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Avoiding the Bertrand Trap II: Cooperation

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.

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Avoiding the Bertrand Trap II: Cooperation

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  1. Avoiding the Bertrand Trap II: Cooperation

  2. 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

  3. 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.

  4. 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).

  5. 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 Looking just at today: Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits 1 time time

  6. To Cheat or Not to Cheat:That is the Question Now take into account the future! Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits 1 time time

  7. To Cheat or Not to Cheat:That is the Question Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits Smaller benefits today (because split market). But positive benefits in future. Benefit today But Bertrand trap forever after. 1 time time

  8. To Cheat or Not to Cheat:More Firms or Higher Interest Rate Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits 1 time time

  9. Tacit Collusion • Tacit collusion is easier to sustain when • fewer firms (four or fewer if excess capacity) • interest rate low

  10. To Cheat or Not to Cheat:Dying Industry Cheat (undercut) Cooperate (tacitly collude) Expected PDV of profits Expected PDV of profits 1 time time

  11. 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.

  12. 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.

  13. Making Tacit Collusion Work no Tacit collusion not an issue Incentive to cut price? yes no Easy to detect price cuts? Tacit collusion will fail & the firms will find themselves in the Bertrand trap yes no Can serious punishments be inflicted? yes no Firms willing to punish? Tacit collusion is sustainable in equilibrium yes

  14. Electronic Components Distribution Industry • How do we assess the potential for tacit collusion in the electronic components distribution industry?

  15. Making Tacit Collusion WorkElectronic Components Distribution Industry no Tacit collusion not an issue Incentive to cut price? yes no Easy to detect price cuts? Tacit collusion will fail & the firms will find themselves in the Bertrand trap yes no Can serious punishments be inflicted? yes no Firms willing to punish? Tacit collusion is sustainable in equilibrium yes

  16. Making Tacit Collusion WorkAirline Industry no Tacit collusion not an issue Incentive to cut price? yes no Easy to detect price cuts? Tacit collusion will fail & the firms will find themselves in the Bertrand trap yes no Can serious punishments be inflicted? yes no Firms willing to punish? Tacit collusion is sustainable in equilibrium yes

  17. The Issue with Detection Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits Detection occurs 1 2 time time

  18. The Issue with Detection:Stochastic Discovery Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits Detection occurs Possibly lost to mistaken price war 1 time time

  19. 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

  20. 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)

  21. Making Punishments Severe Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits 1 time time

  22. Making Punishments Severe Cheat (undercut) Cooperate (tacitly collude) PDV of profits PDV of profits Increase the severity of the punishment 1 time time

  23. 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)

  24. 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

  25. 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.

  26. 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.

  27. 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

  28. 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

  29. Other Dimensions of Tacit Collusion • R&D • (Non-price) advertising • No poaching

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