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ME2718: Competition, comittments, entry/exit,

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Anders Broström

on 23 January 2018

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Transcript of ME2718: Competition, comittments, entry/exit,

Competition, Commitments,
Entry/Exit

Strategic commitments
Competitors
Basics
Effects of strategic commitments
The value of not commiting
Overview
Characterisation of how a firm reacts to price/quantity change by a competitor

When a firm’s action induces the rival to take the opposite action the actions are
strategic substitutes
In the Cournot duopoly model quantities are strategic substitutes
A quantity increase is the profit maximizing response to competitor’s quantity reduction
The reaction function is downward sloping

When a firm’s action induces the rival to take the same action the actions are
strategic complements
In Bertrand duopoly model prices are strategic complements
A price cut is the profit maximizing response to competitor’s price cut
The reaction function is upward sloping

Moves that represent commitment:
Capacity expansion with investment in relationship specific assets
Contracts with clauses such as most favored customer clause
Public announcements - provided the reputation of the firm/management will suffer when not backed by action

To achieve the desired result, the commitment should be
Visible
Understandable
Credible - which typically means that is must be difficult to reverse, difficult to stop once set in motion

Through a strategic commitment, a firm imposes inflexibility on itself
Strategic commitments have
long run impact
and are
hard to reverse

Effective strategic commitments affect choices made by rivals
Assessing strategic commitments involves anticipating market rivalry
A
real option
exists if future information can be used to tailor decisions
The value of the real option is the NPV of being allowed to avoid committing to a decicion today
For example: Better information about demand can be utilized by delaying implementation of projects
Value of real options may be limited by the risk of preemption
Key managerial skill in spotting valuable real options

The potential strategic value of commitments is an exception to the rule that flexibility is a virtue in business

Modify the commitment as conditions evolve
Delay commitment until better information is available on profitability
Make unprofitable commitments today to preserve valuable options in the future

In general, commitments that lead to less aggressive behavior from the rivals will have beneficial strategic effect
If the rival is a potential entrant rather than an existing firm, a tough commitment to price aggressively may deter entry
If the rivals is an existing firm and there is excess capacity in the industry, aggressive pricing may invite retaliation
If the products are horizontally differentiated, the strategic effect may be relatively less important since the rival does not have the incentive to react

Tough

Commitments affect the present value of the firm’s profits
Direct effect: Due entirely to its own tactical decisions
Strategic effect: Due to the effect on the tactical decisions of the competitors
The strategic effect can be positive or negative depending on the nature of the commitment
(choice variables being strategic complements or strategic substitutes; tough or soft commitment)

A strategic commitment can make a simultaneous move game into a sequential move game
The simultaneous move game has a unique Nash equilibrium
If firm 1 commits itself to be aggressive, firm 2 finds that it is better off choosing to be passive
The resulting equilibrium improves firm 1's payoff, compared to the non-commitment outcome


Characterisation of the threat imposed on a competitor by an action
A
tough
commitment hurts the competitors while a
soft
commitment helps them
Tough commitment conforms to the traditional view of competition
A soft commitment may be beneficial if the strategic effect of the commitment is sufficiently positive:
A firm that makes a soft commitment to raise its price may experience a negative direct effect on its profitability
If the optimal response of the rival is to raise its price, the strategic effect can be beneficial
The market has two firms and decisions are made in two stages:
In the first stage Firm 1 makes either a soft commitment or a tough commitment
The second stage competition between the rivals will be either Cournot or Bertrand

Soft
Cournot
Bertrand
Firm 1's strategy
Top Dog
Suicidal Siberian
Commitment
posture
Strategic effect
Tough
Soft

!
?
Firm 1's strategy
Mad Dog
Fat Cat
Commitment
posture
Strategic effect
Soft

?
!
Tough

When second stage actions are
strategic substitutes
When second stage actions are
strategic complements
By holding excess capacity, the incumbent can credibly threaten to lower the price if entry occurs.
An incumbent with excess capacity can expand output at a low cost.
Entry deterrence will occur even when the entrant as informed as the incumbent.

Excess capacity works to deter entry when
incumbent has a sustainable cost advantage,
market demand growth is slow,
incumbent cannot back-off from the investment in excess capacity and
entrant is not the type trying to establish a reputation for toughness.

Many firms have
excess capacity:
an ability to produce more in a plant, or consultancy firms selling less than 100% of consultants’ time
When capacity addition has to be lumpy, firms may often have excess capacity in anticipation of future growth
A temporary down turn in demand may leave the firms in an industry with excess capacity with no strategic overtones

Predatory pricing can deter entry if it helps the incumbent establish a
reputation
for toughness
An incumbent can be ‘tough’
either due to low costs
or due to an irrational desire for market share
or because there is other competition entrant is unaware of

Aggressive strategies / commitments:
Announce market share goals
Reward for managers based on market share rather than profits


If the incumbent prices below the monopoly price (regardless of cost), the pricing strategy can alter entrant’s expectation when there is
asymmetric information
about costs and demand:

Entrant infers that either the demand is low or the incumbent’s cost is low.
In either case entry is deterred, since entrant has lowered its expectations for post entry price


Predatory pricing
involves setting the price below short run marginal cost with the expectation of recouping the losses via monopoly profits once the rival exits

Predatory pricing is directed at entrants who have already entered while limit pricing is directed at potential entrants.

If all the entrants can perfectly foresee the future course of incumbent’s pricing, predatory pricing will not work.
The “chain store paradox”: Many firms are commonly perceived to engage in predatory pricing even when it is irrational to expect predatory pricing to deter entry.
Either the firms’ pricing strategies are irrational or the models are incomplete.
Game theoretic models that include uncertainty and information asymmetry show that predation can be a rational strategy.

When multiple periods are considered, the incumbent has to set the price low in each period to deter entry in the following period
The incumbent may be better off being a Cournot duopolist than limit pricing forever as a monopolist
Even in a two period setting, limit pricing equilibrium is not subgame perfect
Potential entrants can rationally anticipate that the post-entry price will not be less than the Cournot equilibrium price

An extreme case where such strategies are not feasible: If there is a possibility of a hit and run entry (zero sunk cost) the market is
contestable.
A monopolist sets the price at competitive levels
It is not worth the monopolist’s while to adopt entry deterring strategies

If
economies of scale or scope
are significant in either production or marketing/branding*, a potential entrant may face cost disadvantages.
Incumbent’s strategic reaction to entry may be to further lower price and cut into entrant’s profits.
If entrant succeeds, intense price competition may ensue.

* Recall the concepts of umbrella branding and Sutton’s endogenous sunk cost

Asymmetry between Incumbents and Entrants:
What is sunk cost for incumbents is incremental cost for the entrants
Established relationships with customers and suppliers are not easy to replicate
Learning curve effects
Switching costs for the customers

Entry is considered
blockaded
when the incumbent does not need to take any action to deter entry
Existing structural barriers are effective in deterring entry

With
accommodated entry
, the incumbents should not bother to deter entry
This condition is typical of markets with growing demand or rapid technological change
Structural barriers may be low and strategic barriers may be ineffective or not cost effective

Deterred entry
- when
entry is not blockaded
entry deterring strategies are effective in discouraging potential rivals and are cost effective
the incumbents have good reasons to engage in predatory acts
Markets can be characterized by whether
the existing barriers to entry are structural or strategic
and
entry deterring strategies are feasible


Incumbents can erect
strategic barriers
by
expanding capacity
strategic bundling
adopting their pricing strategy

For entry deterring strategies to work
Incumbent must earn higher profits as a monopolist than as a duopolist and
The strategy should change the entrants’ expectations regarding post-entry competition


Structural barriers to entry
exist when:
incumbents have cost advantages
incumbent have marketing advantages
incumbents are protected by favorable government policy and regulations
incumbents control essential resources (patents, secrets, natural resources)

Barriers to entry
are factors that
allow the incumbents to earn economic profit while
making it unprofitable for the new firms to enter the industry.
Barriers to entry can be classified into
structural barriers (natural advantages) and
strategic barriers (incumbents’ actions to deter entry)

Cost benefit analysis for entry:
A potential entrant compares the sunk cost of entry with the present value of the post-entry profit stream
Sunk costs of entry range from investment in specialized assets to obtaining government licenses
Post-entry profits will depend on demand and cost conditions as well as post-entry competition

Analysis for exit is analysed in a parallel fashion

Typical patterns from empirical studies:
Entry and exit are pervasive (but intensity varies greatly between regions)
Entrants (exiters) are smaller than incumbents (survivors)
Most entrants fail quickly
The rates of entry and exit vary from industry to industry

Entry and exit less intensive in industries with higher
Market growth.
Capital intensity
Scale economies (measured by MES)
See e.g. Nyström (2009)

Entrants in the early stages of the product life cycle are more knowledge-intensive than incumbent firms
Firms exiting in early stages of the product life cycle are more knowledge-intensive than firms exiting in later stages
(Nyström & Karlsson, 2006)

What determines the attractiveness of entry into an industry?
Entry and Exit

There are
barriers to exit
, stemming from:
Sunk costs (such as obligations and commitments to suppliers and employees) make the marginal cost of staying low
Relationship specific assets may have low resale value
Government regulations

PEntry = the minimum price that will induce a firm to enter an industry
PExit = the minimum price that will induce an incumbent firm to stay in an industry
PEntry > PExit
Exit barriers drive a wedge between PEntry and PExit .

An incumbent using the
limit pricing
strategy will set the price sufficiently low to discourage entrants

Contestable limit pricing:
Incumbent has excess capacity and can set prices below entrant’s marginal cost
Incumbent can meet the market demand at the low prices
Strategic limit pricing
For firms with limited capacity or rising marginal costs, limit pricing may mean sacrifice of profits or inability to meet market demand
Low price can be an entry deterrent if entrant infers that post entry price will be low

Entry threaten incumbents in two ways
The market share of the incumbents is reduced
Price competition is intensified
Exit has the opposite connotations

Entry
could take place in different forms:
An entrant may be a brand new firm…
… of which some are started as spin-offs from incumbent firms
An entrant may also be an established firm that is diversifying into a new product/market
The form of entry is important for analyzing the costs of entry and the strategic response by incumbents

Exit
also takes place i different forms:
A firm may simply fold up
A firm may discontinue a particular product or product group (Sega leaves the video game hardware market)
A firm may leave a particular geographic market segment (Peugeot leaves the U. S. market)
Predatory pricing strategy can degenerate into a
war of attrition
.
If no one leaves in the early stages, a prolonged price war can be bad for all the firms in the industry.
Even the winner may be worse off compared to not having had the price war at all.

The more a firm believes it can outlast its rivals, the more willing it to stay in the price war
A firm that faces exit barriers is well positioned to engage in a price war.
A firm can also try to convince its rivals that it can outlast them (For example, by claiming to be making money even during the price war)

"Judo economics":
Use opponent’s strength to one’s advantage.
Entrant discourages the incumbent from entry deterrence strategies by appearing to be a non-threat in the long term
Incurring large losses may not appear worthwhile to the incumbent due to the revenue-destruction effect and/or sunk costs and rigidity

What can incumbents do to make entry less attractive?
Two types of barriers
Limit pricing
Predatory pricing
Excess capacity
Structural barriers
Strategic barriers
Strategic barriers -- pricing
The choice to enter and to exit
Entry conditions
Competition

Early in the industry’s life cycle many small firms compete
The winners invest in their brand name capital and grow large
The smaller firms can try to match the investment and build their own brands or differentiate their products and seek niches

Theory predicts that the larger the minimum efficient scale (MES) of production the greater will be the concentration
MES related to technology and associated with sunk costs of incumbents
If entry is not easy concentration will be the result


If the firms are identical to begin with, they will be setting the same price as each other in the
Bertrand equilibrium
The price will equal marginal cost (same as perfect competition) no matter how many firms are competing, since otherwise each firm will have the incentive to undercut the other

A market with a small number of sellers are referred to as an
oligopoly
Pricing and output decisions by each firm affects the price and output in the industry

Two basic models:
In the
Cournot
model, firms determine quantities, price regulated over the market
In the
Bertrand
model, firms determine prices and supply whatever quantity demanded

Two types of differentiation:
Vertically differentiated
products unambiguously differ in quality
Horizontally differentiated
products vary in certain product characteristics to appeal to different consumer groups


Prices are generally higher in markets with higher concentration
For locally provided services (doctors, plumbers etc.) the “entry threshold” – population needed to support a given number of sellers – increases fourfold between 1 and 2 sellers
Intensity of price competition reaches the maximum with three sellers (Bresnahan and Reiss)


If one firm’s strategic choice adversely affects the performance of another they are competitors
A firm may have competitors in several input markets and output markets at the same time

Direct
competitors: Strategic choice of one firm directly affects the performance of the other

Indirect
competitors: Strategic choice of one firm affects the performance of the other because of a strategic reaction by a third firm

Consumer goods markets seem to have a few large firms and many small firms
The number of large firms and the total number of firms depend more on advertising costs than production costs (Sutton)
Advertising costs are
endogenous sunk costs

When are either of these models applicable ?
If the firms can adjust the output quickly, Bertrand type competition will ensue
If the output cannot be increased quickly (capacity decision is made ahead of actual production) Cournot competition is the result


Horizontal differentiation is possible with
search costs
and
idiosyncratic preferences
Search costs are the cost of finding information about alternatives
Search costs discourage switching when prices are raised
Location and Taste are important sources of idiosyncratic preferences

For example:
Grocery stores attract clientele based on their location
Consumers choose the store based on “transportation costs”
Transportation costs prevent switching for small differences in price

Oligopoly
The output in
Cournot equilibrium
will be less than the output under perfect competition but greater than under joint profit maximizing collusion
As the number of firms increases, the output will drift towards perfect competition and prices and profits per firm will decline

Factors explaining market structure
Market structure
Differentiation
Herfindahl index: sum of squared market shares

Markets with one seller are referred to as
monopolies
Markets with many sellers selling homogenous goods correspond to will tend towards
perfect competition
.
Other characteristics associated with perfect competition are limited information asymmetries, excess production capacity and (very) limited entry barriers in place
Markets with many sellers selling differentiated goods are better described by a family of models known as
monopolistic competition
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