Definition of Bertrand Competition
A market structure where it is assumed that there are two firms, who both assume the other firm will keep prices unchanged. Therefore, each firm has an incentive to cut prices, but this actually leads to a price war. If products are perfect substitutes this assumes the price will be driven down to marginal cost. This is allocatively efficient (P=MC) but firms may not cover their fixed costs.
Bertrand Competition was developed by French mathematician Joseph Louis François Bertrand (1822–1900) who investigated claims of the Cournot model in Recherches sur les Principes Mathématiques de la Théorie des Richesses (1838)
The Cournot model argued that firms in duopoly would keep prices above marginal cost and be quite profitable. Bertrand challenged this.
Assumptions of Bertrand Competiton
- No co-operation between firms and no attempt to collude and fix higher prices
- A homogenous product which consumers are indifferent between.
- No search and transaction costs. Like perfect competition, it assumes consumers have perfect information and if a good is 1% cheaper, then consumers will buy
- Firms can easily increase output and there are no capacity constraints. If a firm increases the price, the model assumes that all demand will move to the cheaper firm. But, this requires supply to be perfectly elastic and the firm to easily increase output in response to the surge in demand.
Criticisms of Bertrand Competition
- It assumes firms do not learn from their mistakes. The initial assumption is that the other firm will keep prices constant, but when they see they also cut their price, they may change their behaviour.
- Firms in a duopoly should be able to make high profits. It depends on the degree of barriers to entry.
- With two firms, there is a possibility of tacit collusion – or at least a quiet industry which avoids a price war. Over time, there is the possibility firms will learn from their behaviour and take a risk in keeping prices above marginal cost.
- It depends on the objectives of firms, for example, is it to profit maximise or increase market share. Bertrand Competition may be more likely if they are seeking to maximise sales.
- Consumers are not just motivated by buying the cheapest good. Their choices will reflect factors, such as brand loyalty, convenience, ease of purchase and quality of the good.
- Firms will face capacity constraints and may not be able to increase supply to meet the doubling of demand in a short time.
- Consumers may not have perfect information about the cheapest goods.
- There may be search and transaction costs of moving to a cheaper product.
- It is rare goods are homogenous, even with a good like water, firms may have different brand images.
Published 2 June 2019, Tejvan Pettinger. www.economicshelp.org