Judo Economics The Game

Case Background: A single incumbent player with sufficient capacity to serve all potential buyers in the market. A second company considering entering the market. Decision stages for the players: Stage 1: Potential entrant to decide whether to enter the market or not. Stage 2: If the firm enters, it targets a certain market share and decides the price to be offered to them. Stage 3: The incumbent then sets a single price for all the buyers. Stage 4: Buyers choose to purchase products offered by the two firms at the given prices. Decision Variables Let t be the market share targeted by the entrant and Pe be the price offered by it to the targeted market. Let Pi be the price offered by the incumbent. Case Analysis: The game can be represented in the extensive form as

Arpit Shrivastava PGP 2011-13, IIM Bangalore

Page 1

Assumptions Entry cost plays no role in making pricing decisions. Market is homogenous. Consumers make their purchase decisions based on the consumer surplus. They buy if the consumer surplus is zero or positive. If both firms offer same prices, consumers are indifferent between the firms products.

Judo Strategy for Entrant The best strategy for the entrant firm is to target a particular market share such that the incumbents best response is to serve the non targeted segment only. Also it is important that the targeted consumers perceive more value in the entrants product, thus the pricing decisions of the entrant should lead to more consumer surplus for them. This is simultaneously possible for the firm if it follows Judo Strategy. Game 1: (a) Each buyer has the willingness to pay $200 for one unit of either the incumbents or entrants product and (b) both incumbent and entrant have a unit cost of $100 of serving the buyers. Entrants Strategy Non targeted customers will always be offered the zero consumer surplus price i.e. $200 by the incumbent. After the pricing decisions are made by the entrant, the incumbent can either grab the complete market share by charging a price little less than Pe or just keep the non targeted customers. For entrants judo strategy to be successful, the profit for incumbent should be more in case of serving the non targeted customers than serving the complete market. Mathematically it can be expressed as, (200-100)(100-t) > = (Pe - -100)(100), which gives the relation, Pe <=200 -t + Entrants Profit can be expressed as t*( Pe -100), the maximum value of Pe for it is 200 t + So Entrants Profit = t*(200-t-100) (Ignoring for calculations) The value of t that maximizes its profit is t = 50, which gives Pe = 150 The best strategy for the entrant in this case is to target 50 customers and offer them a price, $150. Game 2: (a) Each buyer has the willingness to pay $200 for one unit of incumbents and $160 for one unit of the entrants product and (b) the incumbent has $120 unit cost and entrant have a unit cost of $80 of serving the buyers. Arpit Shrivastava PGP 2011-13, IIM Bangalore Page 2

Entrants Strategy Non targeted customers will always be offered the zero consumer surplus price i.e. $200 by the incumbent. After the pricing decisions are made by the entrant, the incumbent can either grab the complete market share by charging a price little less than (40+Pe) or just keep the non targeted customers. $40 is the extra amount, the customer is willing to pay to buy the incumbents product to that of entrants product. For entrants judo strategy to be successful, the profit for incumbent should be more in case of serving the non targeted customers than serving the complete market. Mathematically it can be expressed as, (200-120)(100-t) > = (40+ Pe - -120)(100), which gives the relation Pe <= 160 + - 0.8*t Entrants Profit can be expressed as t*(Pe -80), the maximum value of Pe for it is 160 0.8*t + So Entrants Profit = t*(160-0.8*t-80) (Ignoring for calculations) The value of t that maximizes its profit is t = 50, which gives Pe = 120 The best strategy for the entrant in this case is to target 50 customers and offer them the price, $120. Game 3: (a) Each buyer has the willingness to pay of $200 for one unit of incumbents and the entrants product and (b) the incumbent has $120 unit cost and entrant have a unit cost of $80 of serving the buyers. Entrants Strategy Non targeted customers will always be offered the zero consumer surplus price i.e. $200 by the incumbent. After the pricing decisions are made by the entrant, the incumbent can either grab the complete market share by charging a price little less than Pe or just keep the non targeted customers. For entrants judo strategy to be successful, the profit for incumbent should be more in case of serving the non targeted customers than serving the complete market. Mathematically it can be expressed as, (200-120)(100-t) > = (Pe - -120)(100), which gives the relation Pe <= 200 + - 0.8*t Entrants Profit can be expressed as t*(Pe -80), the maximum value of Pe for it is 200 0.8*t + So Entrants Profit = t*(200-0.8*t-80) (Ignoring for calculations) The value of t that maximizes its profit is t = 75, which gives Pe = 140 The best strategy for the entrant in this case is to target 75 customers and offer them the price, $140. Arpit Shrivastava PGP 2011-13, IIM Bangalore Page 3

Game Analysis The profit for both incumbent and entrants, and the consumer surplus is summarized in the following table Game t Pe Per unit cost for Entrant 100 80 80 Per unit cost for Incumbent 100 120 120 Entrants Profit 2500 2000 4500 Incumbents Profit 5000 4000 2000 Consumer Surplus 2500 2000 4500

1 2 3

50 50 75

150 120 140

Initially incumbent completely enjoyed $10,000 as profit, but with the entry of the second firm, $10,000 was split as profits for both the firms and consumer surplus. Initially with incumbent as the only player, the consumer surplus was zero, but the entry of the second firm has lead to rise in consumer surplus in each of the games. The consumer surplus is representing the value added by entrant in each of the games. The entrants profit in each of the games is the maximum it can make in that game and it is equal to the consumer surplus, the value added by entrant, in the respective games. The entrants profit is highest in game 3 and it can be attributed to its low per unit cost. In game 2, although entrant has a lower cost, but the customers are willing to pay a premium of $40 for incumbents product.

Arpit Shrivastava PGP 2011-13, IIM Bangalore

Page 4