1. Administrative Issues

2. Response to Feedback More cases  Cases coming up GE vs. Westinghouse Bitter Competition African Communications Group Raytheon  Lead time for ordering HBS cases such that we can’t add HBS cases at this point.  Will try to add some “mini-cases.”  Also some philosophy here about value of deductive vs. inductive learning for business.  Will post questions about HBS & other cases (as did with GE vs. Westinghouse).

3. Feedback continued … More student participation  Okay, but two-way street – you have to talk up, ask questions, point out connections, etc. Give more explanation and guidance about CSG  Will talk about in a moment Give some guidance about the final exam  Final will consist of Short problems to test understanding of theoretical ideas (1/3 roughly) Short answer questions about aspects of strategic situations (1/3 roughly) A case analysis (1/3 roughly)  I have posted some examples of the type of questions I’ve asked previously on the course web site (“Exam questions from old exam …”).

4. Some Things that are Tricky Be more clear when assignments are due  … but best laid plans: Confusion over when case reader would be ready Technical problem with CSG Stochastic elements in pacing of course Switch to Catalyst  Never used it  Will look into it this weekend … but no promises.

5. One Thing I Won’t Do Distribute printed handouts & lecture notes  Not clear there’s sufficient demand and not clear demand for what.  Expensive (even at 6 slides/page, double sided, talking 720 pages per lecture on average).  Logistically a pain: Dear Haas Community, Unfortunately, BOTH Xerox digital copier / printers (rooms F-580 & S-545) are presently DOWN. Please do not send print jobs to either machine until further notice. Service is pending. I apologize for the inconvenience. Yours truly, Kurt, the Copy Guy  Fails the market test

6. CSG Grading  Dependent on how you do given your situation.  Based on your strategy memorandum It’s intended to be experiential learning  I “want” mistakes to happen because through their analysis we learn  Remember Carter Racing – you don’t learn a lot looking at just your successes Clarification  You produce to order

7. Avoiding the Bertrand Trap II: Cooperation

8. How do Coke & Pepsi Make Money? Coke and Pepsi sell essentially undifferentiated products Prices are widely known, often advertised There are no consumer switching costs No evidence of serious limits on capacity No evidence of cost advantages

9. Coke and Pepsi Recognize Repeated Interaction Suppose Coke forbears cutting price today because it knows Pepsi will follow suit tomorrow. Suppose Pepsi forbears cutting price today because it knows Coke will follow suit tomorrow. Tradeoff for Coke or Pepsi is forgoing a larger market share today in order to avoid the Bertrand trap tomorrow.

10. Method 6: Exploit Repeated Play If firms play repeatedly, then can use repeated play to sustain a form of cooperation on price known as tacit collusion No firm cheats (undercuts rivals) because this will trigger a price war in the future (e.g., reversion to Bertrand competition).

11. To Cheat or Not to Cheat: That is the Question PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude) Looking just at today: Profits from just undercutting rivals and capturing entire market. Profits from matching rivals at monopoly price but sharing market.

12. To Cheat or Not to Cheat: That is the Question PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude) Now take into account the future!

13. To Cheat or Not to Cheat: That is the Question PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude) Benefit today But Bertrand trap forever after. Smaller benefits today (because split market). But positive benefits in future.

14. To Cheat or Not to Cheat: More Firms PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude)

15. To Cheat or Not to Cheat: Higher Interest Rate PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude)

16. Tacit Collusion Tacit collusion is easier to sustain when  fewer firms (four or fewer if excess capacity)  interest rate low

17. To Cheat or Not to Cheat: Dying Industry Expected PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude)

18. Dying Industries In fact, if “death date” known with certainty, then cooperation generally not sustainable at all. Backwards induction:  In last period there is no future period, so no punishment to deter cheating in last period. Hence cheating (Bertrand) in last period  But then same is true of penultimate period and so on back to first period.

19. General Phenomenon Firm going bankrupt not paid by other firms that owe it money. Management problems when boss announces she’s leaving. Basically don’t let others know the end is coming.

20. The Issue with Detection PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude) 2 Detection occurs

21. The Issue with Detection: Stochastic Discovery (Demand Fluctuation) PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude) Detection occurs Possibly lost to mistaken price war

22. When Demand Fluctuates Play trigger strategies Sometimes to avoid temptation, firms don’t charge maximum price during high-demand periods  Evidence that gasoline refiners don’t charge maximum price during summer, the high-demand season. If too much (unpredictable) variability in demand, then would have price wars too often.  Hence, value of tacitly colluding is reduced.  Relative cost of cheating today is reduced.  So difficult or impossible to sustain tacit collusion.

23. Making Tacit Collusion Work Incentive to cut price? Tacit collusion not an issue no yes Easy to detect price cuts? Tacit collusion will fail & the firms risk finding them- selves in the Bertrand trap no Firms willing to punish? Can serious punishments be inflicted? yes Tacit collusion is sustainable in equilibrium

24. Electronic Components Distribution Industry How do we assess the potential for tacit collusion in the electronic components distribution industry?

25. Making Tacit Collusion Work Electronic Components Distribution Industry Incentive to cut price? Tacit collusion not an issue no yes Easy to detect price cuts? Tacit collusion will fail & the firms risk finding them- selves in the Bertrand trap no Firms willing to punish? Can serious punishments be inflicted? yes Tacit collusion is sustainable in equilibrium

26. Making Tacit Collusion Work Airline Industry Incentive to cut price? Tacit collusion not an issue no yes Easy to detect price cuts? Tacit collusion will fail & the firms risk finding them- selves in the Bertrand trap no Firms willing to punish? Can serious punishments be inflicted? yes Tacit collusion is sustainable in equilibrium

27. VS.

28. Exiting a Price War Need to signal that price war at end without engaging in illegal explicit collusion.  American Airlines and the NYT  Price leaders Traditional leaders are  GM in automobiles  American Airlines in airline industry  Tesco is a price leader with respect to Asda and Sainsbury  Public adoption of means for facilitating tacit collusion

29. Facilitating Tacit Collusion: Improving Detection Firms want to make sure that  cheating is detected promptly  cheating is detected accurately Numerous devices to make this work  public posting of prices  simplified pricing e.g., GE and Westinghouse airlines & per-mile pricing  collection & dissemination of prices (some antitrust issues— Maple Flooring Mfrs.’ Ass’n v. United States)

30. Making Punishments Severe PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude)

31. Making Punishments Severe PDV of profits time 1 Cheat (undercut) Cooperate (tacitly collude) Increase the severity of the punishment

32. How to Make Severe Most Favored Nation Clauses  MFN: If cut price today, give refund to past customers. Note: the other guy better adopt this too!  Also contemporaneous MFN: All customers get same price today (makes detection of price cutting easier)

33. How to Make Willing Build in “doomsday devices”  Dr. Strangelove Meeting the Competition Clauses (MCC)  state that will meet lowest price available just advertised policy or put into contracts (some antitrust issues)  if rival cuts price, either honor clause (a reputational or contractual obligation) or suffer consequences. We miss you Stanley

34. Tacit Collusion on Non-Price Dimensions to Lessen Price Competition When tacit collusion on price would be difficult, firms can tacitly collude to maintain conditions that lessen price competition Generally, these are conditions that make one of the assumptions of the Bertrand model fail. Concept of market discipline.

35. Tacit Collusion on Non-Price Competition Raising search costs  tacit agreements not to price advertise  not locating outlets near each other Raising switching costs  making products incompatible with rivals’  signing customers to long-term contracts  Note: As we will see, these can also serve to deter entry.

36. Tacit Collusion on Non-price Competition Restrict capacity  Firms can tacitly agree not to expand capacity  Note: can be difficult to coordinate Think about GE vs. Westinghouse Industrial capacitor industry In reverse: lead additive industry

37. Product Differentiation Tacitly agree to split market on non-price dimensions  location: non-overlapping territories (usually invites antitrust scrutiny)  product space: e.g., split market between high- end and low-end

38. Other Dimensions of Tacit Collusion R&D (Non-price) advertising No poaching

39. Take-aways GE vs. Westinghouse Price fixing is illegal – you can go to jail for it. Tacit collusion requires  An ability to detect deviation  Sufficient punishments Sometimes need to facilitate tacit collusion  By improving ability to detect (e.g., multiplier, audits)  By increasing punishments, including use “doomsday devices” (e.g., MFN)  By serving as a price leader

40. Conclusions Recognizing repeated play can allow firms to avoid the Bertrand trap via tacit collusion.  Tacit collusion is distinct from explicit collusion or pricing fixing, which is illegal. Tacit collusion works best when  The number of firms is relatively small.  The future is sufficiently important.  Detection of undercutting is easy and not too subject to error.

41. Conclusions (continued …) Firms can take steps to facilitate tacit collusion  Making prices public  Using MFN and MCC clauses to increase punishment  Signal to each other through the press and other means  But be careful: Devices intended to facilitate tacit collusion can run afoul of the antitrust authorities.

42. Conclusions (continued …) The logic of repeated games has many applications in business. Among them …  Payments to bankrupt firms  Treatment of a leaving supervisor  Quality assurance (see reading)  Entry deterrence (upcoming)

43. List of some of the firms and industries mentioned American Airlines Asda Coca-Cola GE Pepsi Sainsbury Tesco Westinghouse Airline industry Electronic components distribution industry Industrial capacitor industry Lead additive industry Maple flooring industry