strategic behaviour by incumbent

© Sørgard Konkurransestrategi 1

How should the incumbentincumbent behave?

SOL 310 – Competitive strategy

Lars Sørgard

Hjemmeside til Konkurransestrategi (2003), Fagbokforlaget

Co-opetition, ch. 6-7 (see http://mayet.som.yale.edu/coopetition/index2.html)

Judo strategy, ch. 8 (see http://www.judostrategy.com/)

http://mayet.som.yale.edu/coopetition/index2.html





http://www.judostrategy.com/




Today’s topic

• Incumbent’s strategic decisions– Deter an entrant?– If accommodation, how to behave?

• Strategic commitment– Direct effect– Strategic effect

• How to signal an aggressive response?


SUMOSUMO strategies

• If you are a dominant firmdominant firm, how to respond to entry?– What to do beforebefore entry?– What to do afterafter entry?

• But whatwhat is the incumbent’s goal?– High market share?– In conflict with max profits, or not?– Short run versus long run?


SUMO strategy: A warning

• Fight to deter entry or force rival to exit (predation) is often very costly

• The risk associated with predation:– Large financial costs during the war

– Discounting: loss today, gain in the future

– Entry can take place after the war

• The argument in favour of predation is reputationreputation– Fight today in one niche, to signal that you are a tough

type that might fight in other niches


Act before potential entry

• The incumbent has a first mover advantage– Can make a decision that commits the firm in

the future– Strategic commitment (or inflexibility)

Irreversible decision

Competition

Stage 1: Strategic commitmentStrategic commitment

Stage 2: Meet in the market placeMeet in the market place


Why an irreversible decisionirreversible decision?

• Costs associated with reversing the decision– Takes time to reverse the decision– Will not get back the total amount

• Then an element of sunk costssunk costs• Broad definition of decisions

– Production plants– Advertising– Vertical integration– Mergers– Long term contracts– …..


But is it crediblecredible?• Two requirements

(1) It is not in your own interest to reverse the decision after you have seen your rival’s action

- Must be a credible commitment

(2) Acts before the rival, so that it can react- Must be an observervable action

• Is a price war announcement before entry credible?• The incumbent has two options

(1) Deterrence- Unprofitable with entry

(2) Accommodation- Entrant acts soft (not aggressively) after entry


Strategic commitment:Two kinds of effects

• Direct effect

• Strategic effect


Change rival’srival’s future behaviour


Change ownown future behaviour



Strategic commitment: Direct effect

• Incumbent’s decision has a direct effect on the potential entrant’s profit

• Two kinds of direct effects(1) Raising rivals’ costs(2) Reducing demand for rivals’ products




Direct effect I: Raising rivals’ costs

(1) Acquire input suppliers (upstream integration)– ALCOA bought waterfalls

– Norcem bought areas with limestone

• Rivals are either foreclosed from purchasing inputs, or have to buy at a higher price– Fewer independent input suppliers

– The price the rivals have to pay increases, even if the remaining suppliers do not have cost disadvantages

• BUT: a costly race to acquire input suppliers?


Raising rivals’ costs cont.

(2) Trigger other cost increases in the industry– Propose standards etc that are costly– Not room for many firms in the industry

• Make sure that the you have a competitive advantage

(i) Accept higher wages?- Can hurt a rival more than you, if he is more labour intensive

(ii) Asymmetric standards?- Norsk Hydro in Norway: fertilizers- Standard that is tailormade to Norsk Hydro, and not

tailormade to BASF


Direct effect II:Reducing demand for rivals’ products

(3) Investment in advertising– Increase the number of loyal consumers– Rivals’ demand is smaller

• BUT: How does the incumbent then behave, if entry actually takes place?– Loyal consumers means that the incumbent has

less reason to cut prices– The entrant can then expect a friendly welcome

in the market, and entry can be profitable


(4) Integration downstream– Write contracts with buyers– Acquire retailers

• Potential entrants do not find enough buyers to succeed with profitable entry

• But is that profitable for the incumbent?• Or could it be that the price it has to pay for the

aquisitions is too high?– An aquisition battle between incumbent and entrant

Reducing demand cont.


Red. demand cont.: Acquisition

• Who wins the aquisition battle?

Incumbent Entrant

Retailer 1 Retailer 2

CONSUMERS

??

• Incumbent owns Retailer 1Retailer 1

• Will incumbent acquire Retailer 2Retailer 2?


Acquisition – the game

• If incumbent wins, it gains a monopoly position towards consumers– Monopoly profits: M

• If entrant wins, competition between them– Duopoly profits (for each firm): D

• Incumbent’s max payment: M.- D I

• Entrant’s max payment: D E


Acquisition – who wins?• Who has the highest willingness to pay for Retailer 2?• Incumbent the highest willingness to pay if:

M - D > D (which says that I > E)

M > 2D

• This condition is alwaysalways met– Monopoly profit is higher than total duopoly profits

• The incumbent wins the acquisition– Higher willingness to pay, since acquisition means no

competition– The entrant only reaps a duopoly profit


Red. demand cont.: Examples

• Integrating forward (Judo, p. 184)– Coke and Pepsi bought their bottling networks in the

80s– End of 90s, controlled 80% of their direct distribution

• Contract directly with customers– Nutrasweet made deals with Coke and Pepsi before

HSC enter the US market

• Apply contracts mentioned earlier– MCC to have the final move against a potential rival?– Can wait, instead of cutting prices too early?


Red. demand cont.: Microsoft

• Did numerous things to reduce the demand the rival Netscape would face– Required Internet explorer to be installed on all

new machines with Windows– Numerous distribution channels required to

exclude sales of Netscape– Imposed Internet Service Providers to boycott

Netscape


Red. demand cont.: Microsoft• Paid AOL to drop Netscape (see Judo, pp.

185-194)– Bill Gates to AOL in 1996: ’How much do we

need to pay you to screw Netscape?’– Paid AOL $ 0.25 for every customer that shifter

to Internet Explorer– If AOL converted ’a substantial portion of its

installed base’ by a certain date, then(1) $ 600.000 in bonus(2) AOL icon on the Windows desktop


Strategic commitment: Strategic effect

• Commitment to change your own behaviour in the future• When it is observed, the rival’s best choice is to change its own behaviour• Would like to soften the rival’s behaviour

– Deter him from entering, or– Encourage him to act less aggressively after entry


Change ownown future behaviour



Strategic effect: Capacity

• Installing a large capacity – Top Dog strategy– The best response for a potential entrant is to install a

smaller capacity, or not to enter

• DuPont – titanium dioxide in the 70s (Judo, p. 180)– Expected an increase in demand next decade (more than

500.000 tons increase)– Expanded its own capacity by 500.000, to preempt

potential rivals– Did not succeed in deterring all its rivals– But became the dominant producer, and still it is


Take-or-pay contract with supplier• For any product you take, you agree to pay a

certain price, say $50 per ton• You have to pay even for product you don’t take,

say $40 per ton (up to a quantity ceiling)• Example of such a contract:

– Ceiling of 1000, and buys 900– Then you pay $50 for 900, and $40 for 100

• Take-or-pay good for the supplier; it protects him• As a buyer you in return ask for a discount


Take-or-pay – act aggressively?

• It is a commitment for you as a buyer to act aggressively– You have a de facto low marginal cost– Would therefore typical retaliate against a rival

• In turn, it dampens your rival’s incentive to act aggressively– A device to dampening competition

• Risky: What if your rival actually triggers competition?– Then firms end up competing very aggressively


Strategic effect:Brand proliferation

• A dominant firm can introduce many different brands or versions of its product– One brand for each niche

• Whatever niche the entrant decides to enter, it will face a brand by the incumbent– Tougher competition after entry, then what else would

have been the case

• Numerous examples of such a strategy– KelloggsKelloggs in the US for cereals– OrklaOrkla in Norway for detergents


Brand Proliferation: AOL• AOLAOL attacked by FreeserveFreeserve in UK in 1999

– Freeserve offered no subscription fee, and users paid only per minute (for telephone line)

• JUDO: AOL could lose $ 150 mill if it matched• Finally, it did cut the subscription fee with 45%• Later it fighted back by introducing new brands

– Netscape Online – no subscription fee– A third product: flat rate

• Then Freeserve had a JUDO problem– Fight back with a flat rate, and lose existing revenues?– AOL superior on ads and e-commerce– Freeserve matched, and faced losses


Fighting against entrant:Market segmentation

• A dominant firm’s problem is its size– Would lose a large revenue by cutting prices on all

sales

• Then a more targeted response can make an aggressive response more credible– Brand proliferation

– Sign contract customer by customer

• Can corporate discount schemes be a problem for entrants in the airline market?


Fridstrøm on airlines:• Incumbent airline can meet any challenger by

offering selective discounts to large, attractive clients, making predation a more credible threat

• Selective discounts may lead to intense price rivalry and to exits from the market

• Similarly, potential entrants might be deterred

• Thus, corporate discount schemes may be anti-competitive in a setting with a dominant, incumbent carrier and smaller potential entrants


Incumbent: Fight or not?

• If deterrence or predation is the choice, then different ways to make it credible with fight– Irreversible investments– Market segmentation

• If entry takes place and no predation, then the incumbent would like peace– Take-or-pay contract– Transparency (repeated game mechanism)


Repeated interaction

• In a one shot game, a prisoner’s dilemma outcome concerning price setting– Firms have a dominant strategy to set a low price

• But firms meet at the market place day after day, week after week, …

• Then a collusive outcome can be sustained, without any legal contract– Can be in a firm’s interest to set high rather than low

price


To deviate, or not to deviate?

• If all firms set a high price, then each firm has a trade off when considering to deviate(1) Price cutting would lead to a larger market larger market

shareshare in the short run

(2) Price cutting would trigger a price wartrigger a price war after deviation

• If (1) dominates, the firm would deviate and we are back to the prisoner’s dilemma– When I deviate, all other firm deviate

– The outcome would be static Nash equilibrium


The trade off

• When is the gain from deviating small?• Is there anything the firms can do to make the gain

small and thereby promote collusion?

Collusion

Deviation

Competition

GAIN

LOSS

Time

Profits


A strategy of rapid response

• If the rivals responds quickly to deviation, then less incentives to deviate– The period where you undercut your rival is

short– A price war (retaliation) starts early

• If you can signal a rapid response, then this can prevent firms from deviating

• But how to assure a rapid response?


How to assure a rapid response?

(1) Make the market transparent, transparent, so that you observe any deviation

• Everybody is quickly informed about prices and sales of its rivals

• So ’innocent’ exchange of information in an industry can foster collusion?

• Is Internet making industries more transparent?

• Can make retaliation possiblepossible, but are you willing and able to retaliate?


Danish concrete

• Local sales of concrete, and firms gave secret discounts to customers

• Competition authorities argued that more information is generally good for consumers– Each consumer can find the low price firm– Other firms must match the low price firm

• In line with this argument, they starting announcing secret rebates regularly– Everybody was informed about net prices– They then expected prices to be lower


Danish concrete – what happened?


How to signalsignal a rapid response?

(2) To act in a way so that any deviation will be punished

• Meet-the-competition clause can be such a signal– The punishment is guaranteed

– Accepting your rival’s coupons is such a signal

• Can also do that by word andand action– We will match any discount immediately

– Actually do so when your rival offers a discount


How to achieve high prices?

(1) Direct communication• Direct communication is illegal in most countries• But one way communication, then?

• Where is the limit?– Free Record Shop established in Oslo in January 1995– Interviewed in Aftenposten, december 94:

• ’There is no reason to start a price war. .. We will talk with the other chains. We hope that Akers Mic will raise its prices when we do’,

• Konkurransetilsynet questioned them in a meeting, but no fines


Cont.: How to achieve high prices?

(2) Structural and institutional aspects • High transportation costs and high tariffs

leads to sale in local markets– Sphere of influence established– Example: cement in Europe? …

• … or did they actually cooperate?

• They were given large fines for secret market sharing


Cont.: How to achieve high prices?

(3) Signalling of strategy• Signalling how they will act if the rival changes

his price• Petrol in Norway

– Price competition triggered by JET in 1996

– Sent signal through the press to end the price war

• Newspapers in New York (co-opetition, p. 202)– Signalling price strategies in one market segment

(Staten Island)


Lifting the fog – News in NY

• New York Post ( ) and Daily News ( ) on Staten Island, New York in 1994:

Time

Prices

40

50

25


Petrol in Norway

• 19.12.96 in Dagens Næringsliv (Shell):– ’Everybody is making a loss. .. Not sustainable in the

long run’

• 1.2.97 in Aftenposten (ESSO):– ’ESSO will not in plain words encourage others to

raise their price’

• 8.2.97 in Dagens Næringsliv (Hydro/Texaco):– ’Irrespective of the action by others, Hydro/Texaco will

set a price floor of 7.50’


Petrol in Norway – cont.

• The other followed immediately:– Statoil: ’In those areas where the price is increasing,

we will also raise our price’– ’Jet is prepared to raise our prices, if the other firms do

so’– ESSO: ’We are adjusting our prices’

• JET – transparency as a deliberate system:– Our people check prices on other petrol stations two or

three times every day. If our rivals raise prices, we follow. But we always have prices 30-40 øre below our rivals.’

strategic behaviour by incumbent

Documents

rivals costs1

rivals action

entry credible

futurestrategic commitment

remaining suppliers

favour of predation

potential entrythe incumbent

cost increases