Strategic Substitutes and Complements

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Strategic Substitutes and Complements
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A BIG THEME

• Commitment can either help or hurt you.
• Figure out which.

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Soft vs. Tough Strategies

• Soft less aggressive (but still possibly
  rivalrous)
• Tough more aggressive (but still possibly
  cooperative)
• I prefer that my rival be soft.
• Examples
• Prisoners Dilemma Cooperate (quiet) or Defect
  (confess)
• Battle of the Sexes Choose the other persons
  preferred event, or choose your own.
• Oligopoly Low output or High output
• Lawsuits Settle or Hold Out for trial
• Sometimes Soft vs. Tough is on a continuum, with
  intermediate strategies possible

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Entry Deterrence Soft v. Tough
(10,10)
Soft
Firm 2
Tough
Tough
(-5,-5)
Firm 1
Soft
(0,30)

• If I am tough, my rival will be soft, which is to
  my benefit

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Strategic Substitutes and Complements

• Suppose when I use my strategy more intensely,
  you cut back on your strategy. Then we call the
  two strategies STRATEGIC SUBSTITUTES.
• Example Cournot competition in quantities. If I
  increase my output, you react by reducing yours.
• Suppose when I use my strategy more intensely,
  you use your strategy more intensely too. Then we
  call the two strategies STRATEGIC COMPLEMENTS.
• Example Bertrand competition in prices. If I
  increase my price, you react by increasing your
  price too.

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Advertising
Firm 2s advertising
Strategic complements
R1
R2
Firm 1s advertising
Firm 2s advertising
R1
Strategic substitutes
R2
Firm 1s advertising
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Research and Development
Firm 2s research
Strategic complements
R1
R2
Firm 1s research
Firm 2s research
R1
Strategic substitutes
R2
Firm 1s research
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Political Campaign Spending California 2000
Gores spending
Strategic complements
Rg
Rb
Bushs spending
Gores spending
Rb
Strategic substitutes
Rg
Bushs spending
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Strategic Substitutes and a Commitment to be
Tough
Q2
Commitment here means a shift in my reaction
curve. We still assume I cant commit to a
particular quantity.
R1,new
R1, old
Q2,old
R2
Q2,new
Q1,new
Q1,old
Z
Q1
Strategic Effect
Direct Effect
The Top Dog strategy Commit to be tough in a
situation like this.
(Figure 9.2)
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Strategic Complements and a Commitment to be
Tough
P2
R1, old
R1,new
R2
P2, old
P2, new
Z
P1, old
P1, new
P1
Strategic Effect
Direct Effect
The Puppy Dog Ploy Do NOT commit to be tough
in a situation like this.
(Figure 9.4)
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The Fudenberg-Tirole Taxonomy as a List

• In 1982, Philips has to decide whether to build a
  CD pressing plant in the United States, and, if
  so, how big a plant. CDs were at that time an
  uncertain technology, and Philips was also
  concerned about the response of another possible
  CD manufacturer, Sony. Some strategies Philips
  might think about are
• THE PUPPY DOG PLOY. Don't enter, so Sony won't
  enter either. A commitment would make us TOUGH,
  but then our rivals would become TOUGH too. So
  don't do it.
• THE TOP-DOG STRATEGY. Enter in a big way, so
  Sony will stay out. Make a commitment to be
  TOUGH, so our rivals will be SOFT.
• THE FAT-CAT EFFECT. Enter with a small capacity,
  so Sony will not feel threatened by the
  possibility of entry with a large capacity. Make
  a commitment to be SOFT, so our rivals will be
  SOFT too.
• THE LEAN AND HUNGRY LOOK. Stay out, so more
  resources can be put into other audio products. A
  commitment would make us SOFT, but then our
  rivals would become TOUGH. So don't do it.
• (Fudenberg, Drew and Jean Tirole (1984) The
  Fat-Cat Effect, The Puppy-Dog Ploy, and the Lean
  and Hungry Look,'' American Economic Review May
  1984, 74 361-66.)

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The Fudenberg-Tirole Taxonomy as a Table

Now we can arrange the four categories more
meaningfully.

The first question to answer is whether our
strategies in the game we will play after any
commitments we may make are complements or
substitutes. The second question is whether
commitment makes us Tougher or Softer.
Commitment makes our firm
Tough
Soft
Puppy Dog A commitment would make us Tough, but
then our rival would become Tough too. So dont
commit.
Fat Cat Make a commitment to be Soft, so our
rivals will become Soft too.
Strategic Complements
Lean and Hungry Look A commitment would make us
Soft, but then our rival would become Tough. So
dont commit.
Top Dog Make a commitment to be Tough, so our
rival will be Soft.
Strategic Substitutes
(Figure 9.6)
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Some Strategies to Classify

• 1. Differentiate our product to appeal to a
  narrower group of consumers, in the hope that our
  rival will do the same.
  
• 2. Don't branch out into a new product line, for
  fear of distracting attention from the old
  product line.
• 3. Fire our special promotions marketing dept. ,
  so our rival will fire his too.
• 4. Aggressively seek a new patent, to stop our
  rival from getting it first.
• 5. Enter in just one city, rather than ten, to
  avoid stimulating price cuts.

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Example 3 Fire our special promotions
marketing dept. , so our rival will fire his too.

• If the department cannot easily be rehired , this
  is a commitment to play Soft. So it is Fat Cat.
  
• If the department CAN easily be rehired, this is
  neither Fat Cat nor Puppy Dog, because no
  commitment is possible. If no commitment is
  possible, not committing is vacuous there is
  no decision to be made.
• If your company starts without a promotions dept.
  and there would be a sunk cost to creating one,
  but the company decides not to for fear of
  provoking a promotions race, this would be
  Puppy Dog.

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Example 5 Enter in just one city, rather than
ten, to avoid stimulating price cuts.
The question is Is the decision to
enter N cities reversible? If having chosen to
enter in one city, your company is forestalled
from entering the other 9 soon, because its
marketing and supply arrangements are based on
the one city, then it has committed. This is a
Fat Cat policy. If your company could still
enter the other 9 cities, but having entered a
city it cannot exit without loss, then it has
chosen NOT to commit to the 10 cities, and has
made a much smaller commitment. This is a Puppy
Dog policy. If your company can shift from 1
to 10 and back each year with no more cost than
if it didnt switch, then this is neither Fat Cat
nor Puppy Dog, because no commitment is possible.

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The Fat Cat vs. the Puppy Dog Principles

• Both the Puppy Dog and Fat Cat commitment
  policies start from the assumption that the
  strategies affected are strategic complements
  e.g., if I choose a higher price, you will want
  to choose a higher price too.
• The Puppy Dog policy consists in NOT committing,
  because commitment would give you more incentive
  to be TOUGH, and your rival would respond by
  also being tougher.
• The Fat Cat policy consists in COMMITTING,
  because commitment would give you more incentive
  to be SOFT, and your rival would respond by also
  being softer.
• What is confusing is figuring out the difference
  between (a) Not Committing to be Tough, and (b)
  Committing to be Soft. The key is whether the
  decision is reversible or not. If it is
  reversible, it is not committing.

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Heavy Debt as a Strategic Tool
1. Suppose heavy debt makes the firm more
risk-taking and aggressive, because its lenders
bear part of the downside risk. TOP DOG If
product market competition is Cournot, the debt
helps the firm. PUPPY DOG If Bertrand, debt
HURTS the firm. Dont take on debt. 2. Suppose
debt prevents the firm from committing via
investment, because it cant obtain the funds.
FAT-CAT The firm has cant commit to reduce
costs. This helps keep prices high in a Bertrand
market. LEAN-AND-HUNGRY The firm cant commit
to high capacity. This hurts the firm in a
Cournot market.