Question

Many home improvement retalers like Home Depot and Lowes have low-price guarantee policies. At a minimum, these guarantees promise to match a rival's price, and some promise to beat the lowest advertised price by a given percentage. Do these types of pricing strategles result in cutthroat Bertrand competition and zero economic profits? If not, why not? If so, suggest an alternative pricing strategy that will permit these firms to earn positive economic profits.

Answer 1

Yes, such price matching strategies lead to intense competition (assuming there is no collusion) yielding a Nash equilibrium where both the firms end up selling their goods at a price equal to their marginal cost. This happens as follows:

Suppose both firms A and B have the same marginal cost c. Suppose firm A charges price P ( P >c). Now firm B, in an attempt to get all the market, charges a price below P (but higher than c). Call this P'. Next, firm A, because of its price-matching strategy either matches this price P' or charges something even below P' (but higher than c, again). Call it P''. Next, it is firm B's chance to move and this time it goes even further below P'' (but higher than c). This cycle goes on until both the firms have hit the bottom of their pricing spectrum, which is their marginal cost c. Surely, no firm will go below its marginal cost in an attempt to gain the market since that yields negative profits. Therefore, the equilibrium price is the marginal cost, and both the firms make zero economic profits.

However, the alternative to this "beggar-thy-neighbour" strategy is to collude with your rival and maintain a mutually agreed upon price level, with the condition that neither player undercut the other. This strategy makes the consumer worse off because she is left at the mercy of the colluding parties who can set any price (possible much higher than the marginal cost c).