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