Implications of the Bertrand Model

In 1893 French economist Joseph Bertrand developed his Bertrand type of competition from his review of Antoine Cour nons study of a Spring Water duopoly. His reproach lay with how firms in oligopolies compete. In his present firms compete with indicates sort of than Cornots quantities. ( citation TO Spanish JOURNAL) The stupefy consists of dickens firms who quite a little costs simultaneously and independently (HUGH GRAVIELLE AND AY REES, MICROECONOMICES), jean tiral explains this as when integrity firm sets its price it is ignorant to its rivals price, rather it anticipates what they al first-class honours degree for charge.It is mistaken products argon self-coloured and perfect substitutes (ECCSTRAT) and due to the constitution of the product the firm supplying output at the lowest price testament gain the total foodstuff drive. (GB ) This firm lead stir to supply solely the upcoming necessitate at the price they adjudge set gb1 from this an important pr esumptuousness of the feign is that at that place ar no mental object constraints, that both(prenominal) firms have the equivalent marginal appeal, which remains constant, and that cast off is liner.GB2 As stated, the entire grocery store need for homogeneous products will go to the firm offering the lowest price, although if both firms were to sell at the homogeneous price a sharing rule must be packd GB2. Using an congresswoman from the ((((((( lets suppose the market demand for a homogeneous product is given by, Q = 120-p (where Q is quantity demanded and p is price charged). The marginal cost (MC) for both makers is, C=$30, and both producers sell output at p=c=$30. The demand for each producer is Q=0. 5*120-p=45.Lets say producer A change magnitude their price to c=$31, the entire market demand would transfer to producer B who would right away have a demand function of Qb=120-c=90, epoch producer A would have zero demand. in time if producer A had reduced the ir price to c=$29, they would capture the entire market demand through charging the lowest cost, merely they would make a $1 loss in each product sold. From this, the Nash balance for the Bertrand model lies where P=MC, with demand so heavily influenced by price producers do not want to be undercut by rivals.With P=MC no rival will undercut as zero net are preferable to negative returnss, and some(prenominal)(prenominal) firm trying to charge above the MC and make corroboratory profits will draw no sales. The suggestion is the addition of one firm restores perfect market competition (Jean Tirole, 1998), moving the market form monopoly power and profits (maximum inefficiency) to perfectly competitive (maximum efficiency). It had been deemed a paradox as it is difficult to believe that two firms in a duopolistic market piece of tail make zero profits.We are able to resolve Bertrands paradox through relaxing and of the tether integral assumptions of the model (intro to indus trial org l. M. B Cabrail). In order to die its practical relevance and its subtractions, this essay will now give examples of where the paradox can be deconstructed. The first example of a solution comes from a combination of two assumptions, the first is the absence of capacity constraints, and the second firms make decisions independently.In the model whichever firm firm is charging the lowest price will receive the entire market demand, and is expected to supply all forthcoming demand at the price it has set (old xavior). There are fewer situations in the real world where one firm could satisfy the demand of the whole market. Using the previous example, producer B gained the entire market demand (Q=120-$30=90). Lets assume producer B has a capacity constraint below 90 units.There is now a proportion of the market that can only be snug by producer A, who can use monopoly power and make compulsive profits as the only producer. (managerial Economics a strategic approach). This example shows how with the inclusion of a common real world problem, Bertrands proposed equilibrium of price equal to marginal cost is deconstructed. A second implication of capacity constraints is their effect on collision between firms. Collusion reduces market competiveness, firms tactically agree to set prices above particular levels and to not to hire in price wars,(REF).A positive relationship between extravagance capacity and collusion was identified by David and Deneckere, who found excess capacity is a prerequisite for stable collusion while it provides a stronger dicker position within cartels (QUOTE TO JOURNALS THAT ARE ON JUIBILEE AND WOLF). These effects have been regard in oil cartel OPEC, which has existed since the second world war and where the largest producer, Saudi Arabia can flood the market if small producers cheat on their quotas. (paul Pijush). through with(predicate) years of controlling supply and therefore price the carte will receive one trillion dol lars in revenues this year, (Wall street post). The prisoners dilemma is a particular game between two captured prisoners that illustrates why cooperation is difficult to state even when mutually beneficial (REF). It helps to demonstrate the logic behind Bertrands Paradox. Both firms would benefit from charging a price higher than marginal cost, in time at this level both firms have an incentive to undercut one another. (managerial economics).If the rules of the game can be changed each agent would receive a higher revenue payoff. (Global Business Mike W peng). Two companies who see this were General galvanic (GE) and Westinghouse. In the early 1960s these two companies controlled over 98% of the US market for large turbine generators. Prior to buy, electric utilities would manage with GE and Westinghouse who, as in Bertrand competition, competed on price. Government owned utilities accounted for twenty five percent of the market share and by law had to purchase from the ch eapest provider and publish the price.The two firms generated low profit, as Bertrand competition predicts, until GE changed the rules of the game by introducing a price book. The process effectively set a higher market price and guaranteed higher profits, the price create behaviour continued successfully until 1975 when the US Department of Justice investigated the industry. outlay books were ruled to breach anti-competition laws and the firms were fined. The book, Technology and Transformation in the American Electric Utility Industry by Richard F.Hirsh goes into this example in much greater depth. This is an important example as it demonstrates that Bertrand competition can exist in the real world. However the assumption of zero profits, or in the example, low profits encourages companies to collude to set higher prices and make positive profits. The Bertrand model also assumes that with the entrant of a second firm into the market, and the subsequent Nash equilibrium, price eq ual to marginal cost, removes the need for policy makers to interfere.However form the previous example this is obviously false as policy makers did have to intervene and sanctions were made. To stress this point, another example Pakistans Federal Cabinet go powers of oil price fixation to the Oil Companies Advisory Committee in 2001, through flawed polices profits of the duopolists Pakistan State Oil and Shell Pakistan increased by 232% between 2001 to 2005. which lead to further state involvement to put on price restrictions and encourage competition. (competition reporter. 25,05,2009).In the Bertrand model we assumed that both firms had the same costs of production which remain constant. It is an extreme assumption that two firms would perplex exactly the same costs when producing their products, let us now assume that one firm had a cost advantage, i. e. firm A can produce marginally less expensively that firm B (cA<cB). rigid B, as its only option, prices at their margin al cost because price any higher would give all of the market demand to firm A, while pricing below their marginal cost would produce negative profits. pissed A however could price at a level hardly below firm Bs price, for example PB- ? (? being a small number). The result would see firm A satisfying all market demand, assuming no capacity constraints, while making a positive profit on output, (managerial economics). This example expects that some firm(s) should make positive profits within equilibrium, which contradicts Bertrands theory. Another assumption which needs to be addressed is the absence of sunk costs in Bertrands model. drop costs may be defined as costs that cannot be avoided by going out of business, i. . they are the costs incurred to enter a market place (real estate market analysis- method and applications, john m clap). Without sunk costs any firm can enter any market without financial risk however this situation is very seldom seen in real word scenarios. Ther e would be no incentive for a firm to enter into a market which displays Bertrand competition if the market had significant sunk costs. For a Bertrand market to be productively efficient, pricing must always be at marginal cost.This requires the simultaneous approach of two or more firms, who on simultaneous entry will remove any possibility of gains from the market. The market price will be zero and the sunk costs will never be regained, there would be no benefit to joining only a cost. REFERENCE JOURNAL It is more likely that either one firm enters that market, charging a non-competitive monopoly price and positive profits, or no firms enter and the product is not produced or sold. Both scenarios lead to a reduction in consumer lavishness while questioning the practical relevance of Bertrands assumption.The assumption that both firms produce a homogeneous product, which leads consumers to purchase from the cheapest producer on both occasion (as decisions are based solely on pri ce). (Managerial economics, 2nd ed). Has been seen in real world business, notably from the previous example of GE and Westinghouse, allthough this assumption does not always apply. The location of producers and the transport cost associated with purchase are features that differentiate products in the eyes of consumers. Yet they are excluded from the Bertrand model precisely included in the Hotelling model (introduction to industrial organisation.Location is an example of horizontal product distribution, occurring when the market offers a range of similarly priced products which ease consumers draw for their preference (K. Geroge et al. 2005). Suppose there are two hot dock traffickers either ends of a beach, trafficker A and vendor B. Each vendor sells an undifferentiated product at the same price, however if a node is close together(predicate) to vendor A they would rather purchase from vendor A than vendor B, as they would not have to walk as far. at one time let us sup pose that vendor B charges pB=cB and vendor A charges pA=c+? (?= a small number).Under the Bertrand model of competition vendor B would receive the demand for the entire market, however the Hotelling model argues that vendor A will retain customers located closer to A. This is because the price differential more than offsets the transportation costs associated with the purchase from vendor A, in this example the time customers spend walking. (theory of industrial ornistaion) this demonstrates that zero profit is no longer the equilibrium price, as a firm merchandising at a price above marginal cost retains demand.