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In the previous video, we've seen, or we've introduced the so-called Bertrand
paradox. And the Bertrand paradox basically tells
us that, in a model with seemingly fairly reasonable assumptions, we get a result
that just doesn't make a lot of sense.
So we have the assumptions that you've got prices and little product
differentiation and so on. And the result we got was that firms make
no profits. So what we're going to do in this
video, is we're going to adjust the model assumptions
to see if we can get closer to reality, starting from this model.
So let's just recap what the assumptions were. We have two companies.
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These companies compete in prices, and they have identical products that they're
selling. They play this game a single time in a
completely transparent market. And there is infinite price elasticity
and there are no capacity constraints, okay?
So let's take this model and then let's try to remove these assumptions one by
one and see what the result might be. So, what's an assumption we can change?
I guess the easiest one is that maybe firms do not have identical products.
So in reality consumers will have different tastes and products will
be differentiated. So each seller might well produce a
different flavor of ice cream. And this means that monopolization for
one of the products is not possible. Simply speaking, if one of the products
charges a slightly lower price than the other
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the fans of strawberry ice cream aren't going to care that much about tiny price
differences, and if that is something that's sort of fairly pronounced,
so it's an important factor, this differentiation in terms of the
consumers, and in terms of the sellers, then monopolization is
simply not possible. The game is played just a single time.
So remember, I said that there is just a single day on which the two sellers
get together and they sell ice cream. In reality, you have repetitions that are
infinite or at least indefinite. Right?
So every summer season, the sellers set their prices.
They go to the beach, meet one day, they meet the next day, and they meet the day
after, okay? There's a possibility that from tomorrow
onwards that summer's going to be over. So there's a an element of uncertainty
here, but in principle what's important to know here is that the game
is played a repeated number of times. And that makes collusion possible through
the threat of retaliation. So this is something that we looked at in
Week 2. Another assumption is that we had
complete market transparency. But what does that mean?
It means that every consumer knows the prices of both of the sellers.
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Is that reasonable? Well, in reality there's often imperfect
market transparency, so some consumers will simply only know the price of one seller.
And if you only know the price of one, then it doesn't matter what price the
other one will set. Alright, so it could be that I know the
other price is only half of what I'm paying but if I don't know then I'm not
going to switch. Which means that undercutting prices has
an effect on some consumers only, not on everyone.
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We assumed infinite price elasticity, so in reality if we think about this, there are
costs for consumers associated with switching sellers.
So sellers might introduce a loyalty program, so if you have 10 ice creams, if
you bought 9 ice creams, you get the 10th one for free.
So another possibility. What is that going to do? It's going to mean
that undercutting prices will have a limited affect.
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And finally, we can also relax the assumption of no capacity
constraints. In reality, firms will have limited
capacity. So even with the example that we just
used, the supermarket eventually is going to run out of ice cream as well.
So each seller here can produce a limited amount of ice cream only.
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And so what's interesting is that these are all characteristics of the market,
but firms can actually try to actively influence these aspects, to try and avoid
the Bertrand trap. They might be able to agree on prices,
implicitly or explicitly. They might play the game repeatedly to
make sure that there is no endpoint. You might limit your capacity.
So it kind of keeps you from giving you an incentive to undercut.
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You might increase switching costs, so that's going to make it more difficult
for rivals to steal your customers. And it might simply be a possible
strategy to differentiate your product. So in the last two videos, we've looked
at the Bertrand Paradox. Economic theory will tell us that firms
who sell the same product to the market will end up in a perfectly competitive
situation and make zero profits. In reality however, we see that there is
some aspects that will lower the competitive pressure, and enable firms to
make positive profits. Firms do not have to take these aspects
as given. But they can actually try to actively
influence them in their favor. One aspect that we only touched upon, but
that's of particular importance, is product differentiation.
So we'll have a closer look at this in the next couple of videos, but now it's
just time for a break.