Bertrand with capacity constraint

Industrial Organization (A-B)

Professor: Julio Aguirre
Period: 2024 - I

Antoine Augustin Cournot (1801-1877)

Heinrich Baron von Stackelberg (1905-1946)

Joseph Bertrand (1822-1900)

The Bertrand model
• Joseph Bertrand criticized Cournot (45 years after the publication of Cournot´s
book), claiming that firms choose prices, not quantities, and that they have very
strong incentives to undercut each other.

• Static games with firms competing over prices are called Bertrand games; those
firms are Bertrand competitors; and price competition is often referred to as
Bertrand competition.

• Bertrand paradox: the Nash equilibrium results when price equals marginal cost,
but we do not expect oligopoly pricing to yield the competitive outcome.

• Variation of Bertrand game: capacity constraints.

a. The basic model
 Assumptions:

• There are 2 firms. Their per unit cost is c, and there is no constraint on capacity (how much
they can produce).

• Market demand is Q=D(p)

• The firms compete over prices just once and they make their pricing decision simultaneously.

• Firms produce to meet demand.

• There is no entry by other producers.

The Nash equilibrium to this game is a pair of prices such that given the Nash equilibrium
price of its rival, a firm has no incentive to unilaterally deviate.

1( 1 , 2 )≥ 1( 1, 2 ) for any 1

2( 1 , 2 )≥ 2( 1 , 2) for any 2
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 Assumptions:
• Consumers will buy from the low-price firm.
• When prices are the same, the demand will be split evenly.

( ) < ( ) <

( , )= ( , )=
1 1
Firm i’s demand is: 2
( ) = Firm j’s demand is: 2
( ) =
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• There are four possible equilibrium configurations:

i. 1 > 2 > .
ii. 1 > 2 = .
iii. 1 = 2 > .
iv. 1 = 2 = . These are the Nash equilibrium strategies.
• The Nash equilibrium to this simple Bertrand game has two significant features:
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i. Two firms are enough to eliminate market power.
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ii. Competition between two firms results in complete disipation of profits.
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Source:: Fernández-Baca (2006)
b. Variants of the Bertrand model
 Capacity constraint
• Edgeworth (1897): up to capacity, firms can produce output at unit cost
c, but they cannot produce more than their capacities.

• Assumptions:
➢ c = 0.
➢ k1 and k2 : capacities of firm 1 and firm 2, respectively.
➢ The demand function: Q = D(p) and its inverse is P = P(Q)
➢ 2 > 1, but ( 1) > 1.

• “Efficient rationing” rule: those who value the good the most are served
first by the low-price supplier.

• The sales made by firm i depend on whether it is the low-price supplier:

➢ If < then = min[ ( ), ]

➢ If > then = min[ , ( j) − ]

[ ( ) ]
If = we assume that = , ( )
➢ +
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Source: Church and Ware (2000)
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 Capacity constraint

Case 1: Capacity Constrained: k1 ≤ R1( k2) and k2 ≤ R2( k1)

NE prices are p1 = p2 = p where p = P( k1 + k2).

Case 2: Capacity Not Constrained: k1 ≥ D(0) and k2 ≥ D(0)

NE prices are p1 = p2 = c. Identical to simple Bertrand game.

Cases 3A (and 3B): ki > Ri(kj), ki ≥ kj , and kj < D(0); c = 0 :

i. p1 = p 2 = c
ii. p1 = p2 = p > c and demand < aggregate capacity
iii. p1 = p2 = p > c and demand > aggregate capacity
iv. pi > p j > c

➢Summary: for each of the following possibilities, at least one

firm has an incentive to deviate: Edgeworth cycle: the firms
make turns marginally undercutting each other until one firm
finds it optima to raise its price, and then undercutting
begins again.
Source: Church and Ware (2000)