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.
1
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
1
(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.
1
(tacitly collude)
time
time
To Cheat or Not to Cheat:
More Firms or Higher Interest Rate
Cheat
Cooperate
(undercut)
PDV of profits
(tacitly collude)
1
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
1
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 she’s leaving.
Basically don’t 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
1
time
time
Exiting a Price War

Need to signal that price war at end without
engaging in illegal explicit collusion.
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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
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cheating is detected promptly
cheating is detected accurately
Numerous devices to make this work

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public posting of prices
simplified pricing

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airlines & per-mile pricing
collection & dissemination of prices (some antitrust
issues—Maple Flooring Mfrs.’ Ass’n v. United States)
Making Punishments Severe
Cheat
Cooperate
(undercut)
PDV of profits
(tacitly collude)
1
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
1
time
time
How to Make Severe

Most Favored Nation Clauses
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MFN: If cut price today, give refund to past
customers.
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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”
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Dr. Strangelove
Meeting the Competition Clauses (MCC)

state that will meet lowest price available
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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
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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

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tacit agreements not to price advertise
not locating outlets near each other
Raising switching costs

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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

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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
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location: non-overlapping territories (usually
invites antitrust scrutiny)
product space: e.g., split market between highend and low-end
Other Dimensions of Tacit Collusion
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R&D
(Non-price) advertising
No poaching