Strategic complements and substitutes

Scott Morton, Fiona. Financial Times. London (UK): Nov 8, 1999. pg. 02

Abstract (Document Summary)

Understanding competition and how to influence it can significantly improve decision making in markets where there
are few major competitors, says Fiona Scott Morton. In seeking to predict a competitor's response it helps to know
which game you are playing - strategic substitutes or complements - and whether your commitment is nice or
aggressive. The tools discussed by the author are relatively simple but they represent a critical building block for more
elaborate game theory tools.
In 1883 Joseph Bertrand (see Further Reading) developed an expression for the profits of a company based on this type
of consumer demand. He showed that any company engaged in price competition - in our case Pepsi - has a best (profit-
maximising) response to competitor price changes. If Coke lowers its price, Pepsi does best by lowering its price also,
although it may not match Coke's decrease in full. Why? Pepsi will lose customers to Coke when Coke's price falls. By
lowering its own price, it prevents some of those customers from leaving. However, a lower price means a lower
margin, so Pepsi finds it is not worth exactly matching Coke's price drop, but prefers to preserve some margin on its
existing customers instead.
Suppose the opposite case whereby Coke raises its price. Pepsi would find it could raise profits by partially matching
Coke's increase. It could steal some customers from Coke - and serve them at a higher margin than before - if it matches
only part of the price increase. This example illustrates that the best response in a price game is to imitate the original
move of your rival. Pepsi's best response function is shown in Figure 1. In a price game a lower price inspires a lower
price, while raising a price causes the other company to raise price; competitors' prices move together.

Full Text (1704 words)

Understanding competition and how to influence it can significantly improve decision making in markets where there
are few major competitors, says Fiona Scott Morton. In seeking to predict a competitor's response it helps to know
which game you are playing - strategic substitutes or complements - and whether your commitment is nice or
aggressive. The tools discussed by the author are relatively simple but they represent a critical building block for more
elaborate game theory tools.
What makes competitive strategy difficult is that the other forces in the environment are live - they can change their
strategies at any time. A manager therefore has to chart the best course for the corporate "ship", avoiding fixed hazards
like rocks while trying to avoid collisions with other moving vessels.
Before making a strategic decision in such a setting, it is crucial to understand how your rival will respond to an action.
Advertising may be answered with more advertising, expanding capacity may cause a rival to build less capacity.
Clearly, the advantages of a particular strategy will partially depend on reaction by others.
The essence of strategic thinking is to anticipate your competitor's moves in advance. Knowledge of your competitor's
reaction, or likely reaction, dramatically improves your ability to choose a strategy that will be successful. Some
competitor reactions enhance your own profit, while others reduce it. The economic tools described below allow a
manager to determine what a competitor's reaction will be and what kinds of initial action generate positive or negative
feedback. Informed managers understand and can affect competitive interaction to their advantage.
This analysis only applies in markets where there are few major competitors - an environment in which the actions of
any one company can noticeably affect the profits of the others. Such markets are known as oligopolies. (I will therefore
ignore monopoly and perfectly competitive markets.) Competitive interaction can get complicated and very
sophisticated. The models in this article are the basics, the first steps required before moving on to advanced
competitive strategy. While they may seem simplistic in some regards, they make basic and fundamental points about
how competition works. More elaborate strategies build on these insights, so it is important to understand them.
Assumptions
To figure out the most likely competitive response, a manager needs to know the rival's goal (this is usually to maximise
profit), the possible actions available to that rival (enter a new market or not, raise or lower price), and the gains to the
rival from choosing one action over another. While to an outsider, many of these concepts seem difficult to estimate,
competitors within an industry often have very good estimates of technical options, costs, and profitability of their
competitors. Identifying a goal such as profit maximisation is important because that is how we will predict a company's
choice: if, for example, we know approximately what level of profit will result from two different actions, and the
company's management team steadfastly pursues profit, we can guess that they will choose the higher-profit alternative.
How are profits determined? The "game" being played by the industry is of crucial importance. There are two basic
economic models of competition, price games and quantity games, which I will discuss below. (This distinction was
originally noted by Jeremy Bulow, John Geanakoplos, and Paul Klemperer in their article Multimarket Oligopoly:
Strategic Substitute and Complements - see Further Reading). Both models are short term; they are specifically
designed to reflect the profitability of competitive tactics today. Dynamic concerns such as building market share today
in order to reap profits from it tomorrow are advanced refinements of these models.
Prices or strategic complements
The most common kind of competitive interaction is in prices. Coca-Cola and Pepsi, for example, are substitutes yet
consumers have different preferences for each. If Coke lowered its price in a particular city, some Pepsi customers
would switch to Coke at that moment, while others will prefer Pepsi enough to pay its higher price. Coke will gain some
customers who, until the price declined, were outside the soft drink market; it will also attract some former Pepsi
customers.
In 1883 Joseph Bertrand (see Further Reading) developed an expression for the profits of a company based on this type
of consumer demand. He showed that any company engaged in price competition - in our case Pepsi - has a best (profit-
maximising) response to competitor price changes. If Coke lowers its price, Pepsi does best by lowering its price also,
although it may not match Coke's decrease in full. Why? Pepsi will lose customers to Coke when Coke's price falls. By
lowering its own price, it prevents some of those customers from leaving. However, a lower price means a lower
margin, so Pepsi finds it is not worth exactly matching Coke's price drop, but prefers to preserve some margin on its
existing customers instead.
Suppose the opposite case whereby Coke raises its price. Pepsi would find it could raise profits by partially matching
Coke's increase. It could steal some customers from Coke - and serve them at a higher margin than before - if it matches
only part of the price increase. This example illustrates that the best response in a price game is to imitate the original
move of your rival. Pepsi's best response function is shown in Figure 1. In a price game a lower price inspires a lower
price, while raising a price causes the other company to raise price; competitors' prices move together.
Coke also has a best response function, which is shown in Figure 2, along with the market equilibrium prices. Why is
the equilibrium where the two curves cross? If both companies want to make best responses to the other's price - and
that itself is a best response to their price - the intersection is the only option. A key feature of these markets is that both
companies' choices and profits move together. Industry prices and profits rise or industry prices and profits fall. In some
sense, everyone is in the same boat. This is known as a strategic complements market.
Quantities - or strategic substitutes
The other type of action is a strategic substitute. The classic example of a strategic substitute is a company's choice of
production quantity. Clearly, if companies choose the quantity they will put on the market, they cannot also force a
particular price. (Think of OPEC's decisions over production, not price.) Instead, consumer demand determines the
price. Another Frenchman, Augustin Cournot, (see Further Reading) showed more than a century ago that in a quantity
game you should do the opposite of what your competitor does. For example, if your competitor decreases the quantity
he puts on the market, you should increase yours if you want to maximise profit. Why? Because your competitor's
decrease drives up the (common) market price, which raises your margin on every unit. It is now worth producing more
units. For example, when OPEC organises lower production, the best response by other oil-producing countries is to
produce more.
While quantity competition is the classic parallel to price competition, it is not very common. Commodity markets are
some of the only examples. The most important strategic complements action is capacity choice. For example, increased
levels of computer memory-chip capacity by one player lead others in the industry to scale back. This is because
increased chip production due to increased capacity will lower market prices. Lower prices lower the return on the
capacity investment planned by other companies. Therefore, they scale back their capacity investments in memory
chips. The best response functions for a strategic substitutes market are shown in Figure 3 where the equilibrium is
marked.
Notice that in contrast to the first type of market, the best response to a competitor's move in a strategic substitutes game
is to do the opposite. The pattern of profit changes is also different. Lower quantity goes hand-in-hand with lower
profits; higher quantity with higher profits. When a rival increases output, your profits fall. While you can improve them
somewhat by reducing your own output, you are still worse off, on balance. On the other hand, if a competitor lowers
his capacity, your profits rise and will rise further if you increase your capacity.
Key difference
How do you tell when you are playing a price game rather than a quantity game? Simply that the company chooses to
set the price component of the demand curve. Coke and Pepsi choose the price at which their products sell. In a quantity
game a company chooses what quantity (or capacity) to place on the market, but it is the market demand curve for the
product itself that determines price.
Commitment
There are two types of strategic commitment a company can make. A commitment is either aggressive or nice
depending on whether it hurts or helps the competition. By strategic commitment I mean a choice that is both hard (or
costly) to reverse, and changes the best course of action for the company. Such a choice permanently shifts the location
of a company's best response function by altering its underlying cost or revenue functions.
Let us examine price competition more closely. Suppose a company adopts a new technology that substantially lowers
cost. With lower costs than it had before that company will want to charge a lower price than it did before at each price
its rival might charge. Its best response function has shifted down (to lower prices). Lower prices hurt the competition;
they are aggressive. This strategic commitment is therefore aggressive. On the other hand, if higher local taxes
increased a company's variable costs, at every price its competitor might set it would want to charge a higher price than
it did before. In this case, government policy has committed the company to charge higher prices; its best response
function shifts up. The higher prices that result improve the profitability of the competitor. Therefore, the government
caused the company to make a nice strategic commitment. These shifts are illustrated in Figure 4.
Strategic commitments look somewhat different in a quantity game. Suppose a company signs a long-term contract
(with penalties for breach) to deliver a large quantity of the next generation of memory chips to customers. The
company now wants to build more capacity than it did before it signed the contract. Its best response function has
shifted out; it will produce more chips. We know from the preceding discussion that the competitor's best response is to
build less capacity. Recall that in a quantity game, profits move with market share, so the competitor will earn lower
profit. The original contract is an aggressive strategic commitment because it hurts the rival.
Imagine a case where one company is located in a developing nation and one in an industrialised nation. The
industrialised nation passes a law raising pollution standards. The local company now finds each unit of output is more
expensive due to treatment and disposal costs it did not have to pay before the law took effect. Its best response function
has shifted inwards; its production falls, while its rival's production and profits increase. The government law actually
caused the commitment; the company didn't choose it. However, the rival still benefits, so the final effect is a nice
strategic commitment in a quantity game. See Figure 5 for a graph of the market.
To summarise, when the company's set of best choices shifts, the industry equilibrium also shifts. Obviously, the
company making the strategic commitment wants to change its price or quantity. Less obviously, its rival reacts and
also changes price or quantity in a predictable way. Does the rival's reaction intensify or lessen competitive pressures in
the industry? It depends on what kind of competition exists in the industry and what kind of strategic commitment is
made. Figure 6 on page 13 summarises our analysis thus far.
As you can see from the figure, in a price game, you get what you give: nice strategic commitments are returned with
nice behaviour, aggressive with aggressive behaviour. In capacity games bullies have an advantage: aggressive
behaviour is met with a soft response.
Bluffing
If the rival is not convinced that the company's incentives have changed (for example, the commitment can be easily
reversed), then commitment has no impact. For example, imagine that the memory chip contract mentioned above was
tentative; either side could change its features or cancel it with no penalties. In that case, the best response function of
the manufacturer has moved much less, perhaps not at all. Everyone's strategies will stay the same. In contrast, real
commitments (that are costly to change) alter incentives permanently. In turn, this changes the rival's expectations and
its own choice. The industry "game" will have a different outcome due to the strategic commitment.
Direct costs and benefits of strategic commitment
While the preceding discussion has explained the strategic effect of various types of commitment, keep in mind that the
commitment itself usually has a direct cost and a direct benefit, which we have not discussed. Figure 6 only shows the
sign of the strategic effect. For example, building and using a new factory involves a direct initial capital cost, a direct
long run operating benefit, and a strategic impact due to the change in competitor behaviour. The total impact of the
new factory on company profitability is the sum of the direct and the strategic effects. Straightforward analysis of a
project would consider only the direct effect and naively omit competitor responses. Because the direct and strategic
effects can be either positive or negative, careful analysis is required to determine what signs they take, which is
stronger, and whether the company will benefit from the move. A simplistic view of strategic commitments is that only
the direct effect matters and the strategic effect is minor. This is not true. The strategic effect can be very important and
can even overwhelm the direct effect in some cases.
Negative strategic effects
Imagine, for example, that a new factory would lead to lower costs and lower prices; internal corporate estimates
suggest that the new greater price differential between the rival products will enable the company to steal a 20 per cent
market share from its main competitor. Missing here, though, is an estimate of the reaction of the competitor. The
competitor will not keep price constant in the face of this change. Our framework says the strategic effect (Price Game
+ Aggressive Commitment) is negative. The competitor will drop price in response to its competitor's lower price. As a
result, the new factory will not gain the company as much market share as it had naively anticipated. This means that
analysis of the total returns from a new factory should incorporate the strategic effect, namely the drop in the
competitor's price.
Consider a situation where two companies, A and B, set production for sale in a common market; they are playing a
quantity game. One of the companies, B, is involved in a long-running patent suit. One day, B finds out it has lost the
suit and will now have to pay a steep royalty on each future unit of production. A's costs are unaffected by the legal
decision. What will happen to competition in the market? B's best response function will shift inwards. It will restore its
margin by cutting back production and inducing a rise in the market price. This creates a negative strategic effect
(Quantity Game + Nice Commitment). The legal decision has a negative direct effect on B (higher costs) but also
imposes a negative strategic effect by forcing B to make a nice commitment in a quantity game. A's market share is now
greater and its profits are higher because B is forced into a weak competitive position by the lawsuit. When B was
negotiating the outcome of the suit, it should have asked for equivalently-sized annual payments instead of a royalty per
unit output, because an annual payment would not create a negative strategic effect, benefiting Company A at B's
expense.
Positive strategic effects
Suppose a new generation of semiconductor chip has just been invented. A Korean and a Japanese company are
expected to split the market evenly and the Japanese company makes plans to build a manufacturing facility that will
handle half the market demand. Unexpectedly, the Korean company finishes construction of a large facility before the
Japanese company begins building. The capacity of the Korean facility is two-thirds of expected market size. What will
the Japanese company do? Because marginal costs of chip production are so low, once a facility has been built, it is
most profitable to run it at as high a utilisation rate as possible. The Koreans made an aggressive commitment in a
capacity game. That commitment is credible and irreversible because the facility is built, not just announced. The
Japanese company will drive prices down if it builds according to its original plan; instead it will build a smaller
facility. The new equilibrium (Figure 5) shows this outcome, with increased Korean market share and decreased
Japanese market share. The strategic effect is positive, while the direct cost of the strategic commitment is negative: the
facility is ready too early. If the additional profits earned from a higher market share outweigh the cost of entering early,
then the strategic commitment is worth making.
In 1991 there was a change in the regulation of prices of pharmaceuticals sold to the Medicaid programme in the United
States. For some drugs, the government decreed it would pay only the lowest price offered by the manufacturer to any
other customer. Managers realised a discount to an health maintenance organisation or large buying group could turn
out to be the lowest price offered on the drug, and therefore would apply to Medicaid sales. Without the discount to the
HMO, Medicaid sales would take place at a higher price. The law caused a nice strategic commitment in a price game
(strategic complements), resulting in a positive strategic effect. My own research shows that equilibrium prices rose for
companies affected by the legislation and their competitors; price competition softened. In this example, a substantial
benefit of the legislation would be missed if a manager analysed the direct cost and benefit of the law and ignored the
strategic effect. The direct cost of the law was lower prices to Medicaid and some lobbying expenses. The strategic
effect was higher prices on the remaining 90 per cent of the market.
This article argues that understanding competition and how to affect it can significantly improve managerial decision-
making in oligopoly markets. When your competitors' behaviour has an impact on your profits, it is crucial to manage
the competitive relationship to your advantage. If you know whether you are playing a game of strategic substitutes or
complements and you understand whether your commitment is nice or aggressive, you can predict your competitors'
response. This allows a manager to avoid harmful competitive dynamics and take advantage of profitable opportunities.
While the model is simple and does not encompass all situations of competitive interaction, it is a valuable first step.
More advanced models of competition build on the insights of Cournot and Bertrand."