Game Theory for Managers - Application Entering a Market

Lecture 7 Game Plan „ More on strategic substitutes and complements „ Application to Entry: Ryan Air „ Strategic exercise of real options Systems and Product Compatibility Tape deck + speaker = sound system „ Two firms produce both tape decks and speakers. „ First, firms decide whether or not to allow for compatibility „ • products are compatible if both allow for it „ Second, firms compete on price Sound System Consumers Each firm’s products are described as corners of a square. „ Consumers are represented as points in the square „ Each consumer buys from whatever firm has lowest price + distance „ „ “distance” captures comparative preference for the products Incompatible Competition „ Consumers in upper-left and lowerright prefer to mix and match GREEN SPEAKER RED SPEAKER RED TAPE-DECK represents consumers who buy from firm1 represents firm 1’s products GREEN TAPE-DECK Compatible Competition Consumers are better matched in regions „ AND price competition is less intense „ represents consumers who buy both from firm1 represents consumers who buy from firm1 & firm 2 Compatible Competition Less Intense „ When firm 1 lowers price of RED SPEAKER, it raises demand for GREEN TAPE-DECK „ tends to lead GREEN to raise its price „ Under incompatibility, lowering price of RED SPEAKER lowers GREEN TAPE-DECK demand „ The firms appear to have a common interest in compatibility Incompatibility & Exit „ Previous discussion implicitly assumed entrenched firms „ If firm 1 wants to drive firm 2 out of the market (or deter entry), compatibility is a bad approach since it increases both firms’ payoffs Strategies to Induce Exit in Competitive Games More Makes You Tougher Strategic Complements Strategic Substitutes More Makes You Softer Top Dog Lean & Hungry more investment makes you more aggressive, hurting other player less investment makes you more aggressive, hurting other player Top Dog Lean & Hungry more investment makes you more aggressive, hurting other player less investment makes you more aggressive, hurting other player Reliance Games „ Conclusions for competitive games apply to reliance games, except “flipped” „ to induce entry, do whatever makes you more aggressive Entry “The wise win before they fight, while the ignorant fight to win.” -Zhuge Liang, chief military strategist, Shu Kingdom, 200 AD Real Options „ Entering a new market „ „ Investments in large, risky projects „ „ Option to enter later Option to delay and to stop New technologies: multi-stage option „ R&D Æ patent Æ testing Æ pilot Æ Parking Lots „ You own an unprofitable undeveloped parking lot downtown „ Additional parking revenues would be more than sufficient to cover costs of building a multi-level parking garage „ Building a garage is a no-brainer, right? A Tale of Two Parking Lots „ Another undeveloped lot sits right next to yours „ Does the presence of this other lot make you more or less eager to build an office building on your land? Strategic Incentives to Exercise Real Options „ First-mover effect that we’ve seen before Æ Want to move first exactly when: „ „ „ investments are strategic substitutes OR investments are strategic complements and reaction curves have slope > 1 Informational benefit of observing others’ investment Æ Want to move last „ others’ decision to invest is “good news” about their information • first-mover suffers Winner’s Curse, see Lecture 9 „ outcome of investment also informative Exercising Cascades When others exercise an option this reveals positive information „ Furthermore: „ „ „ more information Æ less option value Æ others more likely to exercise This can lead to cascades in which many firms follow an early exerciser „ Example: “Miracle on Sixth Avenue” Summary „ When considering entering a market anticipate and control incumbents’ incentive to retaliate „ consider how your entry may change followers’ decision whether/how to enter themselves „