chapter fourteen strategy. © 2007 pearson addison-wesley. all rights reserved.14–2 strategic...

Chapter Fourteen

Strategy

© 2007 Pearson Addison-Wesley. All rights reserved. 14–2

Strategic Behavior

• A set of actions a firm takes to increase its profit, taking into account the possible actions of other firms


Strategy• In this chapter, we examine two main

topics– Preventing entry: simultaneous decisions:

When firms make entry decisions simultaneously, firms cannot act strategically to prevent rivals from entering the market.

– Preventing entry: sequential decisions: If an incumbent firm can commit to producing large quantities before another firm decides whether to enter the market, the incumbent may deter entry.


Preventing Entry: Simultaneous Decisions

• When new firms enter an oligopolistic market, the profits of existing firms fall. • Using a market that has either one or two firms, we can examine when and how firms behave strategically to prevent entry.

.


Table 14.1 Simultaneous Entry Game


Room for Two Firms

• Entering the market is a dominant strategy for both firms.

• If Firm 2 does not enter, Firm 1 makes $3 by entering and $0 if it does not enter, so entering is Firm 1’s best strategy.

• If Firm 2 enters, Firm 1 makes $1 by entering and $0 if it does not enter, so entering is Firm 1’s best strategy.


Room for Two Firms

• Because Firm 1 wants to enter regardless of what Firm 2 does, Firm 1 enters. Using the same reasoning, Firm 2 also enters because that’s a dominant strategy.

• The strategies by which both firms enter constitute a Nash equilibrium.


Room for Only One Firm

• The firms’ strategies change where there is enough demand for only one firm to operate profitably.

• Pure Strategies. This game has two Nash equilibria in pure strategies: Firm 1 enters and Firm 2 does not, or Firm 2 enters and Firm 1 does not.

• How do the players know which (if any) Nash equilibrium will result? They don’t. It is difficult to see how the firms choose strategies unless they collude.



• Mixed Strategies. These pure Nash equilibria are unappealing because they call for identical firms to use different strategies. The firms may use the same strategies if their strategies are mixed. When both firms enter with a probability of one-half—say , if a flipped coin comes up heads—there is a Nash equilibrium in mixed strategies.



• One important reason for introducing the concept of a mixed strategy is that some games have no pure-strategy Nash equilibria.

• In this game with no dominant strategies, neither firm has a strong reason to believe that the other will choose a pure strategy. It may think about its rival’s behavior as random.


Summary of the Simultaneous-Decision Entry Game

• In conclusion, if firms make simultaneous entry decisions, their actions depend on the size of the market.

• If the market is large enough for both firms to make a profit, both firms enter.

• If the market can support only one firm, there are many possible Nash equilibria, and it is difficult to predict the outcome.


Preventing Entry: Sequential Decisions

• Additional strategic considerations arise if firms act sequentially.

• Suppose that an incumbent monopoly firm knows that a potential entrant is considering entering. These firms make sequential decisions about what actions to take.


Preventing Entry: Sequential Decisions

Whether the incumbent acts to prevent entry depends on the answers to three questions:

Does it pay for an incumbent to act to prevent entry?

When can an incumbent prevent entry? What strategic acts and threats of future

actions can an incumbent use to prevent entry?


To Act or Not to Act

• Whether the incumbent acts to prevent entry depends on whether it can take actions that will prevent entry and whether it pays to take those actions.



Blockaded entry: Market conditions are such that no additional firm can profitably enter the market, even if the incumbent produces the monopoly output—so it is unnecessary for the incumbent to act strategically to prevent entry.

Deterred entry: The incumbent acts to prevent an additional firm from entering because it pays to do so.



Accommodated entry: Because it doesn’t pay for the incumbent to prevent entry through strategic action, it does nothing to prevent entry but reduces its output (or price) from the monopoly to duopoly level to maximize its post-entry profit.


Figure 14.1 Whether an Incumbent Pays to Prevent Entry

• If the potential entrant stays out of the market, it makes no profit, , and the incumbent firm makes the monopoly profit, . If the potential entrant enters the market, both firms make the duopoly profit, . Entry occurs if the duopoly profit is positive, .

0 e

i m

0 d

d



• Entry is blockaded (does not occur regardless of actions by the incumbent) if the duopoly profit is negative because of low demand or high fixed costs of entering, both of which lower profit, if entry is not blockaded, the incumbent acts to deter entry by paying for exclusive rights to be the only firm at the rest stop only if . Otherwise (if ), the incumbent accommodates entry.

m db m db



Incumbent

Enter

Do not enter(πm, $0)

(πm – b, $0)

(πd, πd = R – F )

Do not pay

Second stageFirst stage

Pay for exclusive rights (entry is impossible)

Entrant

(πi, πe)


Fixed Costs, Demand, and Blockaded Entry.

• Whether an incumbent takes strategic action depends on the size of fixed costs and demand conditions, which determine and , and the cost of taking the strategic action, .

mb

d


Commitment and Entry Prevention

• credible threat– an announcement that a firm will use

a strategy harmful to its rival that the rivals believe because the firm’s strategy is rational in the sense that it is in the firm’s best interest to use it


Figure 14.2 Noncredible Threat

• The incumbent announces that it will produce such a large amount of output (lower path) if entry occurs that the entrant will lose money. The potential entrant doesn’t believe this threat because it is not credible: The incumbent would make a higher profit by accommodating the entrant and the smaller Cournot level of output.


Figure 14.2 Noncredible Threat

Incumbent

($300, $300)

(–$100, –$100)

Cournot output

Large output

(πi, πe)



• By committing to produce a large quantity whether or not entry occurs, the incumbent discourages entry.



• Commitment as a Credible Threat. The intuition for why commitment makes a threat credible is that of “burning bridges.”

• Similarly, by limiting its future options, a firm makes itself stronger.


Figure 14.3 Game Trees for the Deterred Entry and Stackelberg Equilibria

a) When the fixed cost of entry is $100, the incumbent earns more ($800) by deterring entry than by accommodating it ($450).

b) When the fixed cost is only $16, the incumbent’s profit is higher ($450) if it accommodates entry than if it deters entry ($416).


Figure 14.3 Game Trees for the Deterred Entry and Stackelberg Equilibria

Accommodate (qi = 30)

Incumbent

Enter

Do not enter

(a) Entrant’s Fixed Cost Is $100.

($900, $0)

($450, $125)

Enter

Do not enter($800, $0)

($400, $0)

Deter (qi = 40)

Entrant

Entrant

(πi, πe)


Figure 14.3 Game Trees for the Deterred Entry and Stackelberg Equilibria (cont’d)

Incumbent

Enter

Do not enter

(b) Entrant’s Fixed Cost Is $16.

($900, $0)

($450, $209)

Accommodate (qi = 30)

Enter

Do not enter($416, $0)

($208, $0)

Deter (qi = 52)

Entrant

Entrant

chapter fourteen strategy. © 2007 pearson addison-wesley. all rights reserved.14–2 strategic...

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