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
Looking just at today:
Cheat
Cooperate
(undercut)
PDV of profits

(tacitly collude)
PDV of profits

Profits from just

undercutting rivals
and capturing entire
market.

time

Profits from
matching rivals at
monopoly price but
sharing market.

time

To Cheat or Not to Cheat:

That is the Question

Now take into account

the future!

Cheat
PDV of profits

(undercut)

Cooperate
PDV of profits

time

(tacitly collude)

time

To Cheat or Not to Cheat:

That is the Question
Cheat
PDV of profits

Benefit
today

(undercut)

Cooperate
PDV of profits

Smaller benefits
today (because
split market). But
positive benefits
in future.

But Bertrand
trap forever
after.

(tacitly collude)

time

time

To Cheat or Not to Cheat:

More Firms or Higher Interest Rate
Cheat

Cooperate

(undercut)
PDV of profits

(tacitly collude)

PDV of profits

time

time

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
Cheat
(undercut)
Expected PDV of profits

Cooperate
(tacitly collude)
Expected PDV of profits

time

time

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 shes leaving.
Basically dont let others know the end is
coming.

Making Tacit Collusion Work

no

Incentive to
cut price?

Tacit collusion
not an issue

yes
Easy to
detect price
cuts?

yes

no
no

Can serious
punishments be
inflicted?

yes
Tacit
collusion is
sustainable
in equilibrium

Firms
willing to
punish?

yes

no

Tacit
collusion will
fail & the
firms will find
themselves
in the
Bertrand trap

Electronic Components Distribution

Industry

How do we assess the potential for tacit

collusion in the electronic components
distribution industry?

Making Tacit Collusion Work

Electronic Components Distribution Industry
no

Incentive to
cut price?

Tacit collusion
not an issue

yes
Easy to
detect price
cuts?

yes

no
no

Can serious
punishments be
inflicted?

yes
Tacit
collusion is
sustainable
in equilibrium

Firms
willing to
punish?

yes

no

Tacit
collusion will
fail & the
firms will find
themselves
in the
Bertrand trap

Making Tacit Collusion Work

Airline Industry
no

Incentive to
cut price?

Tacit collusion
not an issue

yes
Easy to
detect price
cuts?

yes

no
no

Can serious
punishments be
inflicted?

yes
Tacit
collusion is
sustainable
in equilibrium

Firms
willing to
punish?

yes

no

Tacit
collusion will
fail & the
firms will find
themselves
in the
Bertrand trap

The Issue with Detection

Cheat

Cooperate

(undercut)
PDV of profits

(tacitly collude)
PDV of profits

Detection
occurs

1 2

time

time

The Issue with Detection:

Stochastic Discovery
Cheat

Cooperate

(undercut)
PDV of profits

(tacitly collude)
PDV of profits

Detection
occurs

Possibly lost to
mistaken price
war

time

time

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

issuesMaple Flooring Mfrs. Assn v. United States)

Making Punishments Severe

Cheat

Cooperate

(undercut)
PDV of profits

(tacitly collude)

PDV of profits

time

time

Making Punishments Severe

Cheat

Cooperate

(undercut)
PDV of profits

(tacitly collude)
PDV of profits

Increase the severity

of the punishment

time

time

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 highend and low-end

Other Dimensions of Tacit Collusion

R&D
(Non-price) advertising
No poaching