Strategic Substitutes and Complements. MGT 525 Competitive Strategy Kevin Williams

Transcription

1 Strategic Substitutes and Complements MGT 525 Competitive Strategy Kevin Williams 1

2 Course Outline Fundamentals of Strategy Static Competition Shrimp Game Strategic Complements and Substitutes Price Competition Micro-marketing Financial Condition Auctions Bundling 2-sided Markets Dynamic Competition Corporate Strategy 2

3 Strategic Commitment Strategic commitments have long run impact are hard to reverse Strategic commitments affect choices made by rivals Assessing strategic commitments involves anticipating competitive responses 3

4 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 4

5 Strategy Selection Game Aggressive Passive Aggressive 12.5, , 5 Passive 15, , 6 Unique Nash equilibrium Row Firm: Passive Column Firm: Aggressive 5

6 Sequential Move Game Row Firm commits itself to be aggressive Column Firm finds that it is better of choosing to be passive given Row Firm s commitment Resulting equilibrium has a bigger payoff for Row Firm compared to what it had in the simultaneous move game 6

7 3 Requirements Visible Observable to those it is intended to influence Understandable Comprehensible for those it is intended to influence Credible Talk is cheap Irreversible or expensive to reverse 7

8 Examples Capacity expansion Particularly with investment in specialized assets Contracts to install capacity with clauses that weaken willingness to cut prices with high required advertising expenditures Public announcement of new product introduction If non-introduction adversely affects reputation 8

9 Strategic Commitment & Competition Concepts to describe how a firm reacts to price/quantity change by a competitor Strategic complements Strategic substitutes Concepts that distinguish between actions by a firm that puts its competitors at a disadvantage and those that do not Tough commitments Soft commitments 9

10 Reminder: Best Response Function How do you find it? 1. Write down the profit for the firm 2. Differentiate with respect to the decision variable 3. Set equal to zero and solve for the decision variable is exactly the same thing as the magical mantra MR = MC 10

11 Example: Price Competition 2 symmetric firms q 1 = A bp 1 + ap 2 and q 2 = A bp 2 + ap 1 Marginal cost is c for both, b > a > 0 1. Write down the profit π 1 = p 1 q 1 cq 1 = (p 1 c)(a bp 1 + ap 2 ) 2. Now differentiate with respect to p 1 A 2bp 1 + ap 2 + bc 3. Set equal to 0 and solve for p 1 p 1 = (A + bc + ap 2 ) / (2b) 11

12 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 Best response function is upward sloping 12

13 Strategic Complements p 2 BR 1 (p 2 ) p m BR 2 (p 1 ) MC 2 Bertrand competition with undifferentiated products MC 1 p m p 1 13

14 Strategic Complements p 2 BR 1 (p 2 ) BR 2 (p 1 ) e.g., price competition with differentiated products (not marginal cost pricing) p 1 14

15 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 is downward sloping 15

16 Strategic Substitutes q 2 BR 1 (q 2 ) e.g., standard Cournot competition BR 2 (q 1 ) q 1 16

17 Incentives to Make Commitments Commitments affect the present value of the firm s profits Direct effect: due entirely to its own decisions Strategic effect: due to the effect on the decisions of the competitors Both are important Monopoly? Highly differentiated products? Perfect Competition? Strategic effect can be positive or negative Depends on the choice variables being strategic complements or strategic substitutes 17

18 Tough 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 18

19 Value of Soft Commitments 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 If the strategic effect is sufficiently large, the net benefit from the commitment will be positive 19

20 Analysis of Soft and Tough Commitments 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 Second stage competition between the rivals will be either Cournot or Bertrand 20

21 Cournot after Tough Commitment Firm 1 commits to a higher than previous output for every output choice of the rival Firm 2 s reaction function makes the equilibrium output of Firm 1 even higher Firm 2 produces less than what it used to produce 21

22 Tough in Cournot q 2 BR 1 (q 2 ) BR 1 (q 2 ) Firm 1 may well choose to make this commitment: become Top Dog e.g., R&D investment to lower marginal cost of production BR 2 (q 1 ) q 1 22

23 Cournot after Soft Commitment Firm 1 shifts its reaction function to the left, committing to produce less (than precommitment level) for every level of rival s output Rival s reaction hurts Firm 1 by making its output fall further Firm 2 produces more than what it produced without Firm 1 s soft commitment 23

24 Soft in Cournot q 2 BR 1 (q 2 ) Firm 1 may well choose NOT to make this commitment: stay Lean and Hungry BR 1 (q 2 ) e.g., invest in production technology that is more expensive (in the short run) BR 2 (q 1 ) q 1 24

25 Bertrand after Tough Commitment Firm 1 commits to a lower price by shifting its reaction function to the left Firm 2 s reaction further lowers the equilibrium price Both firms end up being hurt by Firm 1 s tough commitment 25

26 Tough in Bertrand p 2 BR 1 (p 2 ) BR 1 (p 2 ) e.g., improve operations to reduce marginal production cost BR 2 (p 1 ) Firm 1 may well choose NOT to make this commitment: the Puppy Dog Ploy p 1 26

27 Bertrand after Soft Commitment Firm 1 commits to charge a higher (than the pre-commitment level) price for every price level picked by the rival Firm 2 s reaction provides an even higher price (for both firms) Both firms benefit from Firm 1 s soft commitment 27

28 Soft in Bertrand p 2 BR 1 (p 2 ) BR 1 (p 2 ) e.g., sign expensive licensing contract that raises marginal costs BR 2 (p 1 ) Firm 1 may well choose to make this commitment: the Fat-Cat Effect p 1 28

29 Fudenberg-Tirole Taxonomy Strategic Complements Strategic Substitutes Tough Puppy Dog Top Dog Soft Fat Cat Lean & Hungry Avoid this strategic commitment Make this strategic commitment 29

30 Puppy Dog: Serve a Niche Suppose firm is developing a product to compete with that of dominant firm Investment = serving whole market Don t make investment and just serve niche Niche product won t attract customers from dominant firm, decreasing your incentive to compete on price This makes dominant firm less aggressive since prices are strategic complements 30

31 Interpreting the Taxonomy Commitment is beneficial if it makes rivals behave less aggressively Commitment is detrimental if it makes rivals behave more aggressively But, distinguish between existing rivals soften competition to increase profits potential rivals toughen competition to deter entry (more on this later) What about inducing exit? 31

32 Flexibility Tradeoff Commitment is less valuable if it has little impact on rivals there is a lot of uncertainty about future events Flexibility gives the firm options Remember the option value of investment if investment is irreversible Higher option value if variance of outcomes is higher May offset strategic commitment effect 32