# CHAPTER 14 Strategy CHAPTER OUTLINE

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3 Chapter 14\Strategy What can firms do to make credible commitments? 6. List as many ways as you can in which a firm can raise its rivals costs. 7. Can it ever pay for a firm to take an action that raises its own costs more than those of its rivals? 8. Does advertising help or hurt consumers? Does it depend on the nature of the ads? 9. Does an advertisement that contains information about product characteristics and prices help consumers or harm them? Why? ADDITIONAL QUESTIONS AND MATH PROBLEMS 1. In the following payoff matrix, each firm has two possible strategies, and must move simultaneously. Assuming that each knows only its own payoff structure, what decision would each firm make? Is this a Nash equilibrium? Suppose each player can see the entire payoff structure, instead of only its own. How would this affect firm 2? Payoffs shown are (firm1, firm2). A B A 3,1 2,0 B 2,4 1,5 2. In the following game, players must move simultaneously. How many Nash equilibria are there? Which will occur without collusion? Which will occur if collusion is allowed? A B A 3,1 7,0 B 2,4 5,3 3. In the following game, assume that you are an interested bystander (such as the local government in the town where firm 1 is located). Can either firm make a credible commitment to enter? How could you alter the incentives (payoffs) with a non-firm specific prize to ensure that firm 1 enters the market? Under what circumstances would it be worth it to do so? Enter Don t enter Enter -1,-2 4,0 Don t enter 0,4 0,0 4. Two firms are considering entering a new market. Entrance requires construction of a highly specialized plant. Demand is sufficient for either one to be profitable, but not both. A newspaper writer, observing the posturing of the two firms, each stating that they are planning to go ahead with plans for the new facility, noted, sunk costs make for credible threats. What does she mean by this statement? 5. Suppose an industry has one incumbent and three potential new entrants. Any firm can produce as the incumbent does, with no fixed costs, and marginal cost MC = bq. Is entry blockaded? Can/should it be deterred? What type of equilibrium will result?

4 92 Part One\Teaching Aids 6. A monopolist faces demand p = 20 Q +.5A.5. Cost is C = 4Q + A, where A is the quantity of advertisement, measured in \$1 units. What are the profit maximizing output and advertising levels? What are profits? (Hint: see Appendix 14A). 7. What are the merits and disadvantages to developing word processing software that has a very different command structure than others on the market? 8. Show that if learning by doing results in the incumbent firm having the cost function C = Q.5, the firm does not need any further action to deter entry. 9. Suppose the French fry market is a duopoly. Tests show that 95 percent of consumers prefer Brand X. Could it ever be shown that Brand Z is preferred in taste tests? What does this imply about such tests? ANSWERS TO ADDITIONAL QUESTIONS AND MATH PROBLEMS 1. has a dominant strategy of A. However, without knowledge of the other player s possible outcomes, firm 2 must guess, as they do not have a dominant strategy. The solution (A,A) is a Nash equilibrium, but (A,B) is not, since firm 2 would rather switch, given firm 1 s choice of strategy A. If they can each see the entire matrix before play, firm 2 will select strategy A rather than having to guess firm 1 s choice. 2. Each player has the dominant solution of strategy A, which is the only Nash equilibrium, and will occur if collusion is not allowed. However, if collusion is allowed, (B,B) will be the outcome, even though it is not a Nash equilibrium. 3. As the matrix is written, neither player has a dominant strategy, nor can they make a credible threat of entry, since each loses if both enter. However, if the local government offers a \$1 prize to any firm that enters the market, firm 1 can make a credible threat of entry. Payoffs with a \$1 Prize for all Entering Firms Enter Don t enter Enter 0,-1 5,0 Don t enter 0,5 0,0 4. The fact that a firm must invest in fixed costs does not ensure a credible commitment because the cost may be partially or totally recoverable (as in the case of an airplane placed on a particular route). Sunk costs are non-recoverable. Thus, a firm willing to begin the building process by spending funds that cannot be recovered is making a very credible threat that they plan to proceed. 5. In this case, the lack of fixed costs means that entry is neither blockaded nor should it be deterred. If the products are identical, a Bertrand equilibrium will likely occur, with firms pricing at marginal cost. If products are differentiated, a Cournot equilibrium is more likely. If the firms form a cartel, output and price will be identical to the monopoly result. 6. In this case, there is more than one choice variable. To solve, set up the profit function as in equation 14A.1, differentiate with respect to Q and A, and solve two first order conditions simultaneously to obtain Q* and A*.

5 Chapter 14\Strategy 93 π = (20 - Q +.5A.5 )Q - 4Q - A π/ Q = 16-2Q +.5A.5 = 0 π/ A =.25A -.5 Q 1 = 0 A* = 4.55 Q* = 8.53 p* = \$10.4 π* = \$ Difference in command structure creates switching costs in the software market. If the product enjoys or is able to capture a high market share by some other means, such as advertising or quality, switching costs can create market power. If, however, a new product attempts to take market share from an established market leader, but users must pay switching costs, success is much less likely. In addition, with products such as word processing and spreadsheet programs such as Lotus 1,2,3 and Excel, users are reluctant to switch if the new software is unique and thus they would not be able to interact with other users of popular programs. This reluctance creates additional switching costs. 8. In this case, learning by doing results in a natural monopoly. Marginal cost (MC = 2.5Q -0.5 ) declines continuously as output expands. Thus, no further action is necessary by the firm to deter entry. 9. The company need only run the tests enough times, and eventually the firm will get a sample that prefers Brand Z. Recall from your statistics class that sample means are just that based on samples. The implications for information conveyed by these tests is that they show only that preferences are not unanimous, and say very little about what most people prefer.

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