STR 421STR 421

Economics of Economics of

Competitive StrategyCompetitive Strategy

Michael RaithMichael Raith

Spring 2007Spring 2007

Today’s classToday’s class

5. Strategic commitments5. Strategic commitments

5.1 Logic of commitment5.1 Logic of commitment5.2 Strategic commitments and competition5.2 Strategic commitments and competition

5.3 Entry deterrence5.3 Entry deterrence

5.4 Entry strategies (next week)5.4 Entry strategies (next week)

Strategic commitmentsStrategic commitments

Keeping your options open may always seem to be a Keeping your options open may always seem to be a

good thing.good thing. But sometimes, making irreversible commitments can But sometimes, making irreversible commitments can

have important strategic value.have important strategic value. Example: HernExample: Hernáán Cortés’ decision to sink his ships n Cortés’ decision to sink his ships

upon landing in Mexico.upon landing in Mexico.

When the decision to invade When the decision to invade Mexico is easy to reverse:Mexico is easy to reverse:

Montezuma = player 2

Cortééss= player 1

Retreat

Fight

Retreat

Fight

(2, -1)

(0, 0)

(-2, -2)

Commitment is about Commitment is about limiting your options in the future limiting your options in the future

Montezuma

Cortésés

Retreat

Fight

Retreat

Fight

(2, -1)

(0, 0)

(-2, -2)

If Cortés sinks his ships before Montezuma decides what to do:

Commitments as strategic movesCommitments as strategic moves

(2, -1)

(0, 0)

(-2, -2)

(-2, -2)

(-4, 0)

(2, -1)Retreat

Retreat

Retreat

Retreat

Cortésés

Sink

Don’tsink

Monte-zuma

Monte-zuma

Cortésés

Cortésés

Fight

Fight

Fight

Fight

Outcomeif Cortesdoesn’t sink

What makes a move a commitment? What makes a move a commitment? Commitments must be…Commitments must be…

1.1. crediblecredible– ……a problem with NATO’s “massive retaliation” strategy during a problem with NATO’s “massive retaliation” strategy during

Cold WarCold War

– Greatest credibility when decisions are Greatest credibility when decisions are irreversible,irreversible, i.e. involve i.e. involve

sunk costssunk costs

– Alternatively: build up a Alternatively: build up a reputationreputation for credibility for credibility

2.2. visiblevisible

3.3. understandableunderstandable

Commitment vs. flexibilityCommitment vs. flexibility

The cost of commitment: having fewer options is bad if The cost of commitment: having fewer options is bad if

you misjudge the situation or another playeryou misjudge the situation or another player– What if Montezuma’s cost of fighting is lower than expected?What if Montezuma’s cost of fighting is lower than expected?

Sometimes it’s best to wait and decide later:Sometimes it’s best to wait and decide later:– E.g. learn about future market conditions and then make E.g. learn about future market conditions and then make

decision based on new informationdecision based on new information

Today’s classToday’s class

5. Strategic commitments5. Strategic commitments5.1 Logic of commitment5.1 Logic of commitment

5.2 Strategic commitments and competition5.2 Strategic commitments and competition5.3 Entry deterrence 5.3 Entry deterrence

5.4 Entry strategies5.4 Entry strategies

Example: investing in lower costs Example: investing in lower costs under price competitionunder price competition

Modified example from second week: American and Modified example from second week: American and

Southwest in L.A. – Vegas marketSouthwest in L.A. – Vegas market MC=60, daily demand:MC=60, daily demand:

– American’s demand: QAmerican’s demand: QAA = 120 – 1.5 p = 120 – 1.5 pAA + p + pSS

– Southwest’s demand: QSouthwest’s demand: QSS = 120 – 1.5 p = 120 – 1.5 pSS + p + pAA

Best responses:Best responses:– American’s best response: pAmerican’s best response: pA A = 70 + 1/3 p= 70 + 1/3 pSS

– Southwest’s best response: pSouthwest’s best response: pS S = 70 + 1/3 p= 70 + 1/3 pAA

Nash equilibrium: pNash equilibrium: pA A = p= pS S = $105/ticket= $105/ticket

Profits: Profits: ππA A = = ππS S = $3038/day= $3038/day

Invest to lower MC?Invest to lower MC?

Suppose American can lower its MC by 5% (from 60 to Suppose American can lower its MC by 5% (from 60 to

57) by investing $340K. Good idea?57) by investing $340K. Good idea? Suppose: Suppose:

– 1 flight/day, 360 days/year1 flight/day, 360 days/year

– 20% discount rate, “quick and dirty” method20% discount rate, “quick and dirty” method

Then investment is profitable if it leads to increase in Then investment is profitable if it leads to increase in

profit per flight of $340K*.2/360 = $189profit per flight of $340K*.2/360 = $189 Let’s see if that’s the case.Let’s see if that’s the case.

Cost reduction and price changesCost reduction and price changes

Scenario 1: American charges same price => Scenario 1: American charges same price =>

Southwest tooSouthwest too– ππA A = (105 – 57)(120 – 1.5 * 105 + 105) = 3240= (105 – 57)(120 – 1.5 * 105 + 105) = 3240

– Increase by 3240 – 3038 = 202Increase by 3240 – 3038 = 202– Looks profitable!Looks profitable!– Problem: not a Nash equilibrium given lower MCProblem: not a Nash equilibrium given lower MC

Scenario 2: Lower MC => Charge lower priceScenario 2: Lower MC => Charge lower price– American’s profit American’s profit ππA A = (p= (pAA – 57)(120 – 1.5 * p – 57)(120 – 1.5 * pAA + 105) + 105)

– Best response: pBest response: pA A = 68.5 + 1/3 p= 68.5 + 1/3 pSS, at p, at pSS = 105: p = 105: pAA = 103.50 = 103.50

– American’s profit = 3243, increase by 205American’s profit = 3243, increase by 205– Even better!Even better!

The The strategic effectstrategic effect of lowering MC of lowering MC

If American cuts price, Southwest will cut price too, etc.If American cuts price, Southwest will cut price too, etc. What is new equilibrium?What is new equilibrium?

– American’s new best response: pAmerican’s new best response: pA A = 68.5 + 1/3 p= 68.5 + 1/3 pSS

– Southwest’s best response is unchanged: pSouthwest’s best response is unchanged: pS S = 70 + 1/3 p= 70 + 1/3 pAA

– New equilibrium: pNew equilibrium: pA A = 103.31, p= 103.31, pS S = 104.44= 104.44

American’s profit:American’s profit:– With new prices: With new prices: ππA A = 3217= 3217

– Increase by 3217 – 3038 = 180 < 189Increase by 3217 – 3038 = 180 < 189– Investment not profitable!Investment not profitable!

Conclusion: Incentive to cut price triggers response by Conclusion: Incentive to cut price triggers response by

Southwest that makes investment less profitableSouthwest that makes investment less profitable

Illustration: Illustration: Investment by American to lower MC Investment by American to lower MC (tough commitment, price competition):(tough commitment, price competition):

PA

PSAmerican’sbest response

Southwest’sbest response

AB

COriginal equilibrium

After AA’s initialprice adjustment

New equilibrium

When does this happen?When does this happen?

1.1. American’s investment is a American’s investment is a toughtough commitment = commitment =

American’s incentive to cut price shifts Southwest’s American’s incentive to cut price shifts Southwest’s

demand demand downdown

2.2. Competition in prices is case of Competition in prices is case of strategic complements strategic complements

= each firm’s best response is = each firm’s best response is increasingincreasing in other’s in other’s

priceprice When firms compete in prices, tough commitments When firms compete in prices, tough commitments

have a have a negativenegative strategic effect strategic effect

SoftSoft commitments and price commitments and price competitioncompetition

A A softsoft commitment commitment benefitsbenefits your competitor once you your competitor once you

adjust price or quantityadjust price or quantity– Why would you want to do that??Why would you want to do that??

Example: the GM Card of 1992Example: the GM Card of 1992– Cardholders earn credit equal to 5% of charge volume, can be Cardholders earn credit equal to 5% of charge volume, can be

applied to purchase of GM carsapplied to purchase of GM cars

– Most appealing to those who are already inclined to buy GMMost appealing to those who are already inclined to buy GM

How the GM card works:How the GM card works:

Suppose initially GM and Ford charge 20,000 for a carSuppose initially GM and Ford charge 20,000 for a car Now GM gives loyal customers (through the card) a Now GM gives loyal customers (through the card) a

rebate of $2,000 and increases the list price by $1,000rebate of $2,000 and increases the list price by $1,000– A bit counterintuitive…A bit counterintuitive…

How should Ford respond? Go after GM’s loyal How should Ford respond? Go after GM’s loyal

customers or charge Ford’s loyal customers more?customers or charge Ford’s loyal customers more? Positive strategic effect!Positive strategic effect!

Soft commitments can be Soft commitments can be good for yougood for you

When firms compete in prices, soft commitments have When firms compete in prices, soft commitments have

a a positivepositive strategic effect strategic effect An investment that is unprofitable if you ignore the strategic An investment that is unprofitable if you ignore the strategic

effect might be profitable if you take it into accounteffect might be profitable if you take it into account

Soft commitments: anything that reduces incentive to Soft commitments: anything that reduces incentive to

cut price: most-favored customer clauses, moves to cut price: most-favored customer clauses, moves to

increase loyalty, differentiationincrease loyalty, differentiation Bottom line: to get wimpy response, act wimpy. Bottom line: to get wimpy response, act wimpy.

– With these strategies, you are even better off if others copy youWith these strategies, you are even better off if others copy you

Next: investing in lower costs Next: investing in lower costs under under quantityquantity competition competition

Shrimp game again: in Nash equilibrium,Shrimp game again: in Nash equilibrium,– q = 50 for each, P = 15, q = 50 for each, P = 15, ππ = 500 for each = 500 for each

Suppose Arnold can reduce MC from 5 to 4, and…Suppose Arnold can reduce MC from 5 to 4, and… ……investment profitable if profit increases by at least 60investment profitable if profit increases by at least 60 With previous quantities: With previous quantities: ππAA = (15 – 4)*50 = 550, = (15 – 4)*50 = 550,

increase by 50 => not profitableincrease by 50 => not profitable But Arnold would want to produce more:But Arnold would want to produce more:

– New best response: qNew best response: qAA = 102.5 – (q = 102.5 – (qBB + q + qCC)/2, )/2,

– Given qGiven qBB = q = qCC= 50: = 50: qqAA = 52.5 => Price = 14.5 = 52.5 => Price = 14.5

– ππAA = (14.5 – 4)*52.50 = 551.25 = (14.5 – 4)*52.50 = 551.25

– Still not profitableStill not profitable

Strategic effect with quantity Strategic effect with quantity

competitioncompetition

But Beatrice and Charlotte want to produce But Beatrice and Charlotte want to produce lessless if if

Arnold produces more = case of Arnold produces more = case of strategic substitutesstrategic substitutes Best responses: qBest responses: qAA = 102.5 – (q = 102.5 – (qBB+q+qCC)/2, )/2,

qqBB = 100 – (q = 100 – (qAA+q+qCC)/2, )/2, qqCC = 100 – (q = 100 – (qAA+q+qBB)/2)/2

Solve for q’s: Solve for q’s: qqAA = 53.75, = 53.75, qqBB = 48.75, = 48.75, qqCC = 48.75 = 48.75 Arnold’s profit: 578 => investment profitable!Arnold’s profit: 578 => investment profitable! So, when firms compete in quantities (think: capacity So, when firms compete in quantities (think: capacity

investments), tough commitments have a investments), tough commitments have a positivepositive

strategic effectstrategic effect– To get wimpy response, act toughTo get wimpy response, act tough

Illustration: Investment by Arnold to Illustration: Investment by Arnold to lower MC (tough commitment, quantity lower MC (tough commitment, quantity competition):competition):

qA

qB

53.7550

Arnold’s best response

Beatrice’sBest response

A

B

C

Strategic effect

52.5

OriginalEquilibrium

After Arnold’sinitial adjustment

New equilibrium

ConclusionConclusion

In assessing profitability of long-run decisions, In assessing profitability of long-run decisions, consider strategic effects as well! Need to ask:consider strategic effects as well! Need to ask:

1.1. When I adjust price or quantity, is my competitor worse When I adjust price or quantity, is my competitor worse off (tough commitment) or better off (soft off (tough commitment) or better off (soft commitment)?commitment)?

2.2. Is competition in prices (short run) or quantities Is competition in prices (short run) or quantities (capacities, long run)?(capacities, long run)?– More generally, strategic complements vs. substitutes: e.g. if I More generally, strategic complements vs. substitutes: e.g. if I

advertise more, will you advertise more, or less?advertise more, will you advertise more, or less?

Today’s classToday’s class

5. Strategic commitments5. Strategic commitments5.1 Sequential games and the logic of commitment5.1 Sequential games and the logic of commitment

5.2 Strategic commitment and competition5.2 Strategic commitment and competition

5.3 Entry deterrence5.3 Entry deterrence5.4 Entry strategies5.4 Entry strategies

Three possible scenarios facing an Three possible scenarios facing an incumbent in a marketincumbent in a market

1.1. No one wants to enter your industry anywayNo one wants to enter your industry anyway– Recall barriers to entry from Section 2 of lectureRecall barriers to entry from Section 2 of lecture

2.2. Whatever you do, entry will occur anywayWhatever you do, entry will occur anyway– You have little choice, just be preparedYou have little choice, just be prepared

3.3. Borderline case: entry likely if you do nothing, but Borderline case: entry likely if you do nothing, but

might be deterred depending on what you do todaymight be deterred depending on what you do today– Idea: invest to keep entrants outIdea: invest to keep entrants out

– We are talking about (over)investments to be toughWe are talking about (over)investments to be tough

– Usually concerned with own profit only, here also with entrants Usually concerned with own profit only, here also with entrants

profitprofit

Logic of preemptionLogic of preemption

Suppose that Suppose that – if firm 1 does nothing, firm 2 enters at cost Cif firm 1 does nothing, firm 2 enters at cost C

both firms earn duopoly profitsboth firms earn duopoly profits– if firm 1 expands at cost C, no entry occursif firm 1 expands at cost C, no entry occurs

firm 1 remains monopolist, but has paid Cfirm 1 remains monopolist, but has paid C Which is better for firm 1? Expansion, because Which is better for firm 1? Expansion, because

– Monopoly profit > Sum of duopoly profitsMonopoly profit > Sum of duopoly profits– Therefore, gain from preemption Therefore, gain from preemption

= Monopoly profit – C - duopoly profit= Monopoly profit – C - duopoly profit

> Duopoly profit – C = entrant’s net gain > 0> Duopoly profit – C = entrant’s net gain > 0

““Efficiency effect”: Incumbent’s gain from preemption Efficiency effect”: Incumbent’s gain from preemption

> entrant’s gain from entry> entrant’s gain from entry

Examples of this effect at work:Examples of this effect at work:

1.1. Sleeping patents: buy a competing patent and let it Sleeping patents: buy a competing patent and let it

sleep, to keep others from using itsleep, to keep others from using it

2.2. Payoff of generics producers: e.g. in 1998, Abbott Payoff of generics producers: e.g. in 1998, Abbott

Labs paid Zenith and Geneva, two generics producers, Labs paid Zenith and Geneva, two generics producers,

$2M and $4.5M $2M and $4.5M per monthper month, respectively, not to , respectively, not to

produce.produce.

Preemption strategies Preemption strategies

Preemption strategies work like first-mover advantagesPreemption strategies work like first-mover advantages But here, an incumbent, facing threat of entry, actively But here, an incumbent, facing threat of entry, actively

invests in FMAinvests in FMA ExamplesExamples

– Excess capacity (i.e. relative to optimal capacity for Excess capacity (i.e. relative to optimal capacity for

“undisturbed” monopolist)“undisturbed” monopolist)

– Geographic preemption/brand proliferationGeographic preemption/brand proliferation E.g. frequency of flightsE.g. frequency of flights

– Advertise, create switching costs, etc., see Lecture 2Advertise, create switching costs, etc., see Lecture 2

CommitmentCommitment is essential for preemption to work! is essential for preemption to work!

PricingPricing strategies to deter entry: strategies to deter entry:

Predatory pricing:Predatory pricing: = lower price to drive competitor out of market; then raise price to = lower price to drive competitor out of market; then raise price to

recoup lossesrecoup losses– Problems:Problems:

1.1. Fighting very costlyFighting very costly

2.2. If entry is If entry is economicallyeconomically profitable, someone else might enter profitable, someone else might enter– Hard to get convicted, but also rarely a good business strategyHard to get convicted, but also rarely a good business strategy

Limit pricing:Limit pricing: = deliberately lower price to signal that you have low costs or that = deliberately lower price to signal that you have low costs or that

demand is low.demand is low.– Makes sense only if outsiders don’t know your costs. Otherwise, Makes sense only if outsiders don’t know your costs. Otherwise,

what you do what you do todaytoday is irrelevant is irrelevant

Antitrust constraints Antitrust constraints

Section 2 Sherman Act prohibits attempts to Section 2 Sherman Act prohibits attempts to

monopolize marketmonopolize market– Note: does not prohibit monopoly as suchNote: does not prohibit monopoly as such

““Naturally” acquired market power or foul play?Naturally” acquired market power or foul play?– Actions consistent with efficient competition or monopolization Actions consistent with efficient competition or monopolization

look the same, e.g. aggressive pricing vs. predationlook the same, e.g. aggressive pricing vs. predation

– Extremely difficult to decide, e.g. Microsoft caseExtremely difficult to decide, e.g. Microsoft case

All strategies above have been focus of antitrust casesAll strategies above have been focus of antitrust cases When big firms act tough, small firms likely to sueWhen big firms act tough, small firms likely to sue

– Litigation very costly for both sides.Litigation very costly for both sides.