Strategic Substitutes and Strategic Complements

Lecture 6 Game Plan „ Strategic moves continued „ … how to be credible „ Dynamic Pricing Game „ Strategic substitutes and complements „ „ commitments to be tough vs. soft puppy dog ploy, lean & hungry look, etc. Trucking Entry (from Chevalier reading) „ A new trucking company is considering entering two natural monopoly markets for hauling agricultural products 1. Market 1 currently served by railroad with MC = $.20/ton-mile and track that cost $20 million 2. Market 2 currently served by trucking company with MC = $.20/ton-mile and trucks that cost $20 million Irreversibility „ Sunk cost of track is irreversible for the railroad „ „ railroad has credibly committed to stay in this market, regardless of whether another firm comes in Cost of trucks is fixed cost, not sunk „ truck company can not credibly commit to stay in the market after entry Conventional Wisdom „ Don’t burn bridges. „ Decrease downside risk. „ It is nice to have more options. „ This ignores the strategic value of commitment! Strategic Commitment „ You are not credible if you propose to take actions that go against your own incentives … „ How to be credible? Credibility „ Remove strategies „ „ „ from your own set of future choices the strategies that may tempt you in the future Example: giving away your patent Reduce payoffs „ „ from those strategies that may tempt you Example: customers as hostages. Removing Strategies I „ Delegation • In contract negotiation, can “squabble” over many details • Instead, send an agent with power of attorney to “sign as is” or “walk away” • Haggling over prices in a department store Learn from government bureaucracy: “The rules won’t allow me to do what you ask” Removing Strategies II „ Burning Bridges „ Power comes from not being able to retreat Burning Bridges “A surrounded enemy must be given a way out” - Sun Tzu in “Art of War”, 400BC Burning Bridges: Example 1 „ Semiconductor patent sharing “Mosaid Technologies, a designer and licensor of semiconductor chips and technologies, just announced a patent sharing deal with Mitsubishi Electric” • Share patent with another competing firm • Commit to chip supply to production plants • Commit to no opportunistic behavior Burning Bridges: Example 2 „ Polaroid instant photography „ „ Refused to diversify out of its core business. With all its chips in instant photography, it was committed to fight against any intruder in the market. On April 20, 1976, after twenty-eight years of a Polaroid monopoly on the instant photography market, Eastman Kodak entered the fray. Burning Bridges: Example 2 „ 12 October 1990: Court awards Polaroid a $900 million judgment against Kodak. Kodak forced to withdraw from market Contracts with Third Parties „ Reducing one’s own payoffs in a credible, irreversible way can be difficult. „ Third-parties can be useful as “enforcers” The Bocchicchio Family „ „ „ Mafia in Italy, peaceful in the U.S. Mob bosses need to be able to meet safely, but no one trusts anybody Enter the Bocchicchio family „ „ certain revenge if any Bocchicchio harmed act as “hostages” for both sides. • if Don Corleone is killed by Don Barzini, then the Corleone family will kill their Bocchiccio • But then the Bocchiccio will blame Barzini since he promised the Bocchiccio would be safe!! Committing to Fight „ Make yielding market share intolerable adopt high FC, low MC technology „ sign irrevocable agreements for expensive raw materials „ load up on debt, or covenant debt so management loses control of the firm if market share slips „ Reducing Your Payoffs Using Third-Parties „ Contracting with customers to commit to competitors • Most Favored Customer clauses „ Contracting with lenders to commit to a take-over price • Interest-rate rise if loan amount increases Island Bars „ „ „ „ Two firms: Firm 1 and Firm 2 Two prices: low ($4) or high ($5 ) 3000 captive consumers per firm 4000 floating go to firm with lowest price Firm 2 Firm 1 Low High Low 20 , 20 15 , 28 High 28 , 15 25 , 25 Contracting with Customers „ The game is a prisoner’s dilemma Both firms prefer: {High,High} „ Only equilibrium: {Low , Low} „ Cannot credibly promise to play High „ Even if committed to High, other firm would still respond with Low „ „ How to resolve this? „ Third-party contracts with customers Most Favored Customer „ Say in period 1, the firms colluded and each sold to 5000 customers „ In period 2, firms must refund to last period’s customers $1 each if price is low „ What is the impact on the game? Escaping the Prisoners’ Dilemma with MFCs Firm 2 Firm 1 Low Low 20 , 20 High 28 , 15 High 15 , 28 25 , 25 Firm 2 Firm 1 Low High Low 15 , 15 15 , 23 High 23 , 15 25 , 25 Incentives for MFCs Firms can escape Prisoners’ Dilemma if they adopt MFC clauses „ BUT each firm appears to have a dominant strategy not to adopt „ If other has MFC, you get 25 with MFC and 28 without. (In latter case, you price Low while other prices High) „ If other does not have MFC, you get 15 with MFC and 20 without „ Meta-Prisoners’ Dilemma? We appear to have simply created a new Prisoners’ Dilemma „ Is there any reason this Dilemma might be easier to resolve? „ Firm 2 Firm 1 MFC MFC 25 , 25 Not 28 , 15 Not 15 , 28 20 , 20 Contracting with Lenders „ „ „ „ „ Takeover offer: $200 million You can “afford” $20 million / year Finance takeover for 20 years at 7% Add penalty: if amount greater than $200 million, +1.5 points on interest rate Annual Payments: • $200 million: • $210 million: • with penalty: $18.6 million / year $19.6 million / year $21.9 million / year Summary of Commitment Methods „ Reduce available strategies „ Reduce payoffs The Flip Side „ „ „ „ You want to make it difficult for opponent to commit to actions that hurt you / help opponent commit to actions in your favor Increase opponent’s strategy space •Exclude bargaining agents Lower opponent’s payoffs •Poison pills Raise opponent’s payoffs •Reputation bolstering Dynamic Pricing Game Dynamic Pricing: Rules „ „ Two firms. 100 customers. Zero costs. Stage 1: Firms decide whether to invest in creating “loyal” customers „ „ „ “loyal” customer will always buy from you no matter what the price choice: 0 loyal or 30 loyal at cost $250 Stage 2: Firms alternate with (nonincreasing) price announcements until they stop changing. Prices start at $50 each. „ choices: $50, $40, $30, $20, $10 Dynamic Pricing: Payoffs „ „ „ Payoff = Revenue – Loyalty Cost If prices stay $50 for both firms, each firm gets Revenue = $2500 Otherwise they won’t split market equally: „ „ „ “bigger firm” is one that has (1) lower price or (2) was first to announce final price (if equal) bigger firm sells 100 or 70 at its own price, depending on loyalty of others’ customers smaller firm sells 0 or 30 at its own price Play Dynamic Pricing Game! You will play as a team. (Pair up with another team.) 1. 2. Play Loyalty Stage: simultaneously choose “Loyal” or “Not Loyal” TA will tell you who goes first in Pricing Stage Record game progress on handout and give this to TA at end of game Upside of Loyalty „ If other firm undercuts you, your final payoff will be higher than if you had disloyal customers „ Suppose first that other has no loyal customers and undercuts with $40 „ What would you do? Loyal undercut by Disloyal $50 Game ends. You get rev = $1500 $40 $30 $20 $10 „ Game ends. You get rev = $1000 Don’t respond with $10 Loyal undercut by Disloyal $50 $1500 $40 $30 Other firm will stay at $40. You get rev $40*30 = $1200 $20 „ „ Don’t respond with $40 What about $30 or $20? Loyal undercut by Disloyal $50 $1500 $30 $20 „ Since other firm has no loyal customers, it will re-undercut with $10. You get $20*30 Other firm will re-undercut for sure since it has no loyal customers Loyal undercut by Disloyal $50 $1500 $30 If other firm responds with $20, you will re-undercut with $10 since you prefer 100*$10 over 30*$30. So, other firm will undercut with $10 ending the game and you with $30*30 „ Payoff if you have loyal customers and get undercut is $1500 - $250 = $1250 Disloyal undercut by Disloyal $50 Game ends. You get rev = $0 $40 $30 $20 $10 „ Game ends. You get rev = $1000 Don’t respond with $50 or $40 Disloyal undercut by Disloyal $30 Since each firm has no loyal customers, each will reundercut until price equals $10. If you bid $30 or $20, other will go to $10 and you will get zero revenue $20 $10 $1000 „ „ Respond with $10 and get $1000 Not as good as $1500 if you had Loyal Downside of Loyalty „ Your unwillingness to re-undercut makes you an easy target Disloyal opponent (whether first or second) will undercut you with $40, leaving you with only $1500 „ Loyal opponent (if first) will also undercut you with $40 „ • this is not obvious but can be shown Upside of Disloyalty You are so “Lean & Hungry” that no Loyal opponent messes with you „ Against Loyal opponent, you get 70*$40 = $2800 „ „ What about against Disloyal? Disloyal vs. Disloyal „ Any undercutting must lead to ultimate price of $10 Æ no better than $1000 „ no price war in subgame-perfect equilibrium! $50 $50 $10 $40 $50 2500,2500 0,1000 1000,0 $10 $10 1000,0 0,1000 To Be Loyal or Not To Be … Loyal Disloyal Loyal Disloyal Chicken Loyal Servant „1st gets $2800 „2nd gets $1500 „Average $2150 Loyal Servant „DL gets $2800 „L gets $1500 „DL gets $2800 „L gets $1500 Assurance „Both get $2500 Commitments to be Tough “At the critical moment, the leader of an army acts like one who has climbed up a height, and then kicks away the ladder behind him” - Sun Tzu, “The Art of War”, 400 BC Commitments to be Soft “What is more fluid, more yielding than water? Yet back it comes again, wearing down the rigid strength that can not yield to withstand it. So it is that the strong are overcome by the weak, the haughty by the humble.” - Lao Tzu, “Tao Te Ching”, 600 BC Club Z „ Zeller’s is a major Canadian massmerchandiser „ 1/3 of Canadians belong to Club Z, Zeller’s “loyalty rewards” program „ 4/5 of Zeller’s shoppers are in Club Z „ Club Z appears to give Zeller’s an advantage over competitors. At any given price, more people will buy from Zeller’s Potential New Entry „ In 1990, Q-Co is considering entering the Canadian market. „ Would Club Z give Zeller’s an advantage in deterring entry? Competing with Wal-Mart „ In 1990s, Wal-Mart is (definitely) entering the Canadian market. „ Does Club Z give Zeller’s an advantage in price competition with Wal-Mart? Tough or Soft? „ Three main factors determine whether to be tough or soft: 1. 2. 3. Does your opponent view strategies as strategic substitutes or complements? Do you want your opponent to be more or less aggressive? Are you trying to induce exit/deter entry or to deal with an entrenched opponent? Strategic Substitutes vs Strategic Complements „ Player A views the strategies as strategic substitutes if its reaction curve is downward-sloping „ „ i.e. A prefers to be less aggressive if other player is more aggressive Player A views the strategies as strategic complements if its reaction curve is upward-sloping „ i.e. A prefers to be more aggressive if other player is more aggressive Strategic Substitutes vs Strategic Complements? „ Which is in strategic substitutes and which in strategic complements? competing „ competing „ competing „ competing „ on on on on price capacity/quantity advertising research Assurance Game: Strategic Complements 100% Col’s prob. of High 25% 0% 0% 25% 100% Row’s prob. of High Chicken Game: Strategic Substitutes 100% Col’s prob. of Swerve 50% 0% 0% 50% 100% Row’s prob. of Swerve Competition vs Reliance „ Do you want the other player to be more or less aggressive? • Interpretation of “more aggressive” depends on the situation and need not have anything to do with actual aggression „ „ “Competition”: any game in which players want others to be less aggressive “Reliance”: any game in which players want others to be more aggressive Competition with Investment „ Firms often have the opportunity to take an action prior to a game that makes it tend to be more or less aggressive than otherwise „ Such actions are called “investment” though they may actually not be related to any actual investment A Lot or a Little Investment? „ „ You want to commit to do more of whatever will lead the other player to be less aggressive So, decision to invest a lot or a little depends only on two factors: 1. 2. Does your investment lead you to be more or less aggressive? Does your opponent view strategies as strategic substitutes or complements? Taxonomy of Optimal Competitive Strategies Strategic Complements Strategic Substitutes More Makes You Tougher More Makes You Softer Puppy Dog Fat Cat less investment makes you softer, makes other less aggressive more investment makes you softer, makes other less aggressive Top Dog Lean & Hungry more investment makes you tougher, makes other less aggressive less investment makes you tougher, makes other less aggressive Puppy Dog: Serve a Niche „ Suppose firm is developing a product to compete with that of dominant firm „ “Investment”= potential clientele „ „ 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 Top Dog: Export Subsidies „ Suppose domestic firm competes in quantities in a foreign market „ “Investment” = export subsidy With export subsidy, domestic firm will export more into foreign market „ This leads foreign firm to produce less „