An alternating-move price-setting duopoly model with stochastic costs

This paper examines an alternating-move price-setting duopoly model, in which marginal costs are stochastic without persistence. It is shown that provided marginal costs do not fluctuate excessively, equilibria in which firms match the current monopoly price do not exist. By contrast, equilibria in which firms always match their rival along the equilibrium path do exist. In these equilibria, deviations off of the equilibrium path result in extended price wars, in which firms repeatedly undercut each other. Finally, examples in which such price wars are observed in equilibrium are constructed. (C) 2004 Elsevier B.V. All rights reserved.