Economics of Strategy Sixth Edition Besanko Dranove Shanley
Economics of Strategy Sixth Edition Besanko, Dranove, Shanley, and Schaefer Chapter 7 Dynamics: Competing Across Time Copyright 2013 John Wiley Sons, Inc.
Strategic Commitment Strategic commitments have long run impact and are hard to reverse Strategic commitments can affect choices made by rivals Assessing strategic commitments involves anticipating market rivalry
Strategic Commitment Inflexibility can add value Strategic commitment limits options but alters competitors’ expectations Strategic commitment can make a simultaneous move game into a sequential move game
Strategic Substitutes When a firm’s action induces the rival to take the opposite action the actions are strategic substitutes In Cournot duopoly model quantities are strategic substitutes A quantity increase is the profit maximizing response to competitor’s quantity reduction Reaction function slopes downward
Strategic Complements 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
Tough Commitments and Soft Commitments 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
Can the Negative Strategic Effect be Forestalled? If the direct effect is positive and the strategic effect negative, can the firm forestall the latter? Example: The net present value of cost reducing commitment is positive. Can the negative strategic effect be avoided by refusing to lower the price?
Can the Negative Strategic Effect be Forestalled? If the profit maximizing strategy (after the commitment) is to lower the price, rival will assume that the firm will do so It is difficult to convince a rival that your firm will act against its own interest in the second stage
A Taxonomy of Strategic Commitments When Second Stage Actions are Strategic Substitutes
A Taxonomy of Strategic Commitments When Second Stage Actions are Strategic Complements
Flexibility and Options The value of commitments lies in creating inflexibility However, when there is uncertainty, flexibility is valuable since future options are kept open Commitments can sacrifice the value of the options
Commitment-Flexibility Tradeoff By waiting, a firm preserves its option values By waiting, the firm also may allow its competitors to make preemptive investments Example: Philips decides to delay its CD manufacturing plant in the U. S. , allowing Sony to build its plant first
Preserving Flexibility 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
Flexibility and Real Options A real option exists if future information can be used to tailor decisions 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
A Framework for Analyzing Commitments Pankaj Ghemawat has developed a four step process for analyzing commitment intensive decisions Positioning Analysis Sustainability Analysis Flexibility Analysis Judgment Analysis
Flexibility Analysis Flexibility analysis incorporates uncertainty and option value A key determinant of the option value is the ratio of the “learn rate” to the “burn rate” of the firm The rate at which a firm receives new information that allows it adjust its strategy is termed the “learn rate”
Flexibility Analysis The rate at which the firm makes irreversible investments in support of its strategy is the “burn rate” A high learn to burn ratio indicates that the option value of delay is low Firms can increase their learn to burn ratios through experimentation and pilot programs
Judgment Analysis Judgment analysis involves looking at the organizational and managerial factors to ensure that incentives exist to support the optimal strategy Hierarchical decision making may create a bias towards Type I errors - rejecting good projects
Judgment Analysis Decentralized decision making may result in higher incidence of Type II errors - accepting unprofitable projects Managers should be cognizant of the biases imparted by the structure of the organization and its politics and culture
Dynamic Price Competition Price competition can be viewed as a dynamic process Decisions by a firm today will affect its behavior as well as its competitors’ in the future Dynamic competition can also occur in nonprice dimensions such as quality
Dynamic versus Static Models Dynamic models can address questions that static models cannot (Example: What determines the intensity of price competition? What appears as short term profits (in a static model) are often followed by long term negative effects (in a dynamic model)
Dynamic Model Scenarios Static models cannot explain how firms can maintain prices above competitive levels without formal collusion In other situations, even a small number of firms are sufficient to produce intense price competition Dynamic models are useful in exploring such situations
Tit-for-Tat Pricing When two firms compete over several periods, a tit-for-tat strategy make cooperative pricing possible Since each firm knows that its rival will match any price cut, neither has an incentive to engage in price cutting
Tit-for-Tat Pricing with Many Firms Condition for sustainable cooperative pricing N = Number of firms i = Discount rate M = Monopoly profit for the industry 0 = Prevailing profit for the industry
Tit-for-Tat Pricing with Many Firms The numerator is the annuity a firm will receive by cooperating The denominator is the one time gain by not cooperating and inviting a tit-for-tat response from the rivals When the condition is met, the present value of the annuity exceeds the one time gain from refusal to cooperate
Coordination Problem While cooperative pricing is sustainable, the folk theorem does not rule out other equilibria Achieving a desirable equilibrium out of many possible equilibria is a coordination problem A cooperation inducing strategy that is also a compelling choice is a focal point
Coordination in Practice Round number price points will help with coordination Even splits of the market (or status quo for market shares) is likely to be durable Coordination easier with fewer products that are identical
Coordination in Practice Conventions and traditions make rivals’ intentions transparent and help with coordination Examples: Standard cycles for adjusting prices, using standard price points for price quotes
Grim Trigger and Tit-for-Tat Grim trigger strategy is to lower price to marginal cost indefinitely in response to rival’s price cutting in one period In tit-for-tat, the response lasts for only one period and future responses depend on future actions of the rival Both grim trigger and tit-for-tat are capable of sustaining cooperative pricing
The Superiority of Tit-for-Tat Tit-for-tat is easy to communicate: “We will not be undersold, ” “Lowest price guaranteed” Easy to describe and easy to understand Combines the properties of “niceness, ” “provocability, ” and “forgiveness”
Evolution of Cooperation In his book, The Evolution of Cooperation, Robert Axelrod describes a computer tournament of repeated prisoners’ dilemma Tit-for-tat strategy had the highest combined scores across matches even though in any one match the strategy could at best tie another strategy
Tit-for-Tat and Misreads When it is possible to misread rival’s move tit-for-tat may not perform as well as more forgiving strategies A firm may be able to observe rival’s list price but not the effective price A drop in the list price may be read as a price cut when effectively it may not be
Tit-for-Tat and Misreads A single misread will lead the firm to alternate between cooperative and noncooperative moves Any additional misreads can make the pattern of moves even worse When there is a possibility of misreads, deferred response may be better than immediate response
Market Structure & Cooperative Pricing Achieving cooperative pricing may depend on certain market structure conditions Some examples are: Concentration Conditions that affect reaction speeds and detection lags Asymmetries among firms Price sensitivity of buyers
Concentration & Cooperative Pricing Cooperative pricing is more likely to happen in concentrated markets In concentrated markets the revenue loss from a price cut is larger Potential gain from new customers is smaller The benefit to cost ratio tilts in favor of higher prices
Concentration and the Benefit to Cost Ratio As N decreases, the right hand side of the inequality increases, making it easier for cooperative pricing to sustain
Concentration and Cooperative Pricing In a concentrated industry, the typical firm gets a larger share of the benefits of higher prices The deviator’s short term gain is smaller since it started with a larger market share Thus, the more concentrated the market, the larger the benefits from cooperation and the smaller the cost of cooperation
Targeted Price Reduction & Cooperative Pricing With targeted price reduction it may seem that customers of rivals can be stolen without revenue loss But targeted price reduction also enables rivals to retaliate surgically Potential discounters may be discouraged and higher prices across the board may result
Concentration and Cooperative Pricing The more the firms there are the more difficult it will be to coordinate a focal strategy The relationship between concentration and the sustainability of cooperative pricing is an important consideration for antitrust policy
Reaction Speed and Cooperative Pricing As the speed with which a firm can respond to the rival’s moves increases, cooperative pricing becomes easier to sustain If the price cuts can be matched instantaneously, cooperative pricing can be maintained for any discount rate
Reaction Speed and Cooperative Pricing As the time interval for the short term gain for the deviator is reduced, the present value of benefits from cooperation is more likely to exceed this short term gain As the time interval goes to zero, so does i.
Determinants of Reaction Speed Lag in detecting price changes Frequency of interactions with the rival Ambiguity regarding which rival is cutting prices Inability to distinguish between price cuts by rivals and lower demand as the cause of drop in sales
Relevant Structural Conditions Lumpiness of orders Information availability regarding sales transaction The number of buyers Volatility of demand conditions
Lumpiness of Orders When orders are lumpy, the frequency of competitive interactions in reduced Examples: Lumpy orders in airframe manufacturing, ship building Lag between orders makes the gain from price cutting more valuable relative to the cost imposed by rival’s retaliation
Availability of Information about Sales Transactions Deviations from cooperative pricing is easier to detect when the transactions are public than when they are private Example: Transaction prices for gasoline sales are easily observable while they are not easily observable for automobile sales Deviations from cooperative pricing are harder to detect when the products are custom made individual buyers than when they are standardized Complex transactions may make misreadings more likely compared with simple transactions
Volatility of Demand Price cutting is harder to detect when demand conditions are volatile and the firm can observe only its own volume of sales Fall in demand can be misread as competitor cutting prices With large fixed costs, monopoly price fluctuates a lot making coordination difficult
Practices that Facilitate Cooperative Pricing Firms can facilitate cooperative pricing by Price leadership Advance announcement of price changes Most favored customer clauses Uniform delivered pricing
Price Leadership The price leader in the industry announces price changes ahead of others and others match the leader’s price The system of price leadership can break down if the leader does not retaliate if one of the follower firms defects
Advance Announcements of Price Changes Advance announcement reduces the uncertainty that the rival will undercut the firm Advance announcement also allows the firms to roll back the changes if the rival deviates from cooperative pricing
Most Favored Customer Clauses Most favored customer clause allows the buyer to pay the lowest price charged by the seller While this clause appears to benefit the buyer (a price cut to any one customer lowers the price for the most favored customer) it also inhibits price competition
Uniform Delivered Pricing When transportation costs are significant, pricing could be either Uniform FOB pricing or Uniform delivered pricing With uniform delivered pricing, the response to price cutting can be “surgical” and effective in deterring defection from cooperative pricing
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