11  Undifferentiated Bertrand Competition

11.1 Introduction

Competing in business is rarely about having a unique product with no rivals. In many industries, firms offer nearly identical products and find themselves competing on price alone. This is the essence of undifferentiated Bertrand competition—a brutal pricing battle where firms repeatedly undercut each other until profit margins are razor-thin.

For entrepreneurs, understanding undifferentiated Bertrand competition is critical for two reasons: 1. It explains why competing on price alone is dangerous. If you enter a market where customers see no difference between products, price wars will push profits toward zero. 2. It highlights strategic ways to escape the price-cutting trap. Entrepreneurs who manage costs better, leverage capacity constraints, or find creative pricing strategies can still carve out profitable opportunities.

This chapter examines the dynamics of undifferentiated Bertrand oligopoly, why price wars happen, and what strategies can help entrepreneurs avoid the race to the bottom.

11.2 Conditions of Undifferentiated Bertrand Competition

Oligopolies, which lie between perfect competition and monopoly, present unique competitive dynamics. In undifferentiated Bertrand competition, a few key conditions prevail:

1. A Few, Powerful Firms: These firms can influence market equilibrium and each other’s behaviors.
2. Undifferentiated Products: Customers see no difference between products from different firms.
3. Entry Barriers: These maintain industry concentration.
4. Many Powerless Customers: Customers lack influence over market dynamics.
5. Perfect Information: Everyone knows all prices and product availabilities.
6. Price-Based Competition: Firms compete primarily through pricing strategies.
7. Unlimited Capacity: Firms can meet any market demand.

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11.3 Price Wars Are Rational but Mutually Destructive

Imagine a market with just two firms (a duopoly) where products and costs are identical. When one firm sets a price, the other has three options: match it, price higher, or undercut it. The logical move is to undercut, capturing the entire market at a slightly reduced price. This, however, prompts the first firm to respond with its own price cut to regain the market, leading to a continuous undercutting cycle.

This strategic price reduction leads to a price war, with both firms lowering their prices in tandem. Equilibrium is eventually reached when prices fall to the leveo of costs. At this point, lowering prices further would mean operating at a loss, so no incentive remains for either firm to change their pricing strategy. This situation, where firms end up earning zero economic profit, represents the epitome of fierce price competition.

Economic Profit vs. Accounting Profit

Zero economic profit doesn’t imply the absence of accounting profit. It means the business is viable—it covers all expenses and compensates for the entrepreneur’s time and capital—but doesn’t generate surplus profits beyond what could be earned elsewhere with the same investment of time and resources.

The equilibrium where a firm’s best response is to set price equal to cost is competition at its worst.¹ It highlights the need to avoid competing solely on prices. What can a company do in this situation to avoid price wars and zero profit?

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11.4 Strategies to Avoid the Price War Trap

Gaining a Cost Advantage

One effective strategy to steer clear of price wars in undifferentiated Bertrand competition is to establish a cost advantage. Consider firms with varying costs due to different technologies. The firm with the lowest marginal cost (Firm 1) and the next lowest (Firm 2) set the stage for market dynamics.

• Market Dynamics with Varied Costs: When the market price equates to the cost of the higher-cost firm, that firm can’t gain by reducing its price. However, the lower-cost firm (Firm 1) continues to have the incentive to undercut. This process drives the higher-cost firm out of the market, with the price cutting halting at the cost level of Firm 2.

• Position of the Lowest-Cost Firm: Firm 1, with the lowest cost, doesn’t become a monopolist but instead dominates the market share, constrained by the cost structure of its closest competitor (Firm 2). Its pricing power is limited, capping just below the cost of Firm 2.

Exploiting Capacity Constraints

Typically, in undifferentiated Bertrand oligopolies, it’s assumed that firms can satisfy total market demand at the lowest price. However, adding capacity constraints changes this assumption and the resultant market behavior. Firms can only sell as much as they can produce, even if they offer the lowest price, altering the usual trajectory of a price war and offering some protection against it.

Demonstrative Example: Capacity Constraints in Action

Setting the Market Scene

Imagine a scenario in a market where no single firm can satisfy more than 40% of the total demand at the equilibrium price. In such a setup, a minimum of three firms is necessary to fully meet market demand. Let’s consider three firms with the following variable costs:

• Firm 1’s variable unit cost: \(\mathsf{\quad c_1 = \$10}\)
• Firm 2’s variable unit cost: \(\mathsf{\quad c_2 = \$20}\)
• Firm 3’s variable unit cost: \(\mathsf{\quad c_3 = \$30}\)

Market Dynamics and Pricing

In this market structure, the pricing will stabilize at \(\mathsf{\$30}\), aligning with the highest variable unit cost among the firms. Here’s how the market share gets distributed: Firms 1 and 2, with their cost advantages, capture 40% of the market each and Firm 3, with the highest cost, caters to the remaining 20%.

• Firm 1’s market share: 40% of the market
• Firm 2’s market share: 40% of the market
• Firm 3’s market share: 20% of the market

When Firm 3 attempts to expand its market share beyond this 20%, Firms 1 and 2 have the leeway to reduce their prices below \(\mathsf{\$30}\). Their lower costs enable them to do so while maintaining profitability. As a result, Firm 3, operating at the brink of its cost, can only break even and finds itself unable to compete with the lowered prices.

Impact of a New Entrant

Now, introduce a twist in the market with the entry of Firm 4, which has a marginal cost of \(\mathsf{\$25}\). This new competitive dynamic would push the market price down to \(\mathsf{\$25,}\) effectively ousting Firm 3 from the market. Firms 1 and 2, despite experiencing a dip in their profits due to the new lower market price, remain profitable. Firm 4, with its cost aligning with the new market price, manages to break even and captures the market share previously held by Firm 3.

Strategic Implications

This example highlights how capacity constraints and varying cost structures among firms can significantly influence market pricing and distribution of market shares. It illustrates the strategic complexity in an undifferentiated Bertrand oligopoly and underscores the importance of cost management and capacity considerations in competitive positioning.

Mini-mills in the Steel Industry: A Case Study in Undifferentiated Bertrand Competition

The emergence of mini-mills in steel production offers a compelling illustration of the dynamics of an undifferentiated Bertrand oligopoly, particularly in the context of heterogeneous variable costs and capacity constraints.

Innovation and Cost Advantage

Mini-mills, an innovative approach to steel production, utilize scrap metal as their primary raw material, contrasting with the traditional integrated steel mills that begin with iron ore. The mini-mills’ process, which starts with already-refined metal, grants them a significant cost advantage over integrated mills. This advantage becomes pronounced in the production of lower-end steel products, such as rebar for construction.

Market Dynamics and Price Impact

As mini-mills proliferated, they systematically undercut the integrated mills in the rebar market, leveraging their lower costs. This competitive pressure gradually forced the integrated mills to retreat from this segment. Following their exit, rebar prices experienced a notable 20% decline, equal to the cost advantage of the mini-mills. This pattern—a period of stable prices disrupted by the entry of low-cost innovations and subsequent exit of higher-cost incumbents—consistently resulted in price collapses, aligning with the cost level of the most efficient mini-mills.²

The Commodity Nature of Steel and Market Evolution

Steel, being a commodity product, exhibits minimal differentiation within each category. Initially, the presence of low-cost mini-mills prompted a shift in market pricing to the level of the highest-cost integrated mills. The mini-mills, with their limited capacity, were able to fill their production to the brim, leaving the remainder of the market demand to the integrated mills.

However, as more mini-mills entered the market, attracted by the potential profits, they brought additional capacity. This increasing capacity from low-cost producers gradually diminished the market share of the higher-cost incumbents. Once the collective capacity of the mini-mills was sufficient to meet market demand, the integrated mills found themselves redundant and exited the market. Subsequently, the price plummeted to the level of the costliest mini-mill.

Conclusion: The Bertrand Trap for Mini-mills

The mini-mills initially enjoyed attractive profits when their capacity was insufficient to meet total market demand. Yet, as their capacity expanded and their costs converged, they found themselves in a classic undifferentiated Bertrand competition scenario. With similar cost structures, the mini-mills faced intense price competition, leading to the inevitable outcome of such markets: prices equalizing to marginal costs and the erosion of extraordinary profits.

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11.5 Quantitative Case: Drop-Shipping

Background

In the dynamic e-commerce landscape, drop-shipping has become a common business model. Companies partner with manufacturers, often in China, to sell products on platforms like Amazon or Shopify. The products are shipped directly from the manufacturer to the customer upon order. This model, while efficient, often leads to intense price competition, especially for undifferentiated products.

With different costs

Scenario

Imagine a drop-shipping market with four companies: QuickShip, SpeedyDelivery, FastDrop, and RapidSend. They all sell a similar, popular gadget but have different cost structures due to varying agreements with manufacturers.

• Market Demand: The daily market demand for the gadget is given by \(\mathsf{Q=1600−5P}\), where \(\mathsf{Q}\) is the quantity of gadgets and \(\mathsf{P}\) is the selling price.

• Cost Structures:

  Company	Fixed Cost (per day)	Variable Cost (per unit)
  QuickShip	\$2000	\$60
  SpeedyDelivery	\$2200	\$50
  FastDrop	\$2800	\$35
  RapidSend	\$3000	\$25

Competitive Dynamics

In this highly competitive market, companies will undercut each other’s prices. RapidSend, with the lowest variable cost of $25, can profitably offer the gadget at lower prices than competitors. To maximize profits, RapidSend will set a price just low enough to out-compete SpeedyDelivery, the next cheapest competitor.

• Optimal Pricing: RapidSend sets the price at $34, undercutting SpeedyDelivery. At this price, RapidSend becomes the sole supplier in the market.

• Demand and Profit Calculation:

  • At a price of $34, daily demand is \(\mathsf{Q = 1600 − 5 \cdot 34 = 1430}\) units.
  • RapidSend’s daily profit is \[\begin{align} \mathsf{\pi} &= \mathsf{(P − c) Q − f} \\ &= \mathsf{(34 − 25) \cdot 1430 − 3000} \\ &= \mathsf{\$9870}. \end{align}\]
  • QuickShip’s daily profit is $0 if they have not yet entered and can avoid their fixed costs and -$2000 if they have already entered.
  • SpeedyDelivery’s daily profit is $0 if they have not yet entered and -$2200 if they have.
  • FastDrop’s daily profit is $0 if they have not yet entered and and -$2800 if they have.

With capacity constraints and different costs

Scenario

Suppose each company can only handle a maximum of 390 orders per day. Their cost structures are unchanged from above.

Competitive Dynamics

With this capacity constraint, the market dynamics change.

• Market Structure: The market can accommodate up to four firms, with each firm having a maximum capacity of 390 units. Three firms will sell at their capacity of 390 with the fourth selling enough to cover the rest of demand at the equilibrium price.
• Equilibrium Price: The price will adjust to a level where four firms can operate profitably in the market – at the highest-cost firm’s variable unit cost ($60).

Conclusion

This case demonstrates the competitive nature of drop-shipping in an undifferentiated Bertrand market. The key takeaway is the importance of cost management and capacity constraints in determining market dynamics and profitability. Drop-shipping companies often must navigate intense price competition, where having a cost advantage is crucial for survival and profitability.

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11.6 Low Price Guarantees

So far, the methods for avoiding price competition have had more to do with variable cost and fixed cost (capacity) than with pricing. Low-price guarantees represent a pricing strategy aimed at avoiding constant price wars.

The Idea Behind Low-Price Guarantees

Low-price guarantees are promises made to customers that a firm will match or beat the prices of its competitors. While appearing as a customer-centric approach, these guarantees can actually serve as a strategic tool for the firms themselves.

Impact on Price Competition

In a typical Bertrand scenario, a small price cut by one firm can lead to it capturing the entire market. This triggers a race to the bottom, with firms continually undercutting each other. However, with a low-price guarantee in place, this dynamic changes:

• Deterrent to Undercutting: If a competitor lowers its price, the firm with the guarantee can simply match it, retaining its customers. The competing firm gains no additional market share but suffers a reduction in revenue, removing the incentive to undercut prices.³
• Maintaining Prices Above Cost: These guarantees can help maintain prices at a level above cost, benefiting the firms more than their customers.

Why Aren’t Low-Price Guarantees Universal?

Despite their theoretical effectiveness, low-price guarantees are not universally adopted. The reasons include:

• Limited Effectiveness in Differentiated Markets: Firms engaged in differentiated competition find these guarantees less effective and necessary.
• Customer Hassle Factor: The onus is often on the customer to claim the guarantee, which can be a hassle. Not all customers will go through the process, reducing the effectiveness of the guarantee.
• Branding Over Deterrence: Recent studies suggest that low-price guarantees are often used more for branding and advertising than as a genuine pricing strategy.

While low-price guarantees offer some respite from relentless price competition, they are not foolproof. A more sustainable approach for entrepreneurs is to identify a niche market with unmet needs and innovate to provide differentiated solutions. Catering to a heterogeneous group of customers with unique demands can be a more effective path to profitability than relying on pricing strategies alone in an undifferentiated market.

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11.7 Conclusion

Undifferentiated Bertrand competition reveals a harsh truth: when firms sell identical products, price wars are inevitable, and profits disappear. But this does not mean entrepreneurs are doomed. Instead, this chapter has shown several ways to compete strategically:

• Cost Advantages Matter – If your business has lower costs than competitors, you can outlast them in a price war and maintain a sustainable profit margin.
• Capacity Constraints Change the Game – When no single firm can meet total market demand, even higher-cost firms can survive, keeping prices above marginal cost.
• Industry Case Studies Prove the Pattern – From mini-mills in steel to drop-shipping in e-commerce, firms that don’t manage costs or differentiate eventually see their margins collapse.
• Low-Price Guarantees Can Prevent Destructive Price Wars – While not a perfect solution, these strategies can deter excessive undercutting and help maintain pricing discipline.

The key lesson for entrepreneurs is clear: competing on price alone is rarely a winning strategy. The next logical step for entrepreneurs is to find ways to differentiate—to create value beyond just offering the lowest price.

The next chapter explores differentiated Bertrand oligopoly, where branding, product features, and strategic positioning give firms pricing power and a path to sustainable profitability.

Christensen, Clayton M., and Michael E. Raynor. 2003. The Innovator’s Solution: Creating and Sustaining Successful Growth. Boston, Massachusetts: Harvard Business School Press.

Edlin, Aaron S. 1997. “Do Guaranteed-Low-Price Policies Guarantee High Prices, and Can Antitrust Rise to the Challenge?” Harvard Law Review, 528–75.

Hviid, Morten, and Greg Shaffer. 1999. “Hassle Costs: The Achilles’ Heel of Price-Matching Guarantees.” Journal of Economics & Management Strategy 8 (4): 489–521.

Mañez, Juan A. 2006. “Unbeatable Value Low-Price Guarantee: Collusive Mechanism or Advertising Strategy?” Journal of Economics & Management Strategy 15 (1): 143–66.

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1. There are cases where it is rational to set price below cost which are nightmarish pricing scenarios of economic and accounting losses. We will not cover those cases here.

2. Christensen and Raynor (2003) point out what appears to be a puzzle that when high cost competitors (integrated steel mills) are driven out of an industry by innovative lower-cost competitors, the price collapses. This puzzle is easily explained by the competitive dynamics of undifferentiated Bertrand competition.

3. For more detail on how low-price guarantees work as well as their limitations, see Edlin (1997), Hviid and Shaffer (1999), and Mañez (2006).