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Competitive Intelligence

Competitive Intelligence. Week 7 Competing Across Time. Week 10 Outline. Chapter 9: Strategic Commitment Defining Commitment Commitment and competition Flexibility and Options Chapter 10: Dynamic Pricing Uncooperative pricing Cooperative pricing. Dealing with price competition.

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Competitive Intelligence

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  1. Competitive Intelligence Week 7 Competing Across Time

  2. Week 10 Outline • Chapter 9: Strategic Commitment • Defining Commitment • Commitment and competition • Flexibility and Options • Chapter 10: Dynamic Pricing • Uncooperative pricing • Cooperative pricing

  3. Dealing with price competition • Number of firms • Pricing range • Number of firms and pricing

  4. Structure:Number of firms (1) • MES: U-shaped or L-shaped • High initial sunk costs • Sunk costs: • Production (B2B) • Advertising and Branding (B2C) • Differentiation

  5. Structure:Number of firms (2) • Market demand Q* • Minimum efficient scale q** • N = Q*/q** q** q**

  6. Structure:Pricing (1) • Leonard Weiss • Higher prices in concentrated markets • When top three gasoline retailers had market share > 60%, prices were 5% higher compared to other markets where top three retailers had a 50% share

  7. Structure:Pricing (2) • Bresnahan and Reiss • Service industries (doctors, tire dealers, plumbers....) • Market entry threshold • En = Minimum population to support n service providers • E2 is about 4 times E1 (doubled demand to compensate for reduced prices) • E3 – E2 > E2 – E1 (competition more intense with 3) • E4 – E3= E3 – E2 (price competition is close to max.) • Three firms are sufficient for optimal price competition

  8. Structure:Pricing Range (3) Monopoly  MR = MC Perfect Competition  P = MC MC AC Pm Ppc D = AR Qm Qpc MR Market Demand and Firm Cost Structure

  9. Strategic Commitment

  10. Strategic Commitment • Sending clear signals to competitors • Signals: • Visible • Understandable • Credible (no bluff and irreversible) • Example 9.1:Loblaw versus Wal-Mart Canada

  11. Marchionne's grand plan is to create a global car giant by combining the best pieces of Fiat and Chrysler. The strategy makes sense on paper .... "Chrysler can make it," says Hall. "The question is, how committed is Fiat to saving Chrysler?"

  12. Strategic Decisions • Tough Commitments (No Matter What) • Cournot: Capacity expansion • Bertrand: Price reduction • Soft Commitments (Else) • Cournot: Capacity adjustment • Bertrand: Price adjustment

  13. Game Theory(Nash Equilibrium) Payoffs matrix for a simple strategy What is Nash equilibrium with simultaneous and independent strategies? What is Nash equilibrium if Firm 1 takes leadership and moves first?

  14. Strategic Substitution in a Cournot Equilibrium Q2 Firm 1: Tough Commitment b R2 a R1b R1a Q1

  15. Strategic Complement in a Bertrand Equilibrium R1a P2 R1b a R2 b P1 Firm 1: Tough Commitment

  16. Product Differentiation in Monopolistic Competition R1a R1a P2 R1b P2 R1b a b R2 R2 b a P1 P1

  17. No Differentiation P2 R1-2 Monopoly MC P1

  18. Analysing Commitments • Positioning (NPV) • Benefit, Creation of value? • Sustainability (NPV and sensitivity) • Competitors responses & entrants • Flexibility (Decision Theory) • Incorporating uncertainties • Judgement (Track Record) • Organisational factors (types I and II errors)

  19. Example of NPV Analysis

  20. Cournot EquilibriumChapter 8, Q 10 • ∏1 : (100 - Q1 - Q2g)x Q1 – 40Q1 • ∏2 : (100 - Q2 - Q1g)x Q2 – 40Q2 • Q1 and Q2 = 30 - .5Q2g = 20 • P1 and P2 = (100 – 20 -20) = 60 • Profit (60 – 40) x 20 = 400 • Imagine that F1 makes an investment ($1000) with a 3 three year horizon and reduces its MC to 20 from 40. New profit is (60 – 20) * 20 = 800?

  21. Changes in Cournot Equilibrium • ∏1 : (100 - Q1 - Q2g)x Q1 – 20Q1 • ∏2 : (100 - Q2 - Q1g)x Q2 – 40Q2 • MR1 = 80 – 2Q1 –Q2g • MR2 = 60 – 2Q2 –Q1g • Opt. Q1 = 40 – .5Q2 • Opt. Q2 = 30 – .5Q1 • Q1 = 33.3 and Q2 = 13.3 • P1 = 100 – 33.3 - 13.3 = 53.4 • Profit Firm 1= 1,112 • Profit Firm 2= 178 • Additional profit for Firm 1 = 712

  22. Decision AnalysisChanges in Cournot Equilibrium • Additional profit = 712 • MC reduction from 40 to 20 • Upfront investment = 1000 • Investment horizon = 3 years • Hurdle rate = 20% • What is the PV? Go, No Go?

  23. Decision Analysis • PV Year 1 (712) = 593 • PV Year 2 (712) = 494 • PV Year 3 (712) = 412 1,499 • Upfront investment 1,000 • NPV = 499 PV = FV/(1+r)n NPV = -I0 - n [FV/(1+r)n]

  24. Uncertainty • Sunk cost 100M • Favourable outcome 300M (Revenue) • Unfavourable outcome 50M (Revenue) • Probabilities .50/.50 • Expected value?

  25. Uncertainty • 300M x .5 = 150M • 50M x .5 = 25M • Expected Revenue 175M • Minus Investment - 100M Expected value 75M

  26. Flexibility • Delaying the investment decision by one year... then the firm will know for sure • One year from now (T + 1) $300 - $100 = 200 x .5 = $100 $No go x .5 = $ 0 $100 • Discount rate at 10% (T + 1) • $100/1.10 = $91 Vs $75 • Reminder PV = FV/(1+R)n NPV = -I0 + FV/(1+R)n

  27. Flexibility (cont.) Pr. 5 Favorable Outcome 300-100 E(Val.) = 100 Situation 1 = Invest 100 now Pr. 5 Unfavorable Outcome 50 - 100 E(Val.) = -25 E(Val.) = 75 Situation 2 = Delay T + 1 Pr. 5 Favorable Outcome 300 - 100 E(Val.) = 100 Pr. 5 Unfavorable Outcome No Go E(Val.) = 0 E(Val.) = 100 However, this 100 is at T+1 PV = (1+r)n FV PV = 1.10 x 100 = 91 Vs 75

  28. Time Horizon -100 NPV =75 T0 T1 -100 FEV(100) NPV =91

  29. Dynamic Pricing

  30. Dynamic Pricing • Why do firms in some markets seem to be able to coordinate their pricing behavior and avoid costly price wars, while in other markets intense competition is the norm?

  31. Pricing Levels • Monopolistic pricing (MR = MC) • Competitive pricing (P = MC) • Cournot equilibrium (Q adjustments) • Bertrand equilibrium (P adjustments) • Horizontally differentiated • No differentiation (competitive pricing)

  32. Dynamic Pricing • Cournot and Bertrand models explain rivalry (price and quantity adjustment) • They do not explain oligopolies were prices are higher or lower than equilibrium

  33. Shell / Exxon Example of Dynamic Pricing (p. 267) • Situation: P = 100 – Q, MC = 20 • Maximum price (Monopoly): Price = 60, Q = 20, ∏ = 800 per firm • Cournot: Price = 47.67, Q = 26.67, ∏ = 317 per firm • Price competition: Price = 20, Q = 40 ∏ = 0 per firm • Current situation: Price = 40, Q = 30, ∏ = 600 per firm

  34. Firm 2’s Reaction Curve Competitive Equilibrium (P = MC; Profit = 0) 40 Cournot Equilibrium Collusive Equilibrium 27 20 Firm 1’s Reaction Curve Collusion Curve 20 27 40 Duopoly Example (Cournot)P = 100 – Q and MC = 20 Q1 Q2

  35. Shell’s Decision • Currently ∏ = 600, P = 40 • Or 11.54 weekly • Collaborative ∏ = 800, P = 60 • Or 15.38 weekly • Non collaborative scenario • One week trial ∏ = 0, P = 60 • Revert back to current situation • P = 40, ∏ = 11.54 weekly • Or 11.54 x 51 weeks= 588.54

  36. Nash Equilibrium:Cooperative Pricing

  37. Shell’s Decision Tree 695

  38. Shell’s Commitment • Announces that prices will go up • Announces that competitors’ prices will be immediately matched (“We will not be undersold”) • Tit-for-tat strategy

  39. Exxon’s reaction(Discount rate = 10%) • Exxon (non-collaborative): 23.08 + 11.54/(1.002) + 11.54/(1.002)2 + 11.54/(1.002)3 + ... + 11.54/(1.002)n = 582 • Exxon (collaborative): 15.38 + 15.38 /(1.002) + 15.38 /(1.002)2 + 15.38 /(1.002)3 + ... + 15.38 /(1.002)n = 760 • Remember that: if FV = PV (1+r)n then PV = FV/(1+r)n

  40. Pricing cooperation • Spread between coop and non coop pricing • Discount rate • Periods (frequency and number) • Time Horizon

  41. Competitive Pricing • Collusion pricing (ex. OPEC, commodity marketing boards) • Cooperative  • Through rationality (NPV) • Power and retaliation • Non Cooperative • Bertrand  P = MC  Profit = 0

  42. Power • Tit-for-Tat (niceness, provocabiblity, forgiveness); “we will not be undersold” • Grim Trigger “we will drop our prices until you choke to death”

  43. Coordination • Misreading competitors and possible effects • Traditions, conventions, firms’ status and role • Market structure and facilitating practices …

  44. Market structure and Cooperative Pricing • Homogeneity of goods or offer (-) • Market concentration (+) • Reaction speed and information (-) • Order size and frequency (-) • Firms’ asymmetries (-) • Price sensitivity (-) • From Chapter 12

  45. Price Competition and Facilitating Practices • Chapter 2: Price leadership through economies of scale or from other forms (+) • Advanced Announcements (+) • Chapter 9: Strategic commitment (+) • Chapter 12: Buying power of customers - Most favored customer clause- Uniform price delivery (+)

  46. Price Competition and Quality • Chapter 13: Value chain, consumer surplus, differentiation, quality and marginal cost (+) • Chapter 14: Resource-based theory of the firm, early mover advantage (+) • Chapter 8: Horizontal differentiation (+)

  47. Non Cooperative Pricing • Managerial incentives (sales, volumes and market share) • Industry cycle (growth, maturity, decline) • Short term or long term views (and motivations) • Managerial egos • Managerial incompetency • Bad mannered managers

  48. Wrap up • Market structure, Number of firms and Price competition • Commitment • Pricing equilibrium: Anywhere from monopoly to pure competition • Pricing strategies: Anywhere from collusion to grim trigger • Pricing behaviors: Anywhere from civilized to wild • Importance of industry analysis • Additional problems were posted on week 9

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