Managerial Economics &
Business Strategy
Chapter 13
Advanced Topics in Business
Strategy
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
13-2
Overview
I. Limit Pricing to Prevent Entry
II. Predatory Pricing to Lessen Competition
III. Raising Rivals’ Costs to Lessen Competition
IV. Price Discrimination as a Strategic Tool
V. Changing the Timing of Decisions
VI. Penetration Pricing to Overcome Network
Effects
13-3
Limit Pricing
• Strategy where an incumbent (existing firm)
prices below the monopoly price in order to
keep potential entrants out of the market.
• Goal is to lessen competition by eliminating
potential competitors’ incentives to enter the
market.
13-4
Monopoly Profits
• This monopolist is
earning positive $
M
economic profits. MC
• These profits may
M
P
induce other firms to AC
enter the market. AC M
• Questions: DM
Can the monopolist
prevent entry?
Q
QM
If so, is it profitable MR
to do so?
Limit Pricing 13-5
• Incumbent produces QL
instead of monopoly
output (QM).
• Resulting price, PL, is
lower than monopoly $
price (PM).
Entrant's residual
• Residual demand curve demand curve
is the market demand P
M
(DM) minus QL .
PL
• Entry is not profitable AC
because entrant’s P = AC M
D
residual demand lies
below AC.
• Optimal limit pricing
results in a residual Q Q
M
Q
L
Quantity
demand such that, if the
entrant entered and
produced Q units, its
profits would be zero.
13-6
Potential Problems with Limit
Pricing
• It isn’t generally profitable for the incumbent to
maintain an output of QL once entry occurs.
• Rational entrants will realize this and enter.
• Solution: Incumbent must link its pre-entry price to
the post-entry profits of the potential entrant.
• Possible links:
Commitments by incumbents.
Learning curve effects.
Incomplete information.
Reputation effects.
13-7
Potential Problems with Limit
Pricing (Continued)
• Even if a link can be forged, it may not be
profitable to limit price! Limit pricing is profitable
only if the present value of the benefits of limit
pricing exceed the up front costs:
L
D
M
.
L
i
13-8
Predatory Pricing
• Strategy of pricing below marginal cost to
drive competitors out of business, then raising
price to enjoy the higher profits resulting from
lessened competition.
• Goal is to lessen competition by eliminating
existing competitors.
13-9
Potential Problems with Predatory
Pricing
• Counter strategies:
Stop production.
Purchase from the predator at the reduced price and
stockpile until predatory pricing is over.
• Rivals can sue under the Sherman Act
But it is often difficult for rivals to prove their case.
• Upfront losses incurred to drive out rivals may
exceed the present value of future monopoly profits.
• Predator must have deeper pockets than prey.
13-10
Raising Rivals’ Costs
• Strategy where a firm increases the marginal
or fixed costs of rivals to distort their
incentives.
• Not always profitable, but may be profitable as
the following example shows.
13-11
Raising a Rival’s Marginal Cost
• Cournot duopoly. Q 2
• Initial equilibrium at
point A.
• Firm 1 raises the
marginal cost of Firm
2, moving equilibrium A
to point B.
• Firm 1 gains market B
share and profits. Q1
13-12
Other Strategies to Raise Rivals’
Costs
• Raise fixed costs in the industry.
• If vertically integrated, increase input prices in
the upstream market.
Vertical Foreclosure: Integrated firm charges
rivals prohibitive price for an essential input.
The Price-Cost Squeeze: Integrated firm raises
input price and holds the final product price
constant.
13-13
Price Discrimination as a Strategic
Tool
• Price discrimination permits a firm to “target”
price cuts to those consumers or markets that
will inflict the most damage to the rival (in the
case of predatory pricing) or potential entrants
(in the case of limit pricing).
• Meanwhile, it can continue to charge the
monopoly price to its other customers.
• Thus, price discrimination may enhance the
value of other pricing strategies.
13-14
Changing the Timing of Decisions or
the Order of Moves
• Sometimes profits can be enhanced by
changing the timing of decisions or the order
of moves.
When there is a first-mover advantage, it pays to
commit to a decision first.
When there is a second-mover advantage, it pays
to let the other player move first.
13-15
Examples of Games with First and
Second-Mover Advantages
• Example 1: Player naming the smaller natural
number gets $10, the other players get nothing.
– First-mover always earns $10.
• Example 2: Player naming the larger natural
number gets $10, the other players get nothing.
– Last-mover always earns $10
• Practical Examples?
13-16
If Firms A and B Make Production
Decisions Simultaneously
Firm B
Strategy Low Output High Output
Firm A Low Output $30, $10 $10, $15
High Output $20, $5 $1, $2
• Firm A earns $10 by playing its dominant
strategy, which is “Low Output.”
13-17
But if A Moves First:
• Firm A can earn
$20 by producing a Low Output ($30, $10)
high output!
B
• Requires Low Output
High Output ($10, $15)
Commitment to a
A
high output.
Low Output ($20, $5)
Player B observes
High Output
A’s commitment B
prior to making its
High Output ($1, $2)
own production
decision.
13-18
Networks
• A network consists of links that connect different
points in geographic or economic space.
• One-way Network – Services flow in only one
direction.
Examples: water, electricity.
• Two-way Network – Value to each user depends
directly on how many other people use the network.
Examples: telephone, e-mail.
13-19
Example: A Two-Way Star Network
Linking 7 Users
• Point H is the hub.
• Points C1 through C7 are C6
C7
C5
nodes representing
users. H C1
• Total number of C4
C2
connection services is C3
n(n - 1) = 7(7-1) = 42.
13-20
Network Externalities
• Direct Network Externality – The direct value
enjoyed by the user of a network because other
people also use the network.
• Indirect Network Externality – The indirect value
enjoyed by the user of a network because of
complementarities between the size of the network
and the availability of complementary products or
services.
• Negative Externalities such as congestion and
bottlenecks can also arise as a network grows.
13-21
Penetration Pricing to Overcome
Network Effects
• Problem: Network externalities typically make
it difficult for a new network to replace or
compete with an existing network.
• Solution: Penetration Pricing
– The new network can charge an initial price that is
very low, give the product away, or even pay
consumers to try the new product to gain users.
– Once a critical mass of users switch to the new
network, prices can be increased.
13-22
The New Network Game
Without Penetration Pricing
Table 13-2 A Network Game
User 2
Network Provider H1 H2
User 1 H1 $10, $10 $0, $0
H2 $0, $0 $20, $20
• Coordination Problem
Neither user has an incentive to unilaterally switch to H 2, even though both
users would benefit if they simultaneously switched.
With many users, it is difficult to coordinate a move to the better equilibrium.
Users may stay locked in at the red equilibrium instead of moving to green
one.
13-23
The New Network Game
With Penetration Pricing
Table 13-3 The Network Game with Penetration Pricing
User 2
Network Provider H1 H1 & H2
User 1 H1 $10, $10 $10, $11
H1 & H2 $11, $10 $21, $21
• Network provider H2 pays consumers $1 to try its network; consumers have nothing
to lose in trying both networks. The green cell is the equilibrium.
• Users will eventually realize that H2 is better than H1 and that other users have
access to this new network.
• Users will eventually quit using H1, at which point provider H2 can eliminate $1
payment and start charging for network access.
13-24
Conclusion
• A number of strategies may enhance profits:
Limit pricing.
Predatory pricing.
Raising rivals’ costs.
Exercising first- or second-mover advantages.
Penetration pricing.
• These strategies are not always the best ones,
though, and care must be taken when using
any of the above strategies.
