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© SørgardKonkurransestrategi1 incumbent How should the incumbent behave? SOL 310 – Competitive strategy Lars Sørgard Hjemmeside til Konkurransestrategi.

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Presentation on theme: "© SørgardKonkurransestrategi1 incumbent How should the incumbent behave? SOL 310 – Competitive strategy Lars Sørgard Hjemmeside til Konkurransestrategi."— Presentation transcript:

1 © SørgardKonkurransestrategi1 incumbent How should the incumbent behave? SOL 310 – Competitive strategy Lars Sørgard Hjemmeside til Konkurransestrategi (2003), Fagbokforlaget Co-opetition, ch. 6-7 (see ) Judo strategy, ch. 8 (see

2 © SørgardKonkurransestrategi2 Today’s topic Incumbent’s strategic decisions –Deter an entrant? –If accommodation, how to behave? Strategic commitment –Direct effect –Strategic effect How to signal an aggressive response?

3 © SørgardKonkurransestrategi3 SUMO SUMO strategies dominant firmIf you are a dominant firm, how to respond to entry? before –What to do before entry? after –What to do after entry? whatBut what is the incumbent’s goal? –High market share? –In conflict with max profits, or not? –Short run versus long run?

4 © SørgardKonkurransestrategi4 SUMO strategy: A warning Fight to deter entry or force rival to exit (predation) is often very costly The risk associated with predation: –Large financial costs during the war –Discounting: loss today, gain in the future –Entry can take place after the war reputationThe argument in favour of predation is reputation –Fight today in one niche, to signal that you are a tough type that might fight in other niches

5 © SørgardKonkurransestrategi5 Act before potential entry The incumbent has a first mover advantage –Can make a decision that commits the firm in the future –Strategic commitment (or inflexibility) Irreversible decision Competition Strategic commitment Stage 1: Strategic commitment Meet in the market place Stage 2: Meet in the market place

6 © SørgardKonkurransestrategi6 irreversible decision Why an irreversible decision? Costs associated with reversing the decision –Takes time to reverse the decision –Will not get back the total amount sunk costsThen an element of sunk costs Broad definition of decisions –Production plants –Advertising –Vertical integration –Mergers –Long term contracts –…..

7 © SørgardKonkurransestrategi7 credible But is it credible? Two requirements (1)It is not in your own interest to reverse the decision after you have seen your rival’s action - Must be a credible commitment (2) Acts before the rival, so that it can react - Must be an observervable action Is a price war announcement before entry credible? The incumbent has two options (1) Deterrence - Unprofitable with entry (2) Accommodation - Entrant acts soft (not aggressively) after entry

8 © SørgardKonkurransestrategi8 Strategic commitment: Two kinds of effects Direct effect Strategic effect Irreversible decision rival’s Change rival’s future behaviour Irreversible decision own Change own future behaviour rival’s Change rival’s future behaviour

9 © SørgardKonkurransestrategi9 Strategic commitment: Direct effect Incumbent’s decision has a direct effect on the potential entrant’s profit Two kinds of direct effects (1)Raising rivals’ costs (2)Reducing demand for rivals’ products Irreversible decision rival’s Change rival’s future behaviour

10 © SørgardKonkurransestrategi10 Direct effect I: Raising rivals’ costs (1) Acquire input suppliers (upstream integration) –ALCOA bought waterfalls –Norcem bought areas with limestone Rivals are either foreclosed from purchasing inputs, or have to buy at a higher price –Fewer independent input suppliers –The price the rivals have to pay increases, even if the remaining suppliers do not have cost disadvantages BUT: a costly race to acquire input suppliers?

11 © SørgardKonkurransestrategi11 Raising rivals’ costs cont. (2) Trigger other cost increases in the industry –Propose standards etc that are costly –Not room for many firms in the industry Make sure that the you have a competitive advantage (i)Accept higher wages? - Can hurt a rival more than you, if he is more labour intensive (ii)Asymmetric standards? -Norsk Hydro in Norway: fertilizers -Standard that is tailormade to Norsk Hydro, and not tailormade to BASF

12 © SørgardKonkurransestrategi12 Direct effect II: Reducing demand for rivals’ products (3) Investment in advertising –Increase the number of loyal consumers –Rivals’ demand is smaller BUT: How does the incumbent then behave, if entry actually takes place? –Loyal consumers means that the incumbent has less reason to cut prices –The entrant can then expect a friendly welcome in the market, and entry can be profitable

13 © SørgardKonkurransestrategi13 (4) Integration downstream –Write contracts with buyers –Acquire retailers Potential entrants do not find enough buyers to succeed with profitable entry But is that profitable for the incumbent? Or could it be that the price it has to pay for the aquisitions is too high? –An aquisition battle between incumbent and entrant Reducing demand cont.

14 © SørgardKonkurransestrategi14 Red. demand cont.: Acquisition Who wins the aquisition battle? IncumbentEntrant Retailer 1 Retailer 2 CONSUMERS ? ? Retailer 1Incumbent owns Retailer 1 Retailer 2Will incumbent acquire Retailer 2?

15 © SørgardKonkurransestrategi15 Acquisition – the game If incumbent wins, it gains a monopoly position towards consumers –Monopoly profits:  M If entrant wins, competition between them –Duopoly profits (for each firm):  D Incumbent’s max payment:  M. -  D  I Entrant’s max payment:  D  E

16 © SørgardKonkurransestrategi16 Acquisition – who wins? Who has the highest willingness to pay for Retailer 2? Incumbent the highest willingness to pay if:  M -  D >  D (which says that I > E)   M > 2  D alwaysThis condition is always met –Monopoly profit is higher than total duopoly profits The incumbent wins the acquisition –Higher willingness to pay, since acquisition means no competition –The entrant only reaps a duopoly profit

17 © SørgardKonkurransestrategi17 Red. demand cont.: Examples Integrating forward (Judo, p. 184) –Coke and Pepsi bought their bottling networks in the 80s –End of 90s, controlled 80% of their direct distribution Contract directly with customers –Nutrasweet made deals with Coke and Pepsi before HSC enter the US market Apply contracts mentioned earlier –MCC to have the final move against a potential rival? –Can wait, instead of cutting prices too early?

18 © SørgardKonkurransestrategi18 Red. demand cont.: Microsoft Did numerous things to reduce the demand the rival Netscape would face –Required Internet explorer to be installed on all new machines with Windows –Numerous distribution channels required to exclude sales of Netscape –Imposed Internet Service Providers to boycott Netscape

19 © SørgardKonkurransestrategi19 Red. demand cont.: Microsoft Paid AOL to drop Netscape (see Judo, pp. 185-194) –Bill Gates to AOL in 1996: ’How much do we need to pay you to screw Netscape?’ –Paid AOL $ 0.25 for every customer that shifter to Internet Explorer –If AOL converted ’a substantial portion of its installed base’ by a certain date, then (1)$ 600.000 in bonus (2)AOL icon on the Windows desktop

20 © SørgardKonkurransestrategi20 Strategic commitment: Strategic effect Commitment to change your own behaviour in the future When it is observed, the rival’s best choice is to change its own behaviour Would like to soften the rival’s behaviour –Deter him from entering, or –Encourage him to act less aggressively after entry Irreversible decision own Change own future behaviour rival’s Change rival’s future behaviour

21 © SørgardKonkurransestrategi21 Strategic effect: Capacity Installing a large capacity – Top Dog strategy –The best response for a potential entrant is to install a smaller capacity, or not to enter DuPont – titanium dioxide in the 70s (Judo, p. 180) –Expected an increase in demand next decade (more than 500.000 tons increase) –Expanded its own capacity by 500.000, to preempt potential rivals –Did not succeed in deterring all its rivals –But became the dominant producer, and still it is

22 © SørgardKonkurransestrategi22 Take-or-pay contract with supplier For any product you take, you agree to pay a certain price, say $50 per ton You have to pay even for product you don’t take, say $40 per ton (up to a quantity ceiling) Example of such a contract: –Ceiling of 1000, and buys 900 –Then you pay $50 for 900, and $40 for 100 Take-or-pay good for the supplier; it protects him As a buyer you in return ask for a discount

23 © SørgardKonkurransestrategi23 Take-or-pay – act aggressively? It is a commitment for you as a buyer to act aggressively –You have a de facto low marginal cost –Would therefore typical retaliate against a rival In turn, it dampens your rival’s incentive to act aggressively –A device to dampening competition Risky: What if your rival actually triggers competition? –Then firms end up competing very aggressively

24 © SørgardKonkurransestrategi24 Strategic effect: Brand proliferation A dominant firm can introduce many different brands or versions of its product –One brand for each niche Whatever niche the entrant decides to enter, it will face a brand by the incumbent –Tougher competition after entry, then what else would have been the case Numerous examples of such a strategy –Kelloggs –Kelloggs in the US for cereals –Orkla –Orkla in Norway for detergents

25 © SørgardKonkurransestrategi25 Brand Proliferation: AOL AOLFreeserveAOL attacked by Freeserve in UK in 1999 –Freeserve offered no subscription fee, and users paid only per minute (for telephone line) JUDO: AOL could lose $ 150 mill if it matched Finally, it did cut the subscription fee with 45% Later it fighted back by introducing new brands –Netscape Online – no subscription fee –A third product: flat rate Then Freeserve had a JUDO problem –Fight back with a flat rate, and lose existing revenues? –AOL superior on ads and e-commerce –Freeserve matched, and faced losses

26 © SørgardKonkurransestrategi26 Fighting against entrant: Market segmentation A dominant firm’s problem is its size –Would lose a large revenue by cutting prices on all sales Then a more targeted response can make an aggressive response more credible –Brand proliferation –Sign contract customer by customer Can corporate discount schemes be a problem for entrants in the airline market?

27 © SørgardKonkurransestrategi27 Fridstrøm on airlines: Incumbent airline can meet any challenger by offering selective discounts to large, attractive clients, making predation a more credible threat Selective discounts may lead to intense price rivalry and to exits from the market Similarly, potential entrants might be deterred Thus, corporate discount schemes may be anti- competitive in a setting with a dominant, incumbent carrier and smaller potential entrants

28 © SørgardKonkurransestrategi28 Incumbent: Fight or not? If deterrence or predation is the choice, then different ways to make it credible with fight –Irreversible investments –Market segmentation If entry takes place and no predation, then the incumbent would like peace –Take-or-pay contract –Transparency (repeated game mechanism)

29 © SørgardKonkurransestrategi29 Repeated interaction In a one shot game, a prisoner’s dilemma outcome concerning price setting –Firms have a dominant strategy to set a low price But firms meet at the market place day after day, week after week, … Then a collusive outcome can be sustained, without any legal contract –Can be in a firm’s interest to set high rather than low price

30 © SørgardKonkurransestrategi30 To deviate, or not to deviate? If all firms set a high price, then each firm has a trade off when considering to deviate larger market share (1) Price cutting would lead to a larger market share in the short run trigger a price war (2) Price cutting would trigger a price war after deviation If (1) dominates, the firm would deviate and we are back to the prisoner’s dilemma –When I deviate, all other firm deviate –The outcome would be static Nash equilibrium

31 © SørgardKonkurransestrategi31 The trade off When is the gain from deviating small? Is there anything the firms can do to make the gain small and thereby promote collusion? Collusion Deviation Competition GAIN LOSS Time Profits

32 © SørgardKonkurransestrategi32 A strategy of rapid response If the rivals responds quickly to deviation, then less incentives to deviate –The period where you undercut your rival is short –A price war (retaliation) starts early If you can signal a rapid response, then this can prevent firms from deviating But how to assure a rapid response?

33 © SørgardKonkurransestrategi33 How to assure a rapid response? transparent, (1)Make the market transparent, so that you observe any deviation Everybody is quickly informed about prices and sales of its rivals So ’innocent’ exchange of information in an industry can foster collusion? Is Internet making industries more transparent? possibleCan make retaliation possible, but are you willing and able to retaliate?

34 © SørgardKonkurransestrategi34 Danish concrete Local sales of concrete, and firms gave secret discounts to customers Competition authorities argued that more information is generally good for consumers –Each consumer can find the low price firm –Other firms must match the low price firm In line with this argument, they starting announcing secret rebates regularly –Everybody was informed about net prices –They then expected prices to be lower

35 © SørgardKonkurransestrategi35 Danish concrete – what happened?

36 © SørgardKonkurransestrategi36 signal How to signal a rapid response? (2) To act in a way so that any deviation will be punished Meet-the-competition clause can be such a signal –The punishment is guaranteed –Accepting your rival’s coupons is such a signal andCan also do that by word and action –We will match any discount immediately –Actually do so when your rival offers a discount

37 © SørgardKonkurransestrategi37 How to achieve high prices? (1)Direct communication Direct communication is illegal in most countries But one way communication, then? Where is the limit? –Free Record Shop established in Oslo in January 1995 –Interviewed in Aftenposten, december 94: ’There is no reason to start a price war... We will talk with the other chains. We hope that Akers Mic will raise its prices when we do’, Konkurransetilsynet questioned them in a meeting, but no fines

38 © SørgardKonkurransestrategi38 Cont.: How to achieve high prices? (2)Structural and institutional aspects High transportation costs and high tariffs leads to sale in local markets –Sphere of influence established –Example: cement in Europe? … … or did they actually cooperate? They were given large fines for secret market sharing

39 © SørgardKonkurransestrategi39 Cont.: How to achieve high prices? (3)Signalling of strategy Signalling how they will act if the rival changes his price Petrol in Norway –Price competition triggered by JET in 1996 –Sent signal through the press to end the price war Newspapers in New York (co-opetition, p. 202) –Signalling price strategies in one market segment (Staten Island)

40 © SørgardKonkurransestrategi40 Lifting the fog – News in NY New York Post ( ) and Daily News ( ) on Staten Island, New York in 1994: Time Prices 40 50 25

41 © SørgardKonkurransestrategi41 Petrol in Norway 19.12.96 in Dagens Næringsliv (Shell): –’Everybody is making a loss... Not sustainable in the long run’ 1.2.97 in Aftenposten (ESSO): –’ESSO will not in plain words encourage others to raise their price’ 8.2.97 in Dagens Næringsliv (Hydro/Texaco): –’Irrespective of the action by others, Hydro/Texaco will set a price floor of 7.50’

42 © SørgardKonkurransestrategi42 Petrol in Norway – cont. The other followed immediately: –Statoil: ’In those areas where the price is increasing, we will also raise our price’ –’Jet is prepared to raise our prices, if the other firms do so’ –ESSO: ’We are adjusting our prices’ JET – transparency as a deliberate system: –Our people check prices on other petrol stations two or three times every day. If our rivals raise prices, we follow. But we always have prices 30-40 øre below our rivals.’

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