' $ Competitive Strategy: Week 11 Reputation and Cooperation Simon Board & % Eco380, Competitive Strategy 1 ' $ Why is Reputation Useful? ² Cooperation between competitors { Prices. { New product design, standards, market development, lobbying, advertising. ² Complementors. { New products. ² Suppliers { Reputation not to hold up suppliers. ² Buyers { Reputation for high quality product ² Entrants { Reputation for toughness to ¯ght entry. & % Eco380, Competitive Strategy 2 ' $ Tacit Cooperation over Prices ² Tacit cooperation { Cooperation without explicit agreements. { Agreements not enforceable by court. ² Key ingredients { Shared interest as basis for cooperation. { Mechanism for punishment. { Mechanism for recovering from mistakes. ² Warning: price ¯xing is illegal! { Cooperation on R&D or advertising is not. & % Eco380, Competitive Strategy 3 ' $ Cases ² American Airlines circa 1990 { After deregulation there were frequent price wars { Interpretation: AA was trying to teaching rivals how to cooperate. { But bankrupt rivals had no interest in playing along. ² 1955 Automobile Price War { 45% more cars were produced in 1955 than 1954 or 1956. ² Joint Executive Committee { Classic railroad cartel from 1880s { Involved in price war 1/3 of the time & % Eco380, Competitive Strategy 4 ' $ Punishment ² Is punishment severe enough to deter defection? { Price war may need to be very long. { AA couldn't punish bankrupt airlines su±ciently. ² Is punishment credible? { Punishment is costly, but must be optimal after defection. { Idea: get punished for not punishing. { Problem: must avoid renegotiation. ² When to punish? { Is deviation deliberate or by mistake? { Threshold rule: market share cannot rise above 20%. { Ambiguous rule: prob of price war rises with market share. & % Eco380, Competitive Strategy 5 ' $ Recovery ² How do you recover from mistakes? ² Could punish for ¯xed time ² Make punishment ¯t the crime { Deeper and longer price war for larger transgression. & % Eco380, Competitive Strategy 6 ' $ A Mathematical Example ² Market { Two ¯rms A and B { Costs zero { Demand p = a ¡ q. ² Bertrand competition { Prices pA = pB = 0 and pro¯ts ¼A = ¼B = 0. ² Joint pro¯t maximisation 2 { Prices pA = pB = a=2 and both industry pro¯ts ¼M = a =4. & % Eco380, Competitive Strategy 7 ' $ Example II ² Suppose both ¯rms agree to set pA = pB = a=2. { Problem: incentive to deviate. ² Punishment { If cheat then we revert to Bertrand competition. ² Grim strategy for i 2 fA; Bg { If no-one has ever defected ! set pi = a=2. { If someone has defected ! set pi = 0. ² Is this a subgame perfect equilibrium? Will any ¯rm defect? & % Eco380, Competitive Strategy 8 ' $ Example III ² Game { Each round ¯rms choose pi { Discount rate ±. ² Suppose no-one has defected. { If don't defect get ¼M =2 forever. { If defect get ¼M today, but get punished for rest of time. { Hence defect if ¼ ¼ ¼ ¼ ¼ > M + ± M + ±2 M + ±3 M + ::: M 2 2 2 2 1 ¼ = M 1 ¡ ± 2 { Defect if ± < 1=2. & % Eco380, Competitive Strategy 9 ' $ Example IV: Some Questions ² What are the shared interests of ¯rms A and B? ² When do ¯rms enter punishment phase? ² How is defection punished? ² Is \Nash reversion" punishment credible? ² Can ¯rms recover from punishment phase? ² What if ¯rms could renegotiate in punishment phase? Would this increase payo®s? & % Eco380, Competitive Strategy 10 ' $ Problems with Tacit Collusion ² Lots of ¯rms { More reason to deviate. { If there are N ¯rms in Bertrand model, need ± ¸ (N ¡ 1)=N. { Harder to detect defection. { Harder to coordinate punishment. ² Small or failing ¯rms { If ¯rms di®er they may have di®erent incentives to defect. { Design punishments to stop those most likely to deviate. { Or ignore these ¯rms. ² Entry { Successful cooperation promotes entry and free{riding. & % Eco380, Competitive Strategy 11 ' $ Problems cont. ² Competition on other dimensions { If cooperate on advertising, then price competition may increase. ² Demand Variation { When demand unusually high, have large incentive to deviate. { Could increase punishments. { Could create exemptions and not risk price war. ² Di®erentiated Products { Makes price comparisons harder. { Also changes nature of competition. ² Reaction Time { Long reaction time like low ±, so cooperation harder to sustain. & % Eco380, Competitive Strategy 12 ' $ Problems cont. ² Environmental Randomness { Suppose market price of oil falls. { Is this random, or did OPEC country defect? ² Communications problems { How specify exactly what type of adverts are allowed? ² Need in¯nite period game. { Suppose game lasts for 10 periods. { Then cheat in period 10 for sure. { Thus cheat in period 9 for sure. { Thus cooperation cannot be sustained! ² When ¯xing prices: Confessions & % Eco380, Competitive Strategy 13 ' $ Problem: Allocating Production in a Cartel ² Two ¯rms A and B with costs cA(q) = 0 and cB(q) = 1. { Linear demand, q(p) = a ¡ p, where a ¸ 2 ² Bertrand production { A prices at pA = 1. Pro¯ts: ¼A = (a ¡ 1) and ¼B = 0. ² Joint pro¯t maximising problem 2 { A prices at pA = a=2. Pro¯ts: ¼A = a =4 and ¼B = 0. ² If transfers are possible { Nash bargaining: A pays B half of gain from cooperation. { Problem: Firm may misrepresent costs. ² If transfers not possible { B gets some production, although this is ine±cient. & % Eco380, Competitive Strategy 14 ' $ Aiding Tacit Cooperation ² Industry associations { Lobby government, help advertising, provide information to consumers. ² Published price lists { Makes pricing more transparent. { Example: General Electric's electric turbines. ² Most{Favoured Customer clauses { Commit not to make secret price cut to an individual. ² Exclusive territories { Make market sharing rule transparent. & % Eco380, Competitive Strategy 15 ' $ Aiding Tacit Cooperation cont. ² Preannouncing future price increases { Reduces lag time. { Example: because of fuel prices, prices will rise by 10% ² Incremental Steps { If don't trust rivals take small steps. ² Multi-market contact { Easy to trust if interact in many markets: more possibilities for punishment. ² Unused capacity { Increases threat of punishment. & % Eco380, Competitive Strategy 16 ' $ Reputation for Quality ² A ¯rm chooses quality q 2 fqL; qH g at cost fcL; cH g. { Utility of buyer equals q ¡ p. { Buyer only sees quality after they purchase good. ² One shot game { Firm produces q = qL and charge price p = qL. ² Repeated game. { Buyer: pays qH if ¯rm chosen qH in past, else pays qL. { Firm chooses high quality if 1 ± (q ¡ c ) ¸ (q ¡ c ) + (q ¡ c ) 1 ¡ ± H H H L 1 ¡ ± L L & % Eco380, Competitive Strategy 17 ' $ Reputation to Fight Entry ² Entry Game 1. Entrant E chooses to enter or not. 2. If E enters, incumbent I chooses to ¯ght or not. (uI ; uE) = (200; 0) E doesn't enter = (75; 75) if E enters and I acquiesces = (¡50; ¡50) if E enters and I ¯ghts ² One period game: E enters and I acquiesces. ² Repeated game (\chain store game") { E's strategy: enter if I has ever acquiesced. { I can credibly ¯ght if ¡50 + 200 ±=(1 ¡ ±) ¸ 75=(1 ¡ ±) & % Eco380, Competitive Strategy 18 ' $ Assignment ² Read \The Real Lesson of Enron's Implosion" by McAfee (on website). ² Why is Enron's collapse puzzling? ² What was Enron's role in the gas market? ² Why is trust important in this market? ² Can you think of other ¯rms in the trust business? & % Eco380, Competitive Strategy 19.