Chapter 7 - Dynamics: Competing

Across Time
Microdynamics
- refers to the unfolding of competition over time among a small number of
firms

The Strategic Benefits of Commitment

- an effective commitment should restrict our freedom of action, by directly
limiting our options (through terms of a contract) or by making certain
options very unattractive (financially, socially, or emotionally) that we avoid
them
- ex. leasing of durable goods such as automobiles and MRI machines last a
long time and have an active resale market
- firms take back durable goods when leases expire, they do not have a desire
to lower prices and often set high initial prices
- leasing today makes future price reductions unattractive, firms do not reduce
price
- strategic commitments alter the strategic decisions of rivals
- if a commitment is to provoke a response, it must be irreversible, visible,
understandable, and credible
- irreversible - or else no commitment weight
- visible and understandable - or else rivals will have nothing to react to
- credible - rivals believe the firm will carry out the commitment

Strategic Substitutes and Strategic Complements

- strategic substitutes - when one firm chooses more of some action such as
an output decision, and its rival firm cuts back on the same action
- quantities in the Stackelberg game are strategic substitutes
- strategic complements - when one firm chooses more of an action and its
rival chooses more as well
- ex. prices - when one firm raises its price, its rivals may raise their price as
well
- ex. if burger king launches an ad campaign, and McDonald’s does the same,
advertising is a strategic complement
- when reaction functions are upward sloping, the firm’s actions (e.g. prices)
are strategic complements
- in Bertrand model, prices are strategic complements, when one firm reduces
prices, the other firm finds it profitable to reduce prices as well
- when reaction functions are downward sloping, actions are strategic
substitutes

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 - in Cournot model, quantities are strategic substitutes because when one firm
increases its quantity, the other firm will also increase

The Strategic Effect of Commitments

- commitments have a direct and strategic effect on a firm’s profitability
- direct effect - the impact on the present value of the firm’s profits if the
competitors’ behaviour does not change
- ex. invest in a process that reduces average variable cost of producing steel,
the direct effect of the investment is the present value of the increase in profit
due to the reduction in average variable costs less the upfront cost of the
investment
- strategic effect - takes into account the competitive side effects of the
commitment
- ex. if it caused rivals to adjust their business decisions

Tough and Soft Commitments

- a firm’s tough commitment is bad for competitors
- a firm’s soft commitment is good for competitors
- capacity expansion is usually a tough commitment
- elimination of production facilities is a soft commitment
- In Bertrand competition, a commitment to reduce prices through a well
publicized advertising campaign so that the firm could not back down is a
tough commitment
- Tough commitments have a profitable strategic effect if they involve strategic
substitutes and a negative strategic effect if they involve strategic
complements
- Ex. if McDonald reduces advertising in the wake of Burger King’s campaign,
that serves to further increase Burger King’s market share
- Whether it is a strategic complement or substitute  would ads be more or
less valuable to McDonald’s when Burger King is heavily advertising
- And depends on experience, how McDonald’s reacted in the past when
Burger King launched an ad campaign
- If McDonald’s previously matched ad campaign for ad campaign, then
advertising is a strategic complement and the tough commitment by Burger
King will have a negative strategic effect
- A soft commitment will have a profitable strategic effect if it involves strategic
complements
- If Burger King finds that McDonald’s stubbornly matches its ad dollars, it
might benefit by reducing its own ad spending

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 The Information Benefits of Flexibility
- the strategic effects of commitment are rooted in inflexibility
- a firm can preserve its flexibility in a number of ways when making strategic
commitments:
- a firm can separate a single large commitment into smaller components
- ex. Walmart opens a few stores at a time in select areas

Real Options
- by delaying important decisions, firms can learn more about market
conditions
- a real option exists when a decision maker has the opportunity to tailor a
decision to information that is unknown today but will be revealed in the
future
- an investment project that has an option to delay is more valuable than one
fro which the firm faces a now or never choice of investing or not investing in
the project
- delay is valuable because it allows the firm to avoid the money losing
outcome of investing when market acceptance is low
- ex. HP tailors different printer models to demand conditions in different
markets
- by delaying investment decisions, firms postpone any of the benefits of the
investment, but they also learn valuable information that can be used to
modify the investment

A Framework for Analyzing Commitments

1. Positioning analysis
2. Sustainability analysis
3. Flexibility analysis
4. Judgment analysis

Positioning analysis:
- analyzing whether the firm’s commitment is likely to result in a product
market position in which the firm delivers superior benefits to consumers or
operates with lower costs than competitors

Sustainability analysis:
- analyzing potential responses to the commitment by competitors and
potential entrants in light of the commitments that they have made and the
impact of those responses on competition
- analyzing the market imperfections that make the firm’s resources scarce and
immobile and the conditions that protect the firm’s competitive advantages
from imitation by competitors

- positioning and sustainability analysis should be a formal analysis of NPV of

alternative strategic commitments

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 - positioning analysis provides the basis for determining the revenues and
costs associated with each alternative
- sustainability analysis provides the basis for determining the time horizon
beyond which the firm’s rate of return on incremental investments is no
greater than its cost of capital - economic profits are zero
- learn rate - the rate at which the firm receives new information that allows it
to adjust its strategic choices
- burn rate - the rate at which the firm invests in the sunk assets to support the
strategy
- a high learn to burn ratio implies that a strategic choice has a high degree of
flexibility
- option value of delay is low because the firm can quickly accumulate
information about the prospects of strategic choice before it is heavily
committed

Competitive Discipline
- total industry profits are less than what could be achieved if the firms acted
like a cartel, choosing the monopoly price and output

Dynamic Pricing Rivalry and Tit-for-tat Pricing

- firms would prefer prices to be close to monopoly levels, but collusions are
prevented by anti trust laws
- if managers are to maintain high prices, they must do so unilaterally
- tit for tat pricing - if a firm lowers its price others must match it to deter
business stealing

Why is Tit-for-Tat so Compelling?

- grim trigger strategy relies on the threat of an infinite price war to keep firms
from undercutting their competitor’s prices
- Tit for tat is usually adopted because it is easy to describe and understand

Coordinating on the Right Price

- folk theorem - if firms expect to interact indefinitely and have sufficiently
low discount rates, then the price between the monopoly price and marginal
costs can be sustained as an equilibrium

Impediments to Coordination/Tit-for-Tat Strategy

The Misread Problem
- tit for tat strategy assumes that firms can perfectly observe each other’s
actions, but rivals will sometimes misread their rivals
- a firm mistakenly believes a competitor is charging one price when it is really
charging another

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 - a firm misunderstands the reasons for a competitor’s pricing decision or its
own change in market share
- price wars stem from misreads rather than deliberate attempts to steal
business

Lumpiness of Orders
- when sales occur relatively infrequently in large batches as opposed to being
smoothly distributed over the year
- reduces the frequency of competitive interactions between firms, lengthens
the time required for competitors to react to price reductions, thereby
making price cutting more attractive

Information about The Sales Transactions

- when sales transactions are public, deviations from cooperative pricing are
easier to detect than when prices are secret
- ex. airlines monitor each others prices using computerized reservation
systems and know immediately when a carrier has cut fares
- retaliation can occur more quickly when prices are public than when they are
secret, price cutting to steal market share from competitors is likely to be less
attractive, enhancing the chances that cooperative pricing can be sustained
- business practices that facilitate secret price cutting create a prisoners’
dilemma
- deviations from cooperative pricing are also hard to detect when product
attributes are customized to individual buyers
- a seller may be able to increase its market share by altering the design of the
product or by throwing in extras such as spare parts or service agreement
- misreads are more likely when there are secret or complex transaction terms,
which intensifies price competition

Volatility of Demand Conditions

- price cutting is harder to verify when market demand conditions are volatile
and a firm can observe only its own volume and not that of its rivals
- if a firm’s sales unexpectedly falls, it will naturally suspect that one of its
competitors has price cut and is taking business from it
- a firm may cut price in response to a decline in demand if firms see the price
cut but cannot the detect the rival’s volume reduction, they may misread the
situation as an effort to steal business

Asymmetries among Firms and the Sustainability of Cooperative

Prices
- when firms are not identical, because they have different costs or are
vertically differentiated, achieving cooperative pricing becomes more difficult

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 - when firms are identical, a single monopoly price can be a focal point
- when firms differ, there is no single focal price, and it becomes more difficult
for firms to coordinate their pricing strategies toward common objectives
- even when all firms can agree on the cooperative price, differences in costs,
capacities, or product qualities may affect their incentives to abide by the
agreement
- small firms often have more incentive to defect from cooperative pricing than
larger firms
- small firms gain more in new business relative to the loss due to the revenue
destruction effect
- large firms have weak incentives to punish a smaller price cutter and will
instead offer a price umbrella under which the smaller firm can sustain its
lower price
- smaller firms have incentive to lower price on most consumer goods to
induce consumers to try its product
- once prices are restored to initial levels, small firms hope that some of its
consumers who sampled its products will become permanent consumers
- only works if there is a lag between the firm’s price reduction and any
response by its larger rivals, otherwise few consumers will sample the small
firm’s products

Price Sensitivity of Buyers and the Sustainability of Cooperative Pricing

- when buyers are price sensitive, a firm that undercuts its rivals’ prices by
even a small amount may be able to achieve a significant boost in its volume
- firms will be tempted to temporarily cut price as it may result in a significant
and profitable boost in market share

Facilitating Practices
Firms can facilitate cooperative pricing through a number of practices:
- price leadership
- advance announcement of price changes
- most favored customer clauses
- uniform deliver prices

Price Leadership
- each firm gives up its pricing autonomy and cedes control over industry
pricing to a single firm
- oligopolistic price leadership, where the same firm is the leader for years

Advance Announcement of Price Changes

- firms may publicly announce the prices they intend to charge in the future
- can facilitate price increases

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 Most Favored Customer Clauses
- provision in a sales contract that promises a buyer that it will pay the lowest
price the seller charges
- two types of most favored customer clauses: contemporaneous and
retroactive
- contemporaneous policy - if it sells the product at a lower price to any other
buyer perhaps to undercut a competitor, it will also lower the price to this
level
- retroactive most favored customer clause - seller agrees to pay a rebate to the
buyer if during a certain period after the contract has expired, it sells the
product for a lower price than what the buyer paid
- most favored customer clauses can inhibit price competition by discouraging
firms from cutting prices to other customers who do not have these clauses

Uniform Delivered Prices

- when buyers and sellers are geographically separated, and transportation
costs are significant, the pricing method can affect competitive interactions
- uniform FOB pricing - seller quotes a price for pickup at the seller’s loading
dock, and the buyer absorbs the freight charges itself
- uniform delivered pricing - firm quotes a single delivered price for all buyers
and absorbs any freight charges itself
- uniform delivered pricing facilitates cooperative pricing by allowing firms to
make a more surgical response to price cutting by rivals
- under FOB pricing, the producer will retaliate by cutting price, which reduces
price to all its customers
- under uniform delivered pricing, the firm could cut its price selectively, it
could cut the delivered price to its customers in a certain area, keeping
delivered prices of other customers at their original level

Where Does Market Structure Come From?

- the number of firms depends on the total size of the market relative to the
MES of production
- concentration is linked to market size
- prices will be lower in more competitive industries

Sutton’s Endogenous Sunk Costs

- consumers gravitate towards brand name products and the creation and
maintenance of brands requires substantial sunk investments
- number of leading brands may remain fixed, as markets keep growing and
the brand leaders keep investing in their brands, and other firms may not
have the costs to match them

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 Innovation and Market Evolution
- R&D in a sunk cost that raises the minimum efficient scale of entry
- Failure to innovate will open doors to newcomers, leaving the incumbent
without any business

Learning and Industry Dynamics

- when a market leader expands its output, it does move down the learning
curve
- it can steal business from its rivals, who may forget some of the skills they
have already accumulated, thus driving up their costs
- staying in front requires learning and forgetting

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