Bertrand Model

Examines the interdependence between rivals' decisions in terms of pricing the product. A set of prices such that no firm can obtain a higher profit by choosing a different price if the other firms continue to charge the same prices.

Assumptions
1. 2 Firms in the market 2. Goods produced are homogenous i.e. products are perfect substitutes. 3. Firms set prices simultaneously. 4. Each firm has the same constant marginal cost(MC).

The Classic Bertrand Model

MC = constant marginal cost (equals constant unit cost of production). p1 = firm 1s price level p2 = firm 2s price level pM = monopoly price level

Firm 1's best response function is p1(p2), this gives firm 1 optimal price for each price set by firm 2.

Firm 1s reaction function p1(p2)

 If P2 < MC => P1=MC. If MC < P2 < pM => P1 < P2. If P2 > pM => p1 = pM. Because firm 2 has the same marginal cost as firm 1, its reaction function is symmetrical with respect to the 45 degree line.

Reaction functions of both Firms

Analysis of Bertrand Model

Nash Equilibrium=> a pair of strategies (i.e. prices) where neither firm can increase profits by unilaterally changing price. At point N, p1=p1(p2), and p2=p2(p1) i.e. both firms are pricing at marginal cost. A firm having lower average cost (a superior production technology) will charge the highest price that is lower than the average cost of the other one (i.e. a price just below the lowest price of the other firm) and take all the business. This is known as limit pricing.

Critical Analysis
Assumption that consumers want to buy from the lowest priced firm may not hold in many markets: non-price competition and product differentiation, transport and search costs. Ignores capacity constraints i.e. if a single firm does not have the capacity to supply the whole market then the "price equals marginal cost" result may not hold.

Bertrand Versus Cournot

Neither model is necessarily "better." If capacity and output can be easily changed, Bertrand is generally a better model of duopoly competition. Or, if output and capacity are difficult to adjust, then Cournot is generally a better model.

Contd..
Cournot equilibrium price for firms with constant marginal costs of is given by:
MC $S p 1 1 /(n ) 1 1 /(n )
where n is the number of firms and is the market demand elasticity. If the market demand elasticity is = 1 and n = 2, then Cournot equilibrium price is almost double the Bertrand equilibrium price.