Competitive Strategy 419honor an agreement only if it is more profitable to do so than to expropriate.
This basic point suggests a number of remedies. One solution is for MNF to give
DC an 81–19 split of the $100 million total gain from the mine. Although this
might not seem particularly fair, it does induce DC’s compliance. Thus, MNF
can invest confidently, counting on a $19 million return. Alternatively, the
50–50 split can be maintained with a monetary penalty exacted if DC breaches
the agreement. For instance, as part of an agreement, DC would place $31 mil-
lion (let’s say) in an account with an international agency, such as the World
Bank. This money would be forfeited to MNF if DC were to expropriate the
mine. Clearly, DC prefers the $50 million from the agreement to the 80 31
$49 million net profit from expropriation.ENTRY DETERRENCE In the earlier example of market entry, two firms made
simultaneous decisions whether or not to enter a market. Let’s modify the sit-
uation and presume that one firm, the incumbent, already occupies the mar-
ket and currently holds a monopoly position. A second firm is deciding
whether to enter. If entry occurs, the incumbent must decide whether to main-
tain or cut its current price. The game tree in Figure 10.2a depicts the situation.
The new firm has the first move: deciding whether or not to enter. (Because of
high fixed costs, entry is a long-term commitment. The new firm cannot test
the waters and then exit.) The incumbent has the next move: maintaining or
cutting its price. As the game tree shows, entry is profitable if a high price is
maintained but leads to losses if price is cut.
A natural strategy for the incumbent is to threaten to cut price if the new
firm enters. If this threat is believed, the new firm will find it in its best inter-
est to stay out of the market. Without a competitor, the incumbent can main-
tain its price and earn a profit of 12. If the threat works, it will not actually have
to be carried out. The beauty of the threat is that the incumbent will have
accomplished its goal at no cost. However, the game-tree analysis reveals a sig-
nificant problem with this strategy. Such a threat lacks credibility. If the new
firm were to take the first move and enter the market, the incumbent would not
rationally cut price. Once the market has become a duopoly, the incumbent
firm’s profit-maximizing choice is to maintain price. (A profit of 6 is better
than a profit of 4.) In fact, maintaining price is a dominant strategy for the
incumbent; high prices are preferred whether or not entry occurs. Thus, the
equilibrium is for one firm to enter and the other to maintain price.
This example of entry deterrence underscores once again the importance
of strategic commitment. If the incumbent could convince the entrant of its
commitment to a low price, this would forestall entry. Perhaps one way to
accomplish this goal is for the incumbent to cut price beforethe other firm
enters to show its commitment to this low price. If the incumbent can move first
and cut its price once and for all, the other firm’s best response will be to stay
clear of the market. The incumbent certainly would prefer this outcome; its
profit is 9, higher than its profit (6) from moving second and accommodatingc10GameTheoryandCompetitiveStrategy.qxd 9/29/11 1:33 PM Page 419