11.7 : Bertrand Competition

In a Bertrand oligopoly, companies compete by strategically setting prices rather than engaging in a continuous price-cutting war. Each company anticipates its rival's reaction and adjusts its prices accordingly. Because customers prefer lower prices, companies undercut one another until prices fall to marginal cost. No company can reduce its price any further without incurring losses, leading to a Bertrand equilibrium, where firms make zero economic profit.

Take two supermarkets selling the same type of milk. If one charges $3, the other lowers its price to $2.90 to attract customers. In response, the first supermarket reduces the price of its milk to $2.80, and this price reduction strategy continues. Here, companies don't reduce prices at random—they think about how their competitor will respond and whether further reducing the price will be profitable. Once the price reaches the marginal cost of supplying milk ($2.50 in this example), further price reductions are no longer viable, and both companies stabilize at that price.

This result occurs because companies know that setting the price too high means losing all customers, whereas setting the price too low leads to losses. Anticipating their competitors' actions, companies price their products to maximize sales while avoiding a price war. The Bertrand oligopoly assumes that companies have unlimited ability to satisfy demand at the current price; thus, the company with the lowest cost captures the entire market.

Companies tend to prevent this situation through product differentiation or customer loyalty. However, under strict Bertrand conditions, companies can only compete on price, and strategic choice forces them to a situation where prices equal marginal cost with no scope for economic profit.