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506 PART • Market Structure and Competitive Strategy TABLE 13.11 PRICING OF COMPUTERS AND WORD PROCESSORS Firm Firm High price Low price High price 100, 80 80, 100 Low price 20, 10, 20 Empty Threats Suppose Firm produces personal computers that can be used both as word processors and to other tasks Firm produces only dedicated word processors As the payoff matrix in Table 13.11 shows, as long as Firm charges a high price for its computers, both firms can make a good deal of money Even if Firm charges a low price for its word processors, many people will still buy Firm 1’s computers (because they can so many other things), although some buyers will be induced by the price differential to buy the dedicated word processor instead However, if Firm charges a low price, Firm will also have to charge a low price (or else make zero profit), and the profit of both firms will be significantly reduced Firm would prefer the outcome in the upper left-hand corner of the matrix For Firm 2, however, charging a low price is clearly a dominant strategy Thus the outcome in the upper right-hand corner will prevail (no matter which firm sets its price first) Firm would probably be viewed as the “dominant” firm in this industry because its pricing actions will have the greatest impact on overall industry profits Can Firm induce Firm to charge a high price by threatening to charge a low price if Firm charges a low price? No, as the payoff matrix in Table 13.11 makes clear: Whatever Firm does, Firm will be much worse off if it charges a low price As a result, its threat is not credible Commitment and Credibility Sometimes firms can make threats credible To see how, consider the following example Race Car Motors, Inc., produces cars, and Far Out Engines, Ltd., produces specialty car engines Far Out Engines sells most of its engines to Race Car Motors, and a few to a limited outside market Nonetheless, it depends heavily on Race Car Motors and makes its production decisions in response to Race Car’s production plans We thus have a sequential game in which Race Car is the “leader.” It will decide what kind of cars to build, and Far Out Engines will then decide what kind of engines to produce The payoff matrix in Table 13.12(a) shows the possible outcomes of this game (Profits are in millions of dollars.) Observe that Race Car will best by deciding to produce small cars It knows that in response to this decision, Far Out will produce small engines, most of which Race Car will then buy As a result, Far Out will make $3 million and Race Car $6 million Far Out, however, would much prefer the outcome in the lower right-hand corner of the payoff matrix If it could produce big engines, and if Race Car produced big cars and thus bought the big engines, it would make $8 million (Race Car, however, would make only $3 million.) Can Far Out induce Race Car to produce big cars instead of small ones?
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