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Strategy: Multistage Games. Key issues. preventing entry: simultaneous decisions preventing entry: sequential decisions creating and using cost advantages advertising. Preventing entry. consider a market with either 1 or 2 firms

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key issues
Key issues
  • preventing entry: simultaneous decisions
  • preventing entry: sequential decisions
  • creating and using cost advantages
  • advertising
preventing entry
Preventing entry
  • consider a market with either 1 or 2 firms
  • simultaneous entry decision: neither firm has an advantage that helps it prevent other firm from entering
  • sequential decision: incumbent may have an advantage over firm deciding whether to enter
simultaneous decisions
Simultaneous decisions
  • initially no gas stations
  • physical space for at most 2 gas stations
  • 2 firms consider opening a gas station at a highway rest stop
simultaneous decisions6
Simultaneous Decisions
  • Room for 2 firms
    • firms have pure (dominant) strategies: both enter
    • unique, pure strategy equilibrium
  • Room for only one firm
    • game is similar to game of chicken
    • neither firm has a dominant strategy
problem with pure strategies
Problem with pure strategies
  • game has two Nash equilibria in pure strategies:
    • Firm 1 enters and Firm 2 does not
    • Firm 2 enters and Firm 1 does not
  • players don’t know which Nash equilibrium will result
  • could collude: firm that enters could pay other firm to stay out of market
  • these pure Nash equilibria are unappealing because identical firms use different strategies
mixed strategies
Mixed strategies
  • mixed strategies: firm chooses between its possible actions with given probabilities
  • firms may use same strategies if their strategies are mixed
  • in our game, each firm enters

with 50% probability

  • result: Nash equilibrium in mixed strategies
firm 2 s response
Firm 2’s response
  • if Firm 1 uses this mixed strategy, Firm 2 cannot do better using a pure strategy
  • if Firm 2 enters with certainty, it earns
    • $1 half of the time time
    • loses $1 other half
    • so its expected profit is $0
  • if Firm 2 stays out with certainty, Firm 2 earns $0
nash equilibria
Nash equilibria
  • firms play mixed strategy
  • one firm plays pure strategy of entering and other firm plays pure strategy of not entering
games without pure strategy equilibria
Games without pure-strategy equilibria
  • some games have no pure-strategy Nash equilibrium, so mixed strategies must be used
  • theorem (Nash, 1950): every game with a finite number of firms and a finite number of actions has at least one Nash equilibrium, which may involve mixed strategies
preventing entry sequential decisions
Preventing entry: Sequential decisions
  • incumbent (monopoly) firm knows potential entrant is considering entering
  • stage 1: incumbent decides whether to take an action to prevent entry
  • stage 2: potential entrant decides whether to enter, and firms choose output levels
    • no entry: incumbent earns monopoly profit
    • entry: each firm earns duopoly profit
  • assume potential entrant does not enter if it breaks even or loses money
three possibilities
Three possibilities
  • blockaded entry: market conditions

make profitable entry impossible so

no action necessary

2. deterred entry: incumbent acts to prevent an additional firm from entering because it pays

3. accommodated entry: doesn't pay for incumbent to prevent entry

    • incumbent does nothing to prevent entry
    • reduces its output (or price) from monopoly to duopoly level
incumbent s advantage
Incumbent’s advantage
  • Because incumbent is already in market,
    • its fixed entry cost is sunk
    • so it ignores its sunk cost in deciding whether to operate
  • potential entrant
    • views fixed cost of entry as avoidable cost
    • incurs cost only if entry takes place
output commitment
Output commitment
  • incumbent can commit to large quantity of output before potential entrant decides whether to enter
  • 3 possibilities
    • no commitment: entry occurs, Cournot equilibrium
    • commit to Stackelberg-leader quantity: entry occurs, Stackelberg equilibrium
    • commit to larger quantity: deters entry, monopoly equilibrium
commitment and fixed cost
Commitment and fixed cost
  • incumbent's decision depends on potential entrant's fixed cost of entry, F
  • illustrate role that F plays in incumbent's decision by looking at demand and cost structure that underlie game tree:
raising rivals costs
Raising rivals' costs
  • by raising its rivals’ variable costs relative to its own, firm may increase its own profit
  • firm can raise rivals’ variable costs either directly or indirectly
preventing customers from switching
Preventing customers from switching
  • incumbent makes it difficult for customers to switch to entrant to discourage entry
  • industrial customers of Pacific Gas and Electric (PG&E) were told that they'd have to pay a fee to stop buying from PG&E
raising all firms costs
Raising all firms' costs
  • incumbent may raise costs of all firms, including its own
  • incumbent wants to raise costs if its cost is sunk and potential rivals' entry costs are avoidable
monopoly advertising
Monopoly advertising
  • successful advertising campaign shifts market demand curve by
    • changing consumers' tastes
    • informing them about new products
  • if advertising convinces some consumers they can't live without product, demand curve may
    • shift out
    • become less elastic at new equilibrium
    • firm charges a higher price for its product
decision whether to advertise
Decision whether to advertise
  • even if advertising shifts demand, it may not pay to advertise
  • if demand curve shifts out or becomes less elastic, firm's gross profit (= profit ignoring cost of advertising) must rise
  • firm undertakes advertising campaign only if it expects net profit (= gross profit - cost of advertising) to increase
how much to advertise
How much to advertise
  • How much should a monopoly advertise in order to maximize its net profit?
  • level of advertising maximizes firm’s net profit if last $1 of advertising increases its gross profit by $1
advertising that helps rivals
Advertising that helps rivals
  • firm informs consumers about a new use for its product increasing demand for its own and rival brands (pink toothbrush)
  • some industry groups advertise collectively to increase demand for their product:
    • raisin growers (dancing raisins)
    • milk producers (milk mustache)
advertising that hurts rivals
Advertising that hurts rivals
  • firm's advertising may increase demand for its product by taking customers from rivals
  • firm may use advertising to differentiate its products from those of rivals (possibly spuriously)
1 preventing entry simultaneous decisions
1. Preventing entry: Simultaneous decisions
  • firm's strategies depend on size of market and possibly on chance
  • if market is large enough that 2 firms can make a profit, both enter
  • if only one firm can profitably produce, there are many possible Nash equilibria
2 preventing entry sequential decisions
2. Preventing entry: Sequential decisions
  • incumbent firm that can commit to producing large quantities before another firm decides whether to enter market
  • may deter entry: first-mover advantage
  • incumbent acts to prevent entry only if it pays to do so (depends on entry costs):
    • blockaded market: no action needed
    • incumbent deters entry if it is profitable to do so
    • incumbent accommodates entrant
3 creating and using cost advantages
3. Creating and using cost advantages
  • firm with a lower MC
    • has a larger market share and a higher profit than a higher-cost rival
    • may prevent entry by a higher-cost rival
    • thus, firms benefit from lowering their marginal costs relative to those of rivals
  • firm invests in technology that raises its total cost of production if it lowers its MC substantially
  • by lowering its MC, firm credibly commits to producing relatively large levels of output, and thereby discourages entry
4 advertising
4. Advertising
  • firms advertise to
    • shift out their demand curve, and/or
    • reduce equilibrium elasticity of demand
  • advertising may
    • differentiate a firm's product, or
    • inform consumers about new products or new uses for a product