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CHAPTER13AdvancedTopicsinBusinessStrategyChapterOutline•Limitpricingtoprevententry–Theoreticalbasisforlimitpricing–Limitpricingmayfailtodeterentry–Linkingthepre-entrypricetopost-entryprofits–Dynamicconsiderations•Predatorypricingtolessencompetition•Raisingrivals’costtolessencompetition–Strategiesinvolvingmarginalcost–Strategiesinvolvingfixedcosts–Strategiesforverticallyintegratedfirms•Pricediscriminationasastrategictools•Changingthetimingofdecisionsortheorderofmoves–First-moveradvantages–Second-moveradvantages•Penetrationpricingtoovercomenetworkeffects–Whatisanetwork?–Networkexternalities–First-moveradvantagesduetoconsumerlockin–Usingpenetrationpricingto“changethegame”13-2ChapterOverviewIntroduction•InChapter12weexaminedhowinformationanduncertaintyimpactedconsumers,firmsandmarkets.Wheninformationiscostlytoacquire,consumersandfirmsmustweightheexpectedbenefitandcostofacquiringinformation.•Chapter12alsoprovidedanoverviewofdifferentauctiontypesandintroducedoptimalbiddingstrategiesfordifferentinformationandauctionenvironments.•Chapter13analyzesstrategiesthatmanagerscanutilizetochangethebusinessenvironmentwiththeaimofenhancinglong-runprofits.–Limitpricingandpredatorypricingcanbeusedtoreducethenumberofcompetitors.–Anothercompetition-reducingstrategyinvolvesraisingrivals’fixedormarginalcosts.•ThesecondpartofChapter13focusesonprofitstrategiesthatchangethebusinessenvironmentbyalteringthetimingorsequenceofthedecisions.13-3ChapterOverviewMotivationforLimitPricing•Successfulbusinessesoftenleadstotheentryofnewcompetitorsintothemarketandthatadverselyaffectstheprofitsofexistingfirms.•Facedwiththatthreatamanagermayconsiderlimitpricing,whichisastrategywhereanincumbentmaintainsapricebelowthemonopolylevelinordertoprevententry.13-4LimitPricingtoPreventEntryTheoreticalBasisforLimitPricing:MonopolyPricing13-5LimitPricingtoPreventEntryPriceQuantityDemandMRMC𝑄𝑀𝑃𝑀ATC𝐴𝑇𝐶(𝑄𝑀)Profits𝑃𝑟𝑜𝑓𝑖𝑡𝑠=𝑃𝑀−𝐴𝑇𝐶𝑄𝑀×𝑄𝑀TheoreticalBasisforLimitPricing:MonopolyPricing13-6LimitPricingtoPreventEntryPriceQuantityDemandEntrant’sresidualdemandcurve𝑄𝐿𝑃𝐿AC𝑃=𝐴𝐶𝑄𝑃𝑀𝑄𝑀WhenLimitPricingMayFail•Underlimitpricing,theentrantwasassumedtohavecompleteinformationabouttheincumbent’sdemandandcosts.–Thestrategydidnot“hide”informationabouttheprofitabilityoftheincumbent’sbusiness.–Thelowpricechargedbytheincumbentdidnotprevententry;theentrantstayedoutbecauseitbelievedtheincumbentwouldproduceatleast𝑄𝐿,ifitentered.•Arevisedstrategyistosetthemonopolyprice,𝑃𝑀,andproducethemonopolyoutput,𝑄𝑀,andthreatentoexpandoutputto𝑄𝐿,ifentryoccurs.–This,however,isnotacrediblethreat;so,arationalentrantwouldfinditprofitabletoenteriftheincumbentsetsprice,𝑃𝐿.13-7LimitPricingtoPreventEntryEffectiveLimitPricing•Forlimitpricingtoeffectivelyprevententrybyrationalcompetitors,thepreentrypricemustbelinkedtothepostentryprofitsofpotentialentrants.13-8LimitPricingtoPreventEntryLinkingPreentryPricetoPostentryProfits•Commitmentmechanisms•Learningcurveeffects•Incompleteinformation•Reputationeffects13-9LimitPricingtoPreventEntryDynamicConsiderations•Eveniftheincumbentcanlinkpreentrypricetopostentryprofits,itmaybemoreprofitabletopermitentry.•Thepresentvalueofmaintainingmonopolystatusis:Π𝑀=𝜋𝑀+𝜋𝑀1+𝑖+𝜋𝑀1+𝑖2+𝜋𝑀1+𝑖3+⋯=1+𝑖𝑖𝜋𝑀•Entryfrommonopolytoduopolyprofits,where𝜋𝑀𝜋𝐷:Π𝑀𝐷=𝜋𝑀+𝜋𝐷1+𝑖+𝜋𝐷1+𝑖2+𝜋𝐷1+𝑖3+⋯=𝜋𝑀+𝜋𝐷𝑖•SinceΠ𝑀𝐷Π𝑀,entrywillharmtheincumbent.13-10LimitPricingtoPreventEntryDynamicConsiderations•Profitsundereffectivelimitpricing:Π𝐿=𝜋𝐿+𝜋𝐿1+𝑖+𝜋𝐿1+𝑖2+𝜋𝐿1+𝑖3+⋯=1+𝑖𝑖𝜋𝐿•Limitpricingisprofitablewhen:𝜋𝐿−𝜋𝐷𝑖𝜋𝑀−𝜋𝐿13-11LimitPricingtoPreventEntryConditionsforDynamicConsiderations•Theconditionsunderwhichlimitpricingisattractiveinclude:–Lowinterestrateenvironments–Monopolyandlimit-priceprofitsareclose–Duopolyprofitsaresignificantlylowerthanlimit-priceprofits.13-12LimitPricingtoPreventEntryDynamicConsiderationsInAction:Problem•BakerEnterprisesoperatesamidsizedcompanythatspecializesintheproductionofauniquetypeofmemorychip.Itiscurrentlytheonlyfirminthemarket,anditearns$10millionperyearbychargingthemonopolypriceof$115perchip.•Bakerisconcernedthatanewfirmmightsoonattempttocloneitsproduct.Ifsuccessful,thiswouldreduceBaker’sprofitto$4millionperyear.Estimatesindicatethat,ifBakerincreasesitsoutputto280,000units(whichwouldloweritspriceto$100perchip),theentrantwillstayoutofthemarketandBakerwillearnprofitsof$8millionperyearfortheindefinitefuture.–WhatmustBakerdotocrediblydeterentrybylimitpricing?–DoesitmakesenseforBakertolimitpriceiftheinterestrateis10percent?13-13LimitPricingtoPreventEntryDynamicConsiderationsInAction:Answer•WhatmustBakerdotocrediblydeterentrybylimitpricing?–Bakermust“tieitshands”topreventitselffromcuttingoutputbelow280,000unitsifentryoccurs,andthiscommitmentmustbeobservabletopotentialentrantsbeforetheymaketheirdecisiontoenterornotenter.•DoesitmakesenseforBakertolimitpriceiftheinterestrateis10percent?–Limitpricingisprofitableif$8−$40.1$10−$8.–Theinequalityholds,therefore,limitpricingisprofitable.13-14LimitPricingtoPreven