11.7
Bertrand Competition
In a Bertrand oligopoly, companies compete by strategically setting prices rather than engaging in a continuous price-cutting war. Each company antici…
A Bertrand Oligopoly is a market structure where a few firms compete on price, undercutting each other’s prices until they equal marginal cost.
Each firm has the same constant marginal cost (MC), assuming identical products and consumers choosing the cheaper option.
The firm with the lowest price captures the market until it reaches its capacity. As a result, firms set equal prices (P1 = P2 = P), which then become the market price.
For instance, two airlines, Delta and United, compete on the New York to Los Angeles route, and their marginal cost is $250.
Delta sets a one-way ticket price of $300, and United sets its price at $290 to attract more passengers.
Delta responds by lowering its price to $280; further, United lowers its price to $270.
This process continues back and forth until prices reach $250, and prices fall until they are equal to MC, the level at which further reductions would cause losses to both airlines.
This outcome demonstrates that in Bertrand oligopoly, firms earn zero economic profit in equilibrium because price equals marginal cost
View the full transcript and gain access to JoVE Business videos
Q1: What happens to prices in a Bertrand oligopoly?
In a Bertrand oligopoly, firms compete by undercutting each other's prices until prices fall to marginal cost. Each firm anticipates its rival's reaction and adjusts prices accordingly. Once prices reach marginal cost, further reductions are impossible without losses, and both firms stabilize at that price level.
Q2: Why do firms earn zero economic profit in Bertrand equilibrium?
Firms earn zero economic profit because price equals marginal cost at equilibrium. When price reaches marginal cost, firms cannot reduce prices further without incurring losses. This outcome occurs because customers prefer lower prices, forcing firms to compete until all profit margins disappear.
Q3: How does the airline price competition example illustrate Bertrand competition?
Delta and United compete on the New York to Los Angeles route with identical $250 marginal costs. Delta sets $300, United undercuts at $290, Delta responds with $280, and United lowers to $270. This back-and-forth continues until prices reach $250, demonstrating how firms progressively undercut each other toward marginal cost.
Q4: What assumptions must hold for Bertrand oligopoly to occur?
Bertrand oligopoly requires that firms have identical products, identical constant marginal costs, and unlimited capacity to satisfy demand at the current price. Consumers must choose based solely on price. The firm with the lowest price captures the entire market until it reaches capacity constraints.
Q5: How can firms avoid the zero-profit outcome of Bertrand competition?
Firms can prevent zero-profit outcomes through product differentiation or building customer loyalty. When products differ or customers show brand preference, firms can maintain price premiums above marginal cost. Under strict Bertrand conditions with homogeneous products, however, firms can only compete on price.
Q6: What is the relationship between Bertrand equilibrium and Nash equilibrium?
Bertrand equilibrium represents a Nash equilibrium where each firm's price strategy is optimal given its competitor's price. No firm can improve profit by unilaterally changing its price. At this equilibrium, both firms charge marginal cost and earn zero economic profit, making further strategic adjustments unprofitable.
Q7: Why does the firm with the lowest price capture the entire market in Bertrand competition?
Consumers prefer lower prices and will purchase from the cheapest supplier when products are identical. The firm with the lowest price attracts all customers until it reaches capacity. This customer preference drives continuous price undercutting, as each firm seeks to undercut rivals and capture market share.