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Econ 368
Competitive Strategy Game Paper
12/15/09
Investigation of Tacit Collusion and Predatory Capacity Building
in the CSG
This combined paper seeks to address two key issues that arose in the
Competitive Strategy Game. The first part will deal the potential for tacit
collusion in Market C, whereas the second part will focus on the predictions
of the predatory capacity building model for Market D. Both parts also
PART 1
Introduction
number of problems can arise in the real world, leading to cases in which
much more transparency than might be available in real life. Though all of
the firms may have had roughly the same amount of information about their
competitors that would be available in a real world situation, the end of the
Market Characteristics
breed collusive behavior. There are many factors that can push firms in one
way or the other and many of them will be touched on in this section.
1
δ= (h)(1 + g)
r
(1 + )
f
that firms are more patient and long-run potential gains will appear more
short-term gains become more attractive for the firm. Therefore, a higher
that the interest rate r = .02, a relatively low number, f = 1 because the
interest rate was “per period” and firms interacted every period (about 3
times per week), and the market growth (g) averages .381 for all 21 periods
will definitely last at least 20 rounds and only then did uncertainty of market
continuation arise. With this knowledge, for periods 1 through 20, we can
1
δ= (1)(1 + .381) = 1.354
.02
(1 + )
1
1 1
δ= ( )(1 + .381) = .451
.02 3
(1 + )
1
From these estimates, we can conclude that because is so high for the
first 20 rounds, patience would not be a limiting factor when it came to firms
colluding in Market C. On the other hand, because δ is much lower for the
21st round, it would appear that collusion would be difficult in the final period
note that this is just an estimate and the value we used for g would most
likely be slightly off depending on each firm’s opinion of expected growth for
the future.
2.) Barriers to entry can have a large effect on the attractiveness of collusion
high without having to worry about the risk of a competitor entering the
2 Market continuation was determined using a random number generator and the game
would end with any value below .333.
market and undercutting them. In the case of the CSG, all costs can be
considered barriers to entry because firms have a general idea of where they
stand compared to other firms. Thus, if they find that they have costs above
entry cost. It also had a mean cost for one unity of capacity that was $500
with a standard deviation of $100, or 20% of the mean capacity cost. Finally,
its mean marginal cost was $20 with a standard deviation of $2 or 10% of
the mean marginal cost. Knowing that the entry cost was a one-time cost,
reason would imply that these firms would consider the potential differences
in capacity costs as the largest barrier to entry, while only being mildly
capacity cost would be multiplied many times over with the production of
feasible levels of capacity (averaging 261 for the first period in Market C) and
with the constant capacity rebuilding because its maximal useful life was
only 3 periods, giving firms with lower costs a much greater advantage.
Therefore, firms with higher capacity costs would be expected to stay out of
the market, while firms with lower costs would be expected to enter the
market. Supporting this theory is the immediate entry of the two lowest cost
of Market C,” information suggests that brand loyalty was certainly strong in
3 Refer to Table 1
this market. According to the table, a firm would actually lose revenue if they
Firm 1 after a 20% price cut by Firm 2. Assuming that there are 2 firms in the
market and they are both pricing at $200 to begin with, we calculate that
that the demand is the same as given.5 However, even if Firm 2 were to
lower their prices 20% to 160, they would not capture enough of the market
= $33,700.8, a full $2,000 lower than when they were pricing the same as
the other firm and splitting the market. Because consumers appear
loyalty plays a large role in Market C, creating a barrier to entry for firms
3.) The number of firms in the market can effect whether collusion is more
Trigger for this example we see that as the number of firms increases,
4 Refer to Table 2
5 Refer to Table 2
This equation implies that as the number of firms increases, the patience
each firm must have increases as well. Therefore, firms must be much more
Market C assuming that there are 4 firms in the market (the average for all
larger the cost asymmetries, the harder it is for collusive behavior to take
hold because collusion is relatively less profitable for the low-cost firm and
punishment will not be as severe. Therefore, when colluding, the low cost
firm must have a high because short-term gains will be more lucrative for
them than for the other firms. Though the cost asymmetries appear to be
fairly large when we look at Table 1 (e.g. 381 to 462 for the two leading
only appear through period 15 and after that they tend to converge.6 This
could mean one of two things: either increases in demand allowed firms to
prices high for the final 6 periods with the other firms. Therefore, we can
conclude that though cost asymmetries were rather large in Market C, they
may not have had a strong effect on whether firms acted collusively or
competitively.
5.) A few final characteristics can also affect the attractiveness of collusion in
This is because it facilitates fast retaliations for defectors and does not allow
defectors to enjoy their potential benefit for too long. Because capacity could
use in just 1, it would appear strategy change were quite easy in Market C.
collusion. Firms knew the price charged by competitors every period, their
competitor’s capacity at the end of each period, and the overall and the
because of the initial data given to each team at the start of the game. With
all of this information, coordination between firms would have been much
normally have had the effect of making collusion more difficult for firms in
the market. However, because market sales each period were known,
companies should have been able to estimate the growth rate of the
previous period and how much demand the other firms were able to capture.
Analysis
tacit collusion may not have been at play despite the strong market
characteristics in favor of it. Though prices certainly were far above costs,
features of collusion.
to entry. The main issue stems from the fact that brand loyalty was so strong
that the pricing behavior of firms did not really matter. This can be seen in
the data in Table 2 and Graph 1.7 As we can see from Graph 1, increases in
price are mirrored by increases in the quantities sold and Table 2 implies
that even with vast price differences, consumers were not willing to change
brands. Applying the same logic shown in Part 2 of the previous section for a
firm trying to enter the market and uncut price, this strong brand loyalty
would have made defecting a poor decision. Total revenues would have been
7 Refer to Table 2 and Graph 1
lower overall because the defecting firm would not have been able to make
there was no incentive to ever defect. Furthermore, prices of one firm did not
greatly affect the performances of the other firms in the market. This implies
that firms did not have control over collusive so the group of firms that would
have been colluding were left without a carrot that they could control. Thus,
we see that there was no carrot or stick possessed by the majority of firms
did is Part 3 of the previous section, then prices would at least have begun to
looking at Graph 2 we can see that prices are constantly rising, pointing to
behavior can be explained with brief consideration of the data and market
producing goods that did not serve as very good substitutes to each other.
This made it seem as if each firm was in its own independent market where
they were able to raise prices very high because of the inelastic demand and
growth rate of the market. However, as we can see from the pricing data, the
8 Leland and I discussed the fact that it was neither collusive nor competitive and came to
this decision on 12/14.
market prices were nowhere near as high as they could have been.
Furthermore because every firm was pricing far below where they could
have been, the firm with the lowest comparable price still was not able to
should have adopted a different strategy. Though Matt and I believed that
we would have been able to gain more of the market by keeping our prices
lower than the other firms, we should have considered that doing this had
the effect of bringing in less revenue than pricing higher as figures from Part
2 above show. Perhaps if other firms had been pricing much higher (in the
thousands) this would have been a productive strategy, but this was not the
we were to replay the game with the current information we have now, our
strategy would have led us to keep prices much higher than they were and
Table 1
Marke Marke Market
tA tC D
Costs Costs Costs
Tea Capacit M Capacit M Capacit
m Entry y C Entry y C Entry y MC
25000 20
OXC 45668 757 58 77949 531 20 7 2093 3
25000 24
MDD 50007 799 57 80017 615 19 5 3185 2
25000 16
CCP 53848 914 54 74190 381 21 7 4379 7
25000 18
JWC 51342 892 56 68375 532 21 3 2993 7
25000 18
BXH 51335 1020 56 76050 548 15 2 4155 1
24999 19
TSM 57896 550 59 67794 462 16 5 2819 6
25000 20
Mean 50000 800 50 70000 500 20 0 4000 0
Std.
Dev. 3000 150 10 10000 100 2 5 1000 20
Table 2
Approximate Market Share of Firm 1
Price Differential of Firm 2 -20% -15% -10% -5%
Price of Firm 1
100 45% 46% 47% 49%
200 41% 46% 49% 49%
300 40% 44% 44% 47%
Graph 1
PART 2
The second part of the paper will examine our situation in Market D
and the extent to which the predatory capacity building model can make
we could take advantage of our low marginal cost to produce over capacity
figured there would not be that much competition, causing prices to stay
high. We did not anticipate that all other players’ capacity costs in market D
would be much lower than ours. The other firms we were competing against
had capacity that was a standard deviation less then the mean (and more
than $1000 less than ours). We thought we could produce at over capacity
and take advantage of our low marginal cost. We had the lowest marginal
cost in market D which was more than one and a half standard deviations
influence their decision to enter the marketplace. The model also asserts
that incumbent firms should consider the effects of their capacity building on
entry deterrence when they are deciding how much capacity to build. I will
look at how effectively firm JWC used predatory capacity expansion to deter
firms that didn't enter market D and also the rationality in our decision to
Expansion Model in the CSG, I will explain the general idea behind the model.
profit. The Predatory Capacity Expansion Model shows how a firm could
potentially increase their capacity in order to deter entry from another firm
advantage over an entrant that has to build capacity and pay costs to
has made a commitment to fighting entry since it will be easier for a firm to
rationalize overproducing if it has already paid the capacity costs. The two
key assumptions in this model are ex post credibility and ex ante rationality.
Firm one's best response obviously depends on their costs. This means
player one's best response will change when player one produces beyond k1.
Firm two's best response function is also shown in the above graph. Both
firms will produce the quantity at which the intersection of the best response
functions. The key to effective predatory conduct is that firm two has to pay
a sunk cost to enter. The amount of capacity held by the incumbent firm
obviously doesn't matter if player two's sunk costs are either so great that
entry is never rational or so low that even maximum capacity will not deter
entry. If sunk costs are within a certain range though, entry can be deterred
by increasing capacity.
I will make several assumptions that will make this model a little
different from the CSG. First of all, I will treat it as a two period game in
which the sunk cost is the sunk cost divided by expected total periods. The
250007/21 = 11905
We will be firm 2, the entrant, and for the sake of simplicity we will assume
that MDD did not enter and firm one will be JWC, the incumbent. I will use
The marginal cost for our firm will be the same as the game: 167. Since we
didn't know firm one's marginal cost we will use the expected marginal cost:
200. Capacity cost will be per period like sunk cost with the resale value of
used capacity factored in. Also we will use our capacity cost and the
expected capacity cost of firm 1. This means that our capacity cost per unit
is:
(1-.3)(4379)/6 = 511
(1-.3)(4000)/6 = 467
Our first task is to find the maximum capacity firm one will charge and
see if maximum rational capacity building can deter entry. First, we must
find the equilibrium where the incumbent firm has no capacity constraints.
q2 = 395
q1 = 2183
P(Q) = 1833 - .343(2183+395) = 949
From this result, we can find the expected profit for each firm:
Would JWC consider purchasing that much capacity? JWC monopoly profits
from deterring entry must be larger than their Stackleberg leader profits if
they allow entry. The Stackleberg leader produces the monopoly quantity
and then the other firm best responds model making monopoly profit:
If Entry is Deterred
If Entry is Allowed
monopoly q1 = (1833 – 200 – 467) = 1700
2(.343)
indeed try and to build capacity to keep us out of the market as long as entry
“As long as entry for our firm isn't inevitable” is the key phrase there.
We should also make sure that capacity building can actually effect our entry
strategy. If our sunk costs are higher than our Stackleberg follower profits,
then we should theoretically never enter. If our sunk cost is so low that even
firm one's maximum capacity will not deter us from entry, then we will
always enter and it would be irrational for firm 1 to try and stop us. To find
Since we will make positive profits even when firm one is producing
maximum capacity and since positive profits are greater than a payoff of
zero for not entering the market even when firm one builds the maximum
capacity, our firm should enter market D every time shown by the chart on
the right.
So we weren't complete idiots for entering market D. There was a potential
for profits.
If our sunk costs had been in between S1 and S2, then it might have been in
firm one's best interest to build capacity to deter entry by firm 2. See charts
below:
There are a few things that happened in the CSG that our model
doesn't account for and some of these omissions could help explain why
what seemed like a good idea turned out to be a colossal failure. First of all,
our entry made the market an oligopoly of three firms not a duopoly. This
will decrease all firms’ profits in the marketplace. The predatory capacity
building may not be worth the profit from being in a duopoly. Furthermore,
firms can produce goods without purchasing capacity. A firm like ours with
low marginal cost and high capacity costs could produce over capacity at
less cost than it would be to produce at capacity (up to a point). This means
that our firm would not be as deterred by predatory capacity building as the
been wary about entering market D because it had the potential to reach a
Bertrand equilibrium (where each firm's price is equal to the highest firm's
marginal cost). The market is set up with a huge incentive to undercut your
price for JWC was $1200 and the price for MDD was $1150. On paper this
undercut JWC by around 5%, they took 98% of the market. We should have
(such as the one dollar deductions in periods 9-11). At the minimum price,
our cost was probably at or below marginal cost – certainly not enough to
reentered the next period so we had to pay the sunk cost twice. The
Bertrand model predicts that it only takes two firms to reach perfect
competition. The CSG seemed to follow that prediction pretty well because
all firms were pretty near our marginal cost. If we had taken this into account
when making our decision to enter market D, we would have realized that
the price would drop to around $600 and it was not profit maximizing to
enter unless we had the lowest cost and could take all of the market. Since
Predicts