Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacity Constraints
Franz Hubert

Capacities

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Motivation

Bertrand price competition:

1

Prices are set.

For given prices quantities are supplied until the demand is

satisfied.

Two (related) objections:

1

Often it is easier to change prices than to change quantities.

Usually a single firm cannot serve the whole market at short

notice (capacity constraints).

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Effect of Capacity Constraints

Intuition:
With capacity constraints the incentive to undercut the rival is
weakened.
Suppose he undercuts, but can serve only half of the customers,
then I am still a monopolist for the residual demand.
Do we observe this often?

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Alternative Approach

Prices are fast, capacity is slow.

Dynamic game:
1 Capacities are set.
2 Given capacities, prices are set.
3 Demand is served, subject to capacity constraints.
Previous decisions cannot be changed (commitment).
Agents rationally anticipate the future.
Solution concept: subgame perfect Nash-equilibrium.

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Think forward, solve backward

We find the subgame perfect equilibrium by backward induction.

3 How is the demand served for all possible prices and
capacities.
2 Nashequilibrium in prices for any given pair of capacities:
pA (kA , kB ), pB (kA , kB ).
, k ) given that price
1 Nashequilibrium in capacities (kA
B
competition is correctly anticipated.

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Two Strategic Decisions

We have to understand two types of strategic decisions:

Choosing prices when capacity is constrained (anticipating how
demand is rationed)
Choosing capacities in anticipation of price competition.

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Capacity Constraints
For simplicity: zero marginal cost of quantity up to the capacity
limit, which is strictly binding. Installing capacity is costly.
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Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Rationing of Demand

Suppose pA < pB but D(pA ) > kA .

random or proportional rationing:
Faced with excess demand buyers are selected at random.
parallel or efficient rationing:
Buyers with the largest willingness to pay are served first.
What does this imply for the residual demand of high price firm B?

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Random rationing
Residual demand for high price firm:


kA
D(pB )
R
D (pB ) = D(pB ) 1
= D(pB ) kA
.
D(pA )
D(pA )
p
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D(p)

DR (pB )

pA

kA

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Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Efficient rationing
Residual demand for high price firm:
DR (pB ) = D(pB ) kA , or P (kB + kA )
p
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D(p)

DR (pB )

kA

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Capacities

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Residual demand is independent of pA .

Rationing is efficient: there is no mutually beneficial trade possible
between those who obtained the good cheap and those who where
rationed out.
Residual demand with efficient rationing is lower than under
random rationing. Hence, efficient rationing is worse for the high
price rival.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Analogy to Monopoly

In a sense both firms resemble a monopolist:

low price firm faces D(p),
high price firm faces DR (p)
When I know which firm is cheaper, it does not matter whether I
consider price or quantity as instrument.
Define accommodating (market clearing) price p0 :
D(p0 ) = kA + kB ,

or p0 = P (kA + kB )

If both firms charge p0 then available capacities will be fully used.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Capacity Constrained Price Competition

We have to find the Nashequilibrium in prices for all possible

(kA , kB ) [0, D(0)]2 .
We do so in several steps.
First we divide the parameter space into different regions, to
distinguish cases, in which capacities are small, intermediate, and
large.

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Dividing the Parameter Space

Let QA (qb ) be firm As best reply in quantities (ignoring capacity

constraints):
QA = argmaxqA P (qA + qB )qA ,
(and likewise QB ).
small: Both firms would like to increase their quantities (reduce
the prices).
intermediate: If one firm sells all its capacity, the rival uses only
part of its own capacity.
large: If one firm sells all its capacity, the rival will not sell
anything.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

kA ,. qA

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Capacities

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huge
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QB

intermediate

small

QA

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kB , qB

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Small capacities

Small capacities: K s = {kA , kB : kA QA (kB ), kB QB (kA )}

Result 1: For small capacities, a Nash equilibrium in pure
strategies exist, in which both firms charge the market clearing
price p0 .
Proof:
Undercutting p0 does not pay because additional demand could
not be served.
Overbidding p0 does not pay by definition of small capacity.
Note: Firms set prices as an auctioneer would do.

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Small capacities
kA ,. qA
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QB

kA

QA

kB

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kB , qB

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Large capacities

Result 2: If both firms can serve the market at zero price, then we
obtain the Bertrand result pA = pB = 0.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Intermediate capacities
Result 3: There exists no equilibrium in pure strategies
(Edgeworth 1897)
Intuition: for small prices, there is excess demand and one firm
would deviate by charging the monopolist price for the residual
demand (becoming thereby the high price firm). If prices are
unequal, the low price firm (selling up to capacity) increases its
price just below the high price. But then the high price firm can
gain by undercutting the low price firm, and prices will fall again
(Edgeworth cycle).
Result 4: There exists an equilibrium in mixed strategies. (Kreps
& Scheinkmann 1983)
Result 5: In the mixed strategy equilibrium the profit of the larger
firm is smaller than in the unconstrained Cournotequilibrium.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Selection of capacities

How will the firms select their capacities if they anticipate this kind
of price competition?
Installing capacity is expensive!
Suppose my rival installs a small capacity. Within the range of
small capacities my optimal response function would be of the
Cournot form.
Since installing capacity is costly, the reaction functions of the two
firms shift inwards.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Cournot solution
k.A
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QB

kB (kA )

kAc

kA (kB )

QA

c
kB

........................

kB

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Cournot solution

It does not pay to deviate to large capacities because this

decreases profit for the deviating firm (Results 4 and 5).
Therefore:
Result 6: In equilibrium both firms will choose Cournot capacities.

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Cournot solution
k.A
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B < c

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D

........................

kB

Discussion

Motivation

Rationing of Demand

Capacity Constrained Price Competition

Capacities

Discussion

Discussion

Competition in capacities followed by price-competition yields

Cournot result.
This explains, why we rarely see high and low prices (for the same
good!) and quantity rationing. Firms will not choose the capacities
which lead to this outcome.
This is true only for efficient rationing of demand. Other forms of
rationing leave more residual demand to the high-price firm and
create incentives to raise the price at the Cournot Solution.