How should the incumbent behave?

1. Hjemmeside til Konkurransestrategi (2003), Fagbokforlaget How should the incumbent behave? SOL 310 – Competitive strategy Lars Sørgard Co-opetition, ch. 6-7 (see http://mayet.som.yale.edu/coopetition/index2.html) Judo strategy, ch. 8 (see http://www.judostrategy.com/) Konkurransestrategi

2. Today’s topic • Incumbent’s strategic decisions • Deter an entrant? • If accommodation, how to behave? • Strategic commitment • Direct effect • Strategic effect • How to signal an aggressive response? Konkurransestrategi

3. SUMO strategies • If you are a dominant firm, how to respond to entry? • What to do before entry? • What to do after entry? • But what is the incumbent’s goal? • High market share? • In conflict with max profits, or not? • Short run versus long run? Konkurransestrategi

4. 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 Konkurransestrategi

5. 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 Stage 1: Strategic commitment Stage 2: Meet in the market place Competition Konkurransestrategi

6. Why an irreversible 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 • ….. Konkurransestrategi

7. But is it credible? • Two requirements • It is not in your own interest to reverse the decision after you have seen your rival’s 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 Konkurransestrategi

8. Strategic commitment:Two kinds of effects • Direct effect Irreversible decision Change rival’s future behaviour • Strategic effect Change rival’s future behaviour Change own future behaviour Irreversible decision Konkurransestrategi

9. Strategic commitment: Direct effect • Incumbent’s decision has a direct effect on the potential entrant’s profit • Two kinds of direct effects • Raising rivals’ costs • Reducing demand for rivals’ products Irreversible decision Change rival’s future behaviour Konkurransestrategi

10. 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? Konkurransestrategi

11. 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 • Accept higher wages? - Can hurt a rival more than you, if he is more labour intensive • Asymmetric standards? • Norsk Hydro in Norway: fertilizers • Standard that is tailormade to Norsk Hydro, and not tailormade to BASF Konkurransestrategi

12. 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 Konkurransestrategi

13. 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 Konkurransestrategi

14. Red. demand cont.: Acquisition • Who wins the aquisition battle? Incumbent Entrant ? ? Retailer 1 Retailer 2 CONSUMERS • Incumbent owns Retailer 1 • Will incumbent acquire Retailer 2? Konkurransestrategi

15. 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 • Incumbent’s max payment: M.- D  I • Entrant’s max payment: D  E Konkurransestrategi

16. 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 > 2D • This condition is always met • Monopolyprofit 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 Konkurransestrategi

17. 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? Konkurransestrategi

18. 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 Konkurransestrategi

19. 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 • $ 600.000 in bonus • AOL icon on the Windows desktop Konkurransestrategi

20. Strategic commitment: Strategic effect Change rival’s future behaviour Change own future behaviour • Commitment to change your own behaviour in the future • When it is observed, the rival’s best choice is to change its own behaviour • Would like to soften the rival’s behaviour • Deter him from entering, or • Encourage him to act less aggressively after entry Irreversible decision Konkurransestrategi

21. 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 Konkurransestrategi

22. 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 don’t 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 Konkurransestrategi

23. 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 rival’s incentive to act aggressively • A device to dampening competition • Risky: What if your rival actually triggers competition? • Then firms end up competing very aggressively Konkurransestrategi

24. 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 Konkurransestrategi

25. 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 Konkurransestrategi

26. Fighting against entrant:Market segmentation • A dominant firm’s 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? Konkurransestrategi

27. Fridstrøm 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 anti-competitive in a setting with a dominant, incumbent carrier and smaller potential entrants Konkurransestrategi

28. 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) Konkurransestrategi

29. Repeated interaction • In a one shot game, a prisoner’s 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 firm’s interest to set high rather than low price Konkurransestrategi

30. 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 share in the short run (2) Price cutting would trigger a price war after deviation • If (1) dominates, the firm would deviate and we are back to the prisoner’s dilemma • When I deviate, all other firm deviate • The outcome would be static Nash equilibrium Konkurransestrategi

31. The trade off Deviation Profits • When is the gain from deviating small? • Is there anything the firms can do to make the gain small and thereby promote collusion? GAIN Collusion LOSS Competition Time Konkurransestrategi

32. 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? Konkurransestrategi

33. How to assure a rapid response? • 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, but are you willing and able to retaliate? Konkurransestrategi

34. 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 Konkurransestrategi

35. Danish concrete – what happened? Konkurransestrategi

36. 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 rival’s 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 Konkurransestrategi

37. How to achieve high prices? • 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 Konkurransestrategi

38. Cont.: How to achieve high prices? • 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 Konkurransestrategi

39. Cont.: How to achieve high prices? • 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) Konkurransestrategi

40. Lifting the fog – News in NY • New York Post ( ) and Daily News ( ) on Staten Island, New York in 1994: Prices 50 40 25 Time Konkurransestrategi

41. Petrol in Norway • 19.12.96 in Dagens Næringsliv (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 Næringsliv (Hydro/Texaco): • ’Irrespective of the action by others, Hydro/Texaco will set a price floor of 7.50’ Konkurransestrategi

42. 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 øre below our rivals.’ Konkurransestrategi