Wk8 DQ - Managerial Eonomics
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Baye_9e_Chapter_131.pptxAdvanced Topics in Business Strategy
© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Chapter 13
Learning Objectives
Explain the economic basis for limit pricing, and identify the conditions under which a firm can profit from such a strategy.
Explain the economic basis for predatory pricing.
Show how a manager can profitably lessen competition by raising rivals’ costs.
Identify some of the adverse legal ramifications of business strategies designed to lessen competition.
Assess whether a firm’s profits can be enhanced by changing the timing of decisions or the order of strategic moves, and whether doing so creates first- or second-mover advantages.
Identify examples of networks and network externalities, and determine the number of connections possible in a star network with n users.
Explain why networks often lead to first-mover advantages, and how to use strategies such a penetration pricing to favorably change the strategic environment.
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Limit Pricing to Prevent Entry
Successful businesses often spawn entry of new competitors into the market, and adversely affect the profits of existing firms.
Faced with that threat, a manager may consider limit pricing, which is a strategy where an incumbent maintains a price below the monopoly level in order to prevent entry.
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Limit Pricing to Prevent Entry
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Monopoly Pricing
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Limit Pricing to Prevent Entry
Price
Quantity
Demand
MR
MC
ATC
)
Profits
4
Limit Pricing and Residual Demand
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Limit Pricing to Prevent Entry
Price
Quantity
Demand
Entrant’s residual
demand curve
AC
5
Limit Pricing May Fail to Deter Entry
Under limit pricing, the entrant was assumed to have complete information about the incumbent’s demand and costs.
The strategy did not “hide” information about the profitability of the incumbent’s business.
The low price charged by the incumbent did not prevent entry; the entrant stayed out because it believed the incumbent would produce at least , if it entered.
A revised strategy is to set the monopoly price, , and produce the monopoly output, , and threaten to expand output to , if entry occurs.
This, however, is not a credible threat; so, a rational entrant would find it profitable to enter if the incumbent sets price,
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Limit Pricing to Prevent Entry
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Effective Limit Pricing
For limit pricing to effectively prevent entry by rational competitors, the preentry price must be linked to the postentry profits of potential entrants.
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Limit Pricing to Prevent Entry
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Linking Preentry Price to Postentry Profits
Commitment mechanisms
Learning curve effects
Incomplete information
Reputation effects
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Limit Pricing to Prevent Entry
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Dynamic Considerations
Even if the incumbent can link preentry price to postentry profits, it may be more profitable to permit entry.
The present value of maintaining monopoly status is:
Entry from monopoly to duopoly profits, where :
Since , entry will harm the incumbent.
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Limit Pricing to Prevent Entry
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Dynamic Considerations
Profits under effective limit pricing:
Limit pricing is profitable when:
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Limit Pricing to Prevent Entry
Conditions for Dynamic Considerations
The conditions under which limit pricing is attractive include:
Low interest rate environments
Monopoly and limit-price profits are close
Duopoly profits are significantly lower than limit-price profits.
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Limit Pricing to Prevent Entry
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Dynamic Considerations In Action: Problem
Baker Enterprises operates a midsized company that specializes in the production of a unique type of memory chip. It is currently the only firm in the market, and it earns million per year by charging the monopoly price of per chip.
Baker is concerned that a new firm might soon attempt to clone its product. If successful, this would reduce Baker’s profit to million per year. Estimates indicate that, if Baker increases its output to units (which would lower its price to per chip), the entrant will stay out of the market and Baker will earn profits of million per year for the indefinite future.
What must Baker do to credibly deter entry by limit pricing?
Does it make sense for Baker to limit price if the interest rate is 10 percent?
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Limit Pricing to Prevent Entry
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Dynamic Considerations In Action: Answer
What must Baker do to credibly deter entry by limit pricing?
Baker must “tie its hands” to prevent itself from cutting output below units if entry occurs, and this commitment must be observable to potential entrants before they make their decision to enter or not enter.
Does it make sense for Baker to limit price if the interest rate is 10 percent?
Limit pricing is profitable if .
Therefore, limit pricing is profitable.
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Limit Pricing to Prevent Entry
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Predatory Pricing to Lessen Competition
Predatory pricing is a strategy where a firm temporarily prices below its marginal cost to drive existing competitors out of the market.
Involves a trade-off between current and future profits, so it is profitable only when the present value of the higher future profits offsets the losses required to drive rivals out of the market.
A firm engaging in predatory pricing must have “deeper pockets” (greater financial resources) than the prey in order to outlast it.
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Predatory Pricing to Lessen Competition
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Predatory Pricing Counterstrategies
To significantly reduce the profitability of predatory pricing, the prey may:
Stop production entirely and cause the predator to lose more money each period.
Purchase the product from the predator and stockpile it to sell when predatory pricing ceases.
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Predatory Pricing to Lessen Competition
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Legality of Predatory Pricing
Engaging is predatory pricing is vulnerable to prosecution under the Sherman Antitrust Act; however, it is often difficult to prove in court.
Some legitimate business practices/scenarios might be deemed “predatory” under legal definitions.
Fierce competition with substantial fixed cost may lead to the departure of the weakest firm.
Firms attempting to penetrate a market with a new product often find it advantageous to sell the product at a low price or give it away for free initially.
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Predatory Pricing to Lessen Competition
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Predatory Pricing In Action: Problem
Baker Enterprises operates a midsized company that specializes in the production of a unique type of memory chip. If Baker were a monopolist, it could earn million per year for an indefinite period of time by charging the monopoly price of per chip. While Baker could have thwarted the entry of potential rivals by limit pricing, it opted against doing so, and it is now in a duopoly situation, earning annual profits of million per year for the foreseeable future.
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Predatory Pricing to Lessen Competition
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Predatory Pricing In Action: Problem
If Baker drops its price to per chip and holds it there for one year, it will be able to drive the other firm out of the market and retain its monopoly position indefinitely. Over the year in which it engages in predatory pricing, however, Baker will lose million. Ignoring legal considerations, is predatory pricing a profitable strategy? Assume the interest rate is 10 percent and, for simplicity, that any current period profits or losses occur immediately (at the beginning of the year).
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Predatory Pricing to Lessen Competition
Predatory Pricing In Action: Answer
If Baker does not engage in predatory pricing, the present value of its earnings (including its current million in earnings) will be
If Baker uses predatory pricing, the present value of its current and future profits will be
Profits are lower under predatory pricing.
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Predatory Pricing to Lessen Competition
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Raising Rival’s Costs to Lessen Competition
Raising rivals’ costs is a strategy in which a firm gains an advantage over competitors by increasing their costs.
Strategies involving marginal cost.
Strategies involving fixed cost.
Strategies for vertically integrated firms.
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Raising Rivals’ Cost to Lessen Competition
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Raising a Rival’s Marginal Cost
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Raising Rivals’ Cost to Lessen Competition
Quantity2
Quantity1
A
B
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Raising a Rival’s Fixed Cost
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Raising Rivals’ Cost to Lessen Competition
E
E
I
$90 License
Enter
Enter
Don’t enter
Don’t enter
No license
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Raising Rivals’ Costs: Vertically Integrated Firms
A vertically integrated firm with market power in the upstream (input) market may be able to exploit this power to raise rivals’ costs in downstream markets.
Vertical foreclosure
Strategy wherein a vertically integrated firm charges downstream rivals a prohibitive price for an essential input, thus forcing rivals to use more costly substitutes or go out of business.
Price-cost squeeze
Tactic used by a vertically integrated firm to squeeze the margins of its competitors.
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Raising Rivals’ Cost to Lessen Competition
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Price Discrimination as a Strategic Tool
Price discrimination – the practice of charging different prices to different consumers – enhances the profitability of predatory pricing, limit pricing and raising rivals’ costs.
Price discrimination means firms only to have lower prices to targeted consumer groups and mitigates the negative aspects of limit pricing and predatory pricing.
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Price Discrimination as a Strategic Tool
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First-Mover Advantages
A first-mover advantage permits a firm to earn a higher payoff by committing to a decision before its rivals get a chance to commit to their decisions.
Changing the timing of a game to move from a simultaneous-move to sequential-move game can yield one player a first-mover advantage.
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Changing the Timing of Decisions or the Order of Moves
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Simultaneous-Move Production Game
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Changing the Timing of Decisions or the Order of Moves
| Firm A | Firm B | ||
| Strategy | Low output | High output | |
| Low output | $30, $10 | $10, $15 | |
| High output | $20 , $5 | $1, $2 |
Firm A has a dominant strategy: Low output
Nash equilibrium: Firm A produces Low output, Firm B produces High output.
| Firm A | Firm B | ||
| Strategy | Low output | High output | |
| Low output | $30, $10 | $10, $15 | |
| High output | $20 , $5 | $1, $2 |
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Sequential-Move Production Game
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Changing the Timing of Decisions or the Order of Moves
B
B
A
Low output
Low output
Low output
High output
High output
High output
Changing the timing of the game,
Firm A gets to move first.
Unique, subgame perfect
equilibrium is:
Firm A: produce High output
Firm B:
produce Low output, if Firm A produces High output
produce High output, if Firm A produces Low output
First-mover
advantage
permits
Firm A to
earn $20
Instead of
$10.
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Second-Mover Advantages
A second-mover advantage can permit a firm to earn a higher payoff by free-riding on the investments made by the first mover and produce at lower costs.
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Changing the Timing of Decisions or the Order of Moves
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What is a Network?
A network consists of links that connect different points (called nodes) in geographic or economic space.
One-way networks
Two-way networks
Star networks
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Penetration Pricing to Overcome Network Effects
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Two-Way, Star Network
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Penetration Pricing to Overcome Network Effects
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Direct Network Externalities
Two-way networks that link users exhibit positive externalities called direct network externalities.
The direct value enjoyed by the user of a network because others also use the network.
Principle: Direct network externalities
A two-way network linking users provides potential connection services. If one new user joins the network, all the existing users directly benefit because the new user adds potential connection services to the network.
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Penetration Pricing to Overcome Network Effects
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Indirect Network Externalities
An indirect network externality is the indirect value enjoyed by the user of a network because of complementarities between the size of a network and the availability of complementary products or services.
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Penetration Pricing to Overcome Network Effects
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Negative Network Externalities
Negative network externalities exist when an additional user to the network decreases the value per user of the services.
Congestion
Bottlenecks
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Penetration Pricing to Overcome Network Effects
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First-Mover Advantages Due to Consumer Lock-In
The presence of network externalities often make it difficult for new networks to replace or compete with existing networks; even a technologically superior network.
Existing network likely have an installed user base and complementary services compared to a new network.
Network externalities can create consumer lock-in: a scenario in which consumers are stuck in a situation (equilibrium) where they are using an inferior network.
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Penetration Pricing to Overcome Network Effects
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Using Penetration Pricing to “Change the Game”
Consumer lock-in resulting from an existing network might be easily resolved by communication between two users; however communication is not feasible with potentially hundreds of millions of users because of transaction costs.
What hope does a firm have of establishing its new network?
One strategy, penetration pricing, involves charging a low price initially to penetrate a market and gain a critical mass of customers; useful when strong network effects are present.
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