Strategic Substitutes and Complements 1 A BIG THEME

Strategic Substitutes and Complements 1

A BIG THEME Commitment can either help or hurt you. Figure out which. 2

Soft vs. Tough Strategies Soft = less aggressive (but still possibly rivalrous) Tough = more aggressive (but still possibly cooperative) I prefer that my rival be soft. Examples: • Prisoner’s Dilemma: Cooperate (quiet) or Defect (confess) • Battle of the Sexes: Choose the other person’s preferred event, or choose your own. • Oligopoly: Low output or High output • Lawsuits: Settle or Hold Out for trial Sometimes Soft vs. Tough is on a continuum, with intermediate strategies possible 3

Entry Deterrence: Soft v. Tough Soft (10, 10) Firm 2 Tough (-5, -5) Firm 1 Soft (0, 30) If I am tough, my rival will be soft, which is to my benefit 4

Strategic Substitutes and Complements Suppose when I use my strategy more intensely, you cut back on your strategy. Then we call the two strategies STRATEGIC SUBSTITUTES. Example: Cournot competition in quantities. If I increase my output, you react by reducing yours. Suppose when I use my strategy more intensely, you use your strategy more intensely too. Then we call the two strategies STRATEGIC COMPLEMENTS. Example: Bertrand competition in prices. If I increase 5 my price, you react by increasing your price too.

Advertising Firm 2’s advertising Strategic complements R 1 R 2 Firm 1’s advertising Firm 2’s advertising R 1 Strategic substitutes R 2 Firm 1’s 6 advertising

Research and Development Firm 2’s research Strategic complements R 1 R 2 Firm 1’s research Firm 2’s research R 1 Strategic substitutes R 2 Firm 1’s research 7

Political Campaign Spending: California 2000 Gore’s spending Strategic complements Rg Rb Bush’s spending Gore’s spending Rb Strategic substitutes Rg 8 Bush’s spending

Strategic Substitutes and a Commitment to be Tough Q 2 Commitment here means a shift in my reaction curve. We still assume I can’t commit to a particular quantity. R 1, new R 1, old Q 2, new R 2 Q 1, old Direct Effect Z Q 1, new Q 1 Strategic Effect The “Top Dog” strategy: Commit to be tough in a situation like this. 9 (Figure 9. 2)

Strategic Complements and a Commitment to be Tough P 2 R 1, new R 1, old R 2 P 2, old P 2, new P 1, new. Z P 1, old P 1 Strategic Direct Effect “The Puppy Dog Ploy”: Do NOT commit to be tough in a situation like this. (Figure 9. 4) 10

The Fudenberg-Tirole Taxonomy as a List In 1982, Philips has to decide whether to build a CD pressing plant in the United States, and, if so, how big a plant. CDs were at that time an uncertain technology, and Philips was also concerned about the response of another possible CD manufacturer, Sony. Some strategies Philips might think about are: • THE PUPPY DOG PLOY. Don't enter, so Sony won't enter either. A commitment would make us TOUGH, but then our rivals would become TOUGH too. So don't do it. • THE TOP-DOG STRATEGY. Enter in a big way, so Sony will stay out. Make a commitment to be TOUGH, so our rivals will be SOFT. • THE FAT-CAT EFFECT. Enter with a small capacity, so Sony will not feel threatened by the possibility of entry with a large capacity. Make a commitment to be SOFT, so our rivals will be SOFT too. • THE LEAN AND HUNGRY LOOK. Stay out, so more resources can be put into other audio products. A commitment would make us SOFT, but then our rivals would become TOUGH. So don't do it. (Fudenberg, Drew and Jean Tirole (1984) ``The Fat-Cat Effect, 11 The Puppy-Dog Ploy, and the Lean and Hungry Look, '' American Economic Review May 1984, 74: 361 -66. )

The Fudenberg-Tirole Taxonomy as a Table Now we can arrange the four categories more meaningfully. The first question to answer is whether our strategies in the game we will play after any commitments we may make are complements or substitutes. The second question is whether commitment makes us Tougher or Softer. Commitment makes our firm: Tough Soft Strategic Complements Strategic Substitutes Puppy Dog A commitment would make us Tough, but then our rival would become Tough too. So don’t commit. Top Dog Make a commitment to be Tough, so our rival will be Soft. Fat Cat Make a commitment to be Soft, so our rivals will become Soft too. Lean and Hungry Look A commitment would make us Soft, but then our rival would become Tough. So don’t commit. (Figure 9. 6) 12

Some Strategies to Classify 1. Differentiate our product to appeal to a narrower group of consumers, in the hope that our rival will do the same. 2. Don't branch out into a new product line, for fear of distracting attention from the old product line. 3. Fire our special promotions marketing dept. , so our rival will fire his too. 4. Aggressively seek a new patent, to stop our rival from getting it first. 5. Enter in just one city, rather than ten, to avoid stimulating price cuts. 13

Example 3: Fire our special promotions marketing dept. , so our rival will fire his too. • If the department cannot easily be rehired , this is a commitment to play Soft. So it is Fat Cat. • If the department CAN easily be rehired, this is neither Fat Cat nor Puppy Dog, because no commitment is possible. If no commitment is possible, “not committing” is vacuous; there is no decision to be made. • If your company starts without a promotions dept. and there would be a sunk cost to creating one, but the company decides not to for fear of provoking a “promotions race”, this would be Puppy Dog. 14

Example 5: Enter in just one city, rather than ten, to avoid stimulating price cuts. The question is: Is the decision to enter N cities reversible? If having chosen to enter in one city, your company is forestalled from entering the other 9 soon, because its marketing and supply arrangements are based on the one city, then it has committed. This is a Fat Cat policy. If your company could still enter the other 9 cities, but having entered a city it cannot exit without loss, then it has chosen NOT to commit to the 10 cities, and has made a much smaller commitment. This is a Puppy Dog policy. If your company can shift from 1 to 10 and back each year with no more cost than if it didn’t switch, then this is neither Fat Cat nor 15 Puppy Dog, because no commitment is possible.

The Fat Cat vs. the Puppy Dog: Principles • Both the Puppy Dog and Fat Cat commitment policies start from the assumption that the strategies affected are strategic complements; e. g. , if I choose a higher price, you will want to choose a higher price too. • The Puppy Dog policy consists in NOT committing, because commitment would give you more incentive to be TOUGH, and your rival would respond by also being tougher. • The Fat Cat policy consists in COMMITTING, because commitment would give you more incentive to be SOFT, and your rival would respond by also being softer. • What is confusing is figuring out the difference between (a) Not Committing to be Tough, and (b) Committing to be Soft. The key is whether the 16 decision is reversible or not. If it is reversible, it is “not committing”.

Heavy Debt as a Strategic Tool 1. Suppose heavy debt makes the firm more risktaking and aggressive, because its lenders bear part of the downside risk. TOP DOG: If product market competition is Cournot, the debt helps the firm. PUPPY DOG: If Bertrand, debt HURTS the firm. Don’t take on debt. 2. Suppose debt prevents the firm from committing via investment, because it can’t obtain the funds. FAT-CAT: The firm has can’t commit to reduce costs. This helps keep prices high in a Bertrand market. LEAN-AND-HUNGRY: The firm can’t commit to high capacity. This hurts the firm in a Cournot market. 17