Michael Raith
STR 421
Spring 2007
Final exam answer key
Part I: Case “Samsung Electronics” (75 points)
Note on grading: some of the questions may overlap a bit, for instance Q1 (a) and (b), or Q2
(a) and (b). Consequently, some people provided answers in one question that I was looking
for in another question. No worries, I generally took those answers into account and adjusted the scores for those questions accordingly.
1. (20 points) Samsung’s competitive advantage I:
(a) (5 points) To what extent does Samsung have a cost advantage over its competitors? To what extent does it have a benefit (differentiation) advantage?
Provide numbers.
This question (only 5 points) was meant to get an overview of Samsungs extent of
competitive advantage. Some of you went into more detail here. To the extent those
details overlapped with (b), I counted them as part of the (b) answer
According to Exhibit 7a, Samsung’s costs per (256MBit equivalent) unit are lower by
$1.39, or 24.4%, than those of its average competitor. They are lower by 10% than
SMIC’s costs, which is Samsung’s lowest-cost competitor.
An indirect way to tell that Samsung has a benefit advantage is by its ability
to charge higher prices than its competitors. According to Exhibit 7a, Samsung’s
prices per chip are on average higher by $0.72 than those of its competitors, or by
14.5%.
Remember that price is not the same as WTP, it’s usually considerably lower
especially in competitive industries. But Samsung’s higher prices do suggest that
customers have a higher WTP for Samsung’s chips.
What explains the price premium? P.2 mentions that OEMS would an “upwards of 1%” premium for superior reliability, which Samsung surely offers, but that’s
only 1% (5-6 cents), not 14.5%. Maybe Samsung’s reputation premium is much
higher. That could be the case because memory chips are an experience good, i.e. a
good whose quality can be ascertained only after purchase (or in the case of chips,
only when there’s a problem).
A second explanation for the premium price could simply be monopoly power
– Exh. 7 indicates that for many specialty products, Samsung is practically a monopolist. A third explanation is that the price premium is a premium for the variety of
products that Samsung offers, one that allows customers to source different chips
from the same supplier and thus save on transaction costs. That would be true to the
extent that many customers indeed each purchase different types of chips, which the
case doesn’t say much about.
(b) (15 points) How has Samsung been able to achieve a “dual advantage”? Organize your answer either around Samsung’s activities or around the cost and
benefit drivers at work in the memory chips industry, whichever you prefer.
By activities (not ordered by importance):
•
HR/Organizational:
- Recruiting: As the largest and one of the most prestigious companies in
South Korea, Samsung can hire some of the most talented people in the
country and elsewhere in Asia. Of course, it pays for that (compare $44,000
average salary at Samsung vs. $24600 at Hynix, the other leading Korean
firm). But chances are that given the scarce use of incentives in Asia in the
past and even at present, a more meritocratic company such as Samsung
can attract talented people without overpaying them.
- Human resource policies (promotions, job rotation etc.): again, Samsung is
described as more meritocratic than most other large Asian companies. That
may no longer be true today but certainly would have been true in the beginning of Samsung’s ascendancy in the 80s. Again, the consequence of standing out in this way would be Samsung’s ability to attract talent at a good price.
- Among the incentives provided, project-based bonuses (p.10), e.g. upon rollout of a new chip, stand out as a more unusual practice. They are useful in a
company in which product development brings people from different departments together.
- A culture of excellence promoted especially by Chairman Lee. His role resembles that of John Connelly at CC&S
•
Location choices:
- As some of you pointed out, Samsung’s location in the mountains outside
Seoul helps lower air purification costs. (How unique is that sort of location?
Maybe it is indeed hard to find locations with very god air right next to large
cities)
- Co-location of fab lines on the same site is estimated to lower construction
costs for fab lines by 12% (p9)
- Co-location of production and R&D facilities brings production and development engineers close together and allows them to sort out problems with
ease
•
R&D: Samsung made some clever bets on technology in the past
- In the early 90s, Samsung invested in the use of 8” wafers to cut chips (p8),
thereby substantially lowering production costs
-
•
ƒ
A little earlier, Lee chose to pursue the “stacking” over the “trenching” technology, which turned out to be the right decision. We could simply interpret
this as a lucky bet. On the other hand, the case makes the stacking technology appear to be the more natural choice for a company like Samsung that
makes quality control a priority.
Production:
- Samsung achieved a first-mover advantage due to both the scale of its facility
and the importance of experience in chip production:
o In the mid-80s, it built a large manufacturing facility in record speed, at a
time when the market was in a recession. (Note here that the argument is
not just about scale, but scale in relation to market size)
o The production of chips is described as difficult, and as early mover Samsung has acquired an expertise in production that has not been matched
by anyone else.
- Samsung is able to produce multiple product architectures on each production line (p9). This is essential for Samsung to able to produce a large variety
of chips, including customized chips, in a cost-effective manner.
To some extent, there must be a tradeoff here: producing different kinds of
chips has to be at least as costly as producing the same number of only one
chip. However, it appears that for Samsung these additional costs are low
compared to the benefit of having a large variety.
Procurement: p2 indicates that as a large customer, Samsung is able to get a 5%
discount on raw materials
Does this analysis of activities really explain Samsung’s dual advantage? Probably
not. To get to the bottom of this, we’d have to ask questions like: why is there no
(say) auto maker with a dual advantage? Why doesn’t BMW compete in the low end
of the market, and why doesn’t Honda compete in the high end? Both companies are
successful, but they occupy distinct positions along the productivity frontier.
The answer to what makes a dual advantage possible in memory chips but
not cars must lie in the details about R&D and production in memory chips, details
not explicitly provided in the case. One likely factor is that “quality” is not a matter of
fancy features like in luxury cars, but simply a matter of reliability, and improving reliability is a matter of process R&D, not product R&D. In that sense, the same process
R&D contributes to lowering costs as well as improving quality. Another factor may
be that breakthroughs in next-generation chip development entail the acquisition of
skills that are useful for mass chip production in general. Finally, this is a market in
which frontier products become mainstream products within just 1-2 years. Given the
importance of experience, this implies that being a leader at the frontier puts Samsung in a good position to be a leader in the mass market later on.
2. (20 points) Chinese entrants:
(a) (5 points) What advantages do Chinese firms have in entering an already established and competitive memory chips industry in 2005?
•
Chinese firms aim to be low-cost competitors that mass-produce mainstream
chips. As such, they can take advantage of known technologies, and thereby in
long run save on R&D costs (though not at present, see Exh. 7a).
•
Their level of technological sophistication is currently low (see part b), but they
are already forming partnerships with firms such Infineon and therefore have access to the necessary technological expertise to compete, in spite of trade restrictions imposed by the U.S.
•
China has a large pool of talented, educated workers, and the costs of labor are
very low.
•
Chinese firms have easy access to cheap capital from both domestic and international sources. Because of their strong financial position, they are prepared to
sustain losses over years in order to gain market share (p11).
•
China is a large and growing market, and chances are that Chinese firms, and to
a lesser extent foreign firms with a presence in China, have an advantage in the
Chinese market over competitors located elsewhere.
(b) (15 points) How likely are the Chinese entrants to become a serious threat to
Samsung over time? Support your answer with data from the case.
Your answers differed considerably here, ranging from “very likely” to “very unlikely”.
There are good arguments for each position; it also depends on you how interpret
“serious threat”.
Clearly, the Chinese firms are currently not nearly as efficient as Samsung. In
DDR SDRAM chips (Exh. 7g), the only one produced by SMIC, Samsung’s operating
margin is a full dollar more than SMIC’s, i.e. more than 20%. SMIC is underpricing
Samsung here in spite of $0.78 higher costs/unit. Behind this cost difference is the
use of old technology, in particular smaller wafer size (see Exh. 11, though keep in
mind it’s 2001 data).
As a further clue, note that one of the biggest advantages of the Chinese
firms is their low labor costs: salaries at SMIC are about ¼ of those at Samsung.
Nevertheless, labor costs per unit are still ½ those of Samsung. This means that
Samsung’s labor productivity must be twice that of SMIC’s:
Costs/unit
=
costs/hour of labor x hours of labor/unit
=
wage x labor productivity
In the long run, it is still hard to imagine Chinese firms becoming more efficient than Samsung. On the other hand, they could well become efficient enough to
substantially reduce Samsung’s margins. In that sense, the Chinese entry is a threat
for Samsung.
There are a few clues many of you mentioned: SMIC’s is already Samsung’s
lowest-cost competitor (Exh 7a) overall, and Chinese firms might partner with a firm
like Infineon, which is Samsung’s lowest-cost competitor in DDR SDRAMs (Exh 7g).
China has a 4% share of the world market capacity in chips, which is expected to
grow to 9% by 2007 (p5).
But even fully achieving the productivity of Infineon would still not enable Chinese firms to outdo Samsung. As a rough approximation, suppose a Chinese firm
could achieve the best possible combination of Infineon’s and SMIC’s cost structure
according to Exh. 7g. That is, suppose a firm could emulate Infineon but still benefit
from lower labor and SG&A costs like SMIC. Then its costs might look like this:
Raw materials:
Labor:
Depreciation:
R&D
SG&A
Total
1.56
0.23
1.41
0.66
0.34
4.20
There are all sorts of objections to this calculation one might raise, but it’s a rough
calculation of what Chinese firms might achieve over time through partnering with
one of Samsung’s Western competitors. Well, $4.20 is still higher than Samsung’s
cost of $4.06. Thus, even under fairly optimistic assumptions Chinese firms would
not be able to beat Samsung. However, aggressive pricing could seriously erode
Samsung’s margins and make this segment of the market much less profitable than
it has been up to now.
As some of you pointed out, the competitive threat by the Chinese could be
mitigated by the fact that Samsung still has a benefit advantage, i.e. customers are
willing to pay more for Samsung’s chips. This means that competitors must price below Samsung in order to compete. Correct, but note that Samsung’s price premium
over e.g. Infineon in DDR SDRAMs is only 7 cents, i.e. much less than for chips on
average (see Q1a).
3. (20 points) Samsung’s competitive advantage II:
(a) (10 points) How important are different product categories within the DRAM
market to Samsung’s bottom line?
Note: some of you answered a slightly different question, namely “How important is it
for Samsung to have different product categories”, to which the answer is “very”.
The main point here is to observe that while 256Mbit chips, and within that category
DDR SDRAM chips, are by far the biggest part of the market, Samsung in fact earns
much larger margins on legacy products (16, 64, 128 MBit), frontier products
(512Mbit), and specialty chips (256 Rambus DRAM) than in mainstream products,
not surprising given the much greater extent of competition in the latter (see p.8 on
the classification of the product mix). Consider the numbers in the following table:
All memory chips: 64 Mbit
Operating profit
Volume
Share of volume
Tot Op. profit
Share of op. profit
Within 256 Mbit:
128 Mbit
256 Mbit
512 Mbit
5.64
16.4
1.8%
2.56
151.6
17.0%
0.94
695.8
77.8%
3.69
30.4
3.4%
92.496
7.4%
388.096
31.1%
654.052
52.5%
112.176
9.0%
SDRAM
DDR
DDR2
Rambus
Operating profit
Volume
Share of volume
0.79
160
23.0%
0.66
485
69.7%
3.9
25.7
3.7%
4.32
25
3.6%
Tot Op. profit
Share of op. profit
126.4
19.3%
320.1
48.9%
100.23
15.3%
108
16.5%
Total
894.2
1246.82
Total
695.7
654.73
As the table shows, non-256Mbit chips account for only about 20% of Samsung’s total volume but almost a half of its operating profit. Even more extreme, within the 256
category, the DDR2 and Rambus DRAM chips account for only 7% of production
volume but 32% of operating profits. The high margins in non-mainstream products
may appear to be the result more of market power (=lack of competition) than of a
superior cost position (note in Ex. 7 that where Infineon is in the market too, its margins are quite decent). But then, the fact that most firms choose not to compete in
these niches suggests that their costs would be too high.
(b) (10 points) Is Samsung’s advantage over existing and new competitors greater
in the “high end” or the “low end” of the market? Where does its advantage
seem easier to sustain?
First of all, the terms “high end” and “low end” are a bit ambiguous because of the
more complicated product mix described on p.8. For instance, 128Mbit chips in general are “low end” in 2004, but the specialty chips Samsung produces in that category (Exh. 7j,k) are extremely profitable, and are not part of the market in which the
Chinese entrants are setting out to compete.
Assuming that “high end” encompasses both frontier and specialty products, Samsung’s R&D and production capabilities are unrivaled here. The Chinese entrants
clearly focus on the mass market, and have no intention of being technological pioneers. Among the existing competitors in the market, too, no firm has in the past
been able to outperform Samsung in any segment of the market.
The main warning sign concerning Samsung’s continued dominance is a remark on p2-3: “leapfrogging” is conceivable in this industry, whereby even a small
startup might get ahead with some completely new technology such as nanotechnology, to the extent that established firms are too much vested in existing technologies
to react.
At the low end of the market, success is to a large degree a matter of scale
and experience. Both give a first mover like Samsung an advantage, but in a large
and growing market others are likely to be able to catch up over time. How soon?
Fortunately for Samsung, it may take them many years.
Thus, while almost all of you concluded that Samsung’s advantage is easier
to sustain at the high end of the market, some of you argued that its advantage in the
low end is quite sustainable as well. This argument is reinforced by the dynamics of
the industry (see Q2b): the frontier products of today become the mainstream products of tomorrow. An advantage at the “high end” today thus translates into an advantage at the “low end” tomorrow.
4. (15 points) What recommendation would you make to Chairman Lee regarding
Samsung’s response to the threat of large-scale Chinese entry? Should Samsung
focus more on defending its low-cost advantage, or on sustaining and growing its
differentiation (=benefit) advantage? Base your recommendation on your conclusions from the previous questions.
There is no question that Samsung should defend its technological leadership and thus
its benefit advantage, mainly by investing the necessary amounts in R&D. Especially as
its dominant position at the lower end/mass market is under threat, Samsung needs to
secure its position at the high end/frontier/niche positions. Several of you argued that
Samsung should expand its presence in the flash memory market.
More difficult to determine is what exactly Samsung should do in the markets directly
affected by entry, e.g. DDR SDRAMs. This is a case of “accommodated entry”. Deterring
entry is out of the question, and engaging in predatory pricing is likely to be unsuccessful
(as it usually is) or even politically precarious with regard to South Korean-Chinese relations.
One option would be to cede the market to the entrants, as some of you suggested.
It is not clear, though, why Samsung should do this anytime soon. As discussed in Q2b,
the Chinese entrants might become a serious threat to Samsung’s profits over time, but
they are at least several years away from getting to close to Samsung’s efficiency. Moreover, the mass market does contribute half of Samsung’s operating profits, so this is not
a market it can afford to just give up without compelling reason.
A “normal” response to entry would simply be to drop price a bit; i.e., to sacrifice a little on the margin to hold on to most of its market share. That may well be what they
should do.
Should Samsung collaborate with the Chinese in some form of joint venture? Probably not, because of the danger of transferring proprietary knowledge. Sure, the Chinese
would otherwise collaborate with firms like Infineon anyway, but Infineon is not nearly as
efficient as Samsung.
Should Samsung build new a new manufacturing facility in China to be better positioned in the Chinese market? One reason that has less to do with Chinese entry and
more with Chinese demand would be to be closer to customers and their demands.
However, it is not clear why this would require manufacturing in China rather than just a
sales representation. It is also that possible Chinese buyers (with or without interference
of the Chinese government through tariffs or other regulation) are more willing to buy
from Samsung if it produced domestically instead of in Korea. That may or may not be
true. There are some potential drawbacks to watch out for. First, since it can’t simply
move fab lines from Seoul to China, this would be additional capacity, which could increase pressure on prices (see Dupont case). Second, Samsung would forgo the advantages mentioned in Q1b of having all facilities on one site.
Bottom line: to the extent that Samsung’s resources force a decision between securing its technological leadership and defending its share in the mass market, Samsung
should focus on technological leadership, ie its benefit advantage.
Part II: Non-case questions (80 points)
5. (18 points, 6 for each part) Assess whether each underlined statement is true or
false. Give a single-word answer, followed by a concise explanation. Your grade
depends on your explanation.
(a) When relationship-specific investments are important, two firms doing business with each other are more likely to merge the less predictable their business environment is.
True. When business is predictable, then the firms can protect their specific investments through long-term contracts. Writing long-term contracts that account for every
contingency that might arise becomes very costly or impossible, however, the more
uncertain the environment is. To prevent holdup problems that are likely to arise if
contracts are short-term or incomplete, the firm may be better off merging.
(b) In industries in which business is “lumpy”, it is easier for firms to collude
(other things equal) because there are fewer opportunities for firms to deviate
from tacit agreements by cutting price.
False. Lumpy business raises a firm’s temptation to cut to win a large order, and reduces the expected loss due to retaliation by other firms. Both make it more difficult
for firms to collude.
(c) The year is 1972, and EMI, the British music company, has just invented the
computerized tomography (CT) scanner. It is unclear how well EMI’s innovation is going to be protected by its patents (in terms of others’ ability to innovate around them). Having no prior experience in the medical equipment industry, EMI must decide whether to produce CT scanners on its own or license
its innovation long-term to one of the major medical equipment companies
such as General Electric (EMI is not considering selling the innovation at a
fixed price). The better the patent protection, the more valuable is EMI’s innovation, and therefore the more strongly EMI should consider producing CT
scanners on its own.
False, for two reasons: first, better patent protection does increase the value of the
innovation, but to both EMI and GE. No matter how large the value of EMI’s innovation, it would always be worth more in GE’s hands than in EMI’s based on the information given, meaning that EMI should sell. Second, weak patent protection is a
problem for licensing agreements, as the licensee might try to innovate around the
patents and eventually take over entirely. To prevent this, EMI might have to produce
on its own in spite of its inexperience. Therefore, the better the patent protection, the
more strongly EMI should consider licensing.
I gave full credit for a complete version of either argument. Partial credit for
“False, because EMI’s decision depends on many other factors” or “False, because
EMI has no experience” or similar answers that didn’t address how and why patent
protection affects EMI’s decision (other things equal!)
6. (20 points) Firm 1 currently serves 120 customers who are willing to pay up to 60
each for its product. Firm 1’s marginal cost per customer is 20. Firm 2 plans to enter 1’s market. Its product is a perfect substitute for 1’s; that is, customers are
willing to pay up to 60 for 2’s product, and they will purchase from the firm that
demands the lowest price. But firm 2 is less efficient than firm 1; its marginal cost
is 30. Will it prevent an aggressive response by firm 1 if firm 2 limits its capacity?
(a) (3 points) Before firm 2’s entry, what is firm 1’s profit-maximizing price p1, and
what is the resulting profit π1?
The optimal price is p1=60, resulting in a profit of (60 - 20)120 = 4,800
(b) (6 points) Suppose firm 2 enters with a capacity of 60. If firm 2 charges a price
of p2=35, what is firm 1’s profit if it ignores 2’s entry and continues to charge to
the price of (a)? What is firm 1’s profit if it matches 2’s price? Assume in the
latter case that firm 1 in fact undercuts it by a small amount (1 cent, say), such
that it regains the entire market. In calculating the profit, however, just assume
p1=p2. Should firm 1 ignore 2’s entry, or match 2’s price? (Disregard any fur-
ther rounds of price adjustments that might follow; i.e. this is not a Nash equilibrium analysis.)
If firm 1 ignores firm 2, then its profit is [margin times quantity] 40 (120-60)=2,400. If
firm matches (or rather slightly undercuts) p2, then its profit is (35 – 20)120 = 1,800.
So it is better for firm 1 to ignore firm 2.
(c) (5 points) Show that with a capacity of 60, the highest price that firm 2 can
charge such that firm 1 has no incentive to match is p2=40.
At any price below 60, firm 1’s profit is 2,400 if it ignores firm 2, as determined in (b).
For matching and regaining the whole market to be the better option, it would need to
attain a margin of at least 2400/120 = 20. Given MC=20, this means that p2=40 is the
highest price at which firm 1 has no incentive to match firm 2.
(d) (6 points) Now suppose firm 2 enters with a capacity of 45. What is the highest
price that firm 2 can charge now, such that firm 1 has no incentive to match?
Should firm 2 enter with a capacity of 60 or a capacity of 45?
If firm 1 ignores firm 2, then its profit is 40(120-45)=3,000. Matching and regaining
the market is worthwhile if the resulting margin is at least 3000/120 = 25. At MC=20,
this means that 2 can charge at most 45.
With a capacity of 60 and p2=40, 2’s profit is (40-30)60 = 600. With a capacity
of 45 and p2=45, 2’s profit is (45-30)45 = 675. So firm 2 is better off entering with the
lower capacity.
7. (20 points) In 1980, the Herfindahl index (10,000 x Σsi2) for the Chicago hospital
market was around 500. Occupancy rates at many hospitals were at 70%. Demand
for admissions was stable. Patients selected hospitals, often based on location or
other preferences, and had their insurance pay the bills.
During the 1980s, Chicago health insurers introduced some important
changes: (1) They contracted with the hospitals that offered the lowest rates, and
offered patients monetary inducements (lower co-payments) to select the contracting hospitals; (2) they conducted rate negotiations with hospitals in secret;
(3) and they established contracts lasting for 1 to 3 years (as opposed to writing
shorter-term contracts).
(a) (10 points) Analyze each determinant of price competition in the Chicago hospital market in 1980. What would be your overall expectation of the level of
price competition between hospitals in that year?
- Concentration: the industry is not very concentrated (HHI = 500 is low). This
means that competitive prices are going to be rather low. Moreover, in a fragmented market, it is difficult for firms to coordinate on prices.
- Capacity utilization is low, which increases hospitals’ incentive to cut prices, as
the ensuing increased demand can be met, and hence tends to make price coordination difficult.
-
Stable demand facilitates high prices in oligopolistic markets, as it makes it easy
to detect and react to a rival’s price cut by looking at market share.
- Patients selected hospitals, often based on location or other preferences: This
means the market is geographically segmented, reducing the responsiveness of
one hospital’s demand to another hospital’s price cut (i.e. the hospitals are differentiated).
- Insurance companies pay the bills: This implies a low price elasticity of demand,
as prices do not enter the decision of which hospital to choose. As a consequence, hospitals have little to gain from lowering prices.
Although the first two factors would lead to high price competition had the patients
cared about prices, the fact that hospitals were in effect very differentiated and customers did not care about prices decreased the attractiveness of price reductions by
hospitals and ensured that the level of price competition would be low.
(b) (10 points) Explain the effects of each change introduced by the health insurers during the 80s from the perspective of their likely effects on price competition.
The changes introduced by insurers ensured that price competition between hospitals increased:
(1)
This decreases differentiation between hospitals, and thus increases the incentives for hospitals to reduce prices.
(2)
With secret negotiations, the incentive to cut price is greater, as deviations
from any price that the hospitals may be trying to coordinate on are more difficult to detect, and hence are less likely to matched immediately by competitors.
(3)
Longer-term contracts imply that transactions are “lumpy”. This increases the
incentive for hospitals to cut price to get a customer, compared with the
downside of a possible price war in the future. If there is one chance every
three years to keep a big insurer, there exists a strong incentive to offer a discounts when the time to negotiate the contracts comes.
8. (22 points) The year is 1983, and Philips (firm 1) and Sony (firm 2) are set to enter
the market for compact discs, a technology invented by Philips [this is based on a
true story]. The firms face uncertainty about the demand for CDs in the popular
music segment of the market. Specifically, both firms, Philips and Sony, expect
that CDs will be bought by pop music fans with a probability of 75%, in which case
the price at which the two firms can sell their (identical) CDs is expected to be P =
16 – q1 – q2, where q1 is Philips’ capacity and q2 is Sony’s capacity. Both firms expect that CDs will not be in high demand with pop music fans with a probability of
25%, in which case the price at which the two firms can sell CDs is expected to be
only P = 10 – q1 – q2. The cost per unit of capacity, normalized to be comparable
with P, is given by 4 for each firm.
As the inventor of the technology, Philips has a timing advantage; it can
choose its capacity for CD pressing before Sony does, but if it still faces uncertainty about demand if it pursues this option. Once Philips has chosen its capacity, both firms learn the state of demand. Then Sony makes its capacity choice. Alternatively, Philips can decide to wait until both firms learn about demand. In that
case, both firms simultaneously choose capacities upon learning the state of demand. The timing of the game is:
1. Philips chooses a capacity of q1 with which to enter the market in 1983 (by
building a plant of that size), or decides to wait.
2. During 1983, both firms learn whether demand for CDs will be high or low.
3. In 1984, Sony chooses its capacity q2 if Philips entered earlier. In this case,
Sony knows Philips’ capacity as it makes this decision. If instead Philips decided to wait in 1983, then both firms simultaneously choose q1 and q2, respectively.
(a) (6 points) Suppose Philips decides to wait in 1983, and demand turns out to be
high. Then at stage 3 of the game described above, the firms’ profits resulting
from choosing a capacity of 3, 4 or 6 (not 5) are shown in the payoff matrix below. Assuming these are the only relevant options, what is the Nash equilibrium of this game?
Sony
Philips
3
4
6
3
18, 18
15, 20
9,18
4
20, 15
16,16
8,12
6
18, 9
12, 8
0, 0
The firms’ best responses are underlined in the matrix above. The unique pair where
each firm’s capacity is a best response to the other’s is q1=q2=4.
(b) (6 points) Suppose Philips happens to know that demand will be large. At
stage 1 of the game, what capacity should Philips choose, knowing that at
stage 3 Sony will choose its best response to Sony’s move? The payoffs are
still given by the matrix above, but now this is a sequential game, not a game
with simultaneous moves.
The matrix above already shows how Sony will respond to Philips’ capacity choice. If
q1=3, then Sony responds with q2=4, and Philips get 15. If q1=4, then Sony again re-
sponds with q2=4, and Philips get 16. If q1=6, then Sony responds with q12=3, and
Philips get 18. So q1=6 is optimal for Philips.
Here’s some more information about the solution to this game that you may take
as given: If demand is low, Sony’s best response to Philips’ capacity choice is
given by q2 = (6-q1)/2. If Philips decides to wait and both firms learn that demand is
low, then Philips’ best response function looks the same (q1 = (6-q2)/2), and the resulting (Cournot) equilibrium is q1=q2=2, where both firms make a profit of 4
(based on the demand function and marginal cost given above).
(c) (4 points) If Philips enters in 1983 with the capacity you determined in (b), what
is Philips’ resulting profit if demand turns out to be low, considering how Sony
will respond?
If Philip enters with q1=6 and the market is small, then Sony’s best response is q2=0.
The resulting market price is 10 – 6 – 0 =4, ie equal to Philips’ MC of capacity. So
Philips’ profit is zero in this case.
(d) (6 points) Given that Philips does not know the level of demand in 1983, what
is its expected profit if it enters in 1983 with the capacity of (b)? What is its expected profit if it waits? Should Philips enter now, or wait?
If Philips enters in 1983 with q1=6, then its expected profit later on is .75 * 18 +.25 * 0
= 13.5. If Philips decides to wait, then its expected profit is .75 * 16 + .25 * 4 = 13
(based on the Nash equilibrium profits for each case). So Philips should enter.
That is, Philips faces a tradeoff between commitment and flexibility. If Philips
knew the market will be large, it would want to enter with a large capacity in order to
preempt Sony. The risk is getting stranded with a large plant if demand turns out to
be low; i.e. the value of waiting is to see how demand turns out. Which option is preferred then depends on the probabilities of each scenario; here, entering early is the
more profitable (albeit riskier) option.