Strategic Commitments

OTHER DIMENSIONS OF COMPETITION

Thus far, our focus has been on quantity and price competition within oligopolies. In this final section, we briefly consider two other forms of competition: strategic commitments and advertising.

Strategic Commitments

A comparison of quantity competition and price competition yields a number of general propositions about the strategic actions and reactions of competing firms. Consider once again the case of symmetric firms competing with respect to quantities. A key part of that example was the way in which one firm’s quantity action affected the other’s—that is, how the competitor would be expected to react. If one firm (for whatever reason) were to increase its quantity of output, then the profit-maximizing response of the other would be to decrease its output. (Roughly speaking, the greater is one firm’s presence in the market, the less demand there is for the other.) Equation 9.3’s reaction function shows this explicitly. We say that the firms’ actions are strategic substitutes when increasing one firm’s action causes the other firm’s optimal reaction to decrease. Thus, the duopolists’ quantity decisions are strategic substitutes.

By contrast, price competition works quite differently. If one firm changes its price (up or down), the optimal response for the competing firm is to change its price in the same direction. (One firm’s price cut prompts a price cut by its rival. Conversely, if one firm raises its price, the other can afford to raise its price as well.) The earlier example of Bertrand (winner take all) price competition exhibits exactly this behavior. Similar (but less dramatic) price reactions occur when competition is between differentiated products. (Here, a price cut by one firm will attract only a portion of the other firm’s customers and so prompts only a modest price reaction.) We say that the firms’ actions are strategic complements when a change in one firm’s action causes the other firm’s optimal response to move in the same direction.

A comparison of competition between strategic substitutes and strategic complements leads to the following proposition.

In a host of oligopoly models, competition involving prices (strategic complements) results in lower equilibrium profits than competition involving quantities (strategic substitutes).

This result underscores the key difference between firm strategies under price competition and quantity competition. When firms compete along the price dimension, a rival’s lower price leads to the firm lowering its own price. In short, competition begets more competition. By contrast, under quantity competition,

a rival’s increase in output induces a lower quantity of output by the firm itself. In this sense an increase in output deters a competitive response. In general, price competition is more intense than quantity competition (which is self-limiting). The upshot is that equilibrium price setting tends to lead to lower profits for the firms than equilibrium quantity setting.

Of course, it is important to keep this result in perspective. Price competition is not always destructive; the particular equilibrium outcome depends, as always, on underlying demand and cost conditions. (For instance, Check Station 3 displays favorable demand conditions in which equilibrium behavior leads to high prices.) In other words, the comparison of equilibrium outcomes requires holding other factors constant. (End-of-chapter Problems 9 and 10 provide a good example of this.) The result does suggest an interesting strategic message. Frequently, firms find themselves surveying any number of strategic dimensions—price, quantity, advertising, and so on— and have the opportunity to “pick their battles.” Most oligopoly models suggest that it is wise to avoid price competition (because this involves strategic complements) and to compete on quantity and advertising (where both involve strategic substitutes).

COMMITMENTS Suppose a firm is about to engage in quantity competition but also faces an earlier decision. For instance, the firm has the opportunity to invest in a new production process that has the advantage of lowering its marginal cost of production. Should the firm commit to this process investment? A complete answer to this question depends on anticipating the investment’s effect on the subsequent quantity competition. Looking just at the firm’s own behavior, we know that the lower marginal cost induces a higher optimal output. But the strategic effect also matters. Because the firms’ quantities are strategic substitutes, an increased output by the first firm will induce a lower output by the rival. This reduction in competing output further spurs the firm to greater output and increases its profitability. (Check Station 1 provides a good example of these equilibrium output effects.) In short, the original commitment to invest in capacity might well be profitable exactly because of its strategic effect on competitor behavior.

Economists Drew Fudenberg and Jean Tirole have explored the general principles underlying this example.10 When the subsequent competition involves strategic substitutes, a tough commitment by one of the firms will advantageously affect the ensuing equilibrium. Here, tough denotes any move that induces an increase in the firm’s own output and (in turn) a decrease in the rival’s output. Making product quality improvements, increasing advertising

10See D. Fudenberg and J. Tirole, “The Fat-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look,” American Economic Review (1984): 361–366. An additional source is J. Bulow, J. Geanakopolos, and P. Klemperer, “Multimarket Oligopoly: Strategic Substitutes and Complements,” Journal of Political Economy (1985): 488–511.