Economics of Strategy 7th Edition by

Dranove Besanko Shanley Schaefer ISBN

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CHAPTER 7: Dynamics: Competing Across Time

CHAPTER OUTLINE

1) Introduction
2) MicroDynamics
• Strategic Commitments
• Strategic Substitutes and Strategic Complements
Example 7.1: Committed to a Settlement
• The Strategic Effect of Commitments
• Tough and Soft Commitments
• Commitment and the Timing of Entry
Example 7.2: Commitment at Nucor and USX: The Case of Thin-Slab Casting
• The Taxonomy of Commitment Strategies
3) The Informational Benefits of Flexibility
• Real Options
• A Framework For Analyzing Committments
4) Competitive Discipline
• Dynamic Pricing Rivalry and Tit-fir-Tat Pricing
Example 7.3: What Happens When a Firm Retaliates Quickly to a Price Cut: Philip Morris versus
B.A.T. in Costa Rica
• Why is Tit-for-Tat So Compelling?
 • Coordinating on the Right Price
6) Impediments to Coordination
• The Misread Problem
Example 7.4: Forgiveness and Provocability: Dow Chemicals and the Market for Reverse Osmosis
Membrane
• Lumpiness of Orders
• Information about the Sales Transaction
• Volatility of Demand Conditions
• Asymmetries among Firms and the Sustainability of Cooperative Prices
• Price Sensitivity of Buyers and Sustainability of Cooperative Pricing
7) Market Structure and the Sustainability of Cooperative Pricing: Summary
8) Facilitating Practices
• Price Leadership
• Advance Announcement of Price Changes
• Most Favored Customer Clauses
Example 7.5: Are Most Favored Nation Agreements Anti-competitive?
• Uniform Delivered Prices
• Where Does a Market Structure Come From?
• Sutton’s Endogenous Sunk Costs
Example 7.6: The Evolution of the Chinese Down Apparel Industry
• Innovation and Market Evolution
• Learning and Industry Dynamics
9) Chapter Summary
10) Questions
8) Endnotes

CHAPTER SUMMARY

Decisions such as investment in new capacity or introduction of new products are examples of strategic
commitment. Strategic commitments are decisions that have long-term impact and are difficult to reverse.
These decisions are different from tactical decisions, which have a short-term impact and are easier to
reverse.

Strategic commitments influence the nature of competition in the industry and competitive dynamics
evolve over time. The decision to build a new plant with substantial capacity in the above example would
discourage other firms from making investments in similar plants. Firms making commitments need to
balance the benefits of commitments with the loss of flexibility that come in by making irreversible
decisions.

In order to be effective a commitment must be visible, understandable and credible. The key to credibility
is irreversibility; that is, a competitive move must be hard or costly to reverse once it is set in motion.
Relationship specific investments, most favored customer clauses in contracts, and public statements of
intention of taking actions are examples of competitive moves that become irreversible commitments.
This section ends with an airline industry example. Ming-Jer Chen and Ira Macmillan’s study of this
industry shows that M&A, investment in creation of hubs, and feeder alliances have highest perceived
irreversibility while promotions, decisions to abandon a route, and increasing commission rates of travel
agents are seen as easiest to reverse.

The impact of Strategic commitments depends on the nature of the product market competition. The
concepts of strategic complements and strategic substitutes are useful for characterizing how commitment
affects competition. Table 7.1 summarizes the taxonomy by Fudenberg and Tirole—that is, the effect of
Cournot and Bertrand competitions or soft vs. tough. The main components of the taxonomy are the
“Puppy-Dog Ploy,” “Top-Dog Strategy,” “Fat-Cat Effect,” and “Lean and Hungry Look.” The main point
that comes out is that a commitment that induces competitors to behave less aggressively will have a
beneficial strategic effect on the firm making the commitment. By contrast, a commitment that induces
competitors to behave more aggressively will have a harmful strategic effect. Other factors may affect the
degree of a competitor’s reaction, like capacity utilization rates and the degree of a firm’s horizontal
differentiation.

The final section is about the practices that can facilitate cooperative pricing. Facilitating practices include
price leadership, advance announcement of price changes, most favored customer clauses, and uniform
delivered prices. High market concentration facilitates cooperative pricing. Asymmetrics among firms,
lumpy orders, high buyer concentration, secret sales transactions, volatile demand, and price-sensitive
buyers make pricing cooperation more difficult.

APPROACHES TO TEACHING THIS CHAPTER

To get the full benefit of this chapter, it is important to understand the following concepts:

This chapter also relies heavily on the concepts of Cournot and Bertrand equilibriums developed in
Chapter 8. A key point made in this chapter is that expected form of competition can have a major
influence on whether the commitment is ultimately beneficial to the committing firm. In this regard, it is
helpful to walk through examples in the text, in which Firm 1 makes a commitment in Stage 1, and both
firms maneuver tactically in Stage 2. This discussion concludes the impact of strategic commitment on the
market equilibrium depends on whether the Stage 2 tactical variables are strategic complements (Bertrand)
or strategic substitutes (Cournot) and whether Firm 1 makes the firm soft or tough (see Table 7.1: A
Taxonomy of Strategic Commitments and Figure 9.6: Strategic Effects and Product Differentiation).

• A natural question students may ask is: “How can one assess whether a market is Cournot or
Bertrand so that the forgoing theory can be applied to a real market?” We would consider that to
be an overly literal interpretation of the key learning points from this section. In our view what is
critical in any real world application of this theory is that analysts be able to assess whether the
commitment is a tough one or a soft one and whether that, in turn, will induce competitors or
potential entrants to act more aggressively than they would have had the form not made the
commitment.

• To help students understand the impact of “strategic commitments” in real markets the examples in
the chapter of Nucor and USX are useful for discussion. The following case studies will give
students hands on experience in analyzing strategic commitments.

DEFINITIONS
“Aggressive” Strategy: Strategy that involves a large and rapid increase in capacity and is aimed at
increasing the firm’s market share.
Direct Effect: is the commitment’s impact on the present value of the firm’s profits, assuming that the firm
adjusts its own tactical decisions in light of this commitment, but that its competitors’ behavior does
not change.
Flexibility Analysis: Another step in Ghemawat’s four-step framework for analyzing commitment-
intensive choices. This analysis incorporates uncertainty into positioning and sustaining strategic
commitments.
Judgment Analysis: The last step in Ghemawat’s four-step framework for analyzing commitment-intensive
choices. The analysis involves taking stock of the organizational and managerial factors that might
distort the firm’s incentive to choose an optimal strategy.
Learn-to-Burn Ratio: This is the ratio of the “learn rate”—the rate at which new information is received by
the firm that allows it to adjust its strategic choices—and the “burn rate”—the rate at which the firm is
investing in the sunk assets to support the strategy.
Option Value: A delay in which the difference between the expected net present value f the firm invests
today and the expected net present value if the firm waits until the uncertainty resolves itself. Option
value is the outcome of preserving flexibility or future options open after a commitment has been
made.
Positioning Analysis: One of the steps in Ghemawat’s four-step framework for analyzing commitment-
intensive choices. This analysis determines the direct effect of the strategic commitment. It involves
the analysis of whether the firm’s commitment is likely to result in a product market position in which
the firm delivers superior consumer benefits or operates with lower costs than competitors.
“Soft” Strategy: A firm’s strategy that involves no change in capacity.
Strategic Commitment: Decision by a firm that has a long-term impact and is difficult to reverse.
Strategic Complements: Occurs when reaction functions of firms are upward sloping. The more of a
certain action one firm chooses the more of the same action the other firm will optimally choose. In
the Bertrand model, prices are strategic complements.
Strategic Effect: This effect takes into account the competitive side effects of the commitment; that is, how
does the commitment alter the tactical decisions of the rival and, ultimately, the Cournot or Bertrand
equilibrium.
Strategic Substitutes: Occurs when reaction functions of firms are downward sloping. The more of a
certain action that one firm takes, the less of that same action the other firm optimally chooses. In the
Cournot model quantities are strategic substitutes.
Sustainability Analysis: Second step in Ghemawat’s four-step framework for analyzing commitment-
intensive choices. This analysis determines the strategic effect of the commitment, which could
involve a formal analysis of the net present value of alternative strategic commitments.
Tactical Decision: Decision by a firm that can easily be reversed and whose impact persists only in the
short run.

SUGGESTED HARVARD CASE STUDIES1

De Beers Consolidated Mines (HBS 9-391-076). This case describes the problems facing De Beers at the
start of 1983. De Beers had, since its formation in 1888, exercised a large measure of control over the
world supply of diamonds. In 1983, the company itself mined over 40% of the world’s natural diamonds
and, through marketing arrangements with other producers, distributed over 70%. For 50 years up to 1983

1
These descriptions have been adapted from Harvard Business School 1995–1996 Catalog of Teaching Materials.
the company never lowered its prices and, overall, had raised them significantly ahead of the rate of
inflation. However, in 1983 the company was faced with a series of problems that threatened the structure
it had so carefully built. First a large producing nation had stopped selling through De Beers. Second, new
discoveries meant that the annual supply of mined diamonds would double by 1986. Finally, the industry
was experiencing its worst slump since the 1930s, resulting in a significant deterioration in the company’s
financial position. It also describes the structure and economics of the diamond industry and asks the
student to decide whether or not De Beers should abandon the business strategy it had pursued for nearly a
century. This case can be taught with some combination of the following chapters: 2, 8, 11, 13, 14 and 16.
You may want to ask students to think of the following questions in preparation for the case:

a) What are the characteristics of rough diamonds that create challenges in sustaining a monopoly of this
trade?
b) Why does De Beers require different countries to pay different commission to participate in the
syndicate?
c) Why might diamond producers agree to participate in the syndicate as opposed to selling their output
on their own?
d) What forces prompt diamond producers to exit the syndicate?

Caterpillar (HBS 9-385-276). This case describes the structure and evolution of the earth moving
equipment industry worldwide in the post war era, particularly focusing on developments in the 1980s
and 1970s. Describes Caterpillar’s strategy in becoming the dominant worldwide competitor with
industry market share exceeding 50%. Includes details on CAT’s manufacturing, marketing research and
development, and organizational policies. Concludes with a description of some environmental changes
occurring in the early 1980’s, and raises the question of how these might affect Caterpillar Tractor Co.’s
record 1981 performance and require changes in its highly successful strategy. You may want to ask
students to think of the following questions in preparation for the case:

a) Describe the key drivers to Caterpillar’s historical success.

b) Describe changes in the competitive environment and explain how these changes might impact CAT.

Gillette’s Launch of Sensor (HBS 9-792-028). This case discusses Gillette’s launch of its Sensor shaving
system, one of the biggest product launches ever, and examines Gillette’s decision to position sensor razor
as a cartridge rather than as disposable in order to blunt potential price competition with disposable razors.

Leading the Charge: The Launch of the GM Card (HBS 9-385-140). This case discusses General Motors’
launch of the GM credit card in 1992. The incentives under the GM card can be interpreted as a kind of
targeted rebate, one of whose effects may be to soften price competition in the automotive business.

Nucor at a Crossroads (HBS 9-793-039). Nucor is a mini-mill deciding whether to spend a significant
fraction of its net worth on a commercially unproven technology in order to penetrate a market. This case
is an integrative one designed to facilitate a full blown analysis of a strategic investment decision. This
case can be prepared with some combination of the following chapters: 3, 11, 12, 15, and 16. You may
want to ask students to think of the following questions in preparation for the case:

a) How attractive do the economics of thin slab casting look?

b) Is thin slab casting likely to afford Nucor a sustainable competitive advantage in flat rolled products?
c) How should Nucor think about the uncertainties surrounding thin slab casting?
Philips Compact Disc Introduction (HBS 9-792-035). Presents the perspective of Philips in 1979, after
technical development of the CD was complete, but three years before it was introduced commercially. At
that time, Philips’ management had to decide whether to attempt to establish a CD standard through an
alliance with another consumer electronics firm. This case raises questions regarding the costs and
benefits of standardization, optimal pricing of CD players and discs (given their complementarity), optimal
pricing of a durable good, and the effects of proprietary information on entry strategies. Also requires
analysis of several related industries, with special attention to opportunities to invest in product specific
capital. This case can be assigned with some combination of Chapters 5, 6, 11, and 16. You may want to
ask students to think of the following questions in preparation for the case:

a) What are the cost and benefits to Philips in having its standard accepted as the industry-wide format (in
the hardware)? How does the degree of Philips vertical integration affect its incentives in the
development of the hardware? How does its vertical integration affect its chances of having its
standard being adapted? How does its vertical integration effect how profitable Philips will be in the
hardware?
b) How does Philips ownership in a record company effect its position in the market for hardware?
c) Will hardware manufacturers be able to successfully engage in product differentiation? What factors
affect your answer?
d) Under what conditions should Philips build extensive disc pressing capacity in the U.S. and under what
condition should Philips wait one year?

EXTRA READINGS

The sources below provide additional resources concerning the theories and examples of the chapter.
Axelrod, R., The Evolution of Cooperation, New York, Basic Books, 1984.
Bernheim, B. D., and M. Whinston, “Multimarket Contact and Collusive Behavior,” RAND Journal of
Economics, 21, 1990, pp. 1–26.
Bulow, J., J. Geanakopolos, and P. Klemperer, “Multimarket Oligopoly: Strategic Substitutes and
Complements,” Journal of Political Economy, 93, 1985, pp. 488–511.
Chen, M.-J., and I. C. MacMillan, “Nonresponse and Delayed Response to Competitive Moves: The Roles
of Competitive Dependence and Action Irreversibility,” Academy of Management Journal, 35, 1992,
pp539-570.
Dixit, A., and B. Nalebuff, Thinking strategically: The Competitive Edge in Business, Politics and
Everyday Life, New York, Norton, 1991.
Dixit, A. K., and R. S. Pindyck, Investments under Uncertainty, Princeton, NJ, Princeton University Press,
1994.
Ghemawat, P. “Commitment to a Process Innovation: Nucor, USX and Thin Slab Casting,” Journal of
Economics and Management Strategy, 2, 1993, pp. 133–161.
Ghemawat, P. Commitment: The Dynamics of Strategy, New York, Free Press, 1991.
Kulatilaka, N., “Capabilities as Real Options,” Organization Science, 2001, pp. 744–758.
McGahan, A. M. “The Incentive not to Invest: Capacity Commitments in Compact Disk Introduction,”
Research on Technological Innovation, Management and Policy, 5, 1993, pp. 177–197.

SUGGESTED ANSWERS TO END-OF-CHAPTER QUESTIONS

1. Why are the Cournot and Bertrand models considered static? What aspects of real world
behaviour might be missing in static models?

In the Cournot and Betrand models of duopoly, each firm decides on the price and quantity choice
once. In a dynamic model, there will be multiple periods and these choices will have to be made
repeatedly in each period. Each period’s decision will have to maximize the present value of future
cash flows. This means in a dynamic model a firm has to anticipate what rivals will do in the future,
not just react to what it has done in the past. Firms do anticipate their rivals actions and they act across
multiple periods.

2. In the Cournot model (see Chapter 5), the revenue destruction effect limits the
willingness of firms to expand output. But in the Stackelberg model, the firm that
moves first produces more than it does in Cournot' s model. How does moving first
reduce the revenue destruction effect?
The firm that moves first anticipates that after its increases production, causing prices to fall,
its rival will cut back production, causing prices to rise somewhat. Thus, the revenue
destruction effect from each additional unit of output of the first mover is offset by the
"revenue enhancement effect" when the rival reduces output.

3. What is the difference between a soft commitment and no commitment?

In making no commitment, a firm has not taken an action or made an investment that alters its own
and/or its rival’s competitive responses. In contrast, a soft commitment is one that, no matter what its
competitors do, the firm will behave less aggressively than if it had not made the commitment. Thus,
in a Cournot game a soft commitment will cause the firm to produce relatively less output, while in a
Bertrand game a soft commitment will induce the firm to charge a higher price than if it had not made
the commitment.

4. Zellers and Walmart are two of Canada’s largest retailers. To reflect the strong position of the
Canadian dollar, each firm is considering lowering prices on some goods in Canadian stores.
The table displays the payoffs for each firm associated with lowering prices (or not), given the
other firm’s decision.

If Zellers decides And Walmart decides Then, Zeller’s And Wal-Mart’s

to… to… profits are… profits are…
Keep prices the same Keep prices the same $200MM $250MM
Keep prices the same Drop prices $150MM $280MM
Drop prices Keep prices the same $230MM $190MM
Drop prices Drop prices $180MM $220MM

If given the opportunity, how much would Zellers be willing to spend for the right to move first?

Zellers would pay up $30mm to be able to move first. This assumes that both firms know the payoff
matrix and are both profit maximizers. By moving first, Zellers realizes that it will make more profit
by dropping prices than by keeping them the same. Because in both cases of keeping them the same,
Walmart (knowing the payoff matrix and being a profit maximizer) would drop its prices and Zellers
 would be left with its lowest possible profit - $150mm. However, by moving first and dropping prices,
Zellers will earn $180mm because Walmart will then drop its prices to maximize its profits – however,
this is $30mm more than keeping prices the same for Zellers. Zellers would therefore pay up to the
difference between $180mm and $150mm to, or $30 million to make the first move. If Walmart
moved first, it would not choose to keep its prices the same because that earns the lowest profit, so it
would definitely drop prices.

5. Which of the following are examples of commitments? Which are strategic

commitments? What response is each strategic commitment likely to elicit?
a) Fiat announces its intention to build an all-electric car in its Belvidere, Illinois
assembly plant, with plans to sell one million vehicles in the first year. It hires 3000
additional workers, enough to keep the plant operating at capacity. Fiat then signs contracts
with its unions committing to pay all of its Belvidere workers for two full years whether or
not production reaches capacity.

b) Airframe manufacturer Embraer currently produces commuter jets that hold up to

90 passengers. Boeing and Airbus produce larger jets that seat at least 120 passengers,
but these jets are very old and badly in need of updating. Embraer signs a contract with
China Eastern Airlines to develop and produce within five years 200 jets capable of seating
120. Embraer must pay an exorbitant penalty if it breaches the contract.

c) The 1960s movie Fail Safe was made during an era when many feared a nuclear
holocaust. In the film, an errant U.S. bomber plane drops a nuclear weapon on Moscow. In
response, the U.S. President instructs the air force to drop an atomic bomb on New York
City in order to appease the Russians. The instructions cannot be reversed, not even by the
President.

d) Jim Schmidt is a father who loves sweets but hates Disney World. He makes the
following New Year's resolution in front of his family: He will lose ten pounds by April. If
he fails, he will take his children to Disney World.

(a) This is a strategic commitment to produce more cars. This will drive down the price of cars
and may cause rivals to scale back production plans.

(b) This is a strategic commitment to enter the market for larger airplanes. Once Embraer has the
capability of producing larger planes, the effective marginal cost of further production is lower.
(Some of the fixed development costs will have been sunk.) As a result, this segment is likely to
be more competitive. Boeing and Airbus might see that prices are going to fall and scale back
their plans. Alternatively, they might try to preempt Embraer by contracting with other airlines.
This would be similar to launching a price war to drive a rival from the market.

(c) Dropping the bomb on New York City was not a commitment, as it did not commit the U.S.
to any further action. If the U.S. wanted to bomb the rest of the Soviet Union, it could do so.
But if that was the intent of the U.S., it would seem rather odd to destroy New York Rather.
Thus, bombing New York was both an apology and a kind of signal of intentions that fell short of
commitment. (Spoiler alert! In the film, an errant bomber accidentally attaches Moscow, and the
final scene shows New York City street scenes frozen in time at the moment the bomb drops.)

(d) This is a commitment but it is probably not strategic. (Though if his children respond by
helping him with his resolution, for example by never tempting their father by asking to go out
for ice cream, then it would have strategic value.)
 Instructor’s Manual to accompany Economics of Strategy, Seventh Edition

6. Explain why prices are usually strategic complements and capacities are usually strategic
substitutes.

If 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, than the actions are said to be strategic complements.
If two firms sell identical products and one firm lowers its price, the other firm will lose many of its
customers. Most likely, a firm can partially restore profits by responding to the price cut of its rival
by a price cut of its own. Hence price-cutting often elicits price-cutting and so prices are usually
strategic complements.

If 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, than the actions are said to be strategic substitutes. If a
firm expands capacity, it is profit maximizing for the firm’s rivals to choose lower capacities. Since a
choice of high capacity by a firm often elicits a response of lower capacity by rival firms, capacity is
usually a strategic substitute.

7. Some firms offer "most favored customer" (MFC) agreements in which new discounts
offered to future customers are applied retroactively to existing customers. Explain why
these agreements represent weak commitments towards competing firms. Under what
circumstances will these agreements facilitate tacit collusion among competitors?

Suppose firm X offers an MFC agreement. X will be reluctant to offer discounts to new
customers. X's rivals know this and realize that they do not need to price as aggressively to win
new customers away from X. If X faces few competitors, then the MFC might facilitate price
increases. But if X faces many competitors, those rivals might still vigorously compete against
each other.

8. Indicate whether the strategic effects of the following competitive moves are likely to be positive
(beneficial to the form making them) or negative (harmful to the firm making them).

a. Two horizontally differentiated producers of diesel railroad engines-one located in the U.S.
and other located in Europe—compete in European market as Bertrand price competitors.
The U.S. manufacturer lobbies the U.S. government to give it an export subsidy, the amount
of which is directly proportional to the amount of output the firm sells in the European
market.

Given that the two firms are competing as Bertrand price competitors, Stage 2 tactical variables
are strategic complements. U.S. government subsidy would reduce U.S. firm’s marginal costs in
Europe, reducing the price. This makes Firm 1 tough (i.e., no matter what its European
counterpart charges Firm 1 would charge a lower price with the subsidy). This shifts Firm 1’s
reaction curve inwards (see Figure 9.4) moving Bertrand equilibrium southwest. Firm 2 would
follow and reduce price (though by not as much as Firm 1), this hurts Firm 1 and strategic effect
is negative.

Copyright © 2016 John Wiley & Sons, Inc.

Economics of Strategy, Seventh Edition Instructor’s Manual

b. A Cournot duopolist issues new debt to repurchase shares of its stock. The new debt issue
will preclude the firm from raising additional debt in the foreseeable future, and is expected
to constrain the firm from modernizing existing production facilities.

Since the firms are competing in a Cournot industry their actions are strategic substitutes. Firm
1’s decision to buy back its shares of stock is a “soft” move, because it constrains it from making
investments in modernizing its production facilities.

Hence this kind of commitment makes Firm 1 “soft”. This means that no matter what level of
output Firm 2 chooses, Firm 1 will produce less output. This corresponds to inward shift in Firm
1’s reaction curve (see Figure 9.2) and has a negative strategic effect since this allows Firm 2 to
respond more aggressively.

9. Which of the following are examples of real options?

a. A basketball team owner delays signing a star free agent to a one year contract,
preferring to wait and see if his team is in contention for a championship.

b. A hockey team owner delays building a new stadium because interest rates are high and
may soon come down.

c. A student delays studying for a final exam because she expects to soon receive a job offer
that would make her grade point average moot.

d. Blockbuster Video delays entering the DVD rental market (see Chapter 6 for more
details on the DVD rental market.)

The real offers are a, b, and d. This is because in each of those cases, there is cost and a payoff
calculable for each scenario. In case c, only one of the scenarios has a calculable payoff.

a. The basketball team has a calculable profit and cost in all four possible outcomes. It either
gets in the playoffs or it doesn’t and each of those has a profit outcome. Lilewise, it either signs
the star now or later and each of those has a finite cost, as does waiting to sign the star at a cost
that may be different than the present. This is a real option.

b. The hockey team has a calculable cost in both cases and a profit in both cases that can be
calculated. The stadium is either built now and begins earning profits, or built later and earns
future profits. Likewise, the cost of the stadium is either the current interest rate or the future
interest rate. This is a real option.

c. This is not a real option. The student either will receive the job offer or she won’t. Delaying
her studying does not affect the future job offer or the income (profit) she will receive from it.
She can still study and receive the job offer as well.

Copyright © 2016 John Wiley & Sons, Inc. 9-11

Instructor’s Manual Economics of Strategy, Seventh Edition

d. Blockbuster faces a real option in entering the DVD rental market. It faces costs if it enters
and costs if it waits – both are calculable. Likewise, it earns a profit stream that is calculable in
both of the situations.

10. Love Never Dies is a musical playing in London’s West End. The producers are planning a
limited run of the musical in Sydney next year. The producers expect that it will cost $1.7
million to mount the play in Sydney. They know that the show could be a hit or a flop. If the
show is a hit in Sydney, the producers expect the resulting revenue (from tickets, merchandise,
etc.) will be $3.1 million. If the play is not a hit in Sydney, the producers expect $2.2 million in
revenues. In either case, the producers would wish to go ahead with the show. What is the
most the producers should be willing to pay a market research firm to help them figure out
whether or not the show will be a hit?

The producers are faced with a real option; however, in this case they plan to go ahead with the show
regardless of its “hit/no hit” status, so the only question is what will be expected profits that can be
spent to determine its probability of becoming a hit. It’s a 50/50 proposition that it will be a hot,
therefore the expected value of the real option is:

0.5($3.1) +0.5($2.2) – $1.7 = $0.95, or $950,000

Given this expected outcome of the real outcome and the knowledge that if it is not a hit will only
earn $500,000 ($2.2 - $1.7), they should be willing to spend $450,000 to determine it potential hit
status. That is the difference between the expected outcome ($950,000) and the lowest profit
($500,000) they would earn.

11. An article on price wars by two McKinsey consultants makes the following argument.
That the (tit-for-tat) strategy is fraught with risk cannot be overemphasized. Your competitor
may take an inordinately long time to realize that its actions can do it nothing but harm;
rivalry across the entire industry may escalate precipitously; and as the “tit-for-tat” game
plays itself out, all of a price war’s detrimental effects on customers will make themselves
felt.
How would you reconcile the views expressed in this quote with the advantages of tit-for-
tat claimed in this chapter?

As the argument in the McKinsey article points out, there are risks involved in adopting the tit-for-tat
strategy. Misreading pricing moves made by competitors can lead to alternating cooperative and
uncooperative responses or all uncooperative responses. When the possibility of misreads exists, it
may be beneficial for a firm to adopt a more forgiving strategy to reduce the likelihood of detrimental
responses to a competitor’s price deviations. However, adopting the tit-for-tat strategy before a price
war ensues can serve as a powerful deterrent sustaining monopoly pricing at a non-cooperative
equilibrium.

12. Firms operating at or near capacity are unlikely to instigate price wars. Briefly explain.

9-12 Copyright © 2016 John Wiley & Sons, Inc.

Economics of Strategy, Seventh Edition Instructor’s Manual

Firms who lower price earn less on every unit they sell up to the quantity they sold before the price
reduction. However, this loss can be offset by an increase in units sold due to the now lower price. If
a firm is at or near capacity, its ability to expand quantity sold is constrained and hence the firm
cannot recover the forgone profits from selling each unit at a lower margin. The capacity-constrained
firm has little incentive to initiate a price reduction.

Firms are more likely to instigate price wars when excess capacity exists. For example, if a firm is
experiencing excess capacity, and a new firm enters the market, the new entry will induce even
greater excess capacity on the part of the incumbent. If there are economies of scale in production,
the costs of idle capacity may rise with the degree of idleness. This suggests that the incumbent will
fight harder to retain market share under excess capacity conditions, and that prices are likely to drop
with entry. The firm with excess capacity may lower its price in order to retain or steal market share.

13. 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? What would you consider to be evidence of tit-for-tat pricing? How can you
distinguish tit-for-tat pricing designed to sustain “collusive” pricing from competitive pricing?

Circumstantial evidence of tit-for-tat pricing is relatively easy to find. Public pricing behavior, like
the advance announcement of price changes and the use of commitments to meet the lowest available
price, support price coordination and stability, as does simplified pricing behavior such as having
annual pricing reviews. However, hard evidence of tit-for-tat pricing is much harder to come by,
unless firms are foolish enough to put a collusive agreement in writing. You would want detailed
data on historical prices and firm profits in an attempt to discern pricing patterns that support above-
average industry profitability. One such telltale pattern is a punishment strategy, where all firms
lower price to “punish” a renegade firm that reduces its price unilaterally. Then, after a period, all
firms raise their price back to the previous, higher level. However, firms can always argue that
external circumstances are responsible for the price moves. Furthermore, if collusion is extremely
effective, you would not observe punishment behavior at all.

14. It is often argued that price wars may be more likely to occur during low-demand periods than
high-demand periods. Are there factors that might reverse this implication? That is, can you
think of reasons why the attractiveness of deviating from cooperative pricing might actually be
greater during booms (high demand) than during busts (low demand)?

Deviation from cooperative pricing can occur during economic booms. During periods of high
demand, gaining the dominant market share position will capture a higher percentage of industry
profits. Also, recognizing the inevitable downturn in their market following a boom period, a firm
may be tempted to capture profits to serve as a cushion during an economic downturn. Gaining a
dominant market share is more profitable during a boom than during a downturn. Furthermore, if the
firm can retain some of it increased share after the boom (through reputational effects, switching
costs, etc.) it will be in a better position during the downturn. These factors may tempt a firm to
deviate from cooperative pricing during a boom.

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Instructor’s Manual Economics of Strategy, Seventh Edition

15. Why does Sutton draw a distinction between endogenous sunk costs such as advertising, and
other sunk costs such as capital investments?

Sutton’s analysis begins with the idea that when markets for a product are established all firms are
essentially small and on a level playing field. They all have invested the same amount in production
lines and equipment. However, over time, some firms grow larger faster and enjoy market
dominance through creating a brand image. This brand image is expensive to create and maintain,
and becomes a large endogenous sunk cost that smaller firms cannot achieve. Consumers tend to
gravitate towards brand products and thus the minimum efficient scale can be very large.

16. Why does Sutton’s model apply so well to the consumer goods market? Does Sutton’s model
describe the structure of other markets?

Consumer products are advertised heavily. Advertising to create branding is expensive and this
makes the minimum efficient scale very large. As a consequence, the consumer goods market is
concentrated and smaller firms that cannot differentiate or find niches, fail. In consumer goods, brand
is a key competitive attribute of a product and therefore Sutton’s model works well. Sutton’s model
could apply to other markets if buyers in that market were brand specific and advertising played a role
in establishing that brand. For example, commercial aircraft manufacturing is not a consumer market,
yet Boeing and Lockeed advertise their planes to potential buyers.

9-14 Copyright © 2016 John Wiley & Sons, Inc.