What is the cost and benefit of such a pricing strategy

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Reference no: EM132207717

Question: TOPIC: signalling costs

There is an incumbent player, labelled A, in a certain market. The incumbent has a $40 unit cost of making its product available to customers, and has sufficient capacity to serve the whole market. There is a second company, labelled B, that is considering entering the market.

The game unfolds in three stages. In the first stage, company A quotes a price for its product. Buyers then make their purchase decisions, and A serves whomever decides to buy from it.

Company B observes the course of play in the first stage--including, in particular, the price quoted by A.

In the second stage of the game, company B decides whether or not to enter the market. If it enters, it incurs a nominal, irrecoverable entry cost. Small-scale entry is not an option: If B enters, it does so with sufficient capacity to serve the whole market. Company B then has a $50 unit cost of making its product available to customers.

The nature of the third stage of the game depends on Bs decision in the second stage. Suppose first that B chose to enter the market. Then, in the third stage, the two companies A and B quote prices for their respective products. Next, buyers make fresh purchase decisions; finally, each company serves whomever decides to buy from it.

If, in the second stage of the game, company B decided against entering, the third stage mirrors the first. Company A again quotes a price for its product; buyers make fresh purchase decisions; and A serves whomever decides to buy from it.

There are 100 potential buyers in the market. In the first stage of the game, each buyer is interested in purchasing one unit of product from company A. In the third stage, each buyer is interested in purchasing a second unit of product--from either company A or company B. (Of course, buyers can actually purchase from B only if it decided to enter in the second stage.) Each buyer has a willingness-to-pay of $100 per unit of either companys product.

Before entering the market, company B does not know company As unit cost. In fact, prior to the first stage of the game, company B assigns positive probability both to the possibility that As unit cost is $40 and to the possibility that it is $60.

1. Does player A want player B to know its cost position (high or low)? (Hint: Does A want to deter the entry of B?)

2. Is there a way to do so? (Hint: Can player A send a credible signal to B? What price should A charge in the first stage? What is the cost and benefit of such a pricing strategy?)

Reference no: EM132207717

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