Hjemmeside til Konkurransestrategi (2003), Fagbokforlaget

How should the incumbent

behave?
SOL 310 Competitive strategy
Lars Srgard
Co-opetition, ch. 6-7 (see http://mayet.som.yale.edu/coopetition/index2.html)
Judo strategy, ch. 8 (see http://www.judostrategy.com/)

Srgard

Konkurransestrategi

Todays topic
Incumbents strategic decisions
Deter an entrant?
If accommodation, how to behave?

Strategic commitment
Direct effect
Strategic effect

How to signal an aggressive response?

Srgard

Konkurransestrategi

SUMO strategies
If you are a dominant firm,
firm how to respond
to entry?
What to do before entry?
What to do after entry?

But what is the incumbents goal?

High market share?
In conflict with max profits, or not?
Short run versus long run?
Srgard

Konkurransestrategi

SUMO strategy: A warning

Fight to deter entry or force rival to exit
(predation) is often very costly
The risk associated with predation:
Large financial costs during the war
Discounting: loss today, gain in the future
Entry can take place after the war

The argument in favour of predation is reputation

Fight today in one niche, to signal that you are a tough
type that might fight in other niches

Srgard

Konkurransestrategi

Act before potential entry

The incumbent has a first mover advantage
Can make a decision that commits the firm in
the future
Strategic commitment (or inflexibility)
Irreversible decision

Competition
Srgard

Stage 1: Strategic commitment

Stage 2: Meet in the market place

Konkurransestrategi

Why an irreversible decision?

decision
Costs associated with reversing the decision
Takes time to reverse the decision
Will not get back the total amount

Then an element of sunk costs

Broad definition of decisions

Production plants
Advertising
Vertical integration
Mergers
Long term contracts
..

Srgard

Konkurransestrategi

But is it credible?
credible

Two requirements
(1) It is not in your own interest to reverse the decision after you
have seen your rivals action
- Must be a credible commitment

(2) Acts before the rival, so that it can react

- Must be an observervable action

Is a price war announcement before entry credible?

The incumbent has two options
(1) Deterrence
- Unprofitable with entry
(2) Accommodation
- Entrant acts soft (not aggressively) after entry

Srgard

Konkurransestrategi

Strategic commitment:
Two kinds of effects
Direct effect
Irreversible
decision

Change rivals
future
behaviour

Strategic effect
Irreversible
decision
Srgard

Change own
future
behaviour
Konkurransestrategi

Change rivals
future
behaviour
8

Strategic commitment:
Direct effect
Irreversible
decision

Change rivals
future
behaviour

Incumbents decision has a direct effect on

the potential entrants profit
Two kinds of direct effects
(1) Raising rivals costs
(2) Reducing demand for rivals products
Srgard

Konkurransestrategi

Direct effect I:
Raising rivals costs
(1) Acquire input suppliers (upstream integration)
ALCOA bought waterfalls
Norcem bought areas with limestone

Rivals are either foreclosed from purchasing

inputs, or have to buy at a higher price
Fewer independent input suppliers
The price the rivals have to pay increases, even if the
remaining suppliers do not have cost disadvantages

BUT: a costly race to acquire input suppliers?

Srgard

Konkurransestrategi

10

Raising rivals costs cont.

(2) Trigger other cost increases in the industry

Propose standards etc that are costly

Not room for many firms in the industry

Make sure that the you have a competitive

advantage
(i) Accept higher wages?
-

Can hurt a rival more than you, if he is more labour intensive

(ii) Asymmetric standards?

-

Norsk Hydro in Norway: fertilizers

Standard that is tailormade to Norsk Hydro, and not tailormade
to BASF

Srgard

Konkurransestrategi

11

Direct effect II:

Reducing demand for rivals products
(3) Investment in advertising
Increase the number of loyal consumers
Rivals demand is smaller

BUT: How does the incumbent then behave,

if entry actually takes place?
Loyal consumers means that the incumbent has
less reason to cut prices
The entrant can then expect a friendly welcome
in the market, and entry can be profitable
Srgard

Konkurransestrategi

12

Reducing demand cont.

(4) Integration downstream
Write contracts with buyers
Acquire retailers

Potential entrants do not find enough buyers to

succeed with profitable entry
But is that profitable for the incumbent?
Or could it be that the price it has to pay for the
aquisitions is too high?
An aquisition battle between incumbent and entrant
Srgard

Konkurransestrategi

13

Red. demand cont.: Acquisition

Who wins the aquisition battle?
Incumbent

Retailer 1

Entrant
?
Retailer 2

CONSUMERS

Incumbent owns Retailer 1

Will incumbent acquire Retailer 2?
2
Srgard

Konkurransestrategi

14

Acquisition the game

If incumbent wins, it gains a monopoly
position towards consumers
Monopoly profits: M

If entrant wins, competition between them

Duopoly profits (for each firm): D

Incumbents max payment: M.- D I

Entrants max payment: D E
Srgard

Konkurransestrategi

15

Acquisition who wins?

Who has the highest willingness to pay for Retailer 2?
Incumbent the highest willingness to pay if:
M - D > D (which says that I > E)
M > 2D
This condition is always met
Monopoly profit is higher than total duopoly profits

The incumbent wins the acquisition

Higher willingness to pay, since acquisition means no
competition
The entrant only reaps a duopoly profit
Srgard

Konkurransestrategi

16

Red. demand cont.: Examples

Integrating forward (Judo, p. 184)
Coke and Pepsi bought their bottling networks in the 80s
End of 90s, controlled 80% of their direct distribution

Contract directly with customers

Nutrasweet made deals with Coke and Pepsi before HSC
enter the US market

Apply contracts mentioned earlier

MCC to have the final move against a potential rival?
Can wait, instead of cutting prices too early?

Srgard

Konkurransestrategi

17

Red. demand cont.: Microsoft

Did numerous things to reduce the demand
the rival Netscape would face
Required Internet explorer to be installed on all
new machines with Windows
Numerous distribution channels required to
exclude sales of Netscape
Imposed Internet Service Providers to boycott
Netscape
Srgard

Konkurransestrategi

18

Red. demand cont.: Microsoft

Paid AOL to drop Netscape (see Judo, pp.

185-194)

Bill Gates to AOL in 1996: How much do we

need to pay you to screw Netscape?
Paid AOL $ 0.25 for every customer that shifter
to Internet Explorer
If AOL converted a substantial portion of its
installed base by a certain date, then
(1) $ 600.000 in bonus
(2) AOL icon on the Windows desktop

Srgard

Konkurransestrategi

19

Strategic commitment:
Strategic effect
Change own
future
behaviour

Irreversible
decision

Change rivals
future
behaviour

Commitment to change your own behaviour in the future

When it is observed, the rivals best choice is to change its own behaviour
Would like to soften the rivals behaviour
Deter him from entering, or
Encourage him to act less aggressively after entry

Srgard

Konkurransestrategi

20

Strategic effect: Capacity

Installing a large capacity Top Dog strategy
The best response for a potential entrant is to install a
smaller capacity, or not to enter

DuPont titanium dioxide in the 70s (Judo, p. 180)

Expected an increase in demand next decade (more than
500.000 tons increase)
Expanded its own capacity by 500.000, to preempt
potential rivals
Did not succeed in deterring all its rivals
But became the dominant producer, and still it is

Srgard

Konkurransestrategi

21

Take-or-pay contract with supplier

For any product you take, you agree to pay a
certain price, say $50 per ton
You have to pay even for product you dont take,
say $40 per ton (up to a quantity ceiling)
Example of such a contract:
Ceiling of 1000, and buys 900
Then you pay $50 for 900, and $40 for 100

Take-or-pay good for the supplier; it protects him

As a buyer you in return ask for a discount

Srgard

Konkurransestrategi

22

Take-or-pay act aggressively?

It is a commitment for you as a buyer to act
aggressively
You have a de facto low marginal cost
Would therefore typical retaliate against a rival

In turn, it dampens your rivals incentive to act

aggressively
A device to dampening competition

Risky: What if your rival actually triggers

competition?
Then firms end up competing very aggressively

Srgard

Konkurransestrategi

23

Strategic effect:
Brand proliferation
A dominant firm can introduce many different
brands or versions of its product
One brand for each niche

Whatever niche the entrant decides to enter, it will

face a brand by the incumbent
Tougher competition after entry, then what else would
have been the case

Numerous examples of such a strategy

Kelloggs in the US for cereals

Orkla in Norway for detergents

Srgard

Konkurransestrategi

24

Brand Proliferation: AOL

AOL attacked by Freeserve in UK in 1999
Freeserve offered no subscription fee, and users paid only per minute
(for telephone line)

JUDO: AOL could lose $ 150 mill if it matched

Finally, it did cut the subscription fee with 45%
Later it fighted back by introducing new brands
Netscape Online no subscription fee
A third product: flat rate

Then Freeserve had a JUDO problem

Fight back with a flat rate, and lose existing revenues?
AOL superior on ads and e-commerce
Freeserve matched, and faced losses

Srgard

Konkurransestrategi

25

Fighting against entrant:

Market segmentation
A dominant firms problem is its size
Would lose a large revenue by cutting prices on all
sales

Then a more targeted response can make an

aggressive response more credible
Brand proliferation
Sign contract customer by customer

Can corporate discount schemes be a problem for

entrants in the airline market?
Srgard

Konkurransestrategi

26

Fridstrm on airlines:
Incumbent airline can meet any challenger by
offering selective discounts to large, attractive
clients, making predation a more credible threat
Selective discounts may lead to intense price
rivalry and to exits from the market
Similarly, potential entrants might be deterred
Thus, corporate discount schemes may be anticompetitive in a setting with a dominant, incumbent
carrier and smaller potential entrants
Srgard

Konkurransestrategi

27

Incumbent: Fight or not?

If deterrence or predation is the choice, then
different ways to make it credible with fight
Irreversible investments
Market segmentation

If entry takes place and no predation, then

the incumbent would like peace
Take-or-pay contract
Transparency (repeated game mechanism)
Srgard

Konkurransestrategi

28

Repeated interaction
In a one shot game, a prisoners dilemma outcome
concerning price setting
Firms have a dominant strategy to set a low price

But firms meet at the market place day after day,

week after week,
Then a collusive outcome can be sustained,
without any legal contract
Can be in a firms interest to set high rather than low
price
Srgard

Konkurransestrategi

29

To deviate, or not to deviate?

If all firms set a high price, then each firm has a trade
off when considering to deviate
(1) Price cutting would lead to a larger market
in the short run
(2) Price cutting would trigger a price war after
deviation

share

If (1) dominates, the firm would deviate and we are

back to the prisoners dilemma
When I deviate, all other firm deviate
The outcome would be static Nash equilibrium

Srgard

Konkurransestrategi

30

The trade off

Deviation

Profits
GAIN

LOSS

Collusion
Competition
Time

When is the gain from deviating small?

Is there anything the firms can do to make the gain small
and thereby promote collusion?
Srgard

Konkurransestrategi

31

A strategy of rapid response

If the rivals responds quickly to deviation,
then less incentives to deviate
The period where you undercut your rival is
short
A price war (retaliation) starts early

If you can signal a rapid response, then this

can prevent firms from deviating
But how to assure a rapid response?
Srgard

Konkurransestrategi

32

How to assure a rapid response?

(1) Make the market transparent, so that you
observe any deviation

Everybody is quickly informed about prices and sales

of its rivals
So innocent exchange of information in an industry
can foster collusion?
Is Internet making industries more transparent?

Can make retaliation possible,

possible but are you
willing and able to retaliate?
Srgard

Konkurransestrategi

33

Danish concrete
Local sales of concrete, and firms gave secret
discounts to customers
Competition authorities argued that more
information is generally good for consumers
Each consumer can find the low price firm
Other firms must match the low price firm

In line with this argument, they starting announcing

secret rebates regularly
Everybody was informed about net prices
They then expected prices to be lower

Srgard

Konkurransestrategi

34

Danish concrete what happened?

Srgard

Konkurransestrategi

35

How to signal a rapid response?

(2) To act in a way so that any deviation will be
punished
Meet-the-competition clause can be such a signal
The punishment is guaranteed
Accepting your rivals coupons is such a signal

Can also do that by word and action

We will match any discount immediately
Actually do so when your rival offers a discount
Srgard

Konkurransestrategi

36

How to achieve high prices?

(1) Direct communication

Direct communication is illegal in most countries

But one way communication, then?

Where is the limit?

Free Record Shop established in Oslo in January 1995

Interviewed in Aftenposten, december 94:

There is no reason to start a price war. .. We will talk with the

other chains. We hope that Akers Mic will raise its prices when
we do,
Konkurransetilsynet questioned them in a meeting, but no fines

Srgard

Konkurransestrategi

37

Cont.: How to achieve high

prices?
(2) Structural and institutional aspects

High transportation costs and high tariffs

leads to sale in local markets
Sphere of influence established
Example: cement in Europe?

or did they actually cooperate?

They were given large fines for secret market
sharing

Srgard

Konkurransestrategi

38

Cont.: How to achieve high

prices?
(3) Signalling of strategy
Signalling how they will act if the rival changes
his price
Petrol in Norway

Price competition triggered by JET in 1996

Sent signal through the press to end the price war

Newspapers in New York (co-opetition, p. 202)

Signalling price strategies in one market segment

(Staten Island)

Srgard

Konkurransestrategi

39

Lifting the fog News in NY

New York Post ( ) and Daily News ( ) on
Staten Island, New York in 1994:
Prices
50
40
25

Time
Srgard

Konkurransestrategi

40

Petrol in Norway
19.12.96 in Dagens Nringsliv (Shell):
Everybody is making a loss. .. Not sustainable in the
long run

1.2.97 in Aftenposten (ESSO):

ESSO will not in plain words encourage others to raise
their price

8.2.97 in Dagens Nringsliv (Hydro/Texaco):

Irrespective of the action by others, Hydro/Texaco will
set a price floor of 7.50
Srgard

Konkurransestrategi

41

Petrol in Norway cont.

The other followed immediately:
Statoil: In those areas where the price is increasing, we
will also raise our price
Jet is prepared to raise our prices, if the other firms do
so
ESSO: We are adjusting our prices

JET transparency as a deliberate system:

Our people check prices on other petrol stations two or
three times every day. If our rivals raise prices, we follow.
But we always have prices 30-40 re below our rivals.

Srgard

Konkurransestrategi

42