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The Effect of Strategic Interaction When Evaluating Projects

The Effect of Strategic Interaction When Evaluating...

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Unformatted text preview: The Effect of Strategic Interaction When Evaluating Projects: The net present value of a project is determined by discounting the cash flow the project is expected to create. In order to have a good forecast of the cash stream, we need to have a good forecast of the economic situation that the firm is going to be operating in. For instance, we need to have accurate forecasts for the market size, the market share, hence the sales quantity devised for each year, as well as the sales price. Since these numbers are forecasted, their realization may end up to be different than what is included in the net present value calculations of the project. To have a bigger picture of what may lay ahead, we discussed several approaches to analyzing the dependency of the NPV to the forecasted ingredients. One such approach is called the sensitivity analysis. By keeping all the variables of our calculation of NPV same but changing one variable(for instance, forcasted sales) we can see how sensitive the NPV to that particular variable. One criticism that we can consider is that, this type of analysis sees the firm in isolation. In reality, every move a company makes is watched by its competitors, and every move the competitors make affects what the Net Present Value of any project a company is undertaking will be. The magnitude of this effect mainly depends on the type of market the firm operates in. Perfect Competition: If the firm produces a homogenous product with very little or no brand differentiation perceived by the consumers, then the firm has very little or no say in its price. In such markets the number of firms is very large. The move of any one firm is so infinitesimal compared to the size of the market that it has almost no effect. The firm operates as a price taker. That is, the market dictates the price to the firm. If the firm increases its price a little bit, it loses all of its customers and its market share. If it decreases its price than it can sell the amount it could sell before but at a loss now (remember, the firm’s size is very small compared to the market). Monopoly: Monopoly refers to the sole producer of a product. If a firm is operating as a monopoly then it does not need to worry about competitors because it has none. The firm simply maximizes its profit by finding its optimal sales and price level taking the market size as its own market share. Monopolistic Competition and Oligopoly: Most markets we have fall in somewhere in between perfect competition and monopoly. There is neither only one producer for a product nor a very high number of producers so as to make the effect of each nonexistent. Monopolistic competition refers to a market with imperfect competition where many competing producers sell products that are differentiated from one another (as opposed to one homogenous product). Firms are not price takers. They can influence their own price but there are still a great number of producers in the same business that makes the dominance of each relatively small. Oligopoly refers to a market structure where there are only a handful or less number of big firms competing against each other. When this is the case each project that is undertaken by one firm needs to incorporate the strategic effect that will be resulting from the moves of the other firms. To get an insight as to what type of an equilibrium the firms may reach, we may use a branch of economics called game theory. Game theory refers to the mathematical analyzation of strategic interactions. Consider the following example: Two big car producers are considering entering the electric car market. They both know the following information. The market size for electric cars is given in the short run with the potential of growth in the long run. Suppose that the firms find themselves in a situation where each has to make a simultaneous move without knowing what the other is up to. To illustrate the point, let’s simplify things and assume that each can either move big or small. That is, each can either invest big to capture the entire market share and incur big expenses or invest small to capture a portion of the market by incurring moderate expenses. Following table gives the relative payoffs of each firm: Firm 2 Firm 1 Invest Small Invest Small win‐win Invest Big win more‐lose more Invest Big lose more‐win more lose‐lose If both firms decide to invest small they both win by a small amount. They recover their investments but do not create sizeable payoffs. If a firm invest small when the competitor invests big then the small investor loses big since the big mover captures the entire market share. If they both move big, then they share the market but the market is not big enough to support two big investors so the firms can not recuperate their entire investments and lose some. To find the equilibrium first take the move of one firm, say firm 1, as given. Let’s say that firm 1 invests small. In this case, for firm 2, it is better to invest big. Now, if firm 2 is given to invest big, then it is better for firm 1 to invest big as well. Then, if firm 1 is given to invest big it is better to invest big for firm 2 as well. Whichever point we start, it is straightforward that we reach to the point where both firms invest big. An interesting point to note is that both firms could have invested small and win. Instead, fearing that the other would move big and capture the entire market, each moves big and both lose albeit by a smaller amount. This illustrates the strategic effect that each firm needs to take into account when a new project is evaluated. ...
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