Lecture 5: Strategic commitment and applications to entry and exit

Transcription

1 Lecture 5: Strategic commitment and applications to entry and exit. Credible commitments. Preemption 3. Predation 4. Taxonomy of strategic commitments 5. Some Examples of Entry Deterrence Credible Commitments Paradox: Less freedom of choice may lead to more favorable outcomes Credible commitments have strategic value - such commitments must be observable and irreversible, or at least perceived as such. Credible Threat of Tough Competition May Discourage Entry or Lead to Exit Some examples Burning bridges behind you - Military Applications Sunk capacity costs - Dupont Rent durable goods instead of selling them - IBM s mainframe computers, -Xerox s plain paper copiers Second-source license -Intel s 8086 microprocessor

2 Preemption Example: DuPont in titanium dioxide industry By expanding rapidly DuPont believed that it would discourage entry or expansion by rival firms. By 985, five of the firms competing with Dupont had exited (3 by acquisition) Monopoly Enter 4 0 DuPont Rival N E E Excess N E 3 0 Preemption (continued): control over a scarce, essential input Alcoa (aluminum) Patents (Xerox) Airport takeoff and landing slots Long-term contracts (Nutrasweet s long term contracts with Coke and Pepsi) Predatory pricing (and limit pricing) Starting paradox: It is difficult to commit to a price. How can price then deter entry / induce exit? MCI Enter Stay out Low P AT&T HP LP 0 HP Chain-store paradox predatory pricing to deter entry will not work

3 Predatory pricing continued: Why the threat of setting low prices may be credible: Reputation building. It may be rational to behave irrationally. (American Airlines fierce price war led to demise of Braniff. AA has a reputation for toughness. Also, Monsanto retaliated against Holland Sweetner s (HSC s) entry into Europe by dropping price from $70 per pound to $-$30 per pound. HSC s capacity at the time was just 5% of world market.) Learning Curves (Boeing vs. McDonnell Douglas) Building up an Installed Base (Microsoft browser) Avoiding Predation An entry strategy Judo (the soft way ) economics Braniff TWA Comfort Class Southwest s Entry (Other carriers have learned to let Soutwest grab the vacation travelers, while they hold on to their business customers and frequent flyers.) Small Incumbent Prey NP P 4 Entrant - 3 Large NP Example : Sunk Costs & Barriers to Entry Let π = (-K -K ) K, π = (-K -K ) K. Simultaneous Move Game (Cournot): FOC: -K -K =0, -K -K =0. Hence K *=K *=/3. π *= π *=/9. Sequential Move Game (Stackelberg): Firm moves first. To find subgame perfect equilibrium, solve by backwards induction. Period : FOC: -K -K =0 K *=(-K )/ Period : π = (-K -K *) K =(-K - (-K )/) K =.5K (-K ) FOC: -K =0 K *=/, K *=/4. π *= /8, π *=/6. (First mover advantage) 3

4 Clearly firm earns more than it does under Cournot competition, and firm earns less than it would under Cournot Competition. Firm is not on its reaction curve ex-post. The best response to K =/4 is K =3/8 < /. Firm would reduce K after the choice of firm if it could. However, then firm would choose K >/4 in anticipation of this response. Hence, firm loses by being flexible. The fact that the investment cost is sunk allows firm to commit to a higher investment level. In the previous example, there is no entry deterrence. (Firm can only deter entry by choosing K =. But in such a case, firm s profits are equal to zero.) Example : A Model of Entry Deterrence. Let π = (-K -K ) K -F if K >0. 0 otherwise. If firm chooses K =/ (as in the Stackelberg setting), firm chooses K =/4 as long as it earns positive profits. Otherwise, it will not enter. In such a case, firm s profits are π *=/6-F. Hence if F>/6, entry is blockaded. Even when firm does not try to strategically deter entry, firm will not enter the market. Hence, we ll restrict ourselves to the setting when F</6. Firm can accommodate entry by choosing the Stackelberg capacity level and in doing so earns profits equal to /8 as before. But firm has another choice. It can choose to strategically deter entry. Firm s profits are given by (-K d -K ) K -F. We know that firm s optimal capacity choice (if it enters) is K *=(-K d )/. Hence firm s maximum profits are: (-K d -K *) K *-F=(- K d - [-K d ]/)(-K d )/-F= (-K d ) /4-F. Hence by choosing K d =-F.5,firm can deter entry. In such a case, π d = (-K d ) K d =F.5 (- F.5 ). Recall that accommodation profits are π a = /8. These profits are equal at F= If F > /6 Entry is blockaded < F < /6 Entry is deterred F< Entry is accommodated. 4

5 Taxonomy of business strategies - Informal More aggressive behavior by Firm implies less aggressive behavior by Firm. Be tough, that is, commit to being more aggressive. Top dog strategy Examples: Preempt Entry, Exclude Competitors Dupont) More aggressive behavior by Firm implies more aggressive behavior by Firm. Be soft, that is, commit not to being aggressive. Judo economics Examples: TWA comfort class, Southwest Taxonomy of business strategies - formal Detergence of Entry (Two period model): π =[K, x * (K ), x * (K )]=0 What strategy can firm use to make firm s entry unprofitable? dπ /dk = π / K +( π / x )( x */ K )+ ( π / x )( x */ K ) = direct effect + zero envelope thm + strategic effect Strategic effect here: K changes firm s ex post action: x */ K Often the direct effect is zero In such cases, dπ /dk = ( π / x )( x */ K ) Investment makes firm tough if dπ /dk <0. Investment makes firm soft if dπ /dk >0. If investment makes firm tough, it should over-invest to deter entry. Taxonomy of business strategies - continued Detergence of Entry (Example): First period: Firm chooses investment K, which lowers its MC Second period: Firms compete in quantities (x,x ) Increase in K, shifts firm s reaction function to right Firm has incentive to produce more, which lowers marginal value of output for firm Formally, x */ K >0. π / x <0 in Cournot setting Hence dπ /dk = ( π / x )( x */ K )<0 Investment makes firm tough (raises x, which hurts firm ) Hence, firm over-invests to deter entry 5

6 Taxonomy of business strategies - continued Entry Accommodated (Two period model): Here incentive to invest dictated by firm s profit function π =[K, x * (K ), x * (K )]=0 dπ /dk = π / K + ( π / x )( x */ K ) = direct effect + strategic effect Direct effect is cost of investment Strategic effect here: K changes firm s ex post action: x */ K In the case of entry accommodation, firm should overinvest if the sign of the strategic effect is positive firm should underinvest if the sign of the strategic effect is negative Same example as before: ( π / x )<0, ( x */ K )<0, hence strategic effect ( π / x )( x */ K )>0, implies overinvest 6