STR 421 Economics of Competitive Strategy Michael Raith Spring 2007

Today’s class 5. Strategic commitments 5.1 Logic of commitment 5.2 Strategic commitments and competition 5.3 Entry deterrence 5.4 Entry strategies (next week)

Strategic commitments Keeping your options open may always seem to be a good thing. Keeping your options open may always seem to be a good thing. But sometimes, making irreversible commitments can have important strategic value. But sometimes, making irreversible commitments can have important strategic value. Example: Hernán Cortés’ decision to sink his ships upon landing in Mexico. Example: Hernán Cortés’ decision to sink his ships upon landing in Mexico.

When the decision to invade Mexico is easy to reverse:

Commitment is about limiting your options in the future If Cortés sinks his ships before Montezuma decides what to do:

Commitments as strategic moves

What makes a move a commitment? Commitments must be… 1.credible –…a problem with NATO’s “massive retaliation” strategy during Cold War –Greatest credibility when decisions are irreversible, i.e. involve sunk costs –Alternatively: build up a reputation for credibility 2.visible 3.understandable

Commitment vs. flexibility The cost of commitment: having fewer options is bad if you misjudge the situation or another player The cost of commitment: having fewer options is bad if you misjudge the situation or another player –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 decision based on new information

Today’s class 5. Strategic commitments 5.1 Logic of commitment 5.2 Strategic commitments and competition 5.3 Entry deterrence 5.4 Entry strategies

Example: investing in lower costs under price competition Modified example from second week: American and Southwest in L.A. – Vegas market Modified example from second week: American and Southwest in L.A. – Vegas market MC=60, daily demand: MC=60, daily demand: –American’s demand: Q A = 120 – 1.5 p A + p S –Southwest’s demand: Q S = 120 – 1.5 p S + p A Best responses: Best responses: –American’s best response: p A = /3 p S –Southwest’s best response: p S = /3 p A Nash equilibrium: p A = p S = $105/ticket Nash equilibrium: p A = p S = $105/ticket Profits: π A = π S = $3038/day Profits: π A = π S = $3038/day

Invest to lower MC? Suppose American can lower its MC by 5% (from 60 to 57) by investing $340K. Good idea? Suppose American can lower its MC by 5% (from 60 to 57) by investing $340K. Good idea? Suppose: Suppose: –1 flight/day, 360 days/year –20% discount rate, “quick and dirty” method Then investment is profitable if it leads to increase in profit per flight of $340K*.2/360 = $189 Then investment is profitable if it leads to increase in profit 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 changes Scenario 1: American charges same price => Southwest too Scenario 1: American charges same price => Southwest too –π A = (105 – 57)(120 – 1.5 * ) = 3240 –Increase by 3240 – 3038 = 202 –Looks profitable! –Problem: not a Nash equilibrium given lower MC Scenario 2: Lower MC => Charge lower price Scenario 2: Lower MC => Charge lower price –American’s profit π A = (p A – 57)(120 – 1.5 * p A + 105) –Best response: p A = /3 p S, at p S = 105: p A = –American’s profit = 3243, increase by 205 –Even better!

The strategic effect 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: p A = /3 p S –Southwest’s best response is unchanged: p S = /3 p A –New equilibrium: p A = , p S = American’s profit: American’s profit: –With new prices: π A = 3217 –Increase by 3217 – 3038 = 180 < 189 –Investment not profitable! Conclusion: Incentive to cut price triggers response by Southwest that makes investment less profitable Conclusion: Incentive to cut price triggers response by Southwest that makes investment less profitable

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

When does this happen? 1.American’s investment is a tough commitment = American’s incentive to cut price shifts Southwest’s demand down 2.Competition in prices is case of strategic complements = each firm’s best response is increasing in other’s price When firms compete in prices, tough commitments have a negative strategic effect When firms compete in prices, tough commitments have a negative strategic effect

Soft commitments and price competition A soft commitment benefits your competitor once you adjust price or quantity A soft commitment benefits your competitor once you adjust price or quantity –Why would you want to do that?? Example: the GM Card of 1992 Example: the GM Card of 1992 –Cardholders earn credit equal to 5% of charge volume, can be applied to purchase of GM cars –Most appealing to those who are already inclined to buy GM

How the GM card works: Suppose initially GM and Ford charge 20,000 for a car Suppose initially GM and Ford charge 20,000 for a car Now GM gives loyal customers (through the card) a rebate of $2,000 and increases the list price by $1,000 Now GM gives loyal customers (through the card) a rebate of $2,000 and increases the list price by $1,000 –A bit counterintuitive… How should Ford respond? Go after GM’s loyal customers or charge Ford’s loyal customers more? How should Ford respond? Go after GM’s loyal customers or charge Ford’s loyal customers more? Positive strategic effect! Positive strategic effect!

Soft commitments can be good for you When firms compete in prices, soft commitments have a positive strategic effect When firms compete in prices, soft commitments have a positive strategic effect  An investment that is unprofitable if you ignore the strategic effect might be profitable if you take it into account Soft commitments: anything that reduces incentive to cut price: most-favored customer clauses, moves to increase loyalty, differentiation Soft commitments: anything that reduces incentive to cut price: most-favored customer clauses, moves to increase 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 you

Next: investing in lower costs under quantity competition Shrimp game again: in Nash equilibrium, Shrimp game again: in Nash equilibrium, –q = 50 for each, P = 15, π = 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 60 …investment profitable if profit increases by at least 60 With previous quantities: π A = (15 – 4)*50 = 550, increase by 50 => not profitable With previous quantities: π A = (15 – 4)*50 = 550, increase by 50 => not profitable But Arnold would want to produce more: But Arnold would want to produce more: –New best response: q A = – (q B + q C )/2, –Given q B = q C = 50: q A = 52.5 => Price = 14.5 –π A = (14.5 – 4)*52.50 = –Still not profitable

Strategic effect with quantity competition But Beatrice and Charlotte want to produce less if Arnold produces more = case of strategic substitutes But Beatrice and Charlotte want to produce less if Arnold produces more = case of strategic substitutes Best responses: q A = – (q B +q C )/2, Best responses: q A = – (q B +q C )/2, q B = 100 – (q A +q C )/2, q C = 100 – (q A +q B )/2 Solve for q’s: q A = 53.75, q B = 48.75, q C = Solve for q’s: q A = 53.75, q B = 48.75, q C = Arnold’s profit: 578 => investment profitable! Arnold’s profit: 578 => investment profitable! So, when firms compete in quantities (think: capacity investments), tough commitments have a positive strategic effect So, when firms compete in quantities (think: capacity investments), tough commitments have a positive strategic effect –To get wimpy response, act tough

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

Conclusion In assessing profitability of long-run decisions, consider strategic effects as well! Need to ask: In assessing profitability of long-run decisions, consider strategic effects as well! Need to ask: 1.When I adjust price or quantity, is my competitor worse off (tough commitment) or better off (soft commitment)? 2.Is competition in prices (short run) or quantities (capacities, long run)? –More generally, strategic complements vs. substitutes: e.g. if I advertise more, will you advertise more, or less?

Today’s class 5. Strategic commitments 5.1 Sequential games and the logic of commitment 5.2 Strategic commitment and competition 5.3 Entry deterrence 5.4 Entry strategies

Three possible scenarios facing an incumbent in a market 1.No one wants to enter your industry anyway –Recall barriers to entry from Section 2 of lecture 2.Whatever you do, entry will occur anyway –You have little choice, just be prepared 3.Borderline case: entry likely if you do nothing, but might be deterred depending on what you do today –Idea: invest to keep entrants out –We are talking about (over)investments to be tough –Usually concerned with own profit only, here also with entrants profit

Logic of preemption Suppose that Suppose that –if firm 1 does nothing, firm 2 enters at cost C  both firms earn duopoly profits –if firm 1 expands at cost C, no entry occurs  firm 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 profits –Therefore, gain from preemption = Monopoly profit – C - duopoly profit > Duopoly profit – C = entrant’s net gain > 0  “Efficiency effect”: Incumbent’s gain from preemption > entrant’s gain from entry

Examples of this effect at work: 1.Sleeping patents: buy a competing patent and let it sleep, to keep others from using it 2.Payoff of generics producers: e.g. in 1998, Abbott Labs paid Zenith and Geneva, two generics producers, $2M and $4.5M per month, respectively, not to produce.

Preemption strategies Preemption strategies work like first-mover advantages Preemption strategies work like first-mover advantages But here, an incumbent, facing threat of entry, actively invests in FMA But here, an incumbent, facing threat of entry, actively invests in FMA Examples Examples –Excess capacity (i.e. relative to optimal capacity for “undisturbed” monopolist) –Geographic preemption/brand proliferation E.g. frequency of flights E.g. frequency of flights –Advertise, create switching costs, etc., see Lecture 2 Commitment is essential for preemption to work! Commitment is essential for preemption to work!

Pricing strategies to deter entry: Predatory pricing: Predatory pricing: = lower price to drive competitor out of market; then raise price to recoup losses –Problems: 1.Fighting very costly 2.If entry is economically profitable, someone else might enter –Hard 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 demand is low. –Makes sense only if outsiders don’t know your costs. Otherwise, what you do today is irrelevant

Antitrust constraints Section 2 Sherman Act prohibits attempts to monopolize market Section 2 Sherman Act prohibits attempts to monopolize market –Note: 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 look the same, e.g. aggressive pricing vs. predation –Extremely difficult to decide, e.g. Microsoft case All strategies above have been focus of antitrust cases All strategies above have been focus of antitrust cases When big firms act tough, small firms likely to sue When big firms act tough, small firms likely to sue –Litigation very costly for both sides.