FIRST MOVER ADVANTAGE IN SEQUENTIAL BERTRAND MARKETS: AN EXPERIMENTAL APPROACH A THESIS Presented to The Faculty of the Department of Economics and Business The Colorado College In Partial Fulfillment of the Requirements for the Degree Bachelor of Arts By Perry Fitz April 2017 FIRST MOVER ADVANTAGE IN SEQUENTIAL BERTRAND MARKETS: AN EXPERIMENTAL APPROACH Perry Fitz April 2017 Mathematical Economics Abstract Literature and applied experimental evidence has established the consensus that firms competing with price competition in sequential markets have a second mover advantage. A high proportion of literature assumes firms have symmetric costs, while in real markets firms tend to have asymmetrical costs. In this paper, I use current literature to define various profit assumptions that yields a theoretical first mover advantage for a low-cost firm in a differentiated-product Bertrand-duopoly. I report on the findings of an experimental 30 round sequential game, where firms have varying levels of cost. The results show that a low-cost firm will not necessarily always have a first mover advantage against a high-cost competitor. KEYWORDS: Experimental Economics, Stackelberg, Bertrand, Asymmetric Firms JEL CODES: C71, C02, C70 ii Acknowledgements I would like to thank my mentor, Rich Fullerton, for the amount of dedication and unconditional support he put throughout my thesis. Without his help from the beginning, I would be lost. Thank you to Kevin Rask and Kathryn Bryant for continuous support and input. iii ON MY HONOR, I HAVE NEITHER GIVEN NOR RECEIVED UNAUTHORIZED AID ON THIS THESIS Signature iv TABLE OF CONTENTS ABSTRACT ii ACKNOWLEDGEMENTS iii 1. INTRODUCTION............................................................................................. 1 2. MODEL............................................................................................................. 6 3. METHOLOGY ................................................................................................. 8 4. THEORITCAL BACKGROUND AND EQUILIBRIA................................... 10 5. HYPOTHESES.................................................................................................. 15 6. EXPERIMENTAL RESULTS.......................................................................... 15 TABLE I …………………………….………………..... 16 TABLE III ……………………………………………….. 17 FIGURE 3 ………………………………………………….. 23 7. DISCUSSION.................................................................................................... 25 8. CONCLUSION.................................................................................................. 26 FIGURE 2......................................................................................................... 28 FIGURE 3......................................................................................................... 29 APPENDIX ...................................................................................................... 30 9. REFERENCES.................................................................................................. 31 v 1. Introduction From 2000 to 2016 the number of listed domestic companies in the United States decreased by 37% according to the World Bank’s Federation of Exchanges database. In the same time frame, research and development expenditure towards technology has increased by 9%1. As technology continues to grow in the United States, more firms are attempting to collect complete information of markets to stay ahead of their competition. Firms can compete against one another in a multitude of strategies; the most basic and popular being quantity or price competition. But having access to a growing amount of market information has added a third complexity: timing. Firms have the ability to use timing as an additional strategy with price or quantity. Firms can decide to compete with competitors simultaneously or sequentially. In sequential markets, companies select to be a leader or a follower, where both literature and experimental markets have supported the advantage of being a first-mover when using quantity competition. However, in price competition a consensus in literature has been gathered that the follower is at an advantage when symmetric firms compete against one another. Even so, real world markets rarely contain symmetric competitors in terms of cost. The main purpose of this paper is to apply experimental evidence to Amir and Stepanova’s theory (2006) that a firm with a sufficient cost lead over its rival has a first 1 According to the World Bank’s Research and Development Expenditure (% of GDP) database. vi mover advantage in a differentiated-product Bertrand-duopoly with general demand and asymmetric linear costs. Asymmetric costs are more relevant in studying real world markets because it is unlikely that two competing firms will have identical cost functions for imperfect substitutes. Asymmetric costs are common in markets of large and small producers, where larger firms can achieve economies of scale (for example Barnes & Noble vs. an independent local bookstore) (Ledvina and Sircar, 2011). The experimental market in this study will be a two-firm duopoly with differentiated products. Differentiated products are goods that are not perfect substitutes, allowing each firm to receive demand regardless of setting the lowest price. For more complex study, the experiment will have three “players”: high-cost, medium-cost, and low-cost participants. Each participant will be randomly matched in the experiment to allow analysis of decision making based on the relative amount of cost a firm has. Finally, to see if a firm with a large cost advantage (Low-cost vs High-cost) has the same advantage as a firm with a modest cost advantage (Medium-cost vs High-cost). By replicating the assumptions used by Amir and Stepanova (2006), this paper focuses on Bertrand Stackelberg competition, which allows for a comparison to relevant literature on profit maximizing and first and second mover advantages. More importantly, this study will analyze the behavior of participants to understand if the Nash equilibrium and first mover advantage for the lower cost firm can be replicated. 1.1 Background Cournot (1929) and Bertrand (1883) competition are among the most frequently applied theories used to describe industry interaction. Firms using the Cournot model will compete with product output, while firms using the Bertrand model will compete on 2 prices. Cournot competition will result in the competitive price from market equilibrium, while Bertrand competition drives price to equal the marginal cost2. In a duopolistic market with homogenous goods and equal marginal costs, Bertrand competition is more efficient than Cournot competition when demand is linearly structured3 (Singh & Vives, 1984). However, firms need to determine the timing of their decision for quantity or price. Competing firms in any market will set their prices or quantities either simultaneously or sequentially. In a sequential duopolistic market, firms will act as either a leader or follower. The timing of the decision to be a leader or follower has a significant impact on the market outcome. Von Stackelberg (1934) argued that players in a market have a preference to which role (leader, follower) they hold4. Both theory and applied experimental evidence5 in quantity competition of homogenous duopolistic markets support that Stackelberg markets yield higher output, consumer rents, and higher welfare levels than Cournot markets6. Higher levels of output and welfare levels in Stackelberg markets substantiate that sequential moves are more efficient than simultaneous timing in quantity competition7. Theoretically, in quantity competition, the first mover in a homogenous duopolistic market has an advantage compared to the second mover as supported by Huck, etc. (2001). Price competition, however, varies to quantity 2 This will be true if the assumptions are set in a duopolistic situation with homogenous goods and equal marginal costs. 3 Regardless if goods are substitutes or complements. 4 In a duopoly both firms prefer the same role meaning that a stable equilibrium will not exist. When firms in a duopoly compete in quantity competition, the position of leader is most preferred, while in price competition the follower position is more advantageous as presented by Damme and Hurkens (2004). 5 See Huck, etc. (2001) and Kübler and Müller (2001). 6 Huck, etc. (2001) use experimental evidence to compare Stackelberg and Cournot duopolistic markets by focusing on homogenous products. Their results for Stackelberg markets show higher yields in output, higher consumer rents, and higher welfare levels than Cournot markets (Huck, 750). 7 This paper focuses on sequential timing because of the higher efficiency of sequential moves in markets. 3 competition as the advantage in Stackelberg markets is held by the follower8. For example, in a homogenous duopolistic market where symmetric firms are competing in prices using sequential timing, the follower has the advantage because using perfect information to undercut the leader’s price leads to the follower receiving higher demand. However, does this hold true when goods are heterogeneous? Kübler and Miller (2001) find when firms are symmetric competing in prices of heterogeneous duopolistic markets there is a significant first-mover disadvantage. Their experiment looks to study the difference between sequential and simultaneous movements. Our paper, however, will focus only on sequential movements