Chapter 13: Advanced Topics In Business Strategy Answers To Questions And Problems

Chapter 13: Advanced Topics in Business Strategy Answers to Questions and Problems 1. a. The horizontal distance between DM and DR: 16 units. b. Note that P = $200, AC = $180, and Q = 16, so profits are ($200 - $180)(16) = $320. c. Yes; if it can credibly commit to a higher output (e.g., 24), and it will earn even greater profits.

2. a.

Π

MD

L b. Π =

M

=π +

πD $ 15 =$ 30+ =$ 180 million . i 0.1

( 1+i i ) π =( 1+0.10.1 )( $ 16) =$ 176 million. Since this is less than the profits L

obtained if entry occurs, the firm should not engage in limit pricing. 3. a. The simultaneous-move equilibrium is (No, No), and Player 1 earns $300 in this equilibrium. By going first player 1’s best strategy is to commit to “Yes.” Player 2’s best response would be “Yes”, and thus Player 1 would earn $400 by going first. The maximum amount Player 1 should pay for going first is this $100 (or perhaps $99.99). Importantly, this assumes Player 1’s move is observed by Player 2 before Player 2 makes her decision. b. Player 2 gets $400 when Player 1 goes first, compared to $525 when they move at the same time. Thus, player 2 would be willing to pay up to $125 to keep player 1 from moving first. 4. a. A network with 12 users provides 12(12 - 1) = 132 potential connection services. b. No. Revenues will be $1,800 which is well short of the $10,000 in costs. c. Yes. With 132 connection services, each consumer will pay $1,584 to join the network. Since there are 12 consumers, total revenues are $19,008. This exceeds the $10,000 required to build the network. d. The number of potential connection services increases by 24 to 156.

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5. a. Two examples include tactics that raise distribution costs or increase the price of inputs. b. No. The benefits stem from the fact that by raising rivals’ costs, your rivals reduce their own output. This tends to increase the market price, thus permitting you to expand your own output (and market share) to enjoy higher profits. 6.

a.

Firm 2 will enter so Firm 1 earns profits of $300,000.

b. By eliminating the fee, Firm 2 still has an incentive to enter. Firm 1 earns profits of $340,000. c. The $300,000 increase in the medallion fee eliminates Firm 2’s incentive to enter (since its profits are -$100,000 upon entry). Since Firm 2 does not enter, Firm 1 earns profits of $400,000. d. The optimal change is an increase of $200,000 (or perhaps $200,000 plus one cent). This makes it unprofitable for Firm 2 to enter. Firm 1 earns profits of $500,000. e. Yes; the city gets a higher fee which is probably good politically. 7. a. Since last year’s market price was $15, it follows that Firm 1 produced 1 million units last year (since P = 20 – 5Q = 15 implies Q = 1 million). For this to be the profitmaximizing price (MR = MC), it follows that 20 – 10Q = MC. Since Q = 1, Firm 1’s marginal cost was $10 last year – the same as Firm 2’s marginal cost this year. Thus, it would appear that Firm 1’s marginal cost has declined over time due perhaps to learning curve effects. b. At the current market price of $15, total market output is 1 million. Thus, each firm sells 0.5 million units. Each firm’s fixed costs are $2 million. Firm 1’s profits are thus ($15 - $2)(.5) - $2 = $4.5 million and Firm 2’s profits are ($15 - $10)(.5) - $2 = $0.5 million. c. Firm 1’s profits would increase to ($10 - $2)(2) - $2 = $14.0 million and Firm 2’s profits would fall to -$2.0 million. d. Yes. The monopoly price is $11 when MC = 2, so Firm 1 would like to raise the price from $10 to $11. e. No; it is not pricing below its own marginal cost. 8.

Your best strategy is to preempt Tom by committing to enter the market before he has a chance to commit to an upscale steakhouse. If you can credibly and publicly commit to your strategy before he commits to his strategy, his best response will be to open a low-cost steakhouse. You will earn $100,000 in profits as opposed to the zero profits you would earn by not entering. 2

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9.

It would make sense to consult legal counsel prior to implementing predatory pricing strategies. It is often illegal to price below cost to drive out rivals only to raise prices in the future.

10.

If you get to move third, you can guarantee yourself $10 by naming an integer that is larger than those named by the first and second mover. If you move second, you know the third mover will name the highest integer, but you can guarantee yourself $5 by naming an integer lower than the one named by the first mover. If you move first, the second mover will name an integer lower than yours and the third mover will name an integer higher than yours, so you earn nothing.

11.

Penetration pricing. There are likely significant network effects in this industry, so you will need to gain a critical mass of consumers for your product to provide sufficient value to ultimately charge a profitable price.

12.

This pattern of pricing is consistent with predatory pricing, which is illegal under the Sherman Antitrust Act. However, it is not illegal to lower prices to meet competition, so the observed pricing is also consistent with competitive behavior. It is often difficult to establish that a firm priced below marginal cost. For the case of an airline, this is even more problematic. At one extreme, one might argue that the marginal cost of putting one more passenger on an existing flight is zero. At the other extreme, one might argue that it is the marginal cost of adding another flight rather than another passenger that is relevant.

13.

No. Profits are negative from limit pricing, but strictly positive otherwise. Regardless of the interest rate and the timing of profit flows (at the start or the end of each period), Way Cool, Inc. would earn less by limit pricing than by permitting entry.

14.

Not necessarily. Due to network effects, penetration pricing was probably optimal for many companies. To the extent that there is consumer lock-in, the number of hits could be a good proxy for the long-run profitability of a site once a firm begins to increase prices above the penetration pricing level. Ultimately, however, hits must translate into profits in order for such companies to survive.

15.

As shown in the text, strategies that raise the cost of potential entrants – even when doing so raises the costs of incumbents – can lead to less entry and higher profits for incumbents. To the extent that such practices raise costs, they may be motivated out of self-interest (to limit entry) rather than a concern about social welfare.

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16.

First, note that the monopoly price is P = $325, the monopoly output is Q = 150,000, and monopoly profits are $11,250,000. (To see this, note that MR = 400 – 0.001Q and MC = $250, so setting MR = MC and solving yields these results). Second, notice that with the subsidy the firm’s average cost curve is constant at $250 per unit. Thus, to prevent entry via limit pricing, Barnacle would have to price its product at $250. Doing so would yield zero profits. A better strategy for Barnacle is to lobby to eliminate the $4 million in subsidies while committing to produce its current (monopoly) level of output. This would reduce Barnacle’s profits to $7.5 million per year. However, the (inverse) residual demand curve for entrants would be P = 325 – 0.0005Q after Barnacle commits to the monopoly output. Solving MR = MC yields the entrant producing 75,000, a market price of $287.50, and profits for the entrant of –$1,187,500, making it unprofitable for an entrant to enter the market.

17.

Such a premium might be justified when there are significant network externalities. In this case, adding one more customer to a network of n customers increases the number of potential network connections by 2n. To the extent that a brokerage company is a two-way network that benefits from having a network of customers that can be matched as buyers and sellers, there is a potential business rationale. Whether this justifies a premium of $100 per customer is an entirely different matter and subject to some debate.

18.

Notice that Argyle earns profits from both the sale of wool and sweaters. To the extent that overall profits are enhanced by selling both, it is rational to do so. However, if selling wool to other downstream suppliers reduces its overall profits, it may be able to increase its profits by raising rivals’ costs, a vertical price squeeze, or vertical foreclosure.

19.

Unfortunately, your best option is to accept the offer. If you don’t, your rival will purchase the machine. If you purchase the machine, your profits are $20 - $23 = -$3 million. This is better than the -$9 million you will earn if your rival has an opportunity to buy the machine.

20.

Each bank and its ATMs can be viewed as a star network: the bank is the hub and ATMs are consumer access points. An agreement that expands the number of ATMs (access points to a hub) and creates value to each consumer and value to each bank.

21.

The first behavior may be an attempt to foreclose the chip market by preventing a customer from buying chips from competitors. The second behavior may be an instance of predatory pricing—selling below cost in order to eliminate a competitor. Both behaviors could be at odds with antitrust law.

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22.

The manager should be extremely cautious in this situation. Lower prices to speed the exit of a rival could be construed as predatory pricing by antitrust authorities, and could trigger action under the Sherman Antitrust Act. Ignoring this important legal constraint, to determine whether this strategy would be profitable, the manager should verify that the present value of the benefits from speeding up the rival’s exit exceeds the up-front cost of doing so. There is no guarantee that predatory pricing actually increases the present value of profits. Another consideration for the manager is to assess the likelihood of another airline entering the market after the rival exited. If a new rival quickly entered the market to service the same routes, it is unlikely that there would be any gain from predatory pricing.

23.

The statement is false. A firm can lessen competition by raising its rival’s fixed costs. When an action is taken that raises its rival’s fixed cost, the entrant must now determine the profitability if it decides to pay the fixed cost and enter. The new fixed costs, if set appropriately, can deter a rival from entering the market and enable the incumbent to maintain profitability.

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