On Competing Sellers with Substitutable Goods

Abstract

We study mechanism design by an incumbent seller facing competition from an entrant seller of a substitute good. The incumbent commits to a potentially randomized mechanism before her competitor responds. A unit-demand buyer with fixed, publicly known values for the two goods observes both mechanisms and may interact with them in either order. How should a revenue-maximizing incumbent design her mechanism when her product is superior or inferior to her competitor's? We determine the incumbent's exact optimal revenue and characterize all mechanisms that obtain it. Commitment and randomization allow her to earn strictly positive revenue even against an arbitrarily superior product, despite earning nothing under posted-price (i.e., Bertrand) competition. Optimal mechanisms can require a continuum of lottery options, even though the buyer selects only one in equilibrium: unselected options shape the competitor's incentives rather than screen private buyer information. We also show that the buyer's ability to choose the interaction order can be strictly beneficial to the incumbent, even though the incumbent is always visited first at equilibrium. Finally, we show that without commitment, every pure Nash equilibrium yields Bertrand revenues even with randomized mechanisms.