Appendix C Undercut-Proof Equilibria

C.1 C.2 C.3 C.4 C.5 C.6

The Simplest Product Dierentiation Model 307 Nonexistence of a Nash-Bertrand Equilibrium 308 The Undercut-Proof Equilibrium 309 Four Important Properties of the UPE 310 Exercises 311 Selected References 312

The goal of this appendix is to explore the simplest possible dierentiated products environment where (pure) Nash-Bertrand equilibrium prices do not exist due to price cycles a la Edgeworth and to suggest an alternative equilibrium concept as better suited to analyzing such environments. We develop and characterize a concept called an Undercut-Proof equilibrium. In an Undercut-Proof equilibrium, each rm chooses its price so as to maximize prot while ensuring that its price is suciently low that any rival rm would not nd it protable to set a lower price in order to grab all of the rst rms customers. Thus, unlike the Nash-Bertrand behavior, where each rm assumes that the rival rm does not alter its price, in an Undercut-Proof equilibrium environment, rms assume that rival rms are more sophisticated in that they are ready to reduce their prices whenever undercutting and grabbing their rivals customers is protable. These beliefs are pervasive amongst rms competing in dierentiated products using pricing strategies. Finally, the UndercutProof equilibrium can be calculated easily for any number of rms in the industry.

C.1

The Simplest Product Dierentiation Model

Consider the following example (see Shilony 1977, Eaton and Engers 1990, and Shy 1996, Ch. 7), of a market with two stores called A and B which sell dierentiated brands. Assume that production costs are zero. There are two groups of consumers, type A (called brand A oriented

308

Undercut-Proof Equilibria

consumers) and type B (called brand B oriented consumers). There are A > 0 type A consumers and B > 0 type B consumers. Each consumer buys one unit either from store A or store B. Let pA and pB denote the prices of the stores and let 0 denote the extra distaste cost a consumer bears if he buys his less preferred brand. Altogether, the utilities of consumers of type A and type B are assumed to be buying from A pA def (C.1) UA = pB buying from B, and UB =
def

pA pB

buying from A buying from B.

One way of interpreting this example is as a discrete version of the Hotelling (1929) location model where the two stores locate on opposite sides of a lake or high terrain and where crossing from one side to the other requires paying a xed transportation cost of . Let qA denote the (endogenously determined) number of consumers buying from store A, and qB denote the number of consumers buying from store B. Then, (C.1) implies that if pA > pB + 0 if pB pA pB + A (C.2) qA = A + B if pA < pB , and 0 B qB = A + B if pB > pA + if pA pB pA + if pB < pA .

C.2

Nonexistence of a Nash-Bertrand Equilibrium

A Nash-Bertrand equilibrium is the nonnegative pair pN , pN such that, A B def for a given pN , store A chooses pN to maximize A = pA qA and, for a B A def given pN , store B chooses pN to maximize B = pB qB , where qA and A B qB are given in (C.2). Proposition C.1 There does not exist a Nash-Bertrand equilibrium in pure price-strategies for the dierentiated products model. Proof. To establish a contradiction, suppose that pN , pN is a Nash A B equilibrium. Then, there are three cases: (1) |pN pN | > , (2) |pN A B A pN | < and (3) |pN pN | = . B A B

C.3 The Undercut-Proof Equilibrium

309

(1) With no loss of generality, suppose that pN pN > . Then (C.2) A B N N implies that qA = 0, and hence A = 0. However, store A can increase its prot by reducing its price to pA = pN + , in which case qA = A B and A = A (pN + ) > 0; a contradiction. B (2) With no loss of generality, suppose that pN < pN + . Then A B store A can increase its prot by slightly increasing its price to pA sat N isfying pN < pA < pN + to earn a prot level of A = A pA > A ; a A B contradiction. (3) With no loss of generality, suppose that pN pN = . Then, A B N pB = pN < pN + and store B can increase its prot by slightly A A raising pN ; a contradiction. B

C.3

The Undercut-Proof Equilibrium

We rst need to provide a precise denition to what we mean by undercutting. Definition C.1 Store i undercuts store j, if pi pj , where i, j = A, B, i = j. Thus, undercutting occurs when store i reduces its price to its competitors price minus the transportation cost. Thus, in some sense undercutting occurs when one store subsidizes the transportation costs. The Undercut-Proof equilibrium is now dened. Definition C.2 The Undercut-Proof equilibrium (UPE) is the pair of prices (pU , pU ) A B satisfying:
U (a) For given pU and qB , rm A chooses the highest price pU subject to B A U U B = pU qB (pA )(A + B ). B U (b) For given pU and qA , rm B chooses the highest price pU subject to A B U U A = pU qA (pB )(A + B ). A

(c) The distribution of consumers between the rms is determined in (C.2). The rst part states that, in an Undercut-Proof equilibrium, rm A sets the highest price it can while preventing rm B from undercutting pU A and grabbing rm As customers. More precisely, rm A sets pU as high A as possible without causing Bs equilibrium prot level to be smaller than Bs prot level when it undercuts by setting pB < pU , and A

310

Undercut-Proof Equilibria

selling to qB = A + B customers. The above two inequalities therefore hold as equalities which can be solved for the equilibrium prices pU = A and pU = B (A + B )(A + 2B ) > (A )2 + A B + (B )2 (A + B )(2A + B ) > . (A )2 + A B + (B )2 (C.3)

First note that by setting pi , each rm can secure a strictly positive market share without being undercut. Hence, in an UndercutProof equilibrium both rms maintain a strictly positive market share. U U Substituting (C.3) into (C.2), we have that qA = A and qB = B . Figure C.1 illustrates how the Undercut-Proof equilibrium is determined. Figure C.1s left panel, shows how rm A is constrained in
pB = A +B (pA ) B pA = A +B (pB ) A

pA

pA N
A does not undercut

pA
B undercuts both

B undercuts pA

B does not undercut

pB

............. . . . . A undercuts . none . . A undercuts pB . . . . pB pB pU B

pU A

Figure C.1: Undercut-Proof equilibrium.

setting pA so that rm B cannot benet from undercutting pU . FigA ure C.1s middle panel shows how rm B is constrained in setting pB so that rm A would not benet from undercutting pU . Figure C.1s right B panel displays the region where neither rm nds it protable to undercut its rival; the Undercut-Proof equilibrium prices maximize prots on this region. It should be emphasized that the curves drawn in Figure C.1 are not best response (reaction) functions (see Denition A.5 on page 295), but simply divide the regions into prices that make undercutting protable or unprotable for each rm.

C.4

Four Important Properties of the UPE

We now conclude this example with characterizations of the UndercutProof equilibrium prices. First, from (C.3), prices rise with distaste

C.5 Exercises

311

(transportation) costs and monotonically decline to zero as distaste costs approach zero, reecting a situation in which the products become homogeneous. Second, pU =pU pU = B A
def

(A )2 (B )2 < . (A )2 + A B + (B )2

(C.4)

Hence, pU 0 if and only if A B . Thus, in an UndercutProof equilibrium, the store selling to the larger number of consumers charges a lower price. This result is commonly observed in retailing, where discount stores sell to larger numbers of consumers (e.g., WalMart and Kmart). Note that this result is not obtained in the conventional Hotelling linear-city location model which predicts that the store with the higher market share sells at a higher price. Third,
U U U = B A = pU B pU A = B A
def

(A + B )2 (B A ) . (A )2 + A B + (B )2

(C.5)

Hence, U 0 if and only if B A . That is, in an Undercut-Proof equilibrium, the rm selling to a larger number of consumers makes a higher prot despite selling at a lower price. Fourth, under a symmetric distribution of consumers (A = B ), the equilibrium prices are given by pU = pU = 2. That is, each rm can A B mark up its price to twice the level of the distaste (transportation) cost without being undercut.

C.5

Exercises

1. In this exercise we introduce production cost into the model. Suppose that A = B = (i.e., there is an equal number of consumers oriented toward each store). The cost of producing one unit by store A is cA and by store B is cB , where 0 < cA < cB (that is, store A is more ecient). Assuming that cB cA < answer the following questions. (a) Calculate the UPE prices as functions of , cA , and cB . (b) Infer which store charges a higher price, and whether the dierence in prices increases or decreases with , cA , and cB . Explain your ndings. 2. Your are given the following pieces of information: (a) The price charged by store B is pB = 12, (b) store A has 5 customers, (c) store B has 10 customers, and (d) there are no production costs and prices are determined by an UPE. Calculate the transportation cost parameter, , associated with traveling between store A and store B; and calculate the price charged by store A.

312

Undercut-Proof Equilibria

C.6

Selected References

Eaton, J., and M. Engers. 1990. Intertemporal Price Competition. Econometrica 58: 637659. Hotelling, H. 1929. Stability in Competition. Economic Journal 39: 4157. Shilony, Y. 1977. Mixed Pricing in Oligopoly. Journal of Economic Theory 14: 373388. Shy, O. 1996. Industrial Organization: Theory and Applications. Cambridge, Mass.: The MIT Press.