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 actor 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 actor in competiitive arena: Assert dominance; force rivals to back of

2. Submissive underdog
Commitment Posture: Tough
Commitment Action: Refrain (hold back)

Role of actor in competiitive arena: accept follower role, avoid fighting

3. Suicidal Siberation
Commitment Posture: Soft
Commitment Action: Make

Role of actor 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 competitors 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