Welcome to the world of Bertrand competition on steroids

Joseph Louis François Bertrand (1822 - 1900)

His theory is a simple but profound one: when firms produce almost identical products they will compete by reducing their prices until they reach the marginal cost of production (the cost of making each unit of the good). Think of two bike shops vying for customers, both of which chip away at their prices tit-for-tat until they hit the cost of making each bicycle.

To this day, however, Bertrand’s theory has remained exactly that – a conceptual model that economists tinkered away with but the wider world duly ignored. The reason? Because it rested on a number of assumptions that have been implausible ever since he formulated the model in the 1880s. Namely that customers have all the information to hand about the prices and quality of products, and that they are within distance of all the businesses selling the item in question.

Yet things are finally beginning to change in Bertrand’s favour. The advent of the internet and related technologies such as search engines have greatly diminished the problem of asymmetrical information. The impact of comparison websites, for example, has allowed customers to find out the costs and quality of everything from energy to insurance to flights within just a few minutes. More recently, we have seen the emergence of apps such as Uber, which offers people a menu of cab drivers, their rating and their prices in just a few seconds.

Indeed, the proliferation of smart phones has been crucial in opening up information to once ill-informed customers. Returning to the example of bike shops, where once we were reliant on mechanics to tell us about the quality of each bike model, as well as its age and origin, now it is feasible to find this information ourselves right at the point of sale. The effect has been to shift power from the producer to the consumer, or in the words of Dan Pink, to move us from an era of ‘caveat emptor’ (buyer beware) to ‘caveat venditor’ (seller beware).

But what about the other problem of distance? One of the reasons why Bertrand’s model of price competition hasn’t been feasible is the simple matter of physics. Up until a decade or so ago our choice as consumers was essentially limited to what was on offer in the places in which we lived. Even if we knew that the price of a book, or a jumper, or a bicycle was cheaper elsewhere, we had to be there to buy it. Think of being in foreign book shop and being charged an extortionate amount for an English novel. The seller knows that they’re the only bookshop with these titles in town, and charges a premium for the exclusivity.

Of course, the birth of Amazon and other ecommerce marketplaces has had a significant impact in diminishing the tyranny of distance. Order pretty much anything you want, at any time of day and night, and you can expect to have it drop through the letterbox in the space of just a few days (Royal Mail allowing). Yet this is nothing compared to the potential impact that might be had by new developments in digitisation. Music, books and films are all now widely accessible from different providers at the press of a button, and education is heading that way too. Indeed anything that can be turned into digital 0s and 1s will be, including potentially physical goods if 3D printing ever takes off.

So the era of hyper Bertrand competition is upon us, but what are the implications for business? According to Bertrand, the intensity of pure competition will send prices into such a free-fall that it becomes difficult for firms to sustain a profit. Needless to say, not all businesses will be affected. But if you run a company reliant solely on asymmetries of information or distance to keep your prices high, don’t be surprised if things become more difficult in the years ahead.

The music and publishing industries, as well as major retailers like Comet and HMV, are just the tip of the iceberg of potential casualties. Some even expect educational institutions to face a similar fate, given that many courses can easily be made available online (thus diminishing the problem of distance). Taxi drivers, who few thought would be subject to the same forces, are now looking down the proverbial barrel as new apps inject a heavy dosage of Bertrand competition into the industry.

The truth is that the only way for firms to succeed in affected markets is to find a new way to differentiate themselves from the competition – in other words, to compete on something other than price. Quality is the obvious way to set yourself apart, but in many sectors there is little scope for qualitative improvements (at least without major jumps in innovation). Instead, my sense is that the next competitive battles will be fought around experience, with firms vying to win over customers by making them ‘feel something’, in the words of business guru Nicholas Lovell.

In my next blog post I’ll unpack what I think this will mean for the future of business, work and education.