strategic behavior in concentrated industriesstrategic

Strategic Behavior in Concentrated IndustriesStrategic Behavior in Concentrated IndustriesOligopoly and Game Theory

• Extreme market structures: Monopoly and perfect competition => No need to consider rivals’ reactionscompetition No need to consider rivals reactions

• Intermediate case: Oligopoly (Greek=few sellers) or concentrated industry=> Need to consider rivals’ yreactions

• Game Theory: formal study of strategic behavior, y y grelation between inter-dependent agents (firms, trade authorities, armies, litigation…)

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F hi i iFashion pricing

• You are working for Armani’s London shop on Bond• You are working for Armani s London shop on Bond Street, next to Ralph Lauren’s store• It’s nearing the end of the season, and you and your

i id (i d d l d i l l )competitor consider (independently and simultaneously) whether to have sales or keep the normal prices• Roughly half the consumers have a preference for g y pArmani. The other half prefer Ralph Lauren• If only you have a sale you will attract some of Ralph Lauren’s customers. If only Ralph Lauren has a sale itLauren s customers. If only Ralph Lauren has a sale it will take some of your customers• If both stores have a sale then the market shares will be unaffected

2

unaffected

Market informationMarket information• You are maximizing revenues P*Q (for simplicity)• If both Armani and Ralph Lauren keep their normal prices pA=3If both Armani and Ralph Lauren keep their normal prices, pA 3

and pRL=3, then they will each sell to 20 customers: qA=20 and qRL=20

• If both Armani and Ralph Lauren have sales p =1 and p =1• If both Armani and Ralph Lauren have sales, pA=1 and pRL=1, then they will each sell to 40 customers: qA=40 and qRL=40

• If Armani keeps its normal price (pA=3) while Ralph Lauren has l ( ) h l h ll da sale (pRL=1), then Ralph Lauren sells to 70 customers and

Armani only to 10: qA=10, qRL=70. • If Armani has a sale (pA=1) while Ralph Lauren keeps its (pA ) p p

normal price (pRL=3), then Armani sells to 50 customers and Ralph Lauren only to 10: qA=50, qRL=10.

• Should you as Armani’s store manager have a sale or not?

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Should you, as Armani s store manager, have a sale or not?

Fashion pricing gameFashion pricing game Ralph Lauren

Sale Normal Price

40 30 Sale

40 40

30 5040 50

Armani

70 60Normal Price 30 60

4

Think through the strategy of your rival!

The Prisoner’s DilemmaCoordination Breakdown

Prisoner 2

Hold Out Confess

2 1 Hold Out

2 4 P i 1 4 3

(Numbers in table are number of years in jail)

Prisoner 1 Confess

4 1

3 3

“Paradox:” Although both prisoners would be better off by

1 3

5

g p yholding out they will both confess!!!

GamesGamesModels of Strategic Interactions

What is a game?Players (e g Coca-Cola and

Pepsi Cola

High Ad Low Ad – Players (e.g. Coca-Cola and

Pepsi-Cola)– Rules (e.g. simultaneously

choose advertising level)

Coca

High Ad

2 2

1 4

Note: N

umb

table are firchoose advertising level)– Strategies (low or high cost ad

campaign)P ff ( l d ti

CocaCola

Low Ad

4 1

3 3

bers in the rm

profits

– Payoffs (sales-production costs-ad costs)

1 3

6

EquilibriumConcept of Reasonable Outcomep

N h E ilib i t f Pepsi ColaNash Equilibrium= concept of “reasonable” outcome

http://www.nobel.se/economics/laureates/1994/index.html

p

High Ad Low Ad

High

2 1

Coca

High Ad

2 4 Cola 4 3

LowAd

4 1

3 3

Definition: Given what other players are doing, no player would want to change strategy unilaterally (i.e. each player’s strategy is an

7

g gy y ( p y gyoptimal response to the other players’ strategies)

Getting to a Nash Equilibrium

• Put yourself in the shoes of your rival• What is the best course of action for your rival?y

– It depends on what you are doing!• But how does your rival know what you are doing?But how does your rival know what you are doing?

At a Nash equilibrium your expectations about yourAt a Nash equilibrium, your expectations about your rival’s strategy are correct and your rival’s

expectations about your use of strategy are correct

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e pectat o s about you use o st ategy a e co ect

Pricing Rivalry: Price Wars

• In July 1999, Sprint announced a nighttime long distance rate of 5 cents per minute. I A t 1999 MCI t h d S i t’ ff k t L t th t th• In August 1999, MCI matched Sprint’s off-peak rate. Later that month, AT&T acknowledged that revenue from its consumer long-distance business was falling, and the company cut its long-distance rates to 7 cents per minute all day everyday for a monthly fee of $ 5 95per minute all day, everyday, for a monthly fee of $ 5.95.

• AT&T stock dropped 4,7% the day of the announcement. • MCI’s stock price dropped 2.5 %; Sprint’s fell 3.8%.

Pricing Rivalry: Questions

• What determines price competition in an industry?• Why are some firms able to coordinate their pricing behavior and

make large profits while other firms engage in vicious price wars?

The Pricing Game: Relevance

• Price war at rival gas stations• OPEC quantity production decisionsOPEC quantity production decisions• Advertising battles (e.g. Coke and Pepsi)• R&D wars (e.g. Giga-chip race between Intel and AMD)

The Pricing Game:Strategy Formulation

Price war at rival gas stations

You and your rival simultaneously choose a price every morning for the entire day. To simplify, say that you can either choose high price or low price and the payoffs correspond to a prisoner’s dilemma game. Formulateprice and the payoffs correspond to a prisoner s dilemma game. Formulate a strategy for setting the price every morning that you will hand out to your replacement.

The Prisoner’s DilemmaThe Prisoner s Dilemma

Your Rival’s Price

H L

Example: One-Shot Pricing Game

H L

H

100

30100

150

HYour Price

30

30

80

100

L 80150

The Prisoner’s DilemmaThe Prisoner s Dilemma (Continued)

Dominant strategies: low price.

Eq ilibri m pa offs are (80 80) m ch orse than attained b high Equilibrium payoffs are (80,80), much worse than attained by high price, (100,100).

Conflict between individual incentives and joint incentives.

Typical of many business situations.

The Prisoner’s Dilemma: Discussion

• Is there something that troubles you about the prisoner’s dilemma? • Do you really believe that the firms (prisoners) will price low (confess)?Do you really believe that the firms (prisoners) will price low (confess)? • In practice, we sometimes see firms (prisoners) colluding (not confessing)• Which assumptions are violated?

One shot vs Repeated GamesOne-shot vs Repeated Games

A repeated game is simply a game made up of a finite or indefinite repetition of a one-shot game.

The equilibrium of a repeated game may be very different from theThe equilibrium of a repeated game may be very different from the repetition of the equilibrium of the one-shot game. Reasons:

Learning about competitors Influencing their learning/expectations achieving a “co-operative solution”

How repetition can make co-operation an equilibrium?

The Repeated Pricing GameThe Repeated Pricing Game

• What is a good strategy? When does a strategy work well? How do you take your rival’s actions into account? How do you take your rival s actions into account? What is a best response to a given strategy?

• Is tit-for-tat (T4T) a good strategy? What are the properties of T4T? When will it perform well?

Cooperation with Tit-for-TatCooperation with Tit-for-TatIs Tit-for-tat Compelling?

• What are the advantage of T4T?

Niceness: Do no strike first (not too greedy)Niceness: Do no strike first (not too greedy)

Reciprocate both good and bad Provocability: Immediately punish deviators

i i if i l d Forgiveness: Return to cooperation if rival does too

Act simply and clearly

• Robustness: does pretty well on average and it is very simple!p y g y p

The Pricing Game: LLessons

• In a competitive environment, it may not be optimal to try to beat others

• Cooperation occurs even in the absence of formal agreements• In fact, you do not even need face-to-face interaction• Cooperation, however, is unstablep , ,• The game parameters (e.g. length, payoffs) matter

The Pricing Game: Lessons

• You need to take your competitor’s actions into account• You can influence your competitor’s decisions y p• Having long term vision helps• You can build trust and reputation • Punishment is an enforcement mechanism• Punishment is an enforcement mechanism• Be careful toward the end of a game

The graphite electrode cartelThe graphite electrode cartel

• In July 2001, the EuropeanIn July 2001, the European Commission fined eight companies € 218.8 million for fixing the price and g psharing the market for graphite electrodes in the 1990’s

• Used in recycling of scrap steel in mini-mills. Annual sales in Europe € 420 million

• Fines in million euros: SGL Carbon (80.2), UCAR International (50.4), Tokai

b ( ) h k21

Carbon (24.5), Showa Denko (17.4)…

EC’s new leniency programEC s new leniency program

• The European Commission started an investigation in• The European Commission started an investigation in June 1997

• EC offered 70 percent reduction of fine to the member that first provided evidence against the cartelthat first provided evidence against the cartel

• Game: Prisoner’s dilemma situation with eight players rushing to be the first to confess

Sh D k K K (J ) d t il l 1998– Showa Denko K.K. (Japan) gave details early 1998– UCAR International followed and got 40 percent reduction– Other companies paid in full…

http://www.usdoj.gov/atr/public/press_releases/2001/index01.htmhttp://www.usdoj.gov/atr/public/press_releases/2001/8186.htmhttp://europa.eu.int/comm/competition/antitrust/cases/2001/http://europa.eu.int/rapid/start/cgi/guesten.ksh?p_action.gettxt=gt&doc=IP/01/1010|0|RAPID&lg=EN

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I S b 1999

The Ford Price Promise

• In September 1999, customers were “unsettled” by rumors of future price reductions

• Ford launched the £400 000Ford launched the £400,000 “Price Promise” national advertising campaign

• Under the “Price Promise”, Ford will reimburse any reduction in the recommended retail price difference

• a.k.a. “Most Favored Customer Clause”

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http://www.media.ford.com/article_display.cfm?article_id=2702

The Ford Price PromiseThe Ford Price PromiseGame between Ford and its Consumers

• Should consumers buy early or wait?

• Will Ford have much inventory at the end of the season?• Should Ford lower price at the end of the season?

• How does the price promise changes the bargaining game between Ford and its customers?

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The Ford Price PromiseThe Ford Price PromiseGame between Ford and its Consumers

• Consider those consumers who want to buy a Ford before January 2000

• Without the Price Promise, they wait if they believe that Ford will lower its price before January

• With the Price Promise, they have a dominant strategy which is to buy right away

• The Price Promise transforms the game between Ford• The Price Promise transforms the game between Ford and consumers as a tragedy of the commons

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The Ford Price PromiseThe Ford Price PromiseGame between Ford and Competitors

1 - Recall Pricing Rivalry Game. NE is both firms with low price

2 - Ford makes a move that increases its costs in the event of lowering prices same NE, Ford orse off

3 - GM understands and copies Ford move New NE - both firms with high price!!!

Competitor Price

Low High

Competitor Price

Low High

3

Competitor Price

Low High

3 5 3

Ford worse off

Ford

Low

5

5

3

7Price 7 6

Ford

Low

5

3.5

3

5.5Price

Hi h

7 6Ford

Low

3.5

3.5

3

5.5Price

Hi h

5.5 6High

3 6High

3 6High

3 6

Conclusion - both firms make their situation worse in the event of low

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Conclusion - both firms make their situation worse in the event of low prices and thus are able to credibly commit to high prices

Strategic Barriers to EntryStrategic Barriers to EntryEntry Deterrence

• Strategy 1: Increase entrant’s costs• Strategy 2: Commit to fierce response• Strategy 3: Decrease entrant’s demand• Strategy 3: Decrease entrant s demand

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Strategy 1: Increase entrant’s costStrategy 1: Increase entrant s costExamples

• Airport takeoff and landing slots (BA in London)

• Sleeping patents (Rank Xerox, p g p ( ,Procter&Gamble)

• R&D and marketingR&D and marketing

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Strategy 2: Commit to a fierce responsePredatory Pricing: Should you punish entry?

Enter/Stay in

Exit/Stay out

Prey

LP LPHP HPPredator

LP=Low priceHP=High price

5

0

2

2

0

0

-1

-1Predator

Prey

“Paradox:” It is difficult to commit to low prices Cheap-talk is not credible!

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Cheap talk is not credible!

Strategic BarriersS l i fSome logic of entry

Aggressive Aggressive Response

EntrantMove first

ggEntry

Soft Entry IncumbentRespond

Response

Soft ResponseMove first

No Entry

Respond

Accommodates

The Entrant• Anticipate the likely reactions of

The Incumbent• When do entry deterring strategies• Anticipate the likely reactions of

incumbent firms• Only post-entry competition

matters: “Look forward and

• When do entry deterring strategies succeed?

• The strategy must change the entrants’ expectations about the nature of post-

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matters: Look forward and reason backward”

expectations about the nature of postentry competition

E t D t /E it H t iEntry Deterrence/Exit Hastening Why do we observe predatory pricing?

• Asymmetric information about cost (e.g. A i b )American Tobacco)

• Reputation building (e.g. DeBeers, AAirline)k ( k )• Deep pockets (e.g. UK supermarket)

• Learning curve (e.g. Boeing)

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Strategy 2: Excess CapacityStrategy 2: Excess CapacityDuPont titanium dioxide

DuPontMonopolyCapacity

Excess Capacity

Rival

3

E ENE NEE=EnterNE=Do not enter

4 12DuPont00 -11Rival

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Excess CapacityExcess CapacityThe sequence of move matters!

DuPont

Simultaneous moves Sequential moves DuPont

EC MC

1 2 MonopolyCapacity

Excess

DuPont

E

-1 1 Rival 3 4 E E

Capacity

NE

Capacity

NERival

NE

0 0

3

0

4

0

1

-1

2

1DuPontRival

33Equilibrium: Monopoly

Capacity and Enter

strategic behavior in concentrated industriesstrategic

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