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.
 But sometimes, making irreversible commitments can
have important strategic value.
 Example: Hernán Cortés’ decision to sink his ships
upon landing in Mexico.
When the decision to invade
Mexico is easy to reverse:
(2, -1)
Retreat
(0, 0)
Montezuma
= player 2
Retreat
Fight
Cortés
= player 1
Fight
(-2, -2)
Commitment is about
limiting your options in the future
If Cortés sinks his ships before Montezuma decides what to do:
(2, -1)
Retreat
Montezuma
(0, 0)
Retreat
Fight
Cortés
Fight
(-2, -2)
Commitments as strategic moves
(2, -1)
Retreat
Sink
(-4, 0)
Montezuma
Retreat
Fight
Cortés
Retreat
Don’t
sink
Montezuma
Cortés
Fight
(2, -1)
(-2, -2)
(0, 0)
Fight
Retreat
Outcome
if Cortes
doesn’t sink
Cortés
Fight
(-2, -2)
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
– What if Montezuma’s cost of fighting is lower than expected?
 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
 MC=60, daily demand:
– American’s demand:
– Southwest’s demand:
QA = 120 – 1.5 pA + pS
QS = 120 – 1.5 pS + pA
 Best responses:
– American’s best response: pA = 70 + 1/3 pS
– Southwest’s best response: pS = 70 + 1/3 pA
 Nash equilibrium: pA = pS = $105/ticket
 Profits: πA = πS = $3038/day
Invest to lower MC?
 Suppose American can lower its MC by 5% (from 60 to
57) by investing $340K. Good idea?
 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
 Let’s see if that’s the case.
Cost reduction and price changes
 Scenario 1: American charges same price =>
Southwest too
–
–
–
–
πA = (105 – 57)(120 – 1.5 * 105 + 105) = 3240
Increase by 3240 – 3038 = 202
Looks profitable!
Problem: not a Nash equilibrium given lower MC
 Scenario 2: Lower MC => Charge lower price
–
–
–
–
American’s profit πA = (pA – 57)(120 – 1.5 * pA + 105)
Best response: pA = 68.5 + 1/3 pS, at pS = 105: pA = 103.50
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.
 What is new equilibrium?
– American’s new best response: pA = 68.5 + 1/3 pS
– Southwest’s best response is unchanged: pS = 70 + 1/3 pA
– New equilibrium: pA = 103.31, pS = 104.44
 American’s profit:
– With new prices: πA = 3217
– Increase by 3217 – 3038 = 180 < 189
– Investment not 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):
PS
American’s
best response
After AA’s initial
price adjustment
B
C
A
Original
equilibrium
Southwest’s
best response
New
equilibrium
PA
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
Soft commitments and price
competition
 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
– 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
 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?
 Positive strategic effect!
Soft commitments can be
good for you
 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
 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,
– q = 50 for each, P = 15, π = 500 for each
 Suppose Arnold can reduce MC from 5 to 4, and…
 …investment profitable if profit increases by at least 60
 With previous quantities: πA = (15 – 4)*50 = 550,
increase by 50 => not profitable
 But Arnold would want to produce more:
–
–
–
–
New best response: qA = 102.5 – (qB + qC)/2,
Given qB = qC= 50: qA = 52.5 => Price = 14.5
πA = (14.5 – 4)*52.50 = 551.25
Still not profitable
Strategic effect with quantity
competition
 But Beatrice and Charlotte want to produce less if
Arnold produces more = case of strategic substitutes
 Best responses: qA = 102.5 – (qB+qC)/2,
qB = 100 – (qA+qC)/2, qC = 100 – (qA+qB)/2
 Solve for q’s: qA = 53.75, qB = 48.75, qC = 48.75
 Arnold’s profit: 578 => investment profitable!
 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):
qB
Arnold’s best response
Original
Equilibrium
B
A
After Arnold’s
initial adjustment
Strategic effect
New equilibrium
C
50
52.5 53.75
Beatrice’s
Best response
qA
Conclusion
 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
– 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
– 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
 But here, an incumbent, facing threat of entry, actively
invests in FMA
 Examples
– Excess capacity (i.e. relative to optimal capacity for
“undisturbed” monopolist)
– Geographic preemption/brand proliferation
 E.g. frequency of flights
– Advertise, create switching costs, etc., see Lecture 2
 Commitment is essential for preemption to work!
Pricing strategies to deter entry:
 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:
= 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
– Note: does not prohibit monopoly as such
 “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
 When big firms act tough, small firms likely to sue
– Litigation very costly for both sides.