Self-enforcing price leadership

Abstract

A dynamic Bertrand-duopoly model where price leadership emerges in equilibrium is developed. In the price leadership equilibrium, a firm leads price changes and its competitor always matches in the next period. The firms produce a homogeneous product and are identical except for the information they possess about demand. The market size follows a two-state Markov process. Market size realizations are observed by one of the firms but not the other. Without explicit communication, price leadership allows firms to jointly approximate monopolistic profits in equilibrium as the market size becomes more persistent provided that firms are patient. In the presence of persistent market dynamics, the informed firm’s price serves as a signal of current and therefore future market conditions. In the proposed price leadership equilibrium, the informed firm could cut prices without being detected, but it does not do so because it would lead the uninformed to also lower their price in the following period.