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Module Group A

Strategies to Change the Business Environment

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MODULE 1

ENTRY PREVENTION

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LEARNING OBJECTIVES:

Explain the economic basis for limit pricing and identify the conditions under which a firm can profit from such a strategy.

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 (Figure M1-1)

Price

Quantity

Demand

MR

MC

ATC

)

Profits

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Limit Pricing and Residual Demand (Figure M1-2)

Price

Quantity

Demand

Entrant’s residual

demand curve

AC

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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 May Fail to Deter Entry

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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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Effective Limit Pricing

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Commitment mechanisms – incumbent can commit to not reducing output in the face of entry.

Learning curve effects – when a firm enjoys lower costs due to knowledge gained from its past production decisions.

Incomplete information – can delay or eliminate entry.

Reputation effects – being “tough” on new entrants may discourage entry.

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Linking Preentry Price to Postentry Profits

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The Value of Commitment (Figure M1-3)

E

E

I

Commit to

Enter

Enter

Don’t enter

Don’t enter

Don’t Commit

I=Incumbent

E=Potential entrant

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Even if the incumbent can link preentry price to post-entry profits to prevent entry, it may be more profitable to permit entry.

The present value of maintaining monopoly status is:

Entry reduces profit from the monopoly to duopoly level:

Since , entry will harm the incumbent.

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Dynamic Considerations

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Profits under effective limit pricing:

Limit pricing is profitable when:

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Dynamic Considerations

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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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Conditions for Dynamic Considerations

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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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Dynamic Considerations In Action: Problem

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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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Dynamic Considerations In Action: Answer

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MODULE 2

LESSENING COMPETITION

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LEARNING OBJECTIVES:

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.

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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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 Counterstrategies

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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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Legality of Predatory Pricing

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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 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 In Action: Problem

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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 In Action: Problem

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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 In Action: Answer

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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 Rival’s Costs to Lessen Competition

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Raising a Rival’s Marginal Cost (Figure M2-1)

Quantity2

Quantity1

A

B

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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’ Costs: Vertically Integrated Firms

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Raising a Rival’s Fixed Cost (Figure M2-2)

E

E

I

$90 License

Enter

Enter

Don’t enter

Don’t enter

No license

I=Incumbent

E=Potential entrant

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MODULE 3

RESTRUCTURING GAME TIMING

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LEARNING OBJECTIVES:

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.

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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First-Mover Advantages

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Simultaneous-Move Production Game (Table M3-1)

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 (Figure M3-1)

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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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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Second-Mover Advantages

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MODULE 4

OVERCOMING NETWORK EFFECTS

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LEARNING OBJECTIVES:

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 as penetration pricing to favorably change the strategic environment.

A network consists of links that connect different points (called nodes) in geographic or economic space.

One-way networks - services flow in only one direction (ex. residential water)

Key feature is that its value to each user does not directly depend on how many other people use the new network

Two-way networks (ex. telephone systems, e-mail, etc.)

In contrast to one-way networks, the value to each user depends directly on how many other people use the network.

Star networks – an example of a two-way network with a central “hub”

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What is a Network?

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Two-Way, Star Network (Figure M4-1)

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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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Direct Network Externalities

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An indirect network externality (network complementarities) 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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Indirect Network Externalities

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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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Negative Network Externalities

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The presence of network externalities often makes it difficult for new networks to replace or compete with existing networks; even a technologically superior network.

Existing networks 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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First-Mover Advantages Due to Consumer Lock-In

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A Network Game (Table M4-1)

Firm A Firm B
Strategy Low output High output
Low output $30, $10 $10, $15
High output $20 , $5 $1, $2

Both users initially use Provider H1 and receive $10 each in value.

Neither has an incentive to change to H2 even though if they both did simultaneously, they would be better off and receive $20 each in value.

Network externalities create a consumer lock-in.

User 1 User 2
Network Provider H1 H2
H1 $10, $10 $0, $0
H2 $0, $0 $20, $20

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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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Using Penetration Pricing to “Change the Game”

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A Network Game with Penetration Pricing (Table M4-2)

Firm A Firm B
Strategy Low output High output
Low output $30, $10 $10, $15
High output $20 , $5 $1, $2

During the trial period, users pay only $1.

The value to each user of having access to both networks is at least as large as the value of using either network individually.

Consumers have an incentive to “try” the new network since the choice H1, H2 is the dominant strategy for each user.

Once they try the service and determine it is superior, they will quit using H1.

User 1 User 2
Network Provider H1 H1, H2
H1 $10, $10 $10, $11
H1, H2 $11, $10 $21, $21

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