Tutorial 5 & 6

Question 1

Researchers have found that industries with high entry rates tended to also have high exit rates.

Can you explain this finding?

Answer 1

Industries with high entry rates:
- require little or no investment in specialized assets
- require no government licenses
- are characterized by market / demand growth

–>low exit barriers –> high exit rates

Question 2

Industries with high barriers to entry often have high barriers to exit. Explain.

Answer 2

Typical entry barriers:
- High initial capital investments required
- Agreements for essential resources and labor
- Patent and copyright protections
§ …

Exit barriers often stem from sunk costs:

Obligations a firm must meet whether or not it ceases operations (often originally barriers to entry), e.g.:
- Labor contracts
- Commitments to purchase raw materials
- Cost of purchasing patent rights

Question 3

What are typical entry barriers?

Answer 3

• High initial capital investments required
• Agreements for essential resources and labor
• Patent and copyright protections

Question 4

What are exit barriers that stem from sunk costs?

Answer 4

Obligations a firm must meet whether or not it ceases operations (often originally barriers to entry), e.g.:
- Labor contracts
- Commitments to purchase raw materials
- Cost of purchasing patent rights

Question 5

“All else equal, an incumbent would prefer blockaded entry to deterred entry.”
Comment.

Answer 5

• Blockaded entry does not require any significant effort for the incumbent (b/c there exist structural entry barriers),
• while in case of deterred entry, the incumbent has to undertake entry-deterring strategies

–>entry deterring strategies are associated with costs

• A firm able to use (one or a combination of) structural entry barriers does not have to actively guard itself against entry, and so can focus on its core activities

Question 6

Why do incumbents prefer blockaded entry over deterred entry=

Answer 6

Blockaded entry does not require any significant effort for the incumbent (b/c there exist structural entry barriers),

• while in case of deterred entry, the incumbent has to undertake entry-deterring strategies, which are associated with costs

Question 7

Which of the entry-deterring strategies are feasible under uncertainty?

Answer 7

Entry deterring strategies

Only feasible under uncertainty
- 1. Limit pricing
- 2. Predatory pricing

Feasible even under certainty
- 3. Capacity expansion

Question 8

Limit pricing and uncertainty
What is the uncertainty component in the limit pricing strategy?

Answer 8

• Potential entrant is uncertain about some characteristic of the incumbent or the level of market demand

– Incumbent wants the entrant to believe that post-entry prices will be low

• Incumbent’s pricing strategy affects the entrant’s expectations

Question 9

predatory pricing and uncertainty
What is the uncertainty component in the limit pricing strategy?

Answer 9

• Price-cutting by an incumbent may affect the new rival’s expectations of the incumbent’s future pricing strategies
• Under uncertainty it is difficult for the entrant to rule out a bad future scenario

Question 10

Excess capcaity and uncertainty
What is the uncertainty component in the limit pricing strategy?

Answer 10

• If the incumbent is holding an entry-deterring level of capacity, it is in his interest to convey this information to potential entrants
• Unlike predatory pricing and limit pricing, excess capacity can deter entry
• when the entrant possesses full information about the incumbent’s costs and strategic direction

Question 11

Consider a situation, an incumbent has two options:

1) purchase fungible, general-purpose equipment and machinery that can be resold close to its original value
2) It can invest in highly specialized machinery that one in place, has no salavage value

–>Assume each choice results in the same costs.

under which choice should the incumbent expect a greater liklihood of entry and why?

Answer 11

• In general, a significant investment in a highly specialized, relationship specific asset has a high commitment value (the asset has no other use)
• Given such highly specialized assets, the firm is less likely to exit during poor industry conditions
• entry is less attractive
• If the firm invests in a general / cheap asset there is higher likelihood of entry because the incumbent would signal a soft, less aggressive behavio

Question 12

“Judo economics suggests that economies of scale are useless at best.

Name points for agreeing and disagree

Answer 12

Disagree b/c economies of scale can:

• prevent entry
• drive smaller firms from the market
• monopolize the vertical production chain

Agree b/c economies of scale:

• often imply large sunk costs
• in case of a Judo tactic from smaller competitors attacking the market, these sunk costs can become a disadvantage for the larger firm

Question 13

Consider a firm selling two products, A and B, that substitute each other.
Suppose that an entrant introduces a product that is identical to product A.

What factors do you think will affect whether a price war is initiated?

Answer 13

Influencing factors: Existence of exit barriers, type of substitutes, level of
demand

• If exit barriers are minimal, the incumbent might prefer to exit the market for good A
• If exit barriers are high and/or goods A and B are weak substitutes, the incumbent is more likely to stay and fight
• If the level of demand for these goods is high relative to the combined capacities of the firms, the probability of a price war decreases

Question 14

Explain why prices are considered strategic complements ?

Answer 14

Strategic complements:
An increase (decrease) in a particular action on the part of one firm is met by an increase (decrease) in the same action on the part of another firm

Prices are usually strategic complements because:

• If two firms sell identical products and firm 1 lowers its price, then firm 2 will lose many of its customers
• So firm 2 will try to restore profits by responding with a price cut of its own

Question 15

Explain why capacities are considered strategic substitues ?

Answer 15

Strategic substitutes: An increase (decrease) in a particular action on the part of one firm is met by a decrease (increase) in the same action on the part of another firm

Capacities (quantities) are usually strategic substitutes because:

• If a firm expands its capacity, it’s profit-maximizing for the firm’s rivals to choose lower capacities (costs, market saturation,…)
• Hence, a capacity increase elicits a response of lower capacity

Question 16

Firms operating at or near full capacity are unlikely to instigate price wars.

Briefly explain:

Answer 16

Firms with excess capacity

If the incumbent with excess capacity faces market entry of a new firm:

• Even greater excess capacity induced on the part of the incumbent
• Incumbent must fight to retain market share, e.g. by increasing output / lowering price

Firms operating at or near full capacity

• Ability to expand output is constrained
• Firm cannot recover forgone profits from selling each unit at a lower margin –> little incentive to initiate a price reduction

Question 17

What is the **tit for tat strategy? **
(Example: Mark and Anna, with option to study hard or be lazy)?

Answer 17

A possible option is a

Tit-for-Tat strategy:
- begin by cooperating and
- then mimic the other player’s strategy

Question 18

Suppose that you were trying to determine whether the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game.

what would you consider to be evidence of tit-for-tat pricing?

Answer 18

Circumstantial evidence of tit-for-tat pricing

Observable behavior, e.g.:
- advance announcement of price changes,
- use of commitments to meet the lowest price,
- having annual price reviews,
– …

Such pricing behavior supports price coordination and stability

Question 19

Suppose that you were trying to determine whether the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game.

What real world data would you want to examine?

Answer 19

Hard evidence of tit-for-tat pricing

• Much harder to find…

Detailed data on historical prices and firm profits would help to identify punishment strategies:

• All firms lower their prices to “punish” a firm that reduced its price unilaterally
• After a period, all firms raise their prices back to the previous (higher) level

Question 20

Are there any reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high demand) than during busts (low demand)?

Answer 20

Deviation during high demand periods

• Dominant market share position will capture a higher percentage of **industry profits **

After the boom
- Profits captured during the boom may serve as a cushion during the bust

• Increased market share may put the firm in a better position (through reputational effects, switching costs, etc.)

–>cooperative pricing is less likely during booms

Question 21

Situation: In a Market, firm A and B offer identical products, because they are identical, if one charges a lower price than the other, all consumers will buy from this firm.

If prices are the Same, consumers are indifferent and they split the market

–>margincal cost (MC) = 10 and there are no capacity constraints

What are the single-period Nash equilibrium prices, pA and pB?

Answer 21

• Given that there is plenty of capacity to serve the entire market, each firm will try to undercut the other in order to make all the sales in the market (as long as p ≥ 10)
• Therefore, the one-shot Nash equilibrium is: both firms charge p = 10 („Bertrand Trap“)