ASSIGNMENT 3

Individual assignment
 

1. This question is based on the Guest Lecture Explain how the Bertrand Paradox can be

applied to the case

There are some specific assumptions in which Osiris and its rival online websites such as

Lazada and Nha Thuoc Suc Khoe offer the homogenous product (cosmetics); all select the

price simultaneously and consumers want to buy products with a lower price.

The classical Bertrand model prescribes that in equilibrium prices are equal to marginal costs

(MC) and prices do not depend on the number of competitors. However, Bertrand Paradox

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can be applied in which OSIRIS’s prices do depend on the number of competitors when

Osiris sets the price of popular brands such as 3CE and Innisfree nearly equal to the

competitive price of Lazada and Nha Thuoc Suc Khoe to gain market share by achieving

Nash equilibrium

It can be explained as if Osiris decides to charge a higher price above its unit cost (the

competitive price), resulting in Osiris will fail to gain the market share because customers

will purchase from the firm that offers the competitive price. If all companies set the price

higher than MC, each firm has an incentive to remove competitors from the market by setting

a lower price than the competitor to capture the entire market until the price is equal to MC,

and obviously no firms want to charge a price lower than MC because it means losing

money. Hence the only equilibrium in which Osiris can share the market equally with

existing firms occurs when they set the price equal to unit cost (the competitive price) even

though it may earn no profit.

As the speaker presented, because the polular brands like 3CE and Innisfree account for a

small percentage (12% -18%) of the total profit, so in this case Bertrand Paradox can be

applied without taking too much risks.

2. Analyse a real example of quantity competition or price competition in a specific

industry. Include the matter of collusion and punishment in the analysis. Support your

answer with figures and statistics where appropriate. (15 marks)

The initial observation of real time fare price

The figure A and B compares one-way fares (non-stop) from Chicago to New York departing

January 27, 2020 by some of the US domestic airlines. It can be seen that American Airline,

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Delta and Southwest airline charge for minimum price as 89$, while low-cost airline Spirit

has a lower fare of 62$, but it does not allow to carry luggage (Google Flight, 2020). It can

be seen that in general, the price of fare is quite competitive among most popular airline

firms in the United Stated.

Figure A. Reproduced from Google Flight, 2020

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 Figure B. Reproduced from SouthWest, 2020

The potential opportunity in airline industry

The increasing demand for faster transportation as well as travelling is creating a huge source

of revenue for the aviation industry. As figure C shows, the number of air travellers has

increased from 0.3 billion to over 4.2 billion between 1970 and 2018. It accounts for more

than half the world's population last estimated at 7.7 billion (Skyrefund, 2019)

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 Figure C. Reproduced from Skyrefund, 2019

Price-based, not quality based.

Today air travel is no longer seen as commoditized and brand loyalty among customers.

Therefore, competition is price-based, not quality based (Teneva M 2019). A past decade

witnessed the increase in low-cost carriers such as Southwest, Jetblue or Spirit and it puts

traditional airlines into long faced competition (see Figure D)

Figure D. Reproduced from Upgraded Points, 2018

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 Figure E. Reproduced from Skyrefund, 2019

As figure E shows, 4 airline firms account for more than 50% of total market share which

result in airline industry representing oligopoly market. Since the price of fare is quite

competitive among most popular airline firms in the United Stated, it reveals the exist of

Bertrand paradox

Failure in price competition

In 2011, American Airline filed for bankruptcy before they came back with succeed. This is

an inevitable result because since 2001, the company lost nearly $ 500 million annually and

was the only US airline operating unprofitable in 2010. Until the time of bankruptcy,

American Airlines had to pay nearly 30 billion USD in debt, while its assets were less than

25 billion USD (Reuters 2011). The reason for American Airlines' bankruptcy is that it has

failed to cut costs by still hire expensive workers and maintain fuel-efficient aircraft systems

as well as the rising of low-cost carriers (LCCs) such as Southwest Airlines. The figure G

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 shows how profitable the low-cost carrier like Southwest Airline is compared to other big

airline firms

Figure G: Profit margin of 4 airline firms in the US, reproduced from YCHARTS, 2018

Collusion in airline industry

The year of 2018 witnessed the fare collusion lawsuit against the four largest major US airlines,

which are American Airlines, Southwest Airlines, United and Delta Airlines. The lawsuit alleges

that these 4 firms have colluded together to limit plane capacity artificially and drive up domestic

airfares since 2009 (Business Insider 2018). As the result, Southwest Airlines Co agree to pay

$15 million and American Airlines Group Inc $45 million for the settlement to end this lawsuit,

while the other two firms maintain they have done nothing wrong (Genter JT 2018)

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 3. (i) Find the Nash equilibria for this game, assuming that both firms make their decisions

at the same time. (5 marks)

Lavie’s best responses

● If Aquafina chooses low price, Lavie’s best-response is low price.

● If Aquafina chooses high price, Lavie’s best-response is high price.

Aquafina’s best responses

● If Lavie chooses low price, Aquafina’s best-response is low price.

● If Lavie chooses high price, Aquafina’s best-response is low price

The pure-strategy Nash equilibrium is for each firm to choose a low price, as this is the mutual

best response. Choosing a low price is the optimal decision for both firms, given the decision by

the other firm.

(ii) What will be the equilibrium if Lavie makes its selection first? If Aquafina goes first,

will the equilibrium change? (5 marks)

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See the game tree in Figure 1. In the figure Lavie chooses first, and Aquafina’s second.

Figure 1: Sequential Moves Game (Lavie first)

Lavie earns highest profit if it chooses high price and Aquafina chooses high price. But at that

price, Aquafina’s best response is low price and Lavie will earn only 30 profits (measured in

millions of VND). If Lavie charges low price, Aquafina will charge low price too to gain the

maximum profits and at the same time Lavie achieves their best performance. Therefore, Lavie

will gain 40, Aquafina will gain 60, and both players will receive their best outcome by taking

low price strategy

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Aquafina will earn highest profits of 60 if it chooses low price and Lavie chooses low price.

Lavie’s profits are higher if they charge low price instead of high price.

Therefore, if Aquafina goes first, the equilibrium will not change.

(iii) Follow part (ii), suppose the firm managers meet to coordinate pricing strategies and Lavie

promises to charge a low price. Is this promise credible? What would be the likely

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 outcome? (5 marks)

If Lavie goes first, suppose that Lavie breaks their promise by charge a high price to earn the

highest profit of 60, there is no way that Aquafina will set the high price in response because it

only gains the lower profits for them. Once Aquafina set the low price in response, Lavie gains

lower profits of 30.

On the contrary, if Lavie follows the contract and sets the low price, they have the opportunity to

meet their predictable outcome of 40 when Aquafina also want to gain their maximum profit of

60 by taking low price as well. Therefore, Lavie’s promise is considered to be credible.

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If Aquafina goes first, low price is their best option to achieve the best performance of 60, and

Lavie will not break their contract by setting high price because Lavie’s profits are higher if they

choose low price than high price. Therefore, in this case Lavie’s promise is considered to be

credible as well

Reference Lists

Teneva M 2019, ‘Price Wars: Airline Industry Pains and Gains’, Skyrefund, viewed 02 January

2020, <https://skyrefund.com/en/blog/airline-industry-price-wars>

Rodriguez C, ‘Which U.S. Airlines Dominate Market Share in North America?’,

UpgradedPoints 2019, viewed 02 January 2020, <https://upgradedpoints.com/us-airlines-

marketshare-north-america/>

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Reuters 2011, ‘American Airlines files for bankruptcy’, viewed 02 January 2020,

<https://www.reuters.com/article/us-americanairlines-idUSTRE7AS0T220111130>

Business Insider 2018, ‘American Airlines Agrees To Pay $45 Mln To Settle Fare Collusion

Suit’, Markets Insider, viewed 03 January 2020,

<https://markets.businessinsider.com/news/stocks/american-airlines-agrees-to-pay-45-mln-to-

settle-fare-collusion-suit-1027161533>

Genter JT 2018, ‘American Airlines Settles Fare Collusion Lawsuit for $45 Million’,

ThePointsGuy, viewed 04 January 2020, <https://thepointsguy.com/news/aa-fare-collusion-

lawsuit-45-million-settlement/>

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