Bertrand Competition

Bertrand competition is a model that depicts a condition where two or more companies manufacture a homogeneous product. The primary purpose of this model is to analyze and understand how firms in a market will behave and compete when they offer similar or identical products.

The competition model states that when identical products are present in the market, they cancel each other regarding attributes and application. Hence, the selling occurs at marginal costs with no profit. This outcome is the Bertrand paradox, which mainly appears in an oligopolistic market. When such a scenario occurs, the companies compete in price but eventually make no profit.

• Bertrand competition defines a situation where two or three businesses compete over price because of a homogeneous good and eventually make no profit.
• The model was introduced and named after Joseph Louis François Bertrand, a French mathematician who worked in economics and probability theory.
• Moreover, the scenario leads to a situation of no profit, the Bertrand paradox, also represented as Nash equilibrium.
• Besides, the opposite of the Bertrand model is the Cournot model, which is based on production quantity and not the price factor.

Bertrand competition is a concept in economics that models how firms compete when they offer identical or very similar products and compete primarily through pricing. The model was introduced by a French economist and mathematician, Joseph Louis François Bertrand, in the 19th Century.

Hence, in simple terms, when two or more companies are dealing with the same goods, they create an oligopolistic market, and since the products are perfect substitutes for each other, the only competing factor left is price. The firms keep regulating their prices to a marginal point where they compete but do not register any profit. Moreover, on the graph, the fact is represented as Bertrand's competition Nash equilibrium, and the companies get stuck in a paradoxical situation.

Hence, the firms cannot set prices above or below a specific price level, or they will lose customers to their other competitors. Every firm tries to study the competitors' pricing and aims to set their prices in such a way that it maximizes their profit. Besides, it is also called a price trap in which firms, after a certain point, cannot even cover their fixed costs.

The main challenge with the Bertrand competition with different marginal costs is that it is based on several assumptions and needs to consider customers' perspectives while accounting for price regulation. When a customer is in the market to buy a product, several other factors, apart from the price, influence their choices, such as branding, personal opinion, advice from others, mood, buying behavior, need, and importance of the product. The model does not include any such factors and, therefore, is also criticized.

Furthermore, this model helps economists analyze price competition dynamics, market outcomes, and the factors that affect pricing decisions by firms.

Here are two examples of the Bertrand competition model:

Example #1

Imagine three friends, Jake, John, and Justin, start three individual companies but manufacture and sell the same product. All three products are identical with the same attributes. The target audience has market reachability and is considered perfect substitutes for each other. Therefore, in such a scenario, all three have formed an oligopolistic market together, eventually controlling the product market.

Since all three sell a homogeneous product, they are constantly competing with each other, and rather than working on the product quality, they compete over prices. Now and then, all three regulate their prices and try to minimize them until they reach a marginal point where, despite making sales, they cannot make any profit in the business.

Although customer behavior plays a crucial role in it, by constantly regulating the prices, they have induced a price trap in which it becomes challenging for them to cover their fixed costs. It is a simple Bertrand competition example, and the price trap is also referred to as the Bertrand paradox. Hence, the model assumes that all the other market factors will remain constant, which is impossible in the real world.

Example #2

Consider a market with two major ride-sharing companies, A and B, operating in a city. Both companies provide identical services, allowing passengers to book rides with drivers through smartphone apps.

Therefore, A starts by offering a standard ride from any location within the city for $10. Fully aware of the fierce competition, B quickly responded by matching A's price and offering rides for $10.

With these initial prices set, commuters and travelers in the city take advantage of the affordability and book rides with both A and B. Let's assume the market demand equation for rides is Q = 1,000,000 - 100,000P, where Q represents the quantity of rides demanded, and P is the price per ride.

At the initial price of $10 per ride, the total quantity demanded in the market becomes Q = 1,000,000 - 100,000 * 10 = 900,000 rides. A and B capture a significant market share, each providing 450,000 rides. This results in revenue of $4.5 million for both companies.

Recognizing the intense competition and the desire to attract even more riders, both A and B decided to simultaneously lower their prices to $9 per ride. This price reduction increases the quantity demanded to Q = 1,000,000 - 100,000 * 9 = 910,000 rides.

Now, each company provides 455,000 rides, generating revenue of $9 (price) * 455,000 (quantity) = $4.095 million. Both companies continue to adjust their prices in response to each other's moves, aiming to gain a larger market share while maintaining profitability.

Therefore, this cycle of price adjustments and competition continues, reflecting the dynamic nature of Bertrand's competition in markets where firms offer identical services.

Let us look at the graph below to understand the concept better:

In the above graph, the two prices from two firms have different starting points and are constantly regulated. But there is a point at which they intersect, forming the marginal point for both companies. This point is called Bertrand competition Nash equilibrium because when firms start selling the goods at this price, they are not making any profit.

Check out the main advantages and disadvantages of Bertrand competition:

Advantages

• Consumers have the option to choose between multiple companies selling identical products.
• The model encourages companies to work on their product's prices and attributes to attract customers.
• Restricts businesses from falling into the price trap paradox with no profit generation and understands the market dynamics.

Disadvantages

• Induces Bertrand's paradox among the competitors in the market.
• Eventually, businesses cannot cover their fixed costs as they have reached the marginal point.
• It exhibits an oligopolistic market, meaning that two or three businesses control the market on the underlying product.
• There is no monopoly for any business, and they constantly compete.

The critical differences between Bertrand, Cournot, and perfect competition are –

• Bertrand's competition is focused on the pricing setting of the homogeneous product. In Cournot's competition, the competitors focus on a set quantity to produce. Furthermore, in perfect competition, companies cannot determine prices, and market share does not affect prices.
• In Bertrand's competition, the company decides the price and the demand, but in Cournot's competition, the businesses choose the quantity, and the market determines the price. Moreover, in perfect competition, the buyers have perfect and complete information about the product.
• As per Bertrand's economic model, companies compete over prices, but in Cournot's model, businesses compete over production quantity. In perfect competition, businesses work for profit and serve the customers.
• In Bertrand and Cournot's models, two or more firms control the market, and no such practices exist in perfect competition.
• Furthermore, in perfect competition, prices are determined by market forces, while in Bertrand and Cournot competitions, firms have some degree of control over prices or quantities.

This article has been a guide to what is Bertrand Competition. We explain its examples, comparison with cournot & perfect competitions, graph, and advantages. You may also find some useful articles here -

• Stackelberg Model
• Duopoly
• Monopoly vs Oligopoly