Chapter 3

Strategic Behavior
Industrial Organization and Prices
Master in Economics and Finance
Universidad de Navarra

Outline of the chapter

o
o
o
o

The Stackelberg model

Endogenous number of firms
Entry deterrence
Asymmetric information

Strategic behavior
o Think of a situation where firms make their
choices sequentially. This may provide one
of the firms with some sort of advantage
o Strategic behavior refers to the fact that
the firm that moves first might modify its
strategy choice to influence the other firms
decision
o Simplest example is sequential choice of
capacities in a duopoly: The Stackelberg
model
3

Strategic behavior
o In the Stackelberg model, there are two
firms that choose capacities. Firm 1
chooses first, and then firm 2 chooses after
observing firm 1s choice
o Analyze the game by backward induction:
n Analyze firm 2s problem first
n Analyze firm 1s problem taking into account
that its choice of q1 affects firm 2s choice of q2

o Capacity has a commitment value

4

Strategic behavior
o Firm 2s problem is:

max(a b(q1 + q2 ))q2 cq2

q2

giving rise to firm 2s reaction function:

a c bq1
q2 (q1 ) =
2b

Strategic behavior
o Firm 1 incorporates firm 2s reaction
function into its problem:

a c bq1

max a b q1 +
q1 cq1
q1
2b

and hence, the equilibrium is:

ac
q1 =
2b

ac
q2 =
4b

(a c)2
1 =
8b

(a c)2
2 =
16b
6

Strategic behavior
o Firm 1 chooses the optimal point on firm
2s reaction function
q2

qpc
Firm 1s reaction function

qm
Firm 1s isoprofit curve
Firm 2s reaction function

qC

qm

qpc

q1
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Strategic behavior
o The closer the isoprofit to the horizontal
axis, the greater firm 1s profit
q2

qpc
Firm 1s reaction function

qm
Firm 1s isoprofit curves
Firm 2s reaction function

qC

qS =qm

qpc

q1
8

Strategic behavior
o Notice that firm 1s choice is off its reaction
function
o This requires irreversibility in its capacity
choice
o Commitment value is related with
irreversibility: sunk costs have the greatest
commitment value

Outline of the chapter

o
o
o
o

The Stackelberg model

Endogenous number of firms
Entry deterrence
Asymmetric information

10

Endogenous number of firms

o So far, limited number of firms
n Implicit assumption: entry prohibitively costly

o If this assumption is abandoned

n No entry and exit barriers other than entry
costs.
n Firms enter as long as profits can be reaped.

o Two-stage game
1. Decision to enter the industry or not
2. Price or quantity competition

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Endogenous number of firms

o Properties of free entry equilibria
o Setting
o Industry with symmetric firms and equal entry cost
e> 0
o If n active firms, profit is

(n), with

(n) > (n+1)

o Number of firms under free entry, ne such that

(ne ) - e >0

and

(ne +1)

- e< 0

o e ne
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Endogenous number of firms

o Linear Cournot model with free entry
o P(q) = a bq, Ci(q) = cq + e, c < a
o Equilibrium: q(n) = (a c)/[b(n+1)]
o Business-stealing effect: q(n+1) < q(n)
n Free-entry equilibrium
2

1# ac &
(a c)
e
(n ) = % e ( e = 0 n + 1 =
be
b $ n + 1'
e

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Endogenous number of firms

n Social optimum (second best)
2

n(n + 2) " a c %
W (n) = n (n) + CS(n) =
$
' ne
2b # n +1 &
(a c)
W '(n ) = 0 ( n +1) =
be

14

Endogenous number of firms

( n + 1)3

( n + 1)2

(a c)2
be

n*

ne

Result: Socially excessive entry

15

Outline of the chapter

o
o
o
o

The Stackelberg model

Endogenous number of firms
Entry deterrence
Asymmetric information

16

Entry deterrence
o Analyze now strategic capacity choice by an
incumbent firm that faces potential entry
o Let demand be p = a - bq. The cost of one
unit of capacity is c.
o There is an entry cost F
o Timing:
n Firm 1 chooses production
n Firm 2 decides wheter to enter and production if
it enters
n Price is determined, and profits are realized
17

Entry deterrence
o Consider three possibilities
n Blockaded entry: F is high enough so that firm 1
may ignore the threat of entry
n Deterred entry: intermediate values of F. Firm 1
expands its capacity to prevent firm 2 from
entering
n Accomodated entry: low values of F. Firm 1 lets
firm 2 in and behaves as a duopolist

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Entry deterrence
o If entry is blockaded, firm 1 chooses a
capacity level equal to the monopoly
output, and produces up to capacity
o F is so high that firm 2 does not find it
profitable to enter, even though firm 1 acts
as a monopolist
o In order for this to be the case:
2

(a c)
F
16b

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Entry deterrence
o For lower realizations of F, if the incumbent
behaved as a monopolist, it would induce
profitable entry
o Firm 1 might want to expand capacity to
deter firm 2 from entering
o From firm 2s problem, firm 2 will enter as
long as:
2

(a c bk 1 )
2 (k1 ) =
>F
4b
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Entry deterrence
o Hence, the minimum value of k1 that
prevents firm 2 from entering is:

a c 2 bF
k =
b
d
1

which yields profits

a c 2 bF
2 bF
=

d
1

21

Entry deterrence
o Thus, firm 1 will deter entry as long as:

2
a c 2 bF

2 bF (a c) bF (a c) 2 2

b
8b
8

and for lower values of F, firm 1 will

accomodate, earning Stackelberg profits

22

Entry deterrence
o Here is an example of deterred entry
q2

qpc

qm

Firm 2s reaction function

qd

q1
23

Outline of the chapter

o
o
o
o

The Stackelberg model

Endogenous number of firms
Entry deterrence
Asymmetric information

24

Asymmetric information
o We consider asymmetric information on firms
costs
o The unobserved cost is revealed by firms
actions
o Under price competition, firms might have
incentives to signal a high cost
o However, signalling a low cost (charging a low
price) may deter entry
o Analyze Milgrom and Roberts model:
asymmetric information may be exploited by an incumbent firm to set
a limit price that will preclude entry
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Asymmetric information
o Now an incumbent chooses its price prior to
entry by a potential entrant
o The incumbent knows its cost of
production. The entrant knows the
probability p of the cost being low
o Timing:
n Period 1: incumbent chooses price p1 and the
entrant chooses whether to enter
n Period 2: active firm or firms choose second
period prices
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Asymmetric information
o In period one, the incumbent earns
monopoly profits which are a function of
price and cost type.
I
I
o Denote it by H and L, which result
from setting pH and pL
o The first-period price may be
informative about the incumbents cost
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Asymmetric information
o That is, pricing pH when the incumbent
is a high cost type fully reveals its type
to the entrant
o If, as seems likely, the entrant does
better against a high cost firm, then the
incumbent increases probability of entry
by setting pH
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Asymmetric information
o The incumbent may wish to set pL even
when it is a high cost firm to fool the
entrant and prevent entry.
o If entry occurs there is a duopoly. Denote
profits by DHI , DLI , DHE and DLE .
o It happens that DLI > DHI > 0 and assume
that entry is profitable only if the
E
E
incumbents cost is high: DH > 0 > DL
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Asymmetric information
o Given the previous discussion, consider
these two possibilities:
n Separating equilibrium: types choose
different strategies, pH and pL accordingly.

n Pooling equilibrium: both types choose the

same strategy, always pL

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Asymmetric information
o Each of these possible equilibria are
examples of a Perfect Bayesian Equilibrium

The entrant has prior expectations in a

stochastic setting. It observes the first-period
price and updates expectations with the logic
of Bayes rule.
To be part of a NE, no firm must have an
incentive to deviate from its particular strategy
given the strategy of the rival.
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Asymmetric information
o Prior beliefs are p of facing a low cost
incumbent. Denote updated beliefs by p
o Suppose that the entrant adopts the
following strategy to update its beliefs:
n If first period price is less than or equal to pL
then p=1
n If first period price is greater than pL then p=0

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Asymmetric information
o Suppose that it enters when its expected
profit based on those beliefs exceeds zero.
o That is, entrant believes that first-period
price fully reveals its type.

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Asymmetric information
o Knowing this, the incumbent considers how
to price in period one. Note that it could
price following his type or not, but certainly
it won't set a price above pL if it is a lowcost firm!
o It would not maximize profits and would
invite entry, given the entrant's beliefs.

34

Asymmetric information
o Suppose the incumbent prices according to
type.
o If so, the entrants beliefs in previous slides
are consistent.
o For this to be a NE no firm must deviate
from this strategy

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Asymmetric information
o Suppose instead that the incumbent always
sets pL . Then, according to entrants
beliefs this strategy will prevent entry.
o By setting pL in period one (not optimal)
the incumbent suffers a loss of IH IH ( pL )
o However, because it prevents entry, second
period profit increases by IH DHI
o Therefore, a necessary condition to price
according to type is that
I
H

I
H

I
H

I
H

( pL ) D

[C1]
36

Asymmetric information
o It is indeed a sufficient condition to have a
separating equilibrium.
o Incumbent prices high(low) when its costs
are high(low) and the entrants updating
scheme is consistent with what is observed
and leads to a profit maximizing decision.

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Asymmetric information
o What happens if [C1] is not met?
o The incumbent has an incentive to always
pricing pL.
o But now entrant always observes pL and
updating beliefs as above no longer makes
sense.

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Asymmetric information
o Observing the price does not yield any
information about incumbent's type. So it
sticks to its priors. The entrant will enter as
long as expected profit is positive:
E
L

E
H

pD + (1 p) D > 0

[C2]

o However, if [C2] is satisfied the incumbent

will set pH even though [C1] is met: entry
would certainly occur. Therefore, not [C2]
is a necessary condition for a pooling
equilibrium
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Asymmetric information
o Summing up,
n A necessary condition for a separating
equilibrium is, for the incumbent, that the
loss be greater than the gains (of
pretending), which is an IC condition for the
high-cost type.
n A necessary condition for a pooling
equilibrium is that the entrant's expected
profit be negative.

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Asymmetric information
o An example.
o Demand is q=v p under monopoly;
o Denmands in case of duopoly are,

qi = (v pi (1 + ) + p j )
2
2
2

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Asymmetric information
q Take v= 5, =1, cH =1, cL =0, cE =0.
o Then,

pH = 3, = 4, pL = 2.5, = 6.25
I
H

I
L

o And

DHI = 1.82, DLI = 3.13, DHE F = 0.15, DLE F = 0.08

42

Asymmetric information
o It can be checked that [C1] does not hold,
since

IH IH ( pL ) IH DHI
4 - 3.75 < 4 - 1.82

q So incumbent wouldnt price according to

typebut if priors are p=1/2 then

1
1 E
E
( DH F ) + ( DL F ) = 0.07
2
2

q With priors p=2/3 a pooling equilibrium can

be characterized
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Entry deterring strategies

o Another example is predatory pricing.
o A firm using the predatory pricing
strategy sets the price below short run
marginal cost with the expectation of
recouping the losses when the rival exits
o Limit pricing is directed at potential
entrants while predatory pricing is directed
at entrants who have already entered
o Example page 657 Church-Ware. More in
Motta, chapter 7.
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