Advanced Topics in Business Strategy

Question 1

What is Limit Pricing and what is the key question of it?

Answer 1

• A strategy where an incumbent maintains a price below the monopoly price level in order to prevent entry
  
  • Not profit max given the current market structure of one firm
  • Profit max only if changing the number of firms in the long run
• Question: how much output to produce to make entry unprofitable?

Question 2

What does the incumbent want to do when limit pricing and what is the outcome?

Answer 2

• The incumbent wants to shift the residual demand curve such that it is below the AC (assumed same for both firms)
• Therefore produce more than Qm and sell at lower P
• Profit is lower than at monopoly production

Question 3

How can the incumbent maximise his situation in Limit Pricing and what is required to do so?

Answer 3

• Assuming perfect information (about demand and costs), the incumbent can do even better by producing Qm and threatening to increase output to QL if entry were to occur
  
  • Problem: this requires a strong credibility
    
    • Meaning in the subgame where entry does occur, the entrant expects the incumbent to behave rationally (max profit)
    • Mere threat of limit pricing is not credible if it is not in the incumbent’s best interest to carry out the threat (cannot be sustained as a SPNE if this is the case)

Question 4

What are the possible channels to make limit pricing work?

Answer 4

• Commitment mechanisms
  
  • Has to make producing QL the best response upon entry
• Leaning curves effects
  
  • Costs reduces with more output
  • May be credible to produce more for the cost advantage
• Incomplete informaiton
  
  • Incumbent has more info about D or its own costs
• Reputation effects
  
  • Different types of incumbent, try to signal that it is an aggressive incumbent

Question 5

How can irreversibility be achieved in regards to limit pricing?

Answer 5

• Quantities: install production capacity (+ sunk costs (can’t shut down production))
• Prices: ‘most favoured customer clause’, print catalogues

Question 6

When is limit pricing profitable?

Answer 6

• Limit pricing is profitable when (πL - πD)/i > πM - πL

Question 7

What are the conditions which make limit pricing attractive?

Answer 7

• Low interest rate environments
• Monopoly and limit-price profits are close
  
  • Limit pricing not so costly
• Duopoly profits are significantly lower than limit-price profits

Question 8

What is predatory pricing?

Answer 8

• A firm temporarily prices below its marginal cost to drive existing competitors out of th emarket
• 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 than the prety
• Hard to identify. Competitive vs anti

Question 9

Broadly what are the strategies for raising rival’s costs?

Answer 9

• Strategies involving marginal cost
• Strategies involving fixed cost
• Strategies for vertically integrated firms

Question 10

How can rival’s costs be raised through marginal cost?

Answer 10

• This can be done where capital vs labour needs differ etc.

- Lobby for higher wages if you’re capital intensive in a labour intensive industry

Question 11

How can rival’s costs be raised through fixed costs?

Answer 11

• (or entry costs)

- If the incumbent advertises, entrant is incentivised to not enter

Question 12

How can rival’s costs be raised through a firm’s vertical integration?

Answer 12

• A vertically integrated firm with market power in the upstream market may be able to exploit this power to raise rivals’ costs in the 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
  • Raising the input price while lowering (or holding constant) the final product p, squeezes the margins of the downstream competitors
  • Making available to the downstream only firm: p - c, where p is the final product price and c is the input price

Question 13

What is the relationship between price discrimination and aggressive price/cost strategies?

Answer 13

• Enhances the profitability of predatory pricing, limit pricing and raising rivals’ costs
• Means prism only have to lower prices to targeted consumer groups and mitigates the negative aspects of limit pricing and predatory pricing
• e.g. promotional deals for new customer

Question 14

What is a second mover advantage?

Answer 14

• Can permit a firm to earn a higher payoff
• Free riding on the investments made by the first mover and produce at lower costs, e.g. R&D spillover and imitation
• Price Cutting

Question 15

What are direct network externalities?

Answer 15

• The direct value enjoyed by the user of a network because others also use the network
• Value increases the more users there are

Question 16

What are indirect network externalities?

Answer 16

• The indirect value enjoyed by the user of a network because of complementaries between the size of a network and the availability of complementary products or services
• Game consoles and available games
• People using iPhone and available iPhone apps

Question 17

What are negative network externalities?

Answer 17

• Exist when an additional user to the network decreases the value per user of the services
• Congestion
• Bottlenecks: internet speed, airline landings

Question 18

What is the relationship between first mover advantages and network externalities and what is the solution?

Answer 18

• The presence of positive network externaltieis often make it difficult for new networks to replace or compete with existing networks; even a technologically superior one
• Existing networks likely have an installed user base and complementary services compared to a new network
• Network externalities can create consumer lock in: consumers may be a stuck in a situation (equilibrium) where they are using an inferior network
• Penetrate pricing
  
  • Involves charging a low price (may be below MC) initially to penetrate a market and gain a critical mass of customers; useful when strong network effects are present

Question 19

How is changing FC helpful?

Answer 19

ONLY to deter entry

Question 20

What is the difference between predatory pricing and penetrative pricing?

Answer 20

Networks: Value increases more customers

P

Question 21

How can a merger punish another downstream firm?

Answer 21

• Refuse to sell
• Decreases competition in upstream market therefore increasing price
• Increase price on it’s own and other upstreams will have incentive to do the same?

Question 22

If a firm can pay to be the first entrant, what is the comparison?

Answer 22

Cournot vs Stackelberg

Question 23

Why is a Nash eqm not necessarily a SPNE?

Answer 23

Nash equilibria can be supported by non-credible threats in subgames not reached in equilibrium

Question 24

What are the steps to a capacity constraint question?

Answer 24

1. Inverse Demand
2. MC = MR
3. This Q hit capacity?

If not - Q and P @ MC = MR
If so - plug capacity Q into DEMAND to get P
- Works like this because MC vertical at Qcap

Question 25

How are more than 2 firms in oligopoly questions dealt with?

Answer 25

Cournot in eqm q2 = q3

1. Replace q3 with q2 in BR2
2. Rewrite BR2 so only in terms of q1
3. Use this (x2) in Leaders BR

i.e. rewrite BR2(as a function of q1 and q3) replacing q3 with q2 (so that BR2 is only a function of q1)

Question 26

Why can high prices be sustained with price matching?

Answer 26

Use of a implicit trigger strategy
Infinitely repeated games give incentive to cooperate
Ease of monitoring

Question 27

If one firm in an implicit collusive partnership is closing down, what happens?

Answer 27

Other firm’s optimal strategy will be to defect

Question 28

What is depreciation?

Answer 28

A sunk cost, not relevant in production decisions

Question 29

What is FC as a function of depreciation?

Answer 29

FC/q = depreciation

Question 30

When there are multiple outcomes of quantity decisions between two firms, what needs to be done?

Answer 30

Normal form representation

Question 31

What is the profit in 2nd degree price discrimination 2 part tariffing?

Answer 31

P = MC: π = 2x the CS of the low demand consumer

P > MC: π = 2x CS of low demand consumer + area between P and MC: x 2 for area left of low demand consumer’s QD at this price and x 1 to the right

Question 32

What is the most important thing about consumer choice questions?

Answer 32

BC’s are always parallel unless Px/Py changes

Question 33

What is true about P2 Nash elms?

Answer 33

ALWAYS has >1 letter

Question 34

For sequential games, how should Nash eqm be found and how should SPNE be found?

Answer 34

Nash eqm - transfer to normal form

SPNE - Use long form backward induction

Question 35

How should sequential games be transferred to normal form and how should they be solved?

Answer 35

P1: (A), (B)
P2: (W if A, Y if B), (X if A, Y if B) (W if A, Z if B) (X if A, Z if B)

• If we’re here, can either improve? - ONLY APPLIES TO NORMAL NASH EQM

Question 36

Given a relatively higher use of K, what is MPL?

Answer 36

Higher

Question 37

How are multiplant questions solved?

Answer 37

MR = MC1 = MC2
i.e.
MR = a - b(Q1 + Q2) = cQ1 = dQ2
Q1 = (d/c)Q2
MR = a - b((d/c)Q2 + Q2) etc.

Question 38

What does irreversibility in limit pricing achieve?

Answer 38

Makes the threat credible

Question 39

What are the steps to solving values of C to make rivals raising MC profitable?

Answer 39

1. BR1 w/ -c in P
2. BR2 w/ new MC
3. BR1 by subs (result in terms of c)
4. BR2 by subs (result in terms of c)
5. P by subs BR1 and BR2 (result in terms of c)
6. π w/ -c in P
7. Solve c to πc > πno c

Question 40

What is the first step to Profit Br questions?

Answer 40

Incorporate MC into P