avoiding the bertrand trap ii: cooperation. how do coke & pepsi make money? coke and pepsi sell...
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Avoiding the Bertrand Trap II: Cooperation
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
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.
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).
To Cheat or Not to Cheat:That is the Question
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Looking Looking justjust at today: at today:
Profits from just undercutting rivals
and capturing entire market.
Profits from matching rivals at
monopoly price but sharing market.
To Cheat or Not to Cheat:That is the Question
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Now take into account Now take into account the the future!future!
To Cheat or Not to Cheat:That is the Question
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Benefit today But Bertrand
trap forever after.
Smaller benefits today (because split market). But positive benefits in future.
To Cheat or Not to Cheat:More Firms or Higher Interest Rate
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Tacit Collusion
Tacit collusion is easier to sustain when fewer firms (four or fewer if excess capacity) interest rate low
To Cheat or Not to Cheat:Dying Industry
Expected PDV of profits Expected PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
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.
General Phenomenon
Firm going bankrupt not paid by other firms that owe it money.
Management problems when boss announces she’s leaving.
Basically don’t let others know the end is coming.
Making Tacit Collusion Work
Incentive to cut price?
Tacit collusion not an issue
no
yes
Easy to detect price
cuts? Tacit collusion will fail & the firms will find themselves in the Bertrand trap
no
no
no
Firms willing to punish?
Can serious punishments be
inflicted?
yes
yes
yes
Tacit collusion is sustainable in equilibrium
Electronic Components Distribution Industry How do we assess the potential for tacit
collusion in the electronic components distribution industry?
Making Tacit Collusion WorkElectronic Components Distribution Industry
Incentive to cut price?
Tacit collusion not an issue
no
yes
Easy to detect price
cuts? Tacit collusion will fail & the firms will find themselves in the Bertrand trap
no
no
no
Firms willing to punish?
Can serious punishments be
inflicted?
yes
yes
yes
Tacit collusion is sustainable in equilibrium
Making Tacit Collusion WorkAirline Industry
Incentive to cut price?
Tacit collusion not an issue
no
yes
Easy to detect price
cuts? Tacit collusion will fail & the firms will find themselves in the Bertrand trap
no
no
no
Firms willing to punish?
Can serious punishments be
inflicted?
yes
yes
yes
Tacit collusion is sustainable in equilibrium
The Issue with Detection
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
2
Detectionoccurs
The Issue with Detection:Stochastic Discovery
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Detectionoccurs
Possibly lost tomistaken price
war
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
Facilitating Tacit Collusion:Improving 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 issues—Maple Flooring Mfrs.’ Ass’n v. United States)
Making Punishments Severe
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Making Punishments Severe
PDV of profits PDV of profits
time time1
Cheat(undercut)
Cooperate(tacitly collude)
Increase the severity Increase the severity of the punishmentof the punishment
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)
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
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.
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.
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
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
Other Dimensions of Tacit Collusion
R&D (Non-price) advertising No poaching