bertrand Trap

• Must alter the assumptions (Kobayashi Moru) that
  is, do at least one of following
• dont produce a homogeneous product
• dont have unlimited capacity
• dont play myopically (facilitate tacit
  collusion)
• make it difficult for customers to learn prices
• make it difficult for customers to switch from
  one firm to the other
• lower your costs

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Avoiding the Trap Method 1 Lower Costs
Another Game

• Each bidder (except one) has a cost of 1.
• Exception has a cost of 0.
• Simultaneous bid.
• Lowest bid gets amount bid less cost (unless all
  bids exceed 5, in which case no one gets
  anything).
• Ties decided by fair randomization.
• Note A winning bid at less than cost means you
  pay me!

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Potential Problems with Method 1

• Question is sustainability of cost advantage
• Could fail the R test in AURA.
• Care that cost-cutting today does not result in
  negative long-run consequences.
• Could make firm vulnerable to fluctuations in
  trade policy (if cost advantage gained by
  exporting jobs).

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Avoiding the Trap Method 2 limit capacity
Capacity Game

• Each firm has 7 objects.
• Simultaneously set price for objects.
• I will buy 10 objects total. I will pay no more
  than 1 per object.
• I buy first from firm charging the lower
  price/object.

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Avoiding the Trap Method 2 limit capacity
Variant of Capacity Game

• What if each firm decided how many objects it
  had?
• Dont over produce -- that yields the Bertrand
  trap.
• But will tend to produce more than a monopolist
  would, thereby driving down price and profit.

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Setting Capacities

• Limiting capacity is a way to avoid Bertrand
  trap.
• Generally, when firms can set capacity, they
  limit capacity to avoid the Bertrand trap.
• However, overproduce relative to monopoly and
  market price is less than price a monopolist
  would charge.
• Price falls in the number of firms competition
  is bad for profits!

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Avoiding the Trap Method 3 Raise search costs

• Bertrand assumptions, except assume that it costs
  a consumer s gt 0 to visit a second firm
  (store).
• Assume each consumer wants 1 unit max and values
  it at v gt c gt 0.
• Let pe be the equilibrium price. That is, the
  price consumers expect to pay. Then each firm
  can charge p minpe s,v, because a customer
  would not be induced to visit a second store.

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Raise Consumer Search Costs

• Customers expect both firms to charge same price,
  pe, so they are evenly divided between the firms.
• There is no benefit to undercutting on price if
  rival is not charging more than minpes,v, you
  wont attract any of its customers.
• Pressure now is to raise prices.
• Equilibrium is pe v i.e., the monopoly price.

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Issues with Implementation

• How to keep search costs high?
• Must prevent price advertising.
• Must ensure comparison shopping hard (or
  pointless).
• Preventing price advertising.
• Lobby govt to make illegal (liquor stores)
• Gentlemens agreement (a form of tacit
  collusion)
• Have professional association prohibit (generally
  found to be violation of antitrust laws)

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Making Comparison Shopping Hard

• Limit store hours
• Do not readily supply price information
• Make it pointless

• guarantee lowest price
• meeting competition clauses

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Avoiding the Trap Method 4 Raise switching
costs
Switching Costs

• Suppose consumers pay a switching cost if buy
  from a different firm than they did before.
• Examples Frequent-flier programs, modifications
  to adapt existing material to new product, etc.
• Now to steal business, must lower price more than
  just a bit -- must lower it enough that consumers
  willing to switch
• This lessens downward pressure on price.

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Method 5 Product Differentiation

• By causing to consumers to base their decision on
  something other than price, you lessen price
  competition.
• Driving, not football!

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Yes
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No
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Another game

• In this experiment, you need to decide where to
  locate in a differentiated market.
• The market works as follows
• Consumers are located on a number line from 1 to
  31.
• There is one consumer at each location.
• Every consumer will pay 1 to buy one unit of the
  product, but only from the nearest store.
• If there is a tie, then a consumer buys
  fractional units from all the equally distant
  stores.

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Rules continued

• A monopolist can locate anywhere and make 63
  because all consumers will buy from the
  monopolist and pay 1 each.
• Costs Entry costs 5 and unit cost is 0.
• I will invite people (as individuals or teams of
  3 or fewer) to enter.
• You must choose a location that is a counting
  number between 1 and 63 inclusive (i.e., 3.5 is
  not a valid location).
• When people cease to be willing to enter, I will
  collect the entry fees and return profits
  according to location.

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Where to Locate

• You want to locate far-away from your
  rivalsdriving not football.
• Caveats
• If population is concentrated in one place, may
  need to get close to that place.
• When entering, sometimes pays to enter where the
  trade is (e.g., near other restaurants).

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Where to locate (continued )

• Note that product differentiation is not a
  panacea if there is no market discipline.
• Brand proliferation.
• If cant block entry or emulation.

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A repeated Game
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Rules

• Repeat the game until a one or two thrown.

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Conclusions

• You can avoid the Bertrand Trap if
• You can achieve a cost advantage (Method 1)
• You can limit capacity (Method 2)
• You can raise search costs (Method 3)
• You can raise switching costs (Method 4)
• You can differentiate your product (Method 5)
• You dont play myopically (Method 6)