Question

Describe in detail the Bertrand Paradox and how it can be avoided

(Answer this question for 6 marks)

Answer 1

Answer )

Bertrand Paradox

Some firms as set their prices and let the market determine the quantity sold. This model is known as Bertrand competition.*

When firms are selling identical products, as we have been assuming, the Bertrand equilibrium has a very simple structure outcome. It comes out to be the same as competitive equilibrium, where price equals marginal cost*

First we note that price can never be less than marginal cost since then either of 2 firms firm could increase its profits by producing less. So let us consider the case where price is greater than the marginal cost. Suppose that both firms are selling output at some pricp greater than marginal cost. Consider the position of firm- 1. If it lowers its price by any small amount and if the other firm keeps its price fixed at p, all of the consumers will prefer to purchase from firm - 1. By cutting its price by a small amount, it can steal all of the customers from firm 2. If firm 1 really believes that firm 2 will charge a price p that is greater than marginal cost, it will always pay firm 1 to cut its price to p' .But f irm 2 can retaliate the same way! Thus any price higher than marginal cost cannot be an equilibrium in bertrand model; the only equilibrium is the competitive equilibrium.

If we think of the Bertrand model as a model of competitive bidding, then it makes more sense. Suppose that one firm “bids” for the consumers’ business by selling at a price above marginal cost. Then the other firm can always make a profit by cutting this price with a lower price. It follows that the only price that each firm cannot rationally expect to be undercut is the price equal to the marginal cost.

Avoiding Bertrand Paradox:

The bertrand paradox can be avoided if:

(i) Firms don’t produce a homogeneous product.

(ii) Firms don’t have unlimited capacity.

(iii) It is difficult for customers to learn prices of the products.

(iv)It is difficult for customers to switch from one firm to the other firm.