Sequential Move Games II - UNC-Wilmington Department of...

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ECN321 Department of Economics and Finance Dr. Chris Dumas Discrete Action, One-Shot, Sequential Move Games 2 Consider the following game, called Entry Deterrence, between the single Incumbent firm (I) that is already well established in the market, and a firm that is a Potential Entrant (PE) into the industry. The Potential Entrant is considering producing a product that is similar to the product being produced by the Incumbent. The Potential Entrant may decide to either (1) produce and sell its product, thereby entering the market and “Competing” with the Incumbent, or (2) stay out of the market and simply license its new product to the Incumbent for a fee (I’s payoffs in the game tree below include any such fee), and the Incumbent will then sell both products. The Incumbent knows that the Potential Entrant is deciding whether to enter the Incumbent’s market. In the past, the Incumbent has set high prices and earned large profits. Now, however, it must consider the threat of the Potential Entrant entering its market, competing, and driving down prices. The Incumbent could choose to sell its product for a High Price, Medium Price, or Low Price. Solving the game by backward induction, player I chooses Low Price in the upper right node (because 50 is greater than both 35 and 0) and High Price in the lower right node (because 80 is greater than 70 and 40). Given these choices by player I, player PE chooses Compete in the left-most node (because 40 is greater than 30). So, we predict that the outcome of the game is (PE chooses “Compete”, I chooses “Low Price”). Notice that the outcome payoffs (PE = 40, I = 50) are lower for both players compared to the payoffs (PE = 60, I = 70) that would occur if PE chose “License” and player I chose “Md. Price.” Suppose that player I, the player who moves later in the game, tries to achieve this better payoff for both players by making a promise, or commitment, to player PE, the player who moves earlier in the game. Suppose player I says to player PE, “If you will choose License, then I will choose Md. Price, and we will both be better off.” Should PE believe this promise; that is, is player I’s promise/commitment credible ? No, because if PE chose “License,” then it would be in I’s best interest to break his promise and choose “High Price,” because player I would then get 80 instead of the 70 he would get if he kept his promise. Hence, we say that player I’s promise/commitment is not credible , and we predict that player PE will not believe player I’s promise/commitment, and the two players will be stuck in the outcome (PE chooses “Compete”, I chooses “Low Price”) that is worse for both players. 1
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This note was uploaded on 10/22/2009 for the course ECN 321 taught by Professor Dumas during the Fall '08 term at University of North Carolina Wilmington.

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Sequential Move Games II - UNC-Wilmington Department of...

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