New Entry to the Market and Game Theory
Consider a firm that is contemplating entry into a new market.What contribution, if any, can game theory make to the analysis of the economic viability of such a strategy? Refer to the critical time line, reaction functions and the Nash premise in your reply.Introduction: Management decisions lack the full information, so they are bounded rationality decisions.
Companies are players in a game, and the game dimensions are defined in terms of geography and product. So any new entrant will try to enter the market he will play a game in two dimensions geography and product (example Apple entering the smart phone market).
The entrant has to decrease its price from the market price so he can guarantee a portion of the market share (steal market share from the incumbents). The incumbents have two options: either to compete or to accommodate. We introduce the principles of the Game Theory as follows: Critical Timeline: Management can observe behaviour as signals and as patterns in the signals. Patterns do emerge in the observed behaviour, patterns in price movements or patterns to do with achieving growth through acquisition. The patterns create a critical timeline (CTL) of observed actions and as the CTL unfolds, it reveals a strategy.
The new entrant has to observe these patterns and management types of the incumbents over a considerable CTL, to forecast their reaction to his entry, is it going to be a competitive or accommodative reaction. Incumbents for sure faced previous entrants with some kind of reaction when they tried entry, the new entrant can study and analyze this CTL to forecast the possible reaction of the incumbents especially that firms management usually they repeat their type over and over again especially when it succeeds.
Reaction functions: When the new entrant will enter the market, the reaction from the incumbents will be either passive (Cournot model) to balance the quantity in the market, i. e. to adjust his output so that both firms produce the market need and they both sell all their output so that the price will not go down and the profit does not go down as well. Or, the reaction will be aggressive (Bertnard model) by cutting the price of the new entrant and accordingly start a price war. 1) Cournot model reaction function:
In this case, the incumbent will think this way: since the entrant entered the market and already chose a price. If I choose to cut price and enter a price war we will all end up in loss (profit is zero), so the best reaction is to choose an output that will guarantee me a profit-maximizing given the entrant’s output. So after the entrant enters, the incumbent will decrease his output as per the Reaction Function diagram shown below. Because the incumbent thinks if he increases his output then the market price will go down and profit will go down with it.
Knowledge of the market here is crucial, to reach this profit-maximizing condition the market has to be in which firms must make production decisions in advance, are committed to selling all their output. This might occur in the majority of production costs are sunk or it is costly to hold inventories, in this environment firms will do all what it takes to sell all its output. The Cournot equilibrium here makes positive profit for the firms. 2) Bertnard model reaction function:
In this case, the entrant when enters the market will enter in a lower price than incumbents to steal their customers and grant a market share for himself. The incumbents will react by reducing the price even more and the rivalry between the firms will go on and will result in a perfectly competitive outcome. In this condition the competition will be fierce because the products are perfect substitutes. If the products are differentiated, price competition is less intense. (Besanko 2010).
In this Bertnard model the capacity is not constant as in Cournot. This model pertains to markets in which capacity is flexible that firms can meet all of the demand that arises at the prices they announce. If firms products are perfect substitutes, then each Bertnard competitor believes that it can steal massive amounts of business from its competitors through a small cut in price, when all competitors think this way, in equilibrium, price-cost margins and profits are driven to zero (Besanko 2010)
The diagram below shows the Bertnard Reaction function when products are differentiated where both firms reach a Bertnard Equilibrium that are well above marginal cost and so they both make profit, if their products are perfect substitutes to each other then the price will be driven to marginal cost and profit will be zero. Nash Premise: If the incumbents chose the non accommodative approach then either they will reach the zero profit situation if the products are perfect substitutes, or they might reach an equilibrium (Nash) if the products are somehow horizontally differentiated.
Nash Equilibrium is reached when both firms reach a situation when each of them chose a strategy and no one can benefit by changing his strategy while the other players keep their unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium. i. e. Firm 1 making the best decision it can, taking into account Firm 2’s decision, and Firm 2 making the best decision it can, taking into account Firm 1’s decision. (Wikipedia. com) Example:
Beef-processing industry in the US, there were 4 industry leaders, then came JBS SA from South America and purchased Swift & Co. to form JBS Swift & Co. then the quantity produced increased (excess capacity). Capacity had to drop otherwise the outlook would remain bleak. Tyson decided to close its factory at Emporia, Kansas pulling 4000 head of capacity from the market. After this closure the capacity and the beef prices have stabilized. (Besanko 2010) We can see in this example how when a new entrant emerged (JBS Swift & Co. ) the capacity increased caused the prices to drop.
We conclude that the market capacity here is fixed (Cournot model) and when the incumbents saw that effect they knew for fact that reducing the output will benefit everybody. So, Tyson Co. closed one of its factories, the total output in the market dropped caused the prices to stabilize again. Here this is a kind of Cournot equilibrium that is reached. The incumbents went through an accommodative approach in this case rather than competitive. Conclusion: The entrant has to observe closely the Critical Timeline of the market’s incumbents before entering this market.
According to his forecast of their reaction (whether it will be accommodative or competitive) he has to build his strategy whether he can survive or not. The entrant has to study the market demand (capacity), is it going to be affected by the new entry by absorbing the extra quantity (can lead to Bertnard) or the demand is fixed (that can lead to Cournot). The entrant’s strategy had to be built on the Reaction Functions forecasted from the incumbents where from there the entrant can calculate the Nash equilibrium value and the possibility to reach it or the other possibility to reach the zero profit condition.