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Chapter 13 A!"an#e! T$pi#s in B%siness Strate&y
As partia) *%)+)),ent $* the Re-%ire,ents in
SU''ER ./13
Chapter 13 Advanced Topics in Business Strategy
In this chapter, it discussed on the strategies managers can use to change the business
environment in order to enhance the firms longrun profits!
As discussed in my previous synthesis reports, one thing to consider having a business is
the entering in the mar"et! #o$ever, this is a threat to the e%isting firms! Because of this,
management has considered a strategy called limit pricing! This changes the business
environment because it reduces the number of competitors!
&imit pricing occurs $hen a monopolist' incumbent or other firm $ith mar"et po$er
prices belo$ the monopoly price to prevent other firms from entering a mar"et! This ho$ever is
a contradiction of $hat I have learned $ith the price ceiling and price floor topic! (ith those
topics, price ceiling and price floor are used especially by the government to regulate the pricing
of the entities! #o$ever, the definition of limit pricing doesnt coincide $ith that! In limit
pricing, the e%isting firms $ould intentionally lo$er do$n the prices in comparison $ith the
monopoly price! This is to prevent any possible firms to entry to the mar"et!
A further e%ample presented in the boo" is as follo$s)
Consider a situation in $hich a monopolist controls the entire mar"et! The demand curve
for the monopolists product is DM in *igure 13+1! ,onopoly profits are ma%imi-ed at the price
PM, and monopoly profits are given by .M! /nfortunately for this incumbent, if a potential
entrant $ere to learn about this profit opportunity and possesses the technological "no$ho$ to
produce the product at the same cost as the incumbent, the profits en0oyed by the monopolist
$ould be eroded if the potential entrant could profitably enter the mar"et! 1ntry $ould move the
industry from monopoly to duopoly and reduce the incumbents profits! 2ver time, if additional
firms entered the mar"et, profits $ould be further eroded!
2ne strategy for an incumbent is to charge a price belo$ the monopoly price in an
attempt to discourage entry! This is again $hat you call limit pricing $hich is in contradiction
$ith price ceiling or price floor!
To see the potential merits of this strategy, suppose for the moment that the entrants
costs are identical to those of the incumbent and that the entrant has complete information about
the incumbents costs as $ell as the demand for the product! In other $ords, imagine that the
potential entrant "no$s all the information en0oyed by the incumbent!
To limit price, the incumbent produces QL 3$hich e%ceeds the monopoly output of QM4
and charges a price PL that is lo$er than the monopoly price! This situation is sho$n in *igure
13+5! If the potential entrant believes the incumbent $ill continue to produce QL units of output
if it enters the mar"et, then the residual demand for the entrants product is simply the mar"et
demand, DM, minus the amount 3QL4 produced by the incumbent! This difference, DM . QL, is
the entrants residual demand curve and is s"etched in *igure 13+5! The entrants residual
demand curve starts out at a price of PL 3since DM . QL is -ero at this price4! *or each price
belo$ PL, the hori-ontal distance bet$een the entrants residual demand curve and the
monopolists demand curve is QL at each price!
Since the entrants residual demand curve in *igure 13+5 lies belo$ the average cost
curve, entry is not profitable! To see this, note that the entrant loses money if it enters and
produces more output or less output than Q units! By entering and producing e%actly Q units,
total mar"et output increases to Q . QL! This pushes the price do$n to the point $here P.AC for
the entrant, so its economic profits are -ero! Thus, the entrant cannot earn positive profits by
entering the mar"et! *urthermore, if entry involves any e%tra costs $hatsoever 3even one cent4,
the entrant $ill have a strict incentive to stay out of this mar"et! Thus, limit pricing prevents
entry and the incumbent earns higher profits than those earned in the presence of entry 3but
profits under limit pricing are lo$er than if it $ere an uncontested monopoly4!
*or limit pricing to effectively prevent entry by rational competitors, the pre
entry price must be lin"ed to the postentry profits of potential entrants!
Another e%ample for limit pricing is found belo$!
Assume mar"et demand is 6 7 188 + 9! There is one incumbent firm in the industry 3a
monopoly4, and its output is designated by :i! There is a potential entrant to this industry and its
output is designated by the symbol :e!
Both firms have the same costs of production) TC 7 ;88 < 18:, and therefore AC 7 3;88':4 < 18!
The incumbent firm "no$s that there is a potential entrant, and believes that the potential
entrant believes that the incumbent $ill not change its output even if the potential entrant decides
to enter! The incumbent firm therefore $ants to choose :i so that entry $ill be unprofitable! In
fact, the incumbent "no$s that the potential entrant $ill not enter unless it earns a positive profit
3=e > 84, so the incumbent $ill choose :i to ma"e the entrants profit e:ual to -ero! This $ill
happen if the residual demand curve of the potential entrant 0ust touches 3is tangent to4 its AC
curve but does not rise above it any$here!
To find the tangency point, ta"e dAC'd: 7 ;88:
and set this e:ual to the slope of the
residual demand curve d6'd: 7 1! Therefore, ;88:
7 1 or : 7 58! (hen : 7 58, AC 7
3;88'584 < 18 7 ?38! This means that the residual demand curve must pass through the point :
758, 6 7 ?38 and have a slope of +1! The general e:uation for this residual demand curve $ill be
6 7 @ :e 3$here @ is the vertical intercept4, and at the point of tangency, this e:uation $ill
satisfy 38 7 @ + 58! Therefore, @ 7 A8, and the residual demand curve $hich 0ust touches the
AC curve $ill have the e:uation, 6 7 A8 + :e!
The mar"et demand curve is 6 7 188 + 9 or 6 7 188 :i + :e! To leave the appropriate
residual demand curve, :i must 7 A8! This is the entrydeterring output for the incumbent firm!
Biven the beliefs of the potential entrant, it $ill calculate its best output this $ay) 6 7 A8 + :e,
therefore ,Ce 7 A8 + 5:e! Setting this e:ual to ,C, $e have A8 + 5:e 7 18, or :e 7 58! Therefore
6e 7 A8 + 58 7 ?38! At this price and :uantity, profit for the entrant is)
=e 7 338 % 584 + D;88 < 318 % 584E 7 ?8! Biven this calculation, the potential entrant $ould
decide not to enter 3i!e!, the limit pricing scheme $or"s4! The price of ?38 is called the Flimit
priceG because the incumbent firm, by threatening to produce A8 units of output after entry
occurs, is threatening to drive the price do$n to ?38 after entry 3a price $hich $ill limit the
possibility of entry4!
What would the price and profits be before entry occurred?
Before entry, the incumbent has to produce A8 units of output! To ma"e A8 units of output clear
the mar"et, the price must be 6 7 188 + A8 7 ?A8! Therefore, the profit earned before entry
$ould be =i 7 3A8 % A84 + 3;88 < D18 % A8E4 7 ?1,H88!
Is this the monopoly price and profit for the incumbent firm?
Io, its not! The incumbent firm did not choose the output and price to ma%imi-e profits, but to
deter entry by the potential entrant! The monopoly output $ould be) 6 7 188 + :J ,C 7 188 + 5:
7 ,C 7 18, so :i 7 ;A and 6 7 ?AA! ,onopoly profit $ould be =i 7 3AA % ;A4 + 3;88 < D18 %
;AE4 7 ?1,H5A!
(ould the incumbent firm ma"e a profit if it produced A8 units of output after the potential
entrant entered the industryK
The price $ould be ?38 and output A8 units, so =i 7 338 % A84 + 3;88 < D18 % A8E4 7 ?H88! The
ans$er is yesLa reduced profit compared to before entry, but the incumbent firm $ould profit
$hile the entrant earned -ero!
Whats wrong with the model?
The logic of the model is perfect, as long as you accept the assumption that the potential entrant
$ill believe that the incumbent $ill "eep its output constant after entry! But this assumption
seems pretty sha"y! (hy $ould a potential entrant believe thisK *or instance, lets imagine that
the potential entrant entered the mar"et and decided to produce ;A units of output! (ould the
incumbent "eep producing A8 units of outputK Total output in the industry $ould be MA units so
price $ould be 6 7 188 + MA 7 ?A! At this price, the ne$ entrant $ould be earning) =e 7 3A % ;A4
+ 3;88 < D18 % ;AE4 7 ?H5A 3a loss4, but the incumbent $ould be doing even $orse) =i 7 3A %
A84 + 3;88 < D18 % A8E4 7 ?HA8 3a bigger loss4! /nder these conditions, its unli"ely the
incumbent $ould "eep producing A8 units of output!
If the t$o firms settled do$n into a Cournot duopoly result, the incumbent $ould be much better
off! As you can calculate on your o$n, the Cournot result $ould be that each firm produces 38
units of output and the price is ?;8! Therefore, profit of each firm $ould be) = 7 3;8 % 384 +
3;88 < D18 % 38E4 7 ?A88!
How could the incumbent firm make a credible threat?
The incumbent firm $ould have to be able to ma"e a credible threat to produce A8 units
of output if entry occurred! It could do this by precommitting to produce A8 units of output!
This $ould re:uire adoption of an infle%ible production technology that only permitted this level
of production 3and not any other level of output4! Cestricting its o$n options means that the
potential entrant can e%pect a protracted period of lo$ prices and negative profits 3losses4 if entry
occurs! This ma"es entry of the potential entrant very unli"ely!
In an e%tensive form game, you might loo" at the options and the payoffs this $ay)
In production, the outputs are usually based on the learning process! *irms $ith more
e%perience can produce higher amount or level of output! In the mean $hile, firms $ith less or
no e%perience can produce lesser amount or level of output! Therefore the cost of producing a
good or service depends on the firms level of e%perience! These are "no$n as learning curve
effects! &earning curve effects happen $hen a firm en0oys lo$er costs due to "no$ledge gained
from its past production decisions!
Another strategy is the predatory pricing! In this strategy, the firm temporarily prices
belo$ its marginal cost to drive competitors out of the mar"et! (hat $ould happen here is that
D$n0t Enter
D$n0t Enter
Fir, 2314
Entrant 23.4
Entrant 23.4
278//9 7/4
27198//9 7/4
27://9 7://4
27198.:9 7/4
$hen the competitor or the prey e%its the mar"et, the predator or the firm can no$ raise bac" its
price to a higher level! It also includes a tradeoff bet$een current and future profits) It is
profitable only $hen the present value of the higher future profits offsets the losses re:uired to
drive rivals out of the mar"et!
Based from my further readings, I have learned some items)
1! Setting a price to drive ne$ entrants or e%isting firms out of the mar"et or out of
business! 6rice $ill need to be set belo$ cost 3belo$ ANC or shortrun ,C4!

5! 6redatory pricing lac"s credibility in theory! 2nce a firm has entered it is not rational for
the incumbent firm to price lo$ and sacrifice profits + especially if the ne$ entrant is a
diversified firm $ith deep poc"ets 3they are not going to pic" up and leave easily4!
*urthermore, the incumbent must sustain higher costs than the entrant since it must
increase output sufficiently high to drop mar"et price do$n belo$ entrants ANC!
3! The chainstore analysis leads to same conclusion! The chainstore parado% is that,
despite the conclusion that predatory pricing to deter entry is irrational, many firms are
commonly perceived as slashing prices to deter entry!

;! /ncertainty about behavior is needed to get firms to succumb to predatory pricing!
Although, a reputation for toughness may succeed against small firms $ithout deep
poc"ets! A reputation of being a low-cost firm (or the illusion of a lo$cost firm4 may
also lend credibility to an incumbent firm to ma"e predatory pricing successful!
A! 6redatory pricing violates Section II of the Sherman Antitrust Act of 1OM8 3prohibits
attempts to monopoli-e4! #o$ever, it is very difficult to distinguish bet$een the follo$ing)
P 6redatory pricing 3price belo$ ,C to drive out entrants4
P 6romotional strategies to price belo$ ,C $ith ne$ launch
P Competitive pricing to match entrants price
P &earning curve strategies 3price belo$ ,C to increase cumulative output and move do$n
learning curve4
Another $ay a manager may be able to profitably change the business environment is by
raising rivals cost! (ith this, a firm distorts rivals decisionma"ing incentives, and this $ould
affect their prices, output, and entry decisions!
This is the flip side of lo$ering your o$n costs! It creates an asymmetric advantage for the
incumbent and ma"es it difficult for ne$ firms to enter!
1! Qirect ,ethods) dirty tric"s
5! Bovernment regulations) ne$ source bias in environmental policy
3! Tieins or plugin re:uirements) use of FnonstandardG plugins or refusal to release
specifications needed to plugin
;! Caise s$itching costs) use proprietary design rather than standard or opensource design
Caising input costs) (ith asymmetric input usage increase costs of input rival uses intensely!
Another $ay a firm may gain is raising its rivals fi%ed cost! *i%ed cost is the cost of firm
that cant do a$ay no matter ho$ high or lo$ the output may be produced! 1%ample of $hich is
rent! Cegardless of ho$ many products are produced, the cost for rent of the space' building $ill
still be the same!
Terms regarding strategies for vertically integrated terms)
1! Nertical foreclosure + this is a strategy $here in a vertically integrated firm charges
do$nstream rivals a prohibitive price for an essential input, thus forcing rivals to use
more costly substitutes or go out of business!
5! 6ricecost s:uee-e + tactic used by a vertically integrated firm to s:uee-e the margins of
its competitors!
&et us no$ go to the net$or"s $hich play a big role in the forming or organi-ing of most
industries! It $ould be easier for industries to enter the mar"et if there is a net$or"! The simplest
type is one$ay net$or" in $hich the services or transactions $ould flo$ in only one direction
3from the name itself4! Since a net$or" provider often en0oys economies of scale in creating a
net$or" to deliver service to its customers, ne$ entrants $ould find a hard time to build a
net$or" that supplants or overcome the net$or" services of the e%isting firms!
There is also another net$or" called t$o$ay net$or"! An e%ample of $hich is star
The bottom result is the monopoly result 3fle%ible technology, no entry4! #o$ever, if
entry does occur and technology is fle%ible, $e conclude that the entrant $ould be able to force
the incumbent to change its output and that the Cournot result $ould occur 3?A88, ?A884! The
adoption of infle%ible technology re:uires investment in changes to plant and e:uipment, so that
could change the costs of the incumbent! In these calculations, $e assume the firm $as able to
sell its old e:uipment and get this ne$ plant and e:uipment for the same price, so its costs do not
change! If the potential entrant enters, it can no longer get the incumbent to change its output by
threatening to produce ;A units of output, so the best the entrant could do $ould be to produce 58
units and earn a profit of -ero 3$hich $e assume is not enough to encourage entry4! If the
potential entrant doesnt enter, the incumbent does not earn the monopoly profit, because the
infle%ible technology does not allo$ him to produce the monopoly output, so the profit is ?1,H88!
2ur analysis of this game tells us that the potential entrant $ill not enter if the incumbent adopts
the infle%ible technology, but $ill enter if there is a fle%ible technology 3because the threat to
produce A8 units of output is not credible4! Therefore, the best strategy for the incumbent firm is
to adopt the infle%ible technology to deter entry!