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business model by innovating; but failure to innovate will open the door to newcomers, leaving the incumbent without any business.

Economists have long debated whether opportunities for innovation reinforce or undo market concentration. Even disruptive technologies do not necessarily spell doom for incumbents. Digital phones by Sony, Canon, and others may have crippled Kodak and Polaroid, but former landline communications companies like Verizon and France Telecom (under the Orange brand name) have remained highly successful mobile service providers. In a systematic study of 73 industries in the United Kingdom, Paul Geroski and R. Pomroy found that innovation was usually deconcentrating, although the effect was slow and inconsistent.35 We will return to the topics of innovation and disruption in Chapter 11.

Learning and Industry Dynamics

The BCG growth/share matrix described in Chapter 2 suggests that firms can use the learning curve to secure and maintain market leadership. But in new work on the learning curve, David Besanko and his coauthors point out that learning is not enough for a firm to maintain its dominant position. The reason is that trailing firms also move down the learning curve, and as all firms learn, the gap in knowledge, and the associated gap in production costs, shrinks. Yet many firms in knowledge-intensive industries remain market leaders for a long time. Intel is a good example; AMD has produced enough microprocessor chips over the years that it should have moved far down the learning curve, yet it continues to lag behind Intel.

How do these leaders stay in front? David Besanko and colleagues suggest that the answer lies in a combination of learning and forgetting.36 When a market leader expands its output, it does move down the learning curve. Perhaps more importantly, it can steal business from its smaller rivals, limiting the extent of their learning. If their rivals lose business, then they may actually forget some of the skills they had already accumulated, so that their production costs increase. In other words, firms may pursue aggressive growth strategies not so much to move down their own cost curves through learning, but rather to drive up rivals’ costs through forgetting. Using simulations to model how firms might respond to one another in the presence of these dynamics, Besanko et al. show that many markets can experience sustained periods of concentration as the dominant firm exploits this learning/forgetting strategy.

CHAPTER SUMMARY

Competitive dynamics evolve over time. Microdynamics refers to the unfolding of competition among a small number of firms. Macrodynamics refers to the evolution of overall market structure.

Firms can gain an advantage over rivals by making strategic commitments, which are are hard-to-reverse decisions that alter the strategic decisions of rivals.

A firm’s commitments can lead competitors to make decisions that are advantageous for the firm making the commitment.

The impact of strategic commitments depends on the nature of product market competition. The concepts of strategic complements and strategic substitutes are

Questions • 253

useful for characterizing how commitment affects competition. When reaction functions are upward sloping, actions are strategic complements. When reaction functions are downward sloping, actions are strategic substitutes.

In a two-stage setting, in which a firm makes a commitment and then the firm and its competitors choose tactical actions, the desirability of the commitment depends on whether the actions are strategic substitutes or complements and whether the commitment makes the firm tough or soft.

Flexibility gives the firm option value. A simple example of option value occurs when the firm can delay an investment and await new information that bears on the investment’s profitability.

Firms engaged in oligopolistic competition can increase profits through competitive discipline. Strategies such as “tit-for-tat” pricing can facilitate coordination but are difficult to implement.

Coordinating on the “right price” is difficult for several reasons. Coordination must be tacit. Firms may disagree as to what constitutes the “right price” and how to “divide the market.” Misreads and misjudgments can trigger price wars.

Market structure affects the sustainability of cooperative pricing. High market concentration facilitates cooperative pricing. Asymmetries among firms, lumpy orders, high buyer concentration, secret sales transactions, volatile demand, and price-sensitive buyers make pricing cooperation more difficult.

Practices that can facilitate cooperative pricing include price leadership, advance announcements of price changes, most favored customer clauses, and uniform delivered pricing.

A market’s macrodynamics determine its long-run structure. The number of firms is positively correlated with demand and negatively correlated with the minimum efficient scale.

Firms in consumer goods-intensive markets can endogenously increase the minimum efficient scale through branding. Many consumer goods markets feature two or three dominant branded companies and many smaller niche players.

Disruptive technologies are unexpected innovations that transform a product’s benefits or costs of production. Large incumbents may be reluctant or unable to meet the challenges of disruptive technologies.

Firms pursuing a learning strategy can steal business from smaller rivals, limiting the extent to which those rivals also learn. This can give learning firms a permanent market advantage.

QUESTIONS

1.Why are the Cournot and Bertrand models considered static? What aspects of real world behavior might be missing in static models?

2.What is the difference between a soft commitment and no commitment?

3.Zellers and Wal-Mart are two of Canada’s largest retailers. To reflect the strong position of the Canadian dollar, each firm is considering lowering prices on some goods in Canadian stores. The following table displays the payoffs for each firm associated with lowering prices (or not), given the other firm’s decision:

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If given the opportunity, how much would Zellers be willing to spend for the right to move first?

4.Explain why prices are usually strategic complements and capacities are usually strategic substitutes.

5.Use the logic of the Cournot equilibrium to explain why it is more effective for a firm to build capacity ahead of its rival than it is for that firm to merely announce that it is going to build capacity.

6.Consider a monopoly producer of a durable good, such as a supercomputer. The good does not depreciate. Once consumers purchase the good from the monopolist, they are free to sell it in the “secondhand” market. Often in markets for new durable goods, one sees the following pricing pattern: The seller starts off charging a high price but then lowers the price over time. Explain why, with a durable good, the monopolist might prefer to commit to keep its selling price constant over time. Can you think of a way that the monopolist might be able to make a credible commitment to do this?

7.Indicate whether the strategic effects of the following competitive moves are likely to be positive (beneficial to the firm making them) or negative (harmful to the firm making them).

(a)Two horizontally differentiated producers of diesel railroad engines— one located in the United States and the other in Europe—compete in the European market as Bertrand price competitors. The U.S. manufacturer lobbies the U.S. government to give it an export subsidy, the amount of which is directly proportional to the amount of output the firm sells in the European market.

(b)A Cournot duopolist issues new debt to repurchase shares of its stock. The new debt issue will preclude the firm raising additional debt in the foreseeable future, and is expected to constrain the firm from modernizing existing production facilities.

8.Which of the following are examples of real options?

(a)A basketball team owner delays signing a star free agent to a one-year contract, preferring to wait and see if his team is in contention for a championship.

(b)A hockey team owner delays building a new stadium because interest rates are high and may soon come down.

(c)A student delays studying for a final exam because she expects to soon receive a job offer that would make her grade point average moot.

(d)Blockbuster Video delays entering the DVD rental market (see Chapter 6 for more details on the DVD rental market).

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9.Love Never Dies is a musical playing in London’s West End. The producers are planning a limited run of the musical in Sydney next year. The producers expect that it will cost $1.7 million to mount the play in Sydney. They know that the show could be a hit or a flop. If the show is a hit in Sydney, the producers expect that the resulting revenue (from tickets, merchandise, etc.) will be $3.1 million. If the play is not a hit in Sydney, the producers expect $2.2 million in revenues. In either case, the producers would wish to go ahead with the show. What is the most the producers should be willing to pay a market research firm to help them figure out whether or not the show will be a hit?

10. An article on price wars by two McKinsey consultants makes the following argument.37

That the [tit-for tat] strategy is fraught with risk cannot be overemphasized. Your competitor may take an inordinately long time to realize that its actions can do it nothing but harm; rivalry across the entire industry may escalate precipitously; and as the “tit-for-tat” game plays itself out, all of a price war’s detrimental effects on customers will make themselves felt.

How would you reconcile the views expressed in this quote with the advantages of tit-for-tat claimed in this chapter?

11. How does the revenue destruction effect (see Chapter 5) affect the ability of firms to coordinate on a pricing equilibrium?

12. Firms operating at or near capacity are unlikely to instigate price wars. Briefly explain.

13. Suppose that you were trying to determine whether the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game. What realworld data would you want to examine? What would you consider to be evidence of tit-for-tat pricing? How can you distinguish tit-for-tat pricing designed to sustain “collusive” pricing from competitive pricing?

14. It is often argued that price wars may be more likely to occur during low-demand periods than high-demand periods. Are there factors that might reverse this implication? That is, can you think of reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high demand) than during busts (low demand)?

15. Why does Sutton draw a distinction between endogenous sunk costs such as advertising and other sunk costs such as capital investments?

16. Why does Sutton’s model apply so well to consumer goods markets? Does Sutton’s model describe the structure of other markets?

ENDNOTES

1Strategic commitments should be distinguished from tactical decisions—including pricing and short-term production decisions—that are easily reversed and whose impact persists only in the short run.

2Avinash Dixit and Barry Nalebuff’s excellent book, Thinking Strategically: The Competitive Edge in Business, Politics and Everyday Life, New York, Norton, 1991, contains a thorough discussion of credibility and the commitment value of various competitive moves.

3This quote comes from Luecke, R., Scuttle Your Ships Before Advancing and Other Lessons from History on Leadership and Change for Today’s Managers, Oxford, Oxford University Press, 1994, p. 23.

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4Differentiating the equation for 1 with respect to Q1 and equating to zero yields 55 2 Q1 2 10 5 0, or Q1 5 45.

5The terms strategic complements and strategic substitutes were introduced by Bulow, J., J. Geanakopolos, and P. Klemperer, “Multimarket Oligopoly: Strategic Substitutes and Complements,” Journal of Political Economy, 93, 1985, pp. 488–511.

6Reaction functions in the Bertrand model with undifferentiated products do not concern us because a firm always wants to slightly undercut its rival’s price. Hence, throughout this section, we confine our attention to Bertrand industries where firms’ products exhibit some degree of horizontal differentiation.

7This example draws from “Loblaw’s Store of the Future Ready,” Business and Industry, 21(15), September 20, 2004, p. 11; “Loblaw Companies Limited,” Hoovers Guide, http://premium.hoovers.com.

8The concepts of tough and soft commitments were introduced by Bulow, J., J. Geanakopolos, and P. Klemperer, “Multimarket Oligopoly: Strategic Substitutes and Complements,” Journal of Political Economy, 93, 1985, pp. 488–511.

9Fudenberg, D., and J. Tirole, “The Fat-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look,” American Economic Review, 74(2), 1984, pp. 361–366.

10This example is based on Ghemawat, P., “Commitment to a Process Innovation: Nucor, USX, and Thin Slab Casting,” Journal of Economics and Management Strategy, 2, Spring 1993, pp. 133–161.

11The term real is used in order to distinguish this general concept of an option from the narrower notion of a financial option. There are many kinds of financial options. An example is a call option on a share of stock. The owner of a call option has the right, but not the obligation, to buy a share of stock at a prespecified price.

12See Dixit, A. K., and R. S. Pindyck, Investment under Uncertainty, Princeton, NJ, Princeton University Press, 1994, for pioneering work on real options. M. Amaran and N. Kulatilaka,

Real Options: Managing Strategic Investments in an Uncertain World, Boston, Harvard Business School Press, 1999, present a very accessible applied introduction to the analysis of real options.

13The following examples draw from “Exploiting Uncertainty: The Real-Options Revolution in Decision Making,” Business Week, June 7, 1999, p. 118.

14Basic derivations may be found in Dixit and Pindyck, Investment under Uncertainty. 15Kellogg, R., “The Effect of Uncertainty on Investment: Evidence from Texas Oil Drilling,”

NBER Working Paper No. 16541, November 2010.

16Chamberlin, E. H., Monopolistic Competition, Cambridge, MA, Harvard University Press, 1933, p. 48.

17The weekly discount rate is the annual discount rate divided by 52. Thus, 0.10/52 5 0.002.

18This calculation easily follows by using the formula for the present value of an annuity, which is discussed in the appendix to the Economics Primer. Specifically, for any amount C and discount rate i, C/(1 1 i)1C/(1 1 i)2 1... 5 C/i. Thus, the preceding calculation simplifies to 0.2308 1 0.1154/0.002 5 57.93.

19Former Kellogg student Andrew Cherry developed this example. 20Axelrod, R., The Evolution of Cooperation, New York, Basic Books, 1984.

21The term folk theorem is used because, like a folk song, it existed in the oral tradition of economics long before anyone got credit for proving it formally.

22Perhaps the best work on this subject remains Thomas Schelling’s The Strategy of Conflict, Cambridge, MA, Harvard University Press, 1960.

23Kreps, D. M., A Course in Microeconomic Theory, Princeton, NJ, Princeton University Press, 1990, pp. 392–393.

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24Garda, R. A., and M. V. Marn, “Price Wars,” McKinsey Quarterly, 3, 1993, pp. 87–100. 25A marketing allowance is a discount offered by a manufacturer in return for the retailer’s

agreement to feature the manufacturer’s product in some way.

26Dixit, A., and B. Nalebuff, Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life, New York, Norton, 1991.

27An open order price is the price the manufacturer charges any buyer who orders the additive.

28Morton, F.S., “The Strategic Response by Pharmaceutical Firms to the Medicaid MFC Rules,” RAND Journal of Economics, 28(2), 1997, pp. 269–290.

29Wolfram, R., and R. Wolfram, “Most Favored Nations Clauses under the Spotlight,” Wolters Kluwers Antitrust Connect Blog, January 6, 1011. http://antitrustconnect. com/2011/01/06/%E2%80%98most-favored-nations%E2%80%99-mfn-clauses-under-the- spotlight-u-s-v-blue-cross-blue-shield-of-michigan-%E2%80%94-when-might-otherwise- competitively-neutral-or-procompetitive-mfn-clauses/Accessed August 2, 2011.

30FOB stands for “free on board,” so the FOB price is the seller quotes for loading the product on the delivery vehicle. If the seller pays the transport charges, they are added to the buyer’s bill, and the net price the seller receives is known as the uniform net mill price.

31A third type of pricing is basing point pricing in which the seller designates one or more base locations and quotes FOB prices from them. The customer chooses a basing point and absorbs the freight costs between the basing point and its plant.

32Blair, J., Economic Concentration: Structure, Behavior, and Public Policy, New York, Harcourt Brace Jovanovich, 1972.

33Sutton, J., Sunk Costs and Market Structure, Cambridge, MA, MIT Press, 1991.

34Christensen, Clayton M., The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail, Boston, Harvard Business School Press, 1997.

35Geroski, P., and R. Pomroy, “Innovation and the Evolution of Market Structure,” Journal of Industrial Economics, 38(3), 1990, pp. 299–314.

36Besanko, D., Doraszelski, U., Kryukov, Y., and M. Satterthwaite, “Learning-by-Doing, Organizational Forgetting, and Industry Dynamics,” Econometrica, 78(2), 2010, pp. 453–508.

37Garda, R. A., and M. V. Marn, “Price Wars,” McKinsey Quarterly, 3, 1993, pp. 87–100. Quote from pp. 98–99.