CHAPTER 13

Advanced Topics in Business Strategy

© 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
 Learning Objectives
1. Explain the economic basis for limit pricing, and identify the
conditions under which a firm can profit from such a strategy.
2. Explain the economic basis for predatory pricing.
3. Show how a manager can profitably lessen competition by
raising rivals’ costs.
4. Identify some of the adverse legal ramifications of business
strategies designed to lessen competition.
5. Assess whether a firm’s profits can be enhanced by changing
the timing of decisions or the order of strategic moves, and
whether doing so creates first- or second-mover advantages.
6. Identify examples of networks and network externalities, and
determine the number of connections possible in a star
network with n users.
7. Explain why networks often lead to first-mover advantages,
and how to use strategies such a penetration pricing to
favorably change the strategic environment.
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 Limit Pricing to Prevent Entry

Limit Pricing to Prevent Entry

• Successful businesses often spawn entry of new
competitors into the market, and adversely
affect the profits of existing firms.
• Faced with that threat, a manager may consider
limit pricing, which is a strategy where an
incumbent maintains a price below the
monopoly level in order to prevent entry.

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 Limit Pricing to Prevent Entry

Monopoly Pricing
Price 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 = MC
𝑃 − 𝐴𝑇𝐶 𝑄𝑀 × 𝑄𝑀
𝑀
ATC

𝑃𝑀
Profits
𝐴𝑇𝐶(𝑄𝑀 )

Demand

𝑄𝑀 MR
Quantity

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 Limit Pricing to Prevent Entry

Limit Pricing and Residual Demand

Price

AC
𝑃𝑀
𝑃𝐿

𝑃 = 𝐴𝐶

Entrant’s residual
demand curve

Demand

𝑄 𝑄𝑀 𝑄𝐿 Quantity

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 Limit Pricing to Prevent Entry
Limit Pricing May Fail to Deter Entry
• Under limit pricing, the entrant was assumed to
have complete information about the incumbent’s
demand and costs.
– The strategy did not “hide” information about the
profitability of the incumbent’s business.
– The low price charged by the incumbent did not prevent
entry; the entrant stayed out because it believed the
incumbent would produce at least 𝑄𝐿 , if it entered.
• A revised strategy is to set the monopoly price, 𝑃𝑀 ,
and produce the monopoly output, 𝑄𝑀 , and
threaten to expand output to 𝑄𝐿 , if entry occurs.
– This, however, is not a credible threat; so, a rational
entrant would find it profitable to enter if the incumbent
sets price, 𝑃𝐿 .
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 Limit Pricing to Prevent Entry

Effective Limit Pricing

• For limit pricing to effectively prevent entry by
rational competitors, the preentry price must be
linked to the postentry profits of potential
entrants.

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 Limit Pricing to Prevent Entry

Linking Preentry Price to Postentry Profits

• Commitment mechanisms
• Learning curve effects
• Incomplete information
• Reputation effects

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 Limit Pricing to Prevent Entry
Dynamic Considerations
• Even if the incumbent can link preentry price to
postentry profits, it may be more profitable to permit
entry.
• The present value of maintaining monopoly status is:
𝑀 𝑀
𝜋 𝜋 𝜋𝑀 1+𝑖 𝑀
Π𝑀 = 𝜋𝑀 + + 2
+ 3
+⋯= 𝜋
1+𝑖 1+𝑖 1+𝑖 𝑖
• Entry from monopoly to duopoly profits, where
𝜋𝑀 > 𝜋𝐷:
𝜋 𝐷 𝜋 𝐷 𝜋𝐷 𝜋 𝐷
Π 𝑀𝐷 = 𝜋𝑀 + + 2
+ 3
+ ⋯ = 𝜋 𝑀
+
1+𝑖 1+𝑖 1+𝑖 𝑖

• Since Π𝑀𝐷 < Π𝑀 , entry will harm the incumbent.

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 Limit Pricing to Prevent Entry

Dynamic Considerations
• Profits under effective limit pricing:
𝜋 𝐿 𝜋 𝐿 𝜋𝐿
Π𝐿 = 𝜋 𝐿 + + 2
+ 3
+⋯
1+𝑖 1+𝑖 1+𝑖
1+𝑖 𝐿
= 𝜋
𝑖
𝜋𝐿 −𝜋𝐷
• Limit pricing is profitable when: > 𝜋𝑀 − 𝜋𝐿
𝑖

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 Limit Pricing to Prevent Entry

Conditions for Dynamic

Considerations
• The conditions under which limit pricing is
attractive include:
– Low interest rate environments
– Monopoly and limit-price profits are close
– Duopoly profits are significantly lower than limit-
price profits.

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 Limit Pricing to Prevent Entry

Dynamic Considerations In Action: Problem

• Baker Enterprises operates a midsized company that
specializes in the production of a unique type of memory
chip. It is currently the only firm in the market, and it
earns $10 million per year by charging the monopoly
price of $115 per chip.
• Baker is concerned that a new firm might soon attempt
to clone its product. If successful, this would reduce
Baker’s profit to $4 million per year. Estimates indicate
that, if Baker increases its output to 280,000 units (which
would lower its price to $100 per chip), the entrant will
stay out of the market and Baker will earn profits of $8
million per year for the indefinite future.
– What must Baker do to credibly deter entry by limit pricing?
– Does it make sense for Baker to limit price if the interest rate
is 10 percent?

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 Limit Pricing to Prevent Entry

Dynamic Considerations In Action: Answer

• What must Baker do to credibly deter entry by
limit pricing?
– Baker must “tie its hands” to prevent itself from
cutting output below 280,000 units if entry occurs,
and this commitment must be observable to
potential entrants before they make their decision
to enter or not enter.
• Does it make sense for Baker to limit price if the
interest rate is 10 percent?
$8−$4
– Limit pricing is profitable if > $10 − $8.
0.1
– Therefore, limit pricing is profitable.
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 Predatory Pricing to Lessen Competition

Predatory Pricing to Lessen Competition

• Predatory pricing is a strategy where a firm
temporarily prices below its marginal cost to
drive existing competitors out of the market.
– Involves a trade-off between current and future
profits, so it is profitable only when the present
value of the higher future profits offsets the losses
required to drive rivals out of the market.
– A firm engaging in predatory pricing must have
“deeper pockets” (greater financial resources) than
the prey in order to outlast it.

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 Predatory Pricing to Lessen Competition

Predatory Pricing Counterstrategies

• To significantly reduce the profitability of
predatory pricing, the prey may:
– Stop production entirely and cause the predator to
lose more money each period.
– Purchase the product from the predator and
stockpile it to sell when predatory pricing ceases.

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 Predatory Pricing to Lessen Competition

Legality of Predatory Pricing

• Engaging is predatory pricing is vulnerable to
prosecution under the Sherman Antitrust Act;
however, it is often difficult to prove in court.
– Some legitimate business practices/scenarios might
be deemed “predatory” under legal definitions.
• Fierce competition with substantial fixed cost may lead to
the departure of the weakest firm.
• Firms attempting to penetrate a market with a new
product often find it advantageous to sell the product at a
low price or give it away for free initially.

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 Predatory Pricing to Lessen Competition
Predatory Pricing In Action: Problem
• Baker Enterprises operates a midsized company
that specializes in the production of a unique
type of memory chip. If Baker were a
monopolist, it could earn $10 million per year
for an indefinite period of time by charging the
monopoly price of $115 per chip. While Baker
could have thwarted the entry of potential rivals
by limit pricing, it opted against doing so, and it
is now in a duopoly situation, earning annual
profits of $4 million per year for the foreseeable
future.

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 Predatory Pricing to Lessen Competition

Predatory Pricing In Action: Problem

• If Baker drops its price to $68 per chip and holds it
there for one year, it will be able to drive the other
firm out of the market and retain its monopoly
position indefinitely. Over the year in which it
engages in predatory pricing, however, Baker will
lose $60 million. Ignoring legal considerations, is
predatory pricing a profitable strategy? Assume the
interest rate is 10 percent and, for simplicity, that
any current period profits or losses occur
immediately (at the beginning of the year).
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 Predatory Pricing to Lessen Competition
Predatory Pricing In Action: Answer
• If Baker does not engage in predatory pricing, the present
value of its earnings (including its current $4 million in
earnings) will be
𝐷
$4 $4 $4
Π = $4 + + 2
+ 3
+⋯
1 + 0.1 1 + 0.1 1 + 0.1
1 + 0.1
= $4 = $44 million
0.1
• If Baker uses predatory pricing, the present value of its
current and future profits will be
𝐷
$10 $10 $10
Π = −$60 + + 2
+ 3
+⋯
1 + 0.1 1 + 0.1 1 + 0.1
$10
= −$60 + = $40 million
0.1
• Profits are lower under predatory pricing.
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 Raising Rivals’ Cost to Lessen Competition
Raising Rival’s Costs to Lessen
Competition
• Raising rivals’ costs is a strategy in which a firm
gains an advantage over competitors by
increasing their costs.
– Strategies involving marginal cost.
– Strategies involving fixed cost.
– Strategies for vertically integrated firms.

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 Raising Rivals’ Cost to Lessen Competition

Raising a Rival’s Marginal Cost

Quantity2

𝑟1

𝑟2

𝑟2 ∗ A

𝜋1 𝐴
B

𝜋1 𝐵

𝑄1 𝑀 Quantity1

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 Raising Rivals’ Cost to Lessen Competition

Raising a Rival’s Fixed Cost

(−$20, −$20)

($110, $0)
I
($70, $70)

($200, $0)

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 Raising Rivals’ Cost to Lessen Competition

Raising Rivals’ Costs:

Vertically Integrated Firms
• A vertically integrated firm with market power
in the upstream (input) market may be able to
exploit this power to raise rivals’ costs in
downstream markets.
– Vertical foreclosure
• Strategy wherein a vertically integrated firm charges
downstream rivals a prohibitive price for an essential
input, thus forcing rivals to use more costly substitutes or
go out of business.
– Price-cost squeeze
• Tactic used by a vertically integrated firm to squeeze the
margins of its competitors.
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 Price Discrimination as a Strategic Tool

Price Discrimination as a Strategic Tool

• Price discrimination – the practice of charging
different prices to different consumers –
enhances the profitability of predatory pricing,
limit pricing and raising rivals’ costs.
– Price discrimination means firms only to have lower
prices to targeted consumer groups and mitigates
the negative aspects of limit pricing and predatory
pricing.

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 Changing the Timing of Decisions or the Order of Moves

First-Mover Advantages
• A first-mover advantage permits a firm to earn a
higher payoff by committing to a decision
before its rivals get a chance to commit to their
decisions.
– Changing the timing of a game to move from a
simultaneous-move to sequential-move game can
yield one player a first-mover advantage.

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 Changing the Timing of Decisions or the Order of Moves

Simultaneous-Move Production
Game
Firm B

Strategy Low output High output

Firm A
Low output $30, $10 $10, $15

High output $20 , $5 $1, $2

Firm A has a dominant strategy: Low output

Nash equilibrium: Firm A produces Low output, Firm B produces High output.

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 Changing the Timing of Decisions or the Order of Moves

Sequential-Move Production Game

Changing the timing of the game, ($30, $10)
Firm A gets to move first.

First-mover
B advantage
permits
Firm A to
($10, $15) earn $20
A
($20, $5) Instead of
$10.

Unique, subgame perfect

B
equilibrium is:
Firm A: produce High output
Firm B:
produce Low output, if Firm A produces High output ($1, $2)
produce High output, if Firm A produces Low output
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 Changing the Timing of Decisions or the Order of Moves

Second-Mover Advantages
• A second-mover advantage can permit a firm to
earn a higher payoff by free-riding on the
investments made by the first mover and
produce at lower costs.

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 Penetration Pricing to Overcome Network Effects
What is a Network?
• A network consists of links that connect
different points (called nodes) in geographic or
economic space.
– One-way networks
– Two-way networks
• Star networks

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 Penetration Pricing to Overcome Network Effects

Two-Way, Star Network

𝐶6
𝐶5
𝐶7

𝐻 𝐶1

𝐶4 𝐶2
𝐶3

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 Penetration Pricing to Overcome Network Effects

Direct Network Externalities

• Two-way networks that link users exhibit
positive externalities called direct network
externalities.
– The direct value enjoyed by the user of a network
because others also use the network.
• Principle: Direct network externalities
– A two-way network linking 𝑛 users provides
𝑛 𝑛 − 1 potential connection services. If one new
user joins the network, all the existing users directly
benefit because the new user adds 2𝑛 potential
connection services to the network.
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 Penetration Pricing to Overcome Network Effects

Indirect Network Externalities

• An indirect network externality is the indirect
value enjoyed by the user of a network because
of complementarities between the size of a
network and the availability of complementary
products or services.

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 Penetration Pricing to Overcome Network Effects

Negative Network Externalities

• Negative network externalities exist when an
additional user to the network decreases the
value per user of the services.
– Congestion
– Bottlenecks

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 Penetration Pricing to Overcome Network Effects

First-Mover Advantages
Due to Consumer Lock-In
• The presence of network externalities often
make it difficult for new networks to replace or
compete with existing networks; even a
technologically superior network.
– Existing network likely have an installed user base
and complementary services compared to a new
network.
– Network externalities can create consumer lock-in: a
scenario in which consumers are stuck in a situation
(equilibrium) where they are using an inferior
network.
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 Penetration Pricing to Overcome Network Effects
Using Penetration Pricing to
“Change the Game”
• Consumer lock-in resulting from an existing
network might be easily resolved by
communication between two users; however
communication is not feasible with potentially
hundreds of millions of users because of
transaction costs.
• What hope does a firm have of establishing its new
network?
– One strategy, penetration pricing, involves charging a
low price initially to penetrate a market and gain a
critical mass of customers; useful when strong network
effects are present.
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