Simplifying Price Determination by Using the Price Elasticity of Demand

218 Part III: Market Structures and the Decision-Making Environment

Figure 12-6: Preemptive strategy.

3. Your rival decides to expand by using backward induction.

Given you don’t expand, your rival earns $150,000 by expanding into your community, while the rival earns only $100,000 if it doesn’t expand.

And the bad news for you is your profit is only $25,000. You aren’t likely to enjoy this game, so how can you change it?

4. You engage in a preemptive strategy by renting a store location in your rival’s community for $10,000 a year.

This is how much you would have to pay if you decide to expand into your rival’s community. This changes the decision tree by lowering your profit by $10,000 in every situation you don’t expand because of the added expense you incur. It doesn’t change your expense if you do expand — you need the store. So in the decision tree in the lower panel, your profit for when both you and your rival expand doesn’t change — it remains $20,000. Your profit for when your rival expands but you don’t expand goes down by $10,000 from $25,000 to $15,000 because of the rent you pay on the unoccupied store front. Similarly, your profit if your rival decides not to expand goes down by $10,000 for the unoccupied store front, from $80,000 to $70,000.

5. Your rival uses backward induction.

If your rival doesn’t expand, the status quo continues. The profits are $100,000 for your rival and now only $70,000 for you.