0:03
In the previous video,
we've seen where we've introduced the so-called Bertrand paradox.
And the Bertrand paradox basically tells us that in a model with
seemingly fairly reasonable assumptions we get
a result that just doesn't make a lot of sense.
Right? So we have the assumptions that you've got prices,
and product differentiation and so
on and the result we got was that friends make no profits.
So what we're going to do in this video is we're going to adjust
the model assumptions to see if we can get
closer to reality starting from this, from this model.
So let's just recap what the assumptions were.
We have two companies.
These companies compete in prices and they have identical products that they're selling.
They play this game a single time in
a completely transparent market and there is
infinite price elasticity and there are no capacity constraints.
Okay. So let's take this model and then let's try to
remove these assumptions one by one and see what the result might be.
So what's an assumption we can change.
Okay, the easiest one is that maybe firms do not have identical products.
Right, so in reality,
consumers will have different tastes and products will be differentiated.
So each seller might well produce a different flavor of ice cream.
And this means that monopolization for one of the products is not possible.
Simply speaking, if one of the products charges is
slightly lower priced than the other but the other is,
the other sells strawberry,
strawberry ice cream and I sell vanilla ice cream,
the fans of strawberry ice cream aren't going to
care that much about tiny price differences.
And if that is something that's sort of fairly pronounced,
so it's an important factor,
this differentiation in terms of the consumers and in terms of the,
in terms of the sellers then monopolization is simply not possible.
The game's played just a single time.
So remember I said that there's just a single day
on which the two sellers get together and they sell ice cream.
In reality, you have repetitions that are infinite or at least indefinite.
Right. So every summer season the sellers set their prices.
They go to the beach,
meet one day, they meet the next day and they meet the day after.
Okay. There's a possibility that from tomorrow onwards this summer is going to be
over so there's an element of uncertainty here.
But in principle, what's important to know here is that the game is played
a repeated number of times and
that makes collusion possible through the threat of retaliation.
So this is something where we looked at in week two.
Another assumption is that we had complete market transparency. So what does that mean?
It means that every consumer knows the prices of both,
of both the sellers. Is that reasonable?
Well, in reality, there's often imperfect market transparency.
So some consumers will simply only know the price of one seller.
And if you only know the price of one then
it doesn't matter what price the other one will set.
Right. You could be that, I don't know,
the other price is only half of what I'm paying but if I don't know then I'm not going to
switch which means that undercutting prices has an effect on some consumers only,
not on everyone which is going to make it less attractive,
of course, to lower prices.
We assumed infinite price elasticity.
So, in reality, if we think about this,
there are costs for consumers associated with switching sellers.
So sellers might introduce a loyalty program.
So if you have 10 ice creams,
if you bought 10 ice creams or nine ice creams,
you get the 10th one for free.
It's another possibility.
What is that going to do?
It's going to mean that undercutting prices will have a limited effect.
And finally, we can also, or finally,
we can also relax the assumption of no capacity constraints.
In reality firms will have limited capacity.
So even with the example that we just
used the super market eventually is going to run out of
ice cream as well so each seller here can produce a limited amount of ice cream only.
And that means that there is no incentive to induce a price war over
the complete demand because you're simply not going to be able to satisfy this demand.
And so what is interesting is that these are
all characteristics of the market but firms can actually try
to actively influence these aspects to try and avoid the Bertrand trap.
They might be able to agree on prices implicitly or explicitly.
They might play the game repeatedly to make sure that there is no end point.
You might limit your capacity so it, kind of,
keeps you from, from giving you an incentive to undercut.
You might increase switching costs so that's going to make it more
difficult for rivals to steal your customers.
And it might simply be a possible strategy to differentiate your product.
So in the last two videos we've looked at the Bertrand paradox.
Economic theory will tell us that firms who sell the same product to
the market will end up in a perfectly competitive situation and make zero profits.
In reality, however, we see that there are some aspects that will lower
the competitive pressure and enable firms to make positive profits.
Firms do not have to take these aspects as given but they
can actually try to actively influence them in their favor.
One aspect that we only touched upon but that's of
particular importance is product differentiation.
So we'll have a closer look at this in the next couple of videos.
But now it's just time for a break.
Tobias KretschmerProfessor
