I. Two types of strategic behavior

A. Noncooperative strategic behavior - actions of a firm that is trying to maximize its profits by improving its position relative to its rivals.



B. Cooperative strategic behavior - actions that make it easier for firms in an industry to coordinate their actions and to limit their competitive responses. It does not necessarily imply that the firms have an explicit agreement to undertake the behavior.

II. Noncooperative Strategic Behavior

A. Conditions



1. Advantage - firm must be able to act before its rivals



2. Commitment - firm must have a credible threat - rivals must believe that its strategy is rational in the sense that it is in the firm's best interest to continue to employ it.



B. Predatory Pricing - lowering price in order to drive its rivals out of business, scare off potential entrants and then raise its price when rivals exit the market.



1. Identical firms -



A. does not make sense since there is no advantage - (assumes that there are no sunk costs and there is free entry and exit.)



B. Ways to avoid predation



1. Merge with predating firm



2. Make contracts with buyers



3. Reduce output during times of predation to minize harm



2. One firm has an advantage



A. Preliminary considerations



1. reasons for advantages - Size - a larger firm may be thought to have an advantage but this has not proven true



2. Legal standard - Areeda Turner rule - real standard should be price below SRMC - A-T use AVC instead of SRMC.



B. Spatial Preemption - firms sell spatially differentiated products and prevent entry by not allowing enough profit "between" brands to enter. (Example: Breakfast cereals and grocery stores)



1. Price Promotions - give away samples



2. Learning by doing - DVD; new electronics



3. Competitive behavior - don't we want lower prices



C. Limit Pricing - firm sets its price and output so that there is not enough demand left for another firm to profitably enter. (Simple demand curve and declining AC curve)



1. Doesn't make sense for identical firms



2. If one firm has an advantage, it can make threats credible if it commits itslelf to output by building excess capacity.



D. Investments to lower production costs



1. Investing in R&D - example - 2 periods and two firms with identical initial cost functions. Period 1 firm A is a monopolist. Firm B can enter in the second period. Firm A can invest in R&D in period 1 to reduce its cost in period 2. Demand curve Q=12-p. Initial cost is $1 fixed and $6 constant marginal cost. R&D costs $7.01 in period 1 and lower MC in period 2 by $2. Assume cournot duopoly for output if entry occurs.

No R&D; Enter; period 1

Monopoly MR=MC; MR=12-2q=6; q=3; p=9; profit = TR-TC=27-(1+18)=8

period 2

cournot; profit=pq1-TC=(12-q1-q2)q1-(1+6q1)=12q1-q1²-q1q2-1-6q1

dprofit1=12-2q1-q2-6=0

3-1/2q2=q1

by symmetry, q2=3-1/2q1; q1=q2=2; p=8; profit =16-13=3

total profit = 8+3=11

No R&D; No Entry; period 1

Same ; profit =8; period 2 is the same as period 1

profit = 16

R&D; No Entry; period 1

same but cost increases 7.01; profit = 0.99

period 2

monopoly MR=MC; 12-2Q=4; q=4; p=8; profit = 32-(1+4*4)=15

total profit = .99+15=15.99

R&D; Enter; period 1

same as above; profit = 0.99

period 2

firm A cournot; profit = pq1-TC=(12-q1-q2)q1-(1+4q1)

dprofit1 = 12-2q1-q2-4=0

4-1/2q2=q1

firm b cournot profit = pq2-TC=(12-q1-q2)q2-(1+6q1)

dprofit2 = 12-q1-2q2-6=0

3-1/2q1=q2

4-1/2(3-1/2q1)=q1

5/2+1/4q1=q1

5/2=3/4q1

q1=10/3

q2=4/3

P=12-10/3-4/3=(36-14)/3=22/3

profit1 = TR-TC=22/3*10/3-(1+4(10/3))=(220-9-120)/9=91/9=10.11; total =.99+10.11=11.10

profit 2 = TR-TC = 22/3*4/3-(1+6(4/3))=(88-9-72)/9=7/9=0.77

So, firm won't invest in R&D if there is no threat of entry. If there is entry, then the firm will use R&D as a strategic behavior to lower its costs in period 2 and maximize its profits.

E. Raising rivals costs



1. Direct methods - interfering with rivals' production or selling methods - blow up their plant



2. Interference through government regulation



3. Production of complements - camera and film/ computer parts / make plug/film different.



4. Raise switching costs - make it impossible to use computer programs written for one program to work on another.



5. Raising wages - support union activities



F. Advantages of entrants - can use new technology - local telephone competition

III. Cooperative Strategic Behavior - Practices that Facilitate collusion

A. Uniform Prices - same price is offered to all customers. This makes price cutting "expensive. Most favored nation clause - means that firm guarantees that buyer is paying the lowest price charged by the seller to any customer

B. Penalty for price discounts - entitles customer to any discounts offered over the next year.

C. Advance Notice of price change - cars,telephone

D. Information Exchanges

E. Delivered pricing - price including shipping is based on the distance from a specified location but not the location of the seller

1. advantages - cheaters can't cut freight charge to hide price cuts

2. disadvantages - no way to divide market