David J. Bryce © 2002 Michael R. Baye © 2002 Game Theory: Entry Games MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

David J. Bryce © 2002 Michael R. Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

David J. Bryce © 2002 Michael R. Baye © 2002 Entry as a Game Earlier in the course we discussed barriers to entry, how barriers are created, and how they’re overcome. Now that we have (some of) the tools of game theory, we will revisit entry as a game We will examine entrant and incumbent actions and discuss entry deterrence We will look particularly at credible deterrence by the incumbent under the heading “strategic commitment.” Earlier in the course we discussed barriers to entry, how barriers are created, and how they’re overcome. Now that we have (some of) the tools of game theory, we will revisit entry as a game We will examine entrant and incumbent actions and discuss entry deterrence We will look particularly at credible deterrence by the incumbent under the heading “strategic commitment.”

David J. Bryce © 2002 Michael R. Baye © 2002 Competitive Response in an Entry Game Competitive Response in an Entry Game Monopoly Fight Accommodate Enter Not Enter Potential Entrant * * * *

David J. Bryce © 2002 Michael R. Baye © 2002 Commitment Influences Competitive Response in an Entry Game Monopoly Fight Accommodate Enter Not Enter Potential Entrant * *

David J. Bryce © 2002 Michael R. Baye © 2002 Simultaneous Moves in the Game Tree Consider the last game in extensive form: E E Enter Not Enter M M Fight Cooperate Monopoly Payoffs Fight/Cooperate M M * * * *

David J. Bryce © 2002 Michael R. Baye © 2002 Final player chooses the option that maximizes her payoff The previous player chooses the option that maximizes his payoff conditional on the expected choice of the final player, and so on This is backward induction – work backward from the end “sub-game,” each player makes optimal choices assuming that each subsequent rival chooses rationally The equilibrium is called sub-game perfection Final player chooses the option that maximizes her payoff The previous player chooses the option that maximizes his payoff conditional on the expected choice of the final player, and so on This is backward induction – work backward from the end “sub-game,” each player makes optimal choices assuming that each subsequent rival chooses rationally The equilibrium is called sub-game perfection Sequential Strategies in the Game Tree: Review

David J. Bryce © 2002 Michael R. Baye © 2002 Sequential Moves in the Game Tree E E Enter Not Enter M M Fight Monopoly Payoffs Fight/Cooperate M M * * * * Cooperate

David J. Bryce © 2002 Michael R. Baye © 2002 Preemptive Strategic Commitment Let the Monopolist Move First E E Enter Not Enter M M M M Fight E E Enter M M M M Fight Cooperate M M Invest Not Invest Payoffs Monopoly Cooperate Monopoly Not Enter * *

David J. Bryce © 2002 Michael R. Baye © 2002 Kinds of Strategic Commitments that may deter entry Expanding plant capacity (in an environment of economies of scale) Expanding output (or building a new plant) Offering “permanent” price reductions Review: Other strategies –Aggressively spend to move down learning curve –Build “network” to create externalities –Build brand through aggressive advertising Expanding plant capacity (in an environment of economies of scale) Expanding output (or building a new plant) Offering “permanent” price reductions Review: Other strategies –Aggressively spend to move down learning curve –Build “network” to create externalities –Build brand through aggressive advertising

David J. Bryce © 2002 Michael R. Baye © 2002 Summary and Takeaways Entry threats can be modeled as a (sequential) game. Threats of retaliation by incumbent for entry must be credible Incumbents may deter entrants by making major strategic commitments (credible threats).. But these commitments may be so costly that they limit pricing flexibility … allowing entry anyway (and even “ruining” incumbent) Entry threats can be modeled as a (sequential) game. Threats of retaliation by incumbent for entry must be credible Incumbents may deter entrants by making major strategic commitments (credible threats).. But these commitments may be so costly that they limit pricing flexibility … allowing entry anyway (and even “ruining” incumbent)