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Bertrand competition is a model of competition used in economics, named after
Joseph Louis François Bertrand Joseph Louis François Bertrand (; 11 March 1822 – 5 April 1900) was a French mathematician who worked in the fields of number theory, differential geometry, probability theory, economics and thermodynamics. Biography Joseph Bertrand was the ...
(1822–1900). It describes interactions among firms (sellers) that set prices and their customers (buyers) that choose quantities at the prices set. The model was formulated in 1883 by Bertrand in a review of Antoine Augustin Cournot's book ''Recherches sur les Principes Mathématiques de la Théorie des Richesses'' (1838) in which Cournot had put forward the
Cournot model Cournot competition is an economic model used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine Au ...
. Cournot's model argued that each firm should maximise its profit by selecting a quantity level and then adjusting price level to sell that quantity. The outcome of the model equilibrium involved firms pricing above marginal cost; hence, the competitive price. In his review, Bertrand argued that each firm should instead maximise its profits by selecting a price level that undercuts its competitors' prices, when their prices exceed marginal cost. The model was not formalized by Bertrand; however, the idea was developed into a mathematical model by
Francis Ysidro Edgeworth Francis Ysidro Edgeworth (8 February 1845 – 13 February 1926) was an Anglo-Irish philosopher and political economist who made significant contributions to the methods of statistics during the 1880s. From 1891 onward, he was appointed th ...
in 1889.


Underlying assumptions of Bertrand competition

Considering the simple framework, the underlying assumptions that the Bertrand model makes is as follows: * there are n firms (i = 1, 2, ...) competing in the market that produce homogenous goods; that is, identical products; * the market demand function Q=D(p), where ''Q'' is the summation of quantity produced by firms Q=\sum_^nQ_i, is continuous and downward sloping with D'(p)=0'';'' * the
marginal cost In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it r ...
is symmetric, c_1=c_2=...=c '';'' * it is a static game; firms simultaneously set price, without knowing the other firm’s decision; and * firms don't have a capacity constraint; that is, each firm has the capability to produce enough goods to meet market demand. Furthermore, it is intuitively deducible, when considering the law of demand of firms' competition in the market: * the firm that sets the lowest price will acquire the whole the market; since, product is homogenous and there is no cost of switching for the customers; and * if the price set by the firms is the same, p_1=p_2=...=p'','' they will serve the market equally, \frac.


The Bertrand duopoly equilibrium

Why is the competitive price a
Nash equilibrium In game theory, the Nash equilibrium, named after the mathematician John Nash, is the most common way to define the solution of a non-cooperative game involving two or more players. In a Nash equilibrium, each player is assumed to know the equili ...
in the Bertrand model? First, if both firms set the competitive price with price equal to marginal cost (unit cost), neither firm will earn any profits. However, if one firm sets price equal to marginal cost, then if the other firm raises its price above unit cost, then it will earn nothing, since all consumers will buy from the firm still setting the competitive price (recall that it is willing to meet unlimited demand at price equals unit cost even though it earns no profit). No other price is an equilibrium. If both firms set the same price above unit cost and share the market, then each firm has an incentive to undercut the other by an arbitrarily small amount and capture the whole market and almost double its profits. So there can be no equilibrium with both firms setting the same price above marginal cost. This is due to the firms competing over goods and services that are considered substitutes; that is, consumers having identical preferences towards each product and only preferring the cheaper of the two. Also, there can be no equilibrium with firms setting different prices. The firms setting the higher price will earn nothing (the lower priced firm serves all of the customers). Hence the higher priced firm will want to lower its price to undercut the lower-priced firm. Hence the ''only'' equilibrium in the Bertrand model occurs when both firms set price equal to unit cost (the competitive price). Note that the Bertrand equilibrium is a ''weak'' Nash-equilibrium. The firms lose nothing by deviating from the competitive price: it is an equilibrium simply because each firm can earn no more than zero profits given that the other firm sets the competitive price and is willing to meet all demand at that price.


Classic modelling of the Bertrand competition

The Bertrand model of price competition in a duopoly market producing homogenous goods has the following characteristics: * Players: Two firms i=1, 2 with constant marginal cost c,\ (c_1=c_2); * Strategic Variables: Firm’s select the price level (i.e., p_i=p_1); * Timing: Simultaneous move game; * Firm Payoffs: Profit; and * Information: Complete. Firm i’s individual demand function is downward sloping and a function of the price set by each firm: D(p_i,p_j) = \begin D(p_i), & \textp_i Important to note, in this case, the market demand is continuous; however, the firm's demand is discontinuous, as seen in the above function statement. This means the firm's profit function is also discontinuous. Therefore, firm i aims to maximise its profit, as stated below, taking p_j as given: \pi_i=(p_i-c)D(p_i) In order to derive the
best response In game theory, the best response is the strategy (or strategies) which produces the most favorable outcome for a player, taking other players' strategies as given (; ). The concept of a best response is central to John Nash's best-known contribu ...
for firm i, let p_m be the
monopoly price A monopoly price is set by a monopoly.Roger LeRoy Miller, ''Intermediate Microeconomics Theory Issues Applications, Third Edition'', New York: McGraw-Hill, Inc, 1982.Tirole, Jean, "The Theory of Industrial Organization", Cambridge, Massachusetts: Th ...
that maximises total industry profit, where p_m=argmax_p(p-c)D(p). This highlights the incentive for firms to 'undercut' rival firms. As if the rival sets the price at p_m firm i can reduce its price by the smallest currency unit, \epsilon, to capture the entire market demand, D(p). Therefore, firm i ’s best response is:R_i(p_j) = \begin p_m, & \textp_j \geq p_m \\ p_j-\epsilon, & \textc Diagram 1 illustrates firm 1’s best response function, P_1''(P_2), given the price set by firm 2. Note, MC in the diagram stands for marginal cost, c. The
Nash Equilibrium In game theory, the Nash equilibrium, named after the mathematician John Nash, is the most common way to define the solution of a non-cooperative game involving two or more players. In a Nash equilibrium, each player is assumed to know the equili ...
(N) in the Bertrand model is the mutual best response; an equilibrium where neither firm has an incentive to deviate from it. As illustrated in the Diagram 2, the Bertrand-Nash equilibrium occurs when the best response function for both firm’s intersects at the point, where P_1^N= P_2^N =MC. This means both firms make zero economic profits. Therefore, if rival prices below marginal cost, firm ends up making losses attracting extra demand and is better of setting price level to marginal cost. Important to note, Bertrand’s model of price competition leads to a perfect competitive outcome. This is known as the Bertrand paradox; as two competitors in a market are sufficient to generate competitive pricing; however, this result is not consistent in many real world industries. If one firm has lower average cost (a superior
production technology Production may refer to: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production as a stat ...
), it will charge the highest price that is lower than the average cost of the other one (i.e. a price ''just'' below the lowest price the other firm can manage) and take all the business. This is known as "limit pricing".


Critical analysis of the Bertrand model

The Bertrand model rests on some very extreme assumptions. For example, it assumes that consumers want to buy from the lowest priced firm. There are various reasons why this may not hold in many markets: non-price competition and
product differentiation In economics and marketing, product differentiation (or simply differentiation) is the process of distinguishing a product or service from others to make it more attractive to a particular target market. This involves differentiating it from com ...
, transport and search costs. For example, would someone travel twice as far to save 1% on the price of their vegetables? The Bertrand model can be extended to include product or location differentiation but then the main result – that price is driven down to marginal cost – no longer holds. With search costs, there may be other equilibria apart from the competitive price – the monopoly price or even price dispersion may be equilibria as in the classic "Bargains and Rip-offs" model. The model also ignores capacity constraints. If a single firm does not have the capacity to supply the whole market then the "price equals marginal cost" result may not hold. The analysis of this case was started by
Francis Ysidro Edgeworth Francis Ysidro Edgeworth (8 February 1845 – 13 February 1926) was an Anglo-Irish philosopher and political economist who made significant contributions to the methods of statistics during the 1880s. From 1891 onward, he was appointed th ...
and has become known as the
Bertrand–Edgeworth model In microeconomics, the Bertrand–Edgeworth model of price-setting oligopoly looks at what happens when there is a homogeneous product (i.e. consumers want to buy from the cheapest seller) where there is a limit to the output of firms which are wil ...
. With capacity constraints, there may not exist any pure strategy Nash equilibrium, the so-called
Edgeworth paradox To solve the Bertrand paradox, the Irish economist Francis Ysidro Edgeworth put forward the Edgeworth Paradox in his paper "The Pure Theory of Monopoly", published in 1897. In economics, the Edgeworth paradox describes a situation in which two pla ...
. However, in general there will exist a mixed-strategy Nash equilibrium as shown by
Huw Dixon Huw David Dixon (/hju: devəd dɪksən/), born 1958, is a British economist. He has been a professor at Cardiff Business School since 2006, having previously been Head of Economics at the University of York (2003–2006) after being a professor ...
. Moreover, some economists have criticized the model as leading to impractical outcomes in situations, where firms have
fixed cost In accounting and economics, 'fixed costs', also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or r ...
F and, as mentioned previously, constant marginal cost, c. Hence, the total cost, TC, of producing Q units is, TC = F + cQ. As described in the classic model, prices eventually are driven down to marginal cost, where firms are making zero economic profit and earn no margins on inframarginal units. Thus, firms are not able to recouple any fixed costs. However, if firms have an upward-sloping marginal cost curve, they can earn marginal on infra-marginal sales, which contributes to recouping fixed costs. There is a big incentive to cooperate in the Bertrand model;
colluding Collusion is a deceitful agreement or secret cooperation between two or more parties to limit open competition by deceiving, misleading or defrauding others of their legal right. Collusion is not always considered illegal. It can be used to att ...
to charge the
monopoly A monopoly (from Greek language, Greek el, μόνος, mónos, single, alone, label=none and el, πωλεῖν, pōleîn, to sell, label=none), as described by Irving Fisher, is a market with the "absence of competition", creating a situati ...
price, p_m, and sharing the market equally, \frac, where n is the number of firms in the market. However, not colluding and charging
marginal cost In economics, the marginal cost is the change in the total cost that arises when the quantity produced is incremented, the cost of producing additional quantity. In some contexts, it refers to an increment of one unit of output, and in others it r ...
is the non-cooperative outcome and the only
Nash equilibrium In game theory, the Nash equilibrium, named after the mathematician John Nash, is the most common way to define the solution of a non-cooperative game involving two or more players. In a Nash equilibrium, each player is assumed to know the equili ...
of this model. Therefore, moving from a simultaneous move game to a repeated game with infinite horizon, then collusion is possible because of the Folk Theorem.


Bertrand competition versus Cournot competition

The Bertrand and Cournot model focus on different aspects of the competitive process, which has led to the model identifying different set of mechanisms that vary the characteristics of the market demand that are exhibited by the firms. Cournot model assumes that the market allocates sales equal to whatever any given firm quantity produced, but at the price level determined by the market. Whereas the Bertrand model assumes that the firm with the lowest price acquires all the sales in the market. When comparing the models, the oligopoly theory suggest that the Bertrand industries are more competitive than Cournot industries. This is because quantities in the Cournot model are considered as
strategic substitutes In economics and game theory, the decisions of two or more players are called strategic complements if they mutually reinforce one another, and they are called strategic substitutes if they mutually offset one another. These terms were originally ...
; that is, the increase in quantity level produced by a firm is accommodated by the rival, producing less. Whereas the prices in the Bertrand model are
strategic complements In economics and game theory, the decisions of two or more players are called strategic complements if they mutually reinforce one another, and they are called strategic substitutes if they mutually offset one another. These terms were originally ...
; a firm aggressively counters an increase in price level by reducing its price below the rivals. Moreover, both models are criticised based on the assumptions that are made in comparison to the real-world scenario. However, the results from the classic models can be reconciled in a manner of thinking, as presented below. Considering the models appropriate application in the market: * Cournot model is applicable in markets where the firm must make production decision in advance and must be committed to selling that quantity level; thus, unlikely to react to fluctuations in rival’s quantity produced. * Bertrand model is applicable in markets where capacity is sufficiently flexible and firms are capable to meet any market demand that arises at price level, which they set. Neither model is necessarily "better" than the other. The accuracy of the predictions of each model will vary from industry to industry, depending on the closeness of each model to the industry situation. If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. If output and capacity are difficult to adjust, then Cournot is generally a better model. Under some conditions the Cournot model can be recast as a two-stage model, wherein the first stage firms choose capacities, and in the second they compete in Bertrand fashion.


See also

*
Aggregative game In game theory, an aggregative game is a game in which every player’s payoff is a function of the player’s own strategy and the aggregate of all players’ strategies. The concept was first proposed by Nobel laureate Reinhard Selten in 1970 who ...
*
Conjectural variation In oligopoly theory, conjectural variation is the belief that one firm has an idea about the way its competitors may react if it varies its output or price. The firm forms a conjecture about the variation in the other firm's output that will accomp ...
*
Cournot competition Cournot competition is an economic model used to describe an industry structure in which companies compete on the amount of output they will produce, which they decide on independently of each other and at the same time. It is named after Antoine A ...
*
Differentiated Bertrand competition As a solution to the Bertrand paradox in economics, it has been suggested that each firm produces a somewhat differentiated product, and consequently faces a demand curve that is downward-sloping for all levels of the firm's price. An increase in ...
* Stackelberg competition *
Nash equilibrium In game theory, the Nash equilibrium, named after the mathematician John Nash, is the most common way to define the solution of a non-cooperative game involving two or more players. In a Nash equilibrium, each player is assumed to know the equili ...
*
Game theory Game theory is the study of mathematical models of strategic interactions among rational agents. Myerson, Roger B. (1991). ''Game Theory: Analysis of Conflict,'' Harvard University Press, p.&nbs1 Chapter-preview links, ppvii–xi It has appli ...
*
Bertrand paradox (economics) In economics and commerce, the Bertrand paradox — named after its creator, Joseph Bertrand — describes a situation in which two players (firms) reach a state of Nash equilibrium where both firms charge a price equal to marginal cost ("MC"). Th ...
*
Bertrand–Edgeworth model In microeconomics, the Bertrand–Edgeworth model of price-setting oligopoly looks at what happens when there is a homogeneous product (i.e. consumers want to buy from the cheapest seller) where there is a limit to the output of firms which are wil ...
*
Edgeworth paradox To solve the Bertrand paradox, the Irish economist Francis Ysidro Edgeworth put forward the Edgeworth Paradox in his paper "The Pure Theory of Monopoly", published in 1897. In economics, the Edgeworth paradox describes a situation in which two pla ...
* Substitute good


References


Further reading


Oligoply Theory made Simple
Chapter 6 o

by
Huw Dixon Huw David Dixon (/hju: devəd dɪksən/), born 1958, is a British economist. He has been a professor at Cardiff Business School since 2006, having previously been Head of Economics at the University of York (2003–2006) after being a professor ...
.
The Pure Theory of Monopoly, Francis EdgeworthBertrand's review of Walras and Cournot
{{game theory Economics models Competition (economics) Non-cooperative games Oligopoly 1883 in economics