Revisiting Bertrand Competition in the Face of Customer Heterogeneity and Price Discrimination

Abstract

This paper compares uniform vs. discriminative pricing strategies in a competitive setting featuring capacity restrictions, quality differentiation, and customer heterogeneity. It tackles this overarching question through operational lenses, by studying the joint impact of price discrimination and the allocation of limited inventory across customer segments. Thanks to advances in information technology, firms have developed new capabilities in terms of customer segmentation (by clustering customers into different segments) and price discrimination (by offering different prices to different customer segments). Price discrimination, although seemingly beneficial, can hurt firms in competitive environments. It is thus critical for firms to understand when to engage in price discrimination, and how to support discriminative pricing practices with appropriate inventory management strategies. We develop a Bertrand competition game featuring capacity restrictions, quality differentiation, and customer heterogeneity. We characterize (pure- or mixed-strategy) Nash equilibria for a single-stage game reflecting uniform pricing and for a two-stage inventory-price game reflecting discriminative pricing. We identify three sources of market friction in price competition, enabling firms to earn higher profits: capacity limitations, quality differentiation, and customer heterogeneity. Price discrimination eliminates the market frictions from customer heterogeneity, but strategic inventory allocation restores (or strengthens) the market frictions from capacity limitations. Ultimately, price discrimination is only beneficial when combined with optimal inventory allocation, thus underscoring the critical role of inventory allocation in the design of competitive pricing strategies.