In economics and commerce, the Bertrand paradox– named after its creator, Joseph Bertrand–describes a situation in which two players (firms) reach a state of Nash equilibrium where both firms charge a price equal to marginal cost. The paradox is that in reality, it usually takes a large number of firms to ensure that prices equal marginal cost. Typically, a small number of firms (oligopoly) earn positive profits by charging prices above cost. Suppose two firms, A and B, sell an identical commodity, each with the same cost of production and distribution, so that customers choose the product solely on the basis of price. It follows that neither A nor B will set a higher price than the other because doing so would yield the entire market to their rival. If they set the same price, the companies will share both the market and profits.

On the other hand, if either firm were to lower its price, even a little, it would gain the whole market and substantially larger profits. Since both A and B know this, they will each try to undercut their competitor until the product is selling at zero economic profit. This is the pure-strategy Nash equilibrium. Recent work has shown that there may be an additional mixed-strategy Nash equilibrium with positive economic profits (see Kaplan & Wettstein, 2000, and Baye & Morgan, 1999).

The Bertrand paradox rarely appears in practice because real products are almost always differentiated in some way other than price (brand name, if nothing else); firms have limitations on their capacity to manufacture and distribute; and two firms rarely have identical costs.

Bertrand's result is paradoxical because if the number of firms goes from one to two, the price decreases from the monopoly price to the competitive price and stays at the same level as the number of firms increases further. This is not very realistic, as in reality, markets featuring a small number of firms with market power typically charge a price in excess of marginal cost. The empirical analysis shows that in the most industries with two competitors, positive profits are made. Solutions to the Paradox attempt to derive solutions that are more in line with solutions from the Cournot model of competition, where two firms in a market earn positive profits that lie somewhere between the perfectly competitive and monopoly levels.

Some reasons the Bertrand paradox does not strictly apply:

• Capacity constraints–Sometimes firms do not have enough capacity to satisfy all demand
• Product differentiation–If products of different firms are differentiated, then consumers may not switch completely to the product with lower price
• Dynamic competition–Repeated interaction or repeated price competition can lead to the price above MC in equilibrium.
• More money for higher price–It follows from repeated interaction: If one company sets their price slightly higher, then they will still get about the same amount of buys but more profit for each buy, so the other company will raise their price, and so on (only in repeated games, otherwise the price dynamics are in the other direction).
• Oligopoly If the two companies can agree on a price, it is in their long-term interest to keep the agreement: the revenue from cutting prices is less than twice the revenue from keeping the agreement, and lasts only until the other firm cuts its own prices.

[edit] See also

• Joseph Bertrand
• Bertrand model
• Differentiated Bertrand competition
• Edgeworth paradox
• Prisoner's dilemma

[edit] References

• Baye, M.R. and J. Morgan (1997) "Necessary and sufficient conditions for existence and uniqueness of Bertrand paradox outcomes" Princeton Woodrow Wilson School, Discussion Paper in Economics, 186.

• Baye, M.R. and J. Morgan (1999) "A folk theorem for one-shot Bertrand games," Economics Letters, 65:1, 59-65.

• Bertrand, J. (1883) "Book review of theorie mathematique de la richesse sociale and of recherches sur les principles mathematiques de la theorie des richesses", Journal de Savants 67: 499–508.

• Kaplan, T.R. and D. Wettstein (1997) "Mixed strategy equilibria with constant-returns-to-scale technology," Monaster Center Discussion Paper 97–4.
• Kaplan, T.R. and D. Wettstein, (2000) "The Possibility of Mixed-Strategy Equilibria with Constant-Returns-to-Scale Technology under Bertrand Competition", Spanish Economic Review, 2(1):65-71.