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In the previous video, we've seen, or we've introduced the so-called Bertrand

paradox. And the Bertrand paradox basically tells

us that, in a model with seemingly fairly reasonable assumptions, we get a result

that just doesn't make a lot of sense.

So we have the assumptions that you've got prices and little product

differentiation and so on. And the result we got was that firms make

no profits. So what we're going to do in this

video, is we're going to adjust the model assumptions

to see if we can get closer to reality, starting from this model.

So let's just recap what the assumptions were. We have two companies.

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These companies compete in prices, and they have identical products that they're

selling. They play this game a single time in a

completely transparent market. And there is infinite price elasticity

and there are no capacity constraints, okay?

So let's take this model and then let's try to remove these assumptions one by

one and see what the result might be. So, what's an assumption we can change?

I guess the easiest one is that maybe firms do not have identical products.

So in reality consumers will have different tastes and products will

be differentiated. So each seller might well produce a

different flavor of ice cream. And this means that monopolization for

one of the products is not possible. Simply speaking, if one of the products

charges a slightly lower price than the other

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the fans of strawberry ice cream aren't going to care that much about tiny price

differences, and if that is something that's sort of fairly pronounced,

so it's an important factor, this differentiation in terms of the

consumers, and in terms of the sellers, then monopolization is

simply not possible. The game is played just a single time.

So remember, I said that there is just a single day on which the two sellers

get together and they sell ice cream. In reality, you have repetitions that are

infinite or at least indefinite. Right?

So every summer season, the sellers set their prices.

They go to the beach, meet one day, they meet the next day, and they meet the day

after, okay? There's a possibility that from tomorrow

onwards that summer's going to be over. So there's a an element of uncertainty

here, but in principle what's important to know here is that the game

is played a repeated number of times. And that makes collusion possible through

the threat of retaliation. So this is something that we looked at in

Week 2. Another assumption is that we had

complete market transparency. But what does that mean?

It means that every consumer knows the prices of both of the sellers.

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Is that reasonable? Well, in reality there's often imperfect

market transparency, so some consumers will simply only know the price of one seller.

And if you only know the price of one, then it doesn't matter what price the

other one will set. Alright, so it could be that I know the

other price is only half of what I'm paying but if I don't know then I'm not

going to switch. Which means that undercutting prices has

an effect on some consumers only, not on everyone.

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We assumed infinite price elasticity, so in reality if we think about this, there are

costs for consumers associated with switching sellers.

So sellers might introduce a loyalty program, so if you have 10 ice creams, if

you bought 9 ice creams, you get the 10th one for free.

So another possibility. What is that going to do? It's going to mean

that undercutting prices will have a limited affect.

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And finally, we can also relax the assumption of no capacity

constraints. In reality, firms will have limited

capacity. So even with the example that we just

used, the supermarket eventually is going to run out of ice cream as well.

So each seller here can produce a limited amount of ice cream only.

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And so what's interesting is that these are all characteristics of the market,

but firms can actually try to actively influence these aspects, to try and avoid

the Bertrand trap. They might be able to agree on prices,

implicitly or explicitly. They might play the game repeatedly to

make sure that there is no endpoint. You might limit your capacity.

So it kind of keeps you from giving you an incentive to undercut.

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You might increase switching costs, so that's going to make it more difficult

for rivals to steal your customers. And it might simply be a possible

strategy to differentiate your product. So in the last two videos, we've looked

at the Bertrand Paradox. Economic theory will tell us that firms

who sell the same product to the market will end up in a perfectly competitive

situation and make zero profits. In reality however, we see that there is

some aspects that will lower the competitive pressure, and enable firms to

make positive profits. Firms do not have to take these aspects

as given. But they can actually try to actively

influence them in their favor. One aspect that we only touched upon, but

that's of particular importance, is product differentiation.

So we'll have a closer look at this in the next couple of videos, but now it's

just time for a break.