Product differentiation and populistic entry strategies in a mortgage market with Bertrand competition

Abstract

PurposeThe purpose of this paper is to analyse the interaction between a profit maximising mortgagor and a newcomer to a mortgage market with Bertrand competition where the newcomer has a populistic entry strategy and undercuts mortgage market rates. The intention of the paper is to relate the populistic entry strategy to mortgage market characteristics and the strategic market position of both the established mortgagor and the newcomer in question.Design/methodology/approachThe paper analyses a mortgage market by combining the behaviour of a profit maximising mortgagor with that of a newcomer to the mortgage market which has a populistic entry strategy and does not maximise profits. The short-run market solution provides comparative statics on the strategic market position of both the established mortgagor and the newcomer to the mortgage market during the entry phase both related to product differentiation and to price mirroring and undercutting of mortgage rates.FindingsThe model finds a mortgage market solution where a lower mortgage rate helps the newcomer gain a customer base. As the newcomer's strategy to mirror prices makes it unable to pass-through funding cost to its mortgage rate, the strategy is unsustainable over time. The established mortgagor has a strategically beneficial position as the mortgage market rates only relate to its funding cost. Unless the newcomer has a funding cost advantage, the established mortgagor has a higher interest rate margin. Differentiation impacts the newcomers’ interest rate margin positively. If the newcomer lacks a funding cost advantage, there is a critical mirroring rate that ensures it a higher interest rate margin. The higher the newcomers’ own funding cost, the higher is the upper bound for price mirroring, relating market entry to a small undercutting of mortgage rates and a mortgage market with weak competition. The funding cost of the established mortgagor pulls pricing in the opposite direction, allowing for a lower mirroring rate and tougher mortgage market competition during entry.Originality/valueThe paper aims to contribute to the understanding of market equilibrium in the absence of profit maximising behaviour. Framing a mortgage market in terms of a duopoly where a newcomer enters with a populistic entry strategy offering a lower mortgage rate and a mortgage product with a different loan-to-value (LTV) ratio, a novel mortgage market case comes about. The populistic entry strategy produces an augmented reaction curve, crucial for the mortgage market rates.