One important strategy that an oligopolist can use to deter market entry is to t

Question

One important strategy that an oligopolist can use to deter market entry is to threaten to lower its price and thus impose a loss on a potential entrant. However, such a threat only works if it is credible.

Suppose Firm B is considering entering the market, the above table (matrix) shows the payoffs in US$ millions for each firm.

If Firm A threatens to charge a Low Price to deter entry by Firm B, based on the above information:

1) Do the Firms have a dominant strategy? Explain

2) Is there a Nash Equilibrium? Explain

3) Is the threat credible? Why?

FIRM B ENTER DON'T ENTER Firm B =-$2.0 mill -$0 mill LOW PRICE Firm A = $4 mill $6 mill FIRM A $2.0 mill = $0 mill HIGH PRICE $3.0 mill -$8.0 mill

Explanation / Answer

1) A dominant strategy is one where the Firm is doing the best it can no matter what the other firm does. In this case there is no dominant strategy for either player. For Firm A we have 4>3 and 6<8 and for Firm B we have -2<0 and 2>0. Thus there is no dominant strategy for either player.

2) A Nash equilibrium is one where the firm does the best it can given what the other firm does. Thus in this case there is no pure strategy Nash equilibrium as there is no clear best strategy.

3). The threat is a credible threat, because charging a lower price does not compromise the profits of Firm A. And so Firm A can make a credible threat that it will lower its price if Firm B threatens to enter.

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