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 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.
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.
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
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
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
, 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”,
“Low Price”) that is worse for both players.