Strategy

Lecture 1 – Firms:
o What is a firm:
o An organisation or company
o A supplier of goods to a market, characterised by a production function and a
profit function
o A decision making process, including the pattern of communication and relations
between human beings
o A legal entity able to enter into binding agreements with external parties
o A governance structure for regulating internal activity

o Three perspectives:
o Classical – competitive behaviour
o Behaviouralist – adaptation vs. coordination
§ Helps us understand how to adapt to competitors and reflect those
changes within the firm
o Transaction cost – make vs. buy
§ Do we make our own CPUs or buy them?

o Firms vs. Markets:

o Firms:
§ Centralised decision making – hierarchical/delegatory decision making –
efficient
§ Coordination via communication
§ Personal interaction – consistency, motivation, passion – unified objectives
o Markets:
§ Decentralised decision making
§ Coordination via prices
§ Anonymous interaction
o Why do firms exist?
o Because it is efficient!
o There is a monetary and time value cost to using a market – transaction cost:
§ Inefficiency and opportunity costs, barriers to entry, economies of scale
§ Third party brokerage costs – market-maker fees
§ Negotiating or bargaining costs – organise so you don’t have to bargain
each time; opportunity cost of wasted time bargaining
§ Search costs
§ Coordination and incentive costs:
o A huge span of Economics is covered by the problems caused by trying to achieve
cooperation and shared objectives. These problems have led to why firms exist
today.

Lecture 2 – Cooperation and Coordination:

o Prisoner’s Dilemma:
o “Two men, charged with a joint violation of law, are held separately by the police.”
o Each knows that:
§ If one confesses and the other does not, the former will be given a reward
of one unit and the latter will be fined two units.
§ If both confess, each will be fined one unit.
§ If neither confesses, both will go clear.
o Prisoner A’s outcome depends on Prisoner B’s choice
§ If B confesses:
• A receives -1 by confessing
• A receives -2 by staying quiet
§ If B stays quiet
• A receives +1 by confession
• A receives 0 by staying quiet
§ For A, confessing will always give the highest pay-off, no matter what B
chooses

o The fundamental problem of exchange:

o For market economies to develop, the prisoner’s dilemma had to be solved.
o Incentive problems:
§ Temptation to cheat, if unchecked, is fatal to market enterprise.
§ Individual’s incentives not aligned with the group:
• Price cutting
• Advertising
• Innovation and product adoption
• Overfishing
• Drug use in sports
• Stockpiling nuclear weapons
• Grade inflation

o Coordination problem:

 o Bad outcome – both open Italian restaurant
o Worst outcome – both open French restaurant
o These bad outcomes are called coordination failures
o Problem alone cannot be solved by communication – unequal pay-offs
o Other examples:
§ Product differentiation
§ Trading and specialisation
§ Bank runs (withdrawing funds en-masse as a result of risk of insolvency)
§ Competing standards
§ Coordinating hiring decisions
§ Crossing the road en-masse

o Incentive vs. coordination problem:

o Incentive:
§ Conflict between best individual outcome and mutual benefit
§ Cheating is the major concern
§ Not always strategic
o Coordination:
§ Many feasible mutually beneficial outcomes
§ Coordination is the major concern
§ Heavily strategic
o To solve incentive problems, we either need a way to align incentives or a way to
forge an agreement to prevent cheating.
o To solve coordination problems, we either need a way to align our expectations
about what the other will do or a way to control the actions of one or both parties.

Lecture 3 – Contracts:

o Spot contracts (sold as seen) – immediate and one off transaction using established
market prices and terms of trade:
o E.g. using a taxi
o Can turn down if either consumer or supplier finds pricing unfavourable
o Best for simple transactions where both parties know what they’re getting
o No further commitment on either side

o Classical contract (comes with guarantees and security provisions) – legally enforceable
contract detailing specific terms of exchange:
o Long-term, often with finite length
o E.g. commercial lease
§ Renting office space/shop front
§ Details of liability for certain things – such as maintenance
§ After term finishes, contract is either renegotiated or terminated
o Desirable for long-term transactions
o Provides “what-if” contingencies
o For firms, classical contracts reduce the cost that is associated with uncertainty –
changing input prices and suppliers, hiring new employees.
o Prevents opportunism:
§ Upstream buyers not paying
§ Suppliers sending lower quality goods
§ Fundamental problems of exchange
§ “Hold-up”:
• Merchant has a courier, but cannot trust he will deliver goods and
return the revenue;
• Classical contract imposed to nullify incentive problem; agent notices
olives delivered in poor condition, so agent has chance to invest in
something to preserve the olives – can fetch more at market as there
is lower degradation of goods; costly but can generate profits for
both agent and merchant;
• If the contract didn’t outline further profit stakes, then merchant can
“hold-up” the agent and take the surplus profit;
• Problem for agent is that his acquired skill and investment are non-
transferable to other businesses.

o Relational contract – unwritten codes of conduct sustained by the value of future

relationships:
o Roles may be informally defined but no explicit terms
o Long-term with no fixed end point
o E.g. Boss-employee relationship
o AKA Implicit contracts
o E.g. discretionary bonuses/promotions:
§ Usually on the basis of qualitatively assessed performance
§ Can be based on tasks not anticipated/included in classical contract
§ Contingent on company performance
§ Often there is a relational contract and classical contract side-by-side

 o Hybrid contracts:
o Employment (Classical/Relational)
o Restaurants (Spot/Relational) – social convention to give a tip
o Electrical goods with guarantee (Spot/Classical)

o Spot contracts pros and cons:

o Pros:
§ Low transaction cost
§ Easily and widely implementable
o Cons:
§ Can lead to short-term opportunism
§ Difficult to encourage long-term investment
§ Exposed to price volatility
o Classical contracts pros and cons:
o Pros:
§ Prevent opportunism
§ Can incentivise mutually beneficial investments
§ Reduce uncertainty
o Cons:
§ High transaction costs
§ Some things are non-contractible – effort is not enforceable (hard to
monitor, hard for court to verify laziness
§ Requires strong legal institutions – think about China where there are no
contracts, simply agreements, or countries with corruption and/or no
infrastructure to deal with breaches in contract
§ Can fail to cover details of every eventuality
o Relational contract pros and cons:
o Pros:
§ Can incentivise non-contractible outcomes
§ Does not require legal enforcement
§ Flexible
o Cons:
§ Limited applicability
§ Open to abuse of power
§ Exposed to cultural misunderstandings

o Classical contracts with incentive problems:

o They lay out what has to be done and by whom
o They are enforceable via legal means
o If both prisoners could sign a contract agreeing that both stay quiet, then 0,0
could be achieved.
o Relational contracts with coordination problems:
o Commitment
o Authority
o Delegation
o Convention
o Reputation

Lecture 4 – Solving Cooperation and Coordination Inside the Firm:

o Free rider problem:
o Can’t legally enforce high effort, but can look at outcomes/other measures of
performance
o Tie these measures to compensation via classical contracts
o Performance related pay: higher effort – higher firm performance – higher pay
o Draw backs:
§ Focus on measurable tasks encourages the employees to neglect other
non-measurable tasks (e.g. teachers only teaching students to pass exams)
§ Manipulation of performance metrics

o Nexus contracts:
o Firm is a nexus of classical and relational contracts
o Relational contracts work well in firms:
§ Authority to resolve conflict
§ Hierarchy to set out roles
§ Managers and employees co-located
§ Shared understanding develops

o New incentive problems created by firms:

o Shirking
o Empire building
o Lobbying for company resources
o For firms to be efficient they must save more on market transaction costs that it
costs in “internal” transaction costs.

o Role of a manager:
o Some coordination problems require only agreement
o Others may require a way to divide the surplus
o Coordination costs increase as firm grows
o Managers solving incentive problems:
§ Maintain relational contracts – resolve conflicts, develop employees
§ Monitor – mitigate free riding
§ Coordinate – set goals and objectives, communicate
§ Lead – establish conventions, provide focal point
o Toyota succeeded over GM (focus on relational contracts):
§ Mostly subjective performance evaluation
§ More collaboration in work environment, emphasis on team working
§ Extensive knowledge exchange across functional boundaries

Lecture 5 – Strategic Assets and Resources:

o Performance differences:
o Industry specific factors – strategic assets
o Firm specific factors – resources – creates competitive advantage
o Creation of resources is under the firm’s control, strategic assets are not

o Strategic assets:
o Natural monopolies
o Barriers to entry
o Licensing and regulation
o Resources:
o Reputation/brand
o Management and governance structure
o Patents/expertise
o Innovation and invention

o Natural monopolies:

o There is only room for one firm

o A competitive firm cannot break even. The industry is loss making where MC=AR
o Firms that are forced to compete will leave the industry
o Only a monopoly firm that sets supply where MC=MR can make a profit and
remain in the industry.
o Natural monopolies are an extreme form of increasing returns to scale
§ When a firm finds it cheaper to produce as they grow in size and output
o NMs are characterised by:
§ Increasing returns to scale
§ Large fixed costs
§ Learning
§ Network effects
§ Small market size relative to costs
§ E.g. railroad networks, public utilities – power, water
§ Modern day – Google
 o Google:
o Revenue from search advertising
o Main advantage over competitors is accuracy/relevance
o Search accuracy refined over time by learning from previous searchers
o Approx. 20 years of data, currently estimated to be >100 petabytes/day
o Classic example of increasing returns to scale via learning and network effects

o Barriers to entry:
o If an industry is profitable it encourages entry; to remain profitable firms must
restrict this somehow
o Increasing returns is an example
o Switching costs – costly to switch from one product to another, or one provider to
another – e.g. leaving a number behind when switching phone contracts
o High sunk costs
o Limited access to resources

o Government’s role in strategic assets:

o Gov. can create monopolies – e.g. through nationalisation for the sake of raising
revenue, protecting output or employment,
o Gov. purchasing can foster concentration by excluding outsiders – e.g. military
procurement
o Firms can be heavily subsidised in order to compete – e.g. Long-haul airlines such
as Emirates, Etihad and Qatar

o Resources:
o Reputation signals quality when not quality observed – e.g. you can’t assess the
quality of a firm, but you can base judgement on reputation of director.
o If people don’t know your product, then they are willing to pay less:
§ They have to take a risk
§ They have to experiment
§ Takes time to appreciation
o Reputation allows you to set price higher than those who need to entice
customers with a lower price because they don’t have a reputation.
o Why is a reputation so valuable? It is extremely costly to build and is quick to be
lost. If you could buy a reputation it wouldn’t be valuable.
o Reputation enables firms to maintain dominance in traditional markets, and also
move into new markets:
§ E.g. Google, Apple, Virgin – Virgin have leveraged their brand reputation to
access different industries.
§ This can lead to problems when an established firm has some ability to
control the quality of its goods.

o Managers:
o Managers solve incentive and coordination problems
o Management practice differ significantly across firms but also across cultures

Lecture 6 – Innovation:

o Product vs. Process innovation:
o Product innovation – the introduction of entirely new products
o Process innovation – the production of existing goods at lower costs
o A process innovation lowers the cost of producing an existing good below the
previous level
o A product innovation lowers the cost of producing a new good below some level
that was previously prohibitive
o Product innovation – a new product has become cheap enough to be
supplied/demanded:
§ Costs have decreased to a level consumers are willing to pay
§ It may have been that previous products were not desirable at any price
o Process innovation – an existing product becomes cheaper to supply
§ Process innovation is simply a continuation of product innovation

o Value added to firm:

o At face value continuous innovation leads to continues cost advantage
§ Would be considered best guarantee of competitive advantage
§ Provides a source of product differentiation
§ May spill over to reputation/brand
o On closer inspection it is likely to be costly, uncertain and hard to manage:
§ May not work technically
§ If it works, is there a market?
• How elastic is demand when price falls?
§ If it works and there is a market, can it be defenced against competitors?

o Public goods:
o In competitive markets, innovation and knowledge creation are public goods
o Public goods are such that:
§ They are not depleted the more people use them
§ It is difficult to prevent others using them
o Production of these public goods is very often subject to free rider problems

o The Free Rider problem:

o If free rider problem is not solved there will be little/no investment

o Innovation in a Competitive Industry:

o Innovation in a Monopolised Industry:

o Dilemma:
§ On one hand – competitive industries provide maximum total gain from
innovation
§ On the other hand – monopolised industries provide firms with the much
needed incentives to undertake costly innovation
o Solution to this problem – patents:
§ Patents are government enforced temporary monopoly power
§ Violating a patent can be extremely costly
o Problems with patents:
§ Cost of litigation
§ Length and breadth
§ Patent races
§ Can and should all ideas be patented?
§ Ethical issues
§ Patent trolls
 o Optimal patent length:
o Long enough to incentivise innovation, but not prolong monopoly power

o Patent races:

o Can/should all ideas be patented:

o Can:
§ Menu and signature dishes are a major source of competitive advantage
§ A restaurant menu cannot be patented however, yet chefs continue to be
innovative
§ Why? – tacit knowledge, fast moving product line, relational contracts
o Should:
§ Software industry – innovation occurs organically without patents (open
source software)
§ Software innovations are strongly complementary with other innovations,
restricting diffusion may limit innovation elsewhere
§ Software patents are often broad and abstract, vagueness can lead to
patent wars and costly litigation
o Other solutions:
o Company secrecy – e.g. Coca-Cola
o Resources which allow firms to bring an innovation to market quicker than
competitors – e.g. superior sales force

Lecture 7 – Markets and Mergers:

o Price setting and cost curves:
o Profit = revenue – cost
o Delta profit = delta revenue – delta cost
o MR=MC gives profit maximising given we are producing
o Only profitable if AR>AC (TR>TC)

o Markets vs. industries:

o Markets are defined by demand-side – who does the firm sell to, do consumers
see their products as substitutes
o Industries are defined by supply-side factors – do firms use the same inputs,
production techniques and supply channels

o Mergers and acquisitions:

o Way to enter new market or industries
o Interest in another firm’s supply or demand-side resources
o Most mergers fail – generate negative RoI – 83% failure

o Economies of scope:
o More efficient to produce products X and Y in a single firm, rather than distinct
ones

o False reasons for integration:

o We should make X rather than buy it to avoid cost of purchase
o We should take over our suppliers to capture the profit they are making on us
o We should make rather than buy some input if that input is a source of competitive
advantage
o We should acquire company X because it is undervalued by the market
o Winner’s curse – in bidding the one who overvalues something the most loses out
the most
§ If there are no synergies, a takeover is worth the same to all
§ Each potential suitor has their own valuation
§ Winner’s curse
o Presence of synergies is crucial:
§ Different synergies mean firm has its own personal valuation, winner won’t
necessarily be overvaluing

o Valid reasons for integration:

o We should merge with X to exploit economies of scope (synergies)
o We should merge with X to reduce competition
o We should acquire X to secure its resources (e.g. patents)
o Just because synergies exist, doesn’t mean an acquisition will be profitable – e.g.
Google and YouTube just breaking even, despite 9bn in revenue

o Failure of beneficial mergers – mismatch or relational contracts, free-rider (coordination)

problem

 o Vertical integration:
o Performing two or more stages in one firm (e.g. processing and refining, as well as
manufacturing/sales and marketing)
o Integration starts at spot contracts, develops into long-term classical contracts,
then joint ventures, parent/subsidiary and eventually single firm

o Make vs. buy:

o Make – eases coordination of production flow, good when classical contracts are
too costly
o Buy – market firms can achieve economies of scale more easily, market firms
disciplined by the market – must be efficient and innovative to survive – overall
corporate success may shelter in-house departments

o Coordination of production:
o Can be costly and difficult, especially for complex products
o E.g. Boeing Dreamliner, 70% of inputs subcontracted, coordination failure, delays,
battery fires
o Problems with classical contracts – “hold-up” problem, relationship specific
assets, they are incomplete (hard to specify everything in advance), raises issue of
transaction cost – favours vertical integration

Lecture 8 – Maintaining Competitive Advantage:

o “The most important thing to me is figuring out how big a moat there is around the
business. What I love, of course, is a big castle and a big moat with piranhas and
crocodiles.” – Warren Buffet – absolute gheeze

o Economic profit = Accounting profit – opportunity cost

o Competitive advantage – earning higher rate of economic profit than average rate
in the market

o Competitive advantage persists over time:

o Under perfect competition there is no room for CA
o CA therefore requires heterogeneity between firms:
§ Resources:
• Valuable
• Rare
• Inimitable
• Non-substitutable
§ Strategic assets – rarely a source of CA:
• Usually apply to monopolies, where CA is meaningless
• All firms in the market will have access to same strategic assets
§ Relational contracts:
• Gm vs. Toyota – GM could replicate production but not managerial
practices
• A danger – long-established relational norms and contracts are hard
to shift, organisational inertia
§ Barriers to entry and imitation:
• Increasing returns – learning and network effects
• Switching costs
• Limited access to resources
• High spend on advertising or R&D
• Government control of entry
• Intellectual property rights
• Company secrecy
• Other barriers – historical dependence, casual ambiguity

o A warning:
o Be careful when inferring future lessons from past events
o Imitating success is influenced by survivor bias – we do not observe the many
firms who tried to follow these techniques and failed miserably
o We have no idea of the true success rate
o Having a logical theory for why X strategy worked is best

Lecture 9 – Pricing and Positioning:

o Market power:
o When the price a firm picks is not governed by their competitors – they have
market power
o Sources – government protection (patents), strategic assets (returns to scale,
barriers), strategic behaviour and product differentiation
o A monopolist is an example of a firm with market power

o Monopolist’s pricing decision – Pi max (Pi)=TR-TC = PQ(P)-C(P), MC=MR

o They could also capture deadweight loss and consumer surplus:
§ Price discrimination
§ Bundling

o Price discrimination:
o Pricing differently for different customers:
§ Discount coupons/vouchers
§ Student/OAP
§ Different prices at different times of day
§ Regional pricing
o Discount offered to individuals would not pay the normal price:
§ Can distinguish between all types of consumer
§ Charge the maximum price each would be willing to pay
§ Zero consumer surplus – all surplus captured

o Problems with price discrimination:

o Needs a way to verify type of buyer
o Consumers have moral objections
o Must prevent arbitrage
 o Bundling:
o Selling multiple goods together as a package
o E.g. TV and software
o Consumer A is a general user interested in both packages
o Consumer B is a specialist and wants just one

o Superficially appears to be something which is beneficial for consumers – not

always the case if products not also sold separately
o Firms generally benefit from bundling when consumers differ greatly in their
valuations of different products

o Other pricing schemes:

o Two-part pricing – fixed fee and per unit gee
o Quantity discounts
o Loyalty cards
o Versioning – offering different qualities
o Positioning – how the product compares to its rivals, mostly in terms of price and quality

Lecture 10 – Quality and Advertising:

o Experience vs. search goods:
o Experience good – a good or service where it is difficult to assess the value before
purchasing:
§ More difficult to position goods
o Search good – characteristics known and value can easily be gauged:
§ Firms can position their products effectively, consumers can make the
quality/price trade-off decision easily
o Potential problems:
§ Uncertainty
§ Asymmetric information

o Asymmetric information:
o Large market with two sellers
o Low quality sellers produce good worth VL at marginal cost CL
o High quality sellers produce good worth VH at marginal cost CH
o VH>CH but VL=CL
o Consumers willing to pay p= ½VL + ½VH
o If CH>P, then no high quality products are made
o Low quality products drive high quality from the market
o Buyers realise any seller willing to sell must be low quality
o Solutions:
o Reputation
o Commitment – e.g. warranty, difficult in case of services such as restaurants
o Third party quality certification – reviewers of hotels and restaurants, MOT tests,
bond rating agencies:
§ Problems:
• How tough should regulations and standards be
• Industry capture
• Ratings shopping – more information should always be better, but
what if firms can selectively display their favourable ratings
§ Let M be the number of reviewers, say that each reviewer correctly
assesses the quality with P=B where ½<B<1
§ For any B there will always exist a favourable review as M tends to infinity
§ Therefore, certification becomes useless
o Signalling via advertising:
§ Advertising can deter entry – sunk cost
§ Non-durable goods require repeat purchases
§ High advertising spend can signal to consumers that the firm sells a high
quality product
§ Initial quality unobserved – but observed after one try
§ Repeat purchases occur if of high quality, never buy again if low quality
§ Large spend indicated to consumers that the firm expects repeat
purchases
§ Only high quality firm would spend on advertising, as low quality would
never recoup investment
o Word of mouth/consumer views

Lecture 11 – Game Theory:

o Best response – yields highest payoff given your opponent’s choice of strategy

o Dominant strategy – a strategy that is always a best response, regardless of your

opponent’s choice:
o Not all games have dominant strategies
o If one exists, it gives a very strong prediction
o They are stable choices

o Dominated strategies – one where it gives a lower payoff than the alternatives for any
opponent strategy

o Nash equilibrium – a pair of strategies where both players are best responding
o A self-enforcing outcome, where no individual has incentive to deviate
o Resting point of dynamic adjustment – trial and error
o Focal outcome – only rational way to play the game

o Single vs. multiple equilibria:

o Presents a problem:
§ Which will happen?
§ Depends on existence of third party to steer play and cultural
norms/conventions
§ Can lead to players becoming stuck in “bad” equilibria

Lecture 12 – Quantity Competition:

o Cournot:
o Products are homogenous
o Firms pick their output
o Price determined by joint output produced
o Firms compete just once and pick outputs without observing the other’s decision
o There is no entry by other producers
o No fixed cost, constant marginal cost

o Best responses:
o Solve max profit:

o The more our competitors produce, the less we should

o The higher our cost, the less we should produce
o If demand shifts out (a increases), we produce more
o If demand curve becomes steeper (b increases), we produce less

 o Nash equilibrium:

o Equilibrium profit:

o Two extensions to the basic model:
o Entry by competitors
o Collusion

o Market entry:
o N = total producers

 o Collusion – acting as a monopoly
o Each produce qM/2
o Need way to enforce collusion, otherwise producers will deviate

Lecture 13 – Price Competition:

o Bertrand model:
o Products are homogenous
o Firms pick prices
o Buyers know all prices and buy from the cheapest firm
o Firms compete just once without observing the other’s decision
o No fixed cost, constant marginal cost

o Demand function:
o All demand goes to cheapest consumer
o Demand split 50:50 if prices are equal
o Demand for output is zero if price is higher than competitor’s

o Solve through consideration of five different cases – can either player improve their
payoff?
o Pi<C
o Pi>Pj>C
o Pi=Pj>C
o Pi>Pj=C
o Pi=Pj=C
o The only pair of prices where neither can improve is the final option – two firms competing
on prices make zero profit
o In Cournot, firms made positive profits. This is the Bertrand paradox – buyers care about
price, not quantities; full control over prices encourages competition; increasing quantity
lowers competitors price too

o Escaping Bertrand NE:

o Developing a cost advantage:

 o Collusion:
§ Can we agree to cooperate; how can we enforce this agreement?
• Collusion is illegal, cannot use a classical contract
• Need a way to quickly detect and punish cheaters
§ Tacit collusion – firms may realise that any price cut will soon be matched,
driving all prices down in a race to the bottom
§ Collusion enhanced by facilitating practices:
• Exchange of information on prices and changes
• Trade associations
• Price leadership
• Resale price maintenance
§ Brand and price matching guarantees:
• By having buyers bring you information on competitor’s price
changes – removes (high, low) or (low, high) in payoff matrix
• By discouraging undercutting
• Price guarantees appear to be beneficial for consumers, but actually
make them worse off
• Meet-or-release clause between buyers and suppliers
o Product differentiation
o Capacity constraints

Lecture 14 – Capacity Constraints:

o Capacity constraints:
o Cournot:
§ Sellers choose first how much to bring to market
§ Once they get there they observe the other seller’s stock level and then
compete on price
§ The decision in the first stage determines our capacity – this is the max we
can sell
o Bertrand:

o NE:
§ Focus first on the pricing game (once capacities already picked)
§ Assume firms pick their capacities optimally in the first period, with a good
idea of prices likely to arise – maybe from past experience
§ This must mean that they have no leftover stock – spare capacity
§ Claim: Pi=Pj=P* are a NE, where P*=P(Kj + Ki)
• P* is the price which equates total demand with total capacity
• If Pi<P*, then total demand will exceed total capacity (Ki+Kj)
• In particular, it will also exceed firm i’s capacity Ki
• So not beneficial to lower price; same sales at a lower price
§ Is it beneficial to raise prices:
• By increasing Pi, we allow firm j to sell to Kj customers at Pj
• Now we are a monopolist on demand left over: D(Pi) – Kj

 o Optimal capacities:

o This is exactly the same maximisation problem as in Cournot competition

o Therefore, we can view firms who compete on price but also choose stock
levels/capacity as if they were actually competing on quantities
o Thus both Cournot and Bertrand are correct models of competition

o Leaders and followers:

o Stackelberg game:
§ Same as Cournot, but timings of their production decisions are different
§ One firm becomes leader, the other a follower
§ The leader is committed to the action they have taken
§ The follower might optimise their own payoff knowing the leader cannot
change strategy
§ Followers have a big advantage
§ First mover (leader) is firm i, follower is firm j

 o We are effectively choosing our competitor’s output – this is the first mover advantage
o Stackelberg equilibrium:

Lecture 15 – Leaders and Followers:

o The power of commitment:
o Limiting your own strategic options can be beneficial if it is:
§ Public
§ Credible
§ Irreversible

o Entry deterrence game:

o Firm i is considering entering either market A or B
o Market A is large but has once incumbent firm – firm j
o Market B is small and has little competition
o Fixed cost of entry is the same for both markets = 100
o If firm i enters A, firm j has two choices – compete by aggressively expanding
output, or accommodate entry

o Credible threats:
o A potential threat of tough competition is not credible – if firm i does enter market
A, j would not follow through with this threat
o But firm j could add credibility by making an irreversible pre-commitment to
competition:

o Commitment:
o Adds credibility to non-credible threats
o Commitment can also be a way to increase bargaining power
o Could be a way to align expectations in credibility problems – Italian vs. French
restaurant game
o Commitment gives a first mover advantage in patent races

o Location and differentiation:

o Product differentiation – buyers care about non-price aspects, products are
differentiated in many industries
o Vertical differentiation – products are differentiated so that all buyers can agree on
which is better (e.g. airline seats)
o Horizontal differentiation – products are differentiation so that buyers can’t agree
on which is better (e.g. holiday destinations)

o Hotelling model:
o Extends Bertrand’s model of price competition to include horizontal differentiation
o Firms are differentiated along one dimension
o Otherwise identical
o They pick prices
o Large number of potential consumers
o Each consumer will have a location on the line – this is their personal preference
o Consumers have a transport cost which measures the disutility of having to buy a
product far from their location
o TC includes price and transport cost

o Duopoly example:
o Beach is 1km in lengths
o Two bars located at ¼ and ¾ along the beach
o Consumers dotted along the beach
o Say Pi=PJ=C
Lecture 16 – Location and Differentiation:

o In previous example i could leverage the fact that L<0.5 will strictly prefer i and raise
prices – and therefore profit
o Consumers have the following payoff functions – where V is their valuation (identical) and t
is the transport cost per unit travelled:

 o When we allow for product differentiation the Bertrand result no longer holds
o Firms make positive profits
o Raising prices above cost is now beneficial as we still keep some customers

o The principle of minimum differentiation:

o Rather than players picking prices, players pick locations
o Prices could be fixed or there are no prices paid at all (e.g. political parties)
o When prices are fixed or otherwise not applicable then players have an incentive to
move inward
o In the extreme case they become completely identical

 o Entry:
o Fix prices, just consider optimal locations
o Firms must sell to at least 40/% of the market to cover fixed costs

o Threat of entry disciplines firms (entry deterrence)

o It forces them to differentiate – this is good for consumers
o Depends on the level of fixed costs – if low fixed costs, the entry deterrence is
difficult

Lecture 17 – Repeated Interaction:

o Repeated games:
o Consider interactions which re-occur at regular intervals:
§ Firms picking prices every month
§ Employees going to work
§ A supplier shipping goods to their buyer every week
o Finitely repeated games:
§ Two firms are competing on advertising in a marker with a finite lifespan
§ They decide on advertising spend every month
§ After a year the product becomes obsolete and they do not interact again

o Threats and punishments:

o Two players in any prisoner’s dilemma want to cooperate but are driven to cheat
o Often no way to enforce the cooperative outcome
o Repetition opens up new strategies:
§ Play low spend for 3 periods, high for 3 periods
§ Do whatever your opponent did last period
§ Threated to react to your opponent playing x by playing y
o Threats are only valuable if they can harm the other player
o Punishments can minimise their maximum achievable payoff – always confess in
prisoner’s dilemma, pricing equal to cost in Bertrand
o “I will begin by cooperating and will continue so long as you do the same. If you
ever compete I will switch to competing”. – advertising, spending low until one
deviates, then switch to spending high
o In this situation a player might offer an incentive to cooperate today by threatening
punishment tomorrow.
o Previously we needed a classical contract to punish deviation, but punishment
here is just the removal of the opportunity to cooperate in the future.

o By going along with i’s cooperative strategy j would get payoff = 1, by competing they
would get 2 initially but 0 thereafter
o There is no incentive to cooperate in the final period as punishment cannot be exacted
after the game has ended
o Backwards induction suggests cooperation unravels, if cooperation ends at stage 11,
why cooperate at 10 – or 9 or 8 etc.
 o Infinitely repeated games:
o Best response is to cooperate if 1/1-d >= 2 or d >= ½

o Repeated games and relational contracts:

o Open ended:
§ Enforced by the shadow of the future, rather than a court
§ Relationships with finite length prone to break down before their conclusion
o Importance of detection in facilitation collusion:
§ To enforce cooperation there needs to be a threat of swift punishment
§ If we could cheat for multiple periods without the other player noticing, then
it is harder to sustain collusion
o More forgiving strategies may work instead of comply or never cooperate again
§ “if you cooperated yesterday I will cooperate today, if you cheated
yesterday I will cheat today”
§ Potential for players to repent
§ More appropriate in volatile environments where firms may have to cheat
occasionally
o Relational contracts and mergers:
§ Distrustful attitude in firm A:
• “If I work hard and don’t receive a bonus, I will never work hard
again”.
§ More lenient attitudes in firm B:
• “If you give me a bonus when I haven’t worked hard then I will begin
to work hard again”.
§ If firms merge, then there is mismatch of expectations over how the game is
played.