Short-Run Price Competition The study of price competition—a fundamental part of oligopoly theory—is one of its weakest links. It so hep- pens that the most obvious natural formalization yields a result that is sometimes unconvincing, Deeper reflection shows that this formalization is economically naive, and alternative approaches come to mind In this chapter we assume that firms “meet only once” in the market. They simultaneously and noncooperatively charge a price, The Bertrand paradox, discussed in section 5. states that under these circumstances even oligopolists, behave like competitive firms—that is, the number of firms in the industry is irrelevant to the study of price behavior. Section 5.2 offers an overview of the three alternative approaches that will be developed below and in the next two chapters. Section 5.3 introduces one such approach which is associated with decreasing retums to scale or capacity constraints; it studies foundations for the rival model to the Bertrand paradigm, the Cournot ‘model of competition in quantities. The Cournot model ‘assumes that firms pick quantities rather than prices, and that an auctioneer chooses the price to equate supply and demand. This model has been justly criticized on the grounds that no such auctioneer exists and that firms ultimately choose prices. The point of section 5.3 is that Cournot competition may be thought of as a two-stage game in which firms first choose capacities, (or, more generally, scale variables) and then compete through prices. Section 5.4 reviews the main properties, of the Cournot paradigm. Section 5.5 discusses concentra- tion indices. The supplementary section completes sec-~ tions 5.3 and 5.4 with a discussion of capacity-constrained price competition and other aspects of the Cournot model, 5.1. The Bertrand Paradox To simplify, let us take the case of a duopoly. The analy- sis generalizes straightforwardly to the case of m firms.Assume that two firms produce identical goods which are “nondifferentiated” in that they are perfect substitutes in the consumers’ utility functions. Consequently, consumers buy from the producer who charges the lowest price. Ifthe firms charge the same price, we must make an assumption about the distribution of consumers between them, We assume that each firm faces a demand schedule equal to half of the market demand at the common price (the half is not a crucial assumption). Further, we assume that the firm always supplies the demand it faces (this assump- tion is not crucial here). The market demand function is 4 = D(p). Each firm incurs a cost c per unit of production, ‘Therefore, the profit of firm iis Tp. pd = (Pr ADCP Py a) where the demand for the output of firm i, denoted D,, is given by Dip) if Py ‘The aggregate profit, min(p; — OD(p), cannot exceed the monopoly profit, TP = maxlp ~ )D(p) Each firm can guarantee itself a non-negative profit by charging a price above the marginal cost. Hence, any reasonable prediction must yield o< sir Or. pp 210 ‘The Bertrand (1883) paradox states that the unique ‘equilibrium has the two firms charge the competitive price: pf = pi = c. The proof is as follows: Consider, for example, p> pe ‘Then firm 1 has no demand, and its profit is zero. On the ‘other hand, if firm 4 charges name (where « is positive and “small”, it obtains the entire ‘market demand, D(p} — 2), and has a positive profit mar- gin of ae ‘Therefore, firm 1 cannot be acting in its own best interest if it charges pj. Now suppose that pam>e The profit of frm 1 is Dipipt — 2. If firm 1 reduces its price slightly to pj —, its profit becomes Dip = yt which is greater for small «. In this situation, the market share of the firm increases in a discontinuous manner. Because no firm will charge less than the unit cost c (the lowest-price firm would make a negative profi), we are left with one or two firms charging exactly . To show that both firms do charge c, suppose that 2. p> ph ‘Then firm 2, which makes no profit, could raise its price slightly, still supply all the demand, and make a positive profit—a contradiction, ‘The conclusions of this simple model are the following: (0 that firms price at marginal cost, and (i) that firms do not make profits ‘These conclusions suggest that the monopoly results of chapter 1 are very special. Even a duopoly would suffice to restore competition. We call this the Bertrand paradox because it is hard to believe that firms in industries with Chaptersfew firms never succeed in manipulating the market price to make profits. In the asymmetric case (say, where firm i has constant unit cost ¢, where 6 < ca), conclusions i and ii do not hold. Indeed, the following can be shown (up to some technical considerations, see exercise 5.1) (ii) that both firms charge price p= ¢, (actually, fem 1 charges an ¢ below c to make sure it has the whole market), and {iv) that firm 1 makes a profit of (¢ — ¢)D(e) and firm 2 makes no profit (as long as ¢ < p™,), where pc) maximizes (p—¢)D(p); otherwise, firm 1 charges p™¢,)). Thus, firm 1 charges above marginal cost and makes a positive profit, and the Bertrand equilibrium is no longer welfare-optimal. But, again, the conclusion isa bit strained Firm T makes very litle proft if, is cose to ¢,, and firm 2 makes no profit a all. Exercise 5.1” Prove conclusions iii and iv. 5.2 Solutions to the Bertrand Parado» ‘An Introduction ‘We can resolve the Bertrand paradox by relaxing any one ‘of the three crucial assumptions of the model. Each of these generalizations brings more realism to the problem of price determination. The first is studied in section 5.3; the other two are taken up in chapters 6 and 7. In the present section we will sketch these possible solutions. 5.2.1 The Edgeworth Solution Edgeworth (1897) solved the Bertrand paradox by intro- ducing capacity constraints, by which firms cannot sell more than they are capable of producing. To understand this idea, suppose that firm 1 has a production capacity smaller than D(Q. Is (pf, 73) = (6.@) still an equilibrium price system? At this price, both firms make zero profit. Suppose that firm 2 increases its price slightly. Firm 1 then faces demand D(c), which it cannot satisfy. Then, rationing dictates that some consumers must resort to firm 2. Firm 2 has a (residual) nonzero demand at a price greater than its marginal cost and, therefore, makes po- sitive profit, Consequently, the Bertrand solution is no longer an equilibrium. To solve explicitly for the equilibrium, we must intro. duce a more specific assumption conceming the manner in which consumers are rationed. As a general rule, in models with capacity constraints, firms make positive profit and the market price Is greater than the marginal cost. The crucial question now is whether or not this property is relevant: Won't firms accumulate capital ex ale until they are capable of satisfying the entire market demand at marginal cost? The answer is No. To accumulate capital is expensive, and itis notin the self-interest of the firms to do so if such behavior yields zero gross profit, (without netting out capital costs)? Using capacity constraints to justify noncompetitive prices is quite reasonable in some applications. For exam- pile, imagine the case of two hatels in a small town. In the short run, these hotels cannot adjust the nusnber of beds, (Capacity). It is useless for them to get involved in cut- throat price competition if they are incapable of satislying ‘market demand individually. In the longer run they do not increase their capacity very much, because they ex- pect keen competition in a situation of collective over- capacity. One can also consider the case where the pro- duction of a good requires a certain delay. Then. the available quantities for sale in the very short run cannot be adjusted at all, and therefore they act as capacity con- straints at the time of price competition. ‘The existence of a rigid capacity constraint is a special case of a decreasing-retums-to-scale technology. In our previous example. a firm has marginal cost that is equal to ¢ up to the capacity constraint and is then equal to infinity. More generally, the marginal cost may increase with the output. Except in special eases (such as the hotel example), a firm usually has some leeway to inerease its production beyond its “efficient level’—extra machines can be rented, existing ones can be utilized beyond their efficient intensity of use, inputs can be provided on short 1, Another paradox of the model & tat one wonders why Ars hother fo cater at alli they do not rake any prof. Along the sume line suppose that the ems face a fed cost of entering the akc. Then ne fm enters, the ‘other frm wil not Follow sat, however smal the fixed cost. Thus one au lesieves inthe exitnee of Jats sal xed cot of production a fen, the markt site to yield a monopoly, 2 See sections 53 and 7. ‘Short-Run Price Competition