Lecture Unit 6: Dynamic competition across time (1/3)

Question 1

How can price competition be viewed?

Answer 1

• Price competition can be viewed as a dynamic process
• Decisions by a firm today will affect its behavior as well as its competitors’ behaviors in the future

Question 2

In what dimensions can dynamic competition occur?

Answer 2

Dynamic competition can occur in non-price dimensions such as quality or advertising

Question 3

What are the limitations of static models in explaining price competition?

Answer 3

• cannot explain how firms can maintain prices above competitive levels without formal collusion
• In other situations, even a small number of firms are sufficient to produce intense price competition.

Question 4

What is the difference between dynamic models and static models?

Answer 4

• Dynamic models can address questions that static models cannot (e.g., what determines the intensity of price competition?)
• If the number of firms is not too large and the response time to price changes is short, firms may adopt a strategy of always matching each other’s prices.
• Short term profits in a static model often lead to long term negative effects in a dynamic model.

Question 5

What is the usefulness of dynamic models?

Answer 5

• are useful in exploring situations where price competition and
• other competitive behaviors need to be analyzed over time.

–>Limitiations of static models

Question 6

What questions can dynamic models address that static models cannot?

Answer 6

Dynamic models can address questions such as what determines the intensity of price competition.

Question 7

Why might it make sense for firms to adopt a strategy of always matching each other’s prices?

Answer 7

• As long as the number of firms is not too large and
• the length of time it takes for firms to respond to each other’s prices is not too long,
• it makes sense for firms to adopt a strategy of always matching each other’s prices.

Question 8

What is a potential long-term effect of short-term profits in a static model?

Answer 8

• What appears as short-term profits in a static model
• are often followed by long-term negative effects in a dynamic model.

Question 9

What are strategic commitment?

Answer 9

• decisions that have long run impacts and
• are difficult to reverse,

Question 10

What are the characteristics of strategic commitment, what do they do

Answer 10

• alter the strategic decisions of rivals through irreversible decisions
• They can make a simulltaneous move game into a sequential move game
• Involves anticipating market rivalry

Question 11

What are the characteristics of the irreversible decision of a strategic commitment have?

Answer 11

A strategic commitment must involve a irreversible decision that is

• visible
• understandable, and
• credible

Question 12

How can one asses strategic commiitment ?

Answer 12

• Assessing strategic commitments involves anticipating market rivalry

Question 13

What are strategic subsitutes?

Answer 13

• When a firm’s action induces the rival to take the opposite action

Question 14

What are the strategic subsitutes in a Cournot duopoly?

Answer 14

• In Cournot duopoly models, quantities are strategic substitutes.
• A quantity increase is the profit-maximizing response to a competitor’s quantity reduction (reaction function with a downward slope)

Question 15

What are strategic complements?
What does the bertrand duopoly say about it?

Answer 15

• When a firm’s action induces the rival to take the same action

Question 16

What are the strategic complements in bertrand duopoly?

Answer 16

• prices are strategic complements:
• a price cut is the profit maximizing response to a competitor’s price cut (reaction function with an upward slope)

Question 17

What are the effects of commitments on a firm’s profitability?

Answer 17

Commitments have both a direct and a strategic effect on a firm’s profitability.

Question 18

What is the meant with the direct effect of commitments on a firm´s profitability?

Answer 18

= is its impact on the PV of the firm’s profits if the competitor’s behavior does not change

Question 19

What is the meant with the strategic effect of commitments on a firm´s profitability?

Answer 19

= takes into account the competitive side effects of the commitment

Question 20

What is the difference between a tough commitment and a soft commitment?

Answer 20

Tough commitment

• hurts the competitors
• conforms to the traditional view of competition

Soft commitment

• may be beneficial if the strategic effect of the commitment is sufficiently positive
• soft commitment helps the competition

Question 21

When do tough commitments have a proftiable and a negative strategic effect?

Answer 21

Tough commitments have a profitable strategic effect

• if they involve strategic substitutes.

Tough commitments have a negative strategic effect

• if they involve strategic complements.

Question 22

What are the different outcomes depending onn the decision tough/soft in a 2-stage model?

Answer 22

1. Stage: Firm 1 makes either a soft or tough commitment
2. Stage: Competition between the rivals
   –>either Cournot or Bertrand

Question 23

What is the situation in a Cournot after a tough commitment?

Answer 23

• Firm 1 commits to a higher than previous output for every output choice of the rival (Tough)
• Firm 2’s reaction function makes the equilibrium output of Firm 1 even higher
• Firm 2 produces less than what it used to produce

Question 24

What is the situation of a Cournot after a soft commitment?

Answer 24

• Firm 1 shifts its reaction function to the left, (Soft)
• committing to produce less (than pre-commitment level) for every level of rival’s output

Firm 2:
- Rival’s reaction hurts Firm 1 by making its output fall further

• Firm 2 produces more than what it produced without Firm 1’s soft commitment

Question 25

What is the situation in a **bertrand** after a **tough** commitment?

Answer 25

- Firm **1** **commits** to a **lower** **price** by shifting its reaction function to the **left** (-->**Tough**) - **Firm 2’s** reaction further **lowers** the **equilibrium** price - **Both firms** end **up** being **hurt** by Firm 1’s **tough** commitment

Question 26

What is the situation in a **Bertrand** after a **soft** commitment?

Answer 26

- **Firm 1** **commits** to **charge** a **higher** (than the pre-commitment level) price for **every** price level **picked by the rival** (**soft**) - **Firm 2’s** reaction **provides** an **even** **higher** price (for both firms) - **Both** firms **benefit** from Firm **1’s soft** commitment

Question 27

When second stage actions are **strategic** **complements**, what are the different strategies of **firm 1**? (Commitment posture: **Tough** commitment action: **Make/refrain** role of actor in competitive area)

Answer 27

**1.MAD—Dog strategy** Commitment **Posture**. Tough Commitment **Action**: Make (**aggressive act**) Role of the actor in **competitive arena**: attack to become top dog, invite battle heedless of costs **2.Puppy-Dog Ploy:** Commitment **Posture**: Tough Commitment **Action**: Refrain (**hold back**) **Role of acto**r in **competiitive** arena: Placate top do; enjoy available scraps **3.Fat-Cat Effect:** Commitment **Posture**: Soft Commitment **Action**: Make **Role of actor** in **competiitive** arena: Confidently take care of self; share the wealth with rivals **4. Weak Kitten** Commitment **Posture**: Soft Commitment **Action**: Refrain **Role of actor** in **competitive arena:** accept status quo out of fear, wait to follow the leader

Question 28

When second stage actions are **strategic** **substitutes**, what are the different strategies for **firm 1**? (Commitment posture, commitment action, role of actor in competitive area)

Answer 28

**1.Top-Dog Strategy** Commitment **Posture**: Tough Commitment **Action**: Make **Role of acto**r in **competiitive** arena: Assert dominance; force rivals to back of **2. Submissive underdog** Commitment **Posture**: Tough Commitment **Action**: Refrain (**hold back**) **Role of acto**r in **competiitive** arena: accept follower role, avoid fighting **3. Suicidal Siberation** Commitment **Posture**: Soft Commitment **Action**: Make **Role of acto**r in **competiitive** arena: invite rivals to exploit you, may indicate exit strategy **4. Learn and Jungry Look** Commitment **Posture**: Soft Commitment **Action**: Refrain **Role of actor** in **competiitive** arena: Actively submissive; posturing to avoid conflict

Question 29

What is the **value of commitments?**

Answer 29

The **value** of **commitments** lies in **creating inflexibility.** Inflexibility can **alter the strategic decisions** of competitor but **limits the firms option value**

Question 30

Why is **flexibility** **valuable** when there is **uncertainty**?

Answer 30

**Flexibility** is **valuable** since **future** options are **kept** **open**.

Question 31

What is the relationship of commitments and options?

Answer 31

**Commitments** can **sacrifice** the **value** of **options**.

Question 32

What are the **strategic** consequences of a **firm choosing to wait** before making a decision? (**Flexibility Tradeoff**)

Answer 32

- firm **preserves** its **option** values, maintaining **flexibility** to respond to market changes - the firm **may** **allow competitors** to make **preemptive** **investments** and **secure** a **competitive** **advantage** because of waiting

Question 33

How can a **firm preserve flexiblity**? (3 points)

Answer 33

- **modify** the **commitment** as conditions **evolve** - **Delay** the **commitment** **until** better **information** is **available** on **profitability** - Make **unprofitable** **commitments** today to **preserve** **valuable** options in the **future**

Question 34

How can one get better information about demand?

Answer 34

- by **delaying** the **implementation** of **projects**

Question 35

What are the key aspects of the **commitment-flexibility tradeoff**?

Answer 35

- Waiting **preserves** a firm's **option values.** - Waiting **may allow competitor**s to make **preemptive** investments - **Example**: Philips delayed its CD manufacturing plant in the U.S., allowing Sony to build its plant first.

Question 36

What is the shape and the direction of the **reaction functions** in a cournot and Bertrand market?

Answer 36

**Cournot market** - Reaction functions R1 and R2 have **slope downward** - this indicates that **quantities are strategic substitutes** **Bertrand market** - Reaction functions of R1 and R2 have **slope upward** - indicates that **prices are strategic complements**

Question 37

**what is the impact** of **inflexibility** on strategic commitments?

Answer 37

- **Inflexibility** can add **value**: strategic commitments **limit** options **but alter competitors‘ expectations**