We consider a game in which firms' owners assign to their managers a delegation scheme weighting profits and market shares. Managers then compete in quantities. We show first that this delegation scheme typically leads to quantities being strategic substitutes or complements depending on firms' relative size. Second, we consider a game of entry and show that the incumbent may achieve entry deterrence using this delegation scheme. When entry is deterred, the incumbent acts as a pure monopolist.Entry deterrence; market shares; strategic delegation

Wauthy, Xavier

English

Research Papers in Economics

                                                                         1
Entry Deterrence and Strategic Delegation
Xavier Wauthy
Fonds National de la Recherche Scientifique
 IRES, Université catholique de Louvain
November 1997
Abstract:
We consider a game in which firms' owners assign to their managers a
delegation scheme weighting profits and market shares. Managers then
compete in quantities. We show first that this delegation scheme typically
leads to quantities being strategic substitutes or complements depending on
firms relative size. Second we consider a game of entry  and show that the
incumbent may achieve entry deterrence using this delegation scheme.
When entry is deterred, the incumbent  acts as a pure monopolist. .
keywords: entry deterrence, market shares, strategic delegation
JEL Classification: L13, L22                                                                         2
1/ Introduction
Several recent papers (i.a. Fersthman and Judd (85), Sklivas (87), Basu (95)) put
forward the idea that managerial delegation could be used as a strategic device in
oligopoly competition. These papers assume that the objective function assigned to the
manager combines profits and sales maximization and provide a rationale for such a
delegation scheme: Owners find it profitable to assign to managers an objective which
departs from standard profit maximization because this contract has a commitment
value in the competition game to follow. For instance, Basu (95) shows that
Stackelberg leadership can be made endogenous using this framework.
The present paper shares many of the ideas of these authors. Indeed, we also consider a
delegation game in which firms' owners and managers may sign a contract in a first
period, whose terms are common knowledge in a second period where market
competition takes place. However, we consider the case where the contract involves a
compensation scheme for the manager which places a positive weight on the level of
the firm's market share, instead of sales.
Many theoretical models have been developed recently in order to explain why firms
should care about market shares. More precisely, we would like to explain why firms
seem to compete for market shares, beyond the level that could be explained by short
run profit maximization. The switching cost literature (Klemperer (95)) or the literature
on network externalities (Katz and Shapiro (85)) emphasizes the role of present market
shares as a determinant of future profits. Caminal and Vives (96) shows that in a
context  of imperfect information about products' quality, a large market share can
signal a high quality. In this case, "the interest of firms in market share then arises from
the informational value attached to market shares by consumers."1.More generally, it
could be argued that market shares are a better indicator of managers' performance
relative to competing firms. Indeed, absolute sales levels may decrease or increase
simply because of demand fluctuations. In the present note market shares do not have
any specific economic value, i.e. they do not influence the shape of industry demand.
However, market shares matter because they have a strong commitment value when the
firm delegates management.
Our main results are the following: First, under our delegation scheme, quantities are
strategic complements (in the sense of Bulow, Geanakoplos and Klemperer (85)) when
1Caminal and Vives, p.222                                                                         3
the firm is largely dominant and strategic substitutes otherwise, even though quantities
are strategic substitutes in the standard Cournot framework. In other words, our
delegation scheme tends to yield non-monotonic best best replies in the quantity game.
Second, this delegation scheme can be used by an incumbent firm as an entry
deterrence mechanism. Moreover,  when entry is deterred the monopoly outcome is
preserved.
The note is organized as follows. In section 2 we consider the implications of our
delegation scheme for the behaviour of the firm in a quantity game. Section 3 is
devoted to the analysis of the entry deterrence game. Section 4 concludes.
2/ Market Share Incentives and Cournot Competition
Let us consider a symmetric Cournot game between n  firms. For simplicity, we assume
that marginal costs are constant and normalized to 0. Let  pQ ()  denote the inverse
demand for the homogeneous product, which is assumed to have all of the standard
properties for quantities being strategic substitutes in the Cournot game, i.e.  pQ ()  is
decreasing and concave. Moreover, we assume that p() 0  is finite.
Delegation from the owner to the manager takes the form of a contract specifying the
wage of the manager. We assume that the contract is designed so that the manager is led
to maximize the following objective function: Oq qQ ii ii i () (, ) = − πβ +s i where si= qi
qj j ∑
and β ≥ 0. Thus, the contract specifies a wage schedule which is linear in Oq ii () . We
assume a competitive market for managers. Therefore, in equilibrium, the manager
must recieve his reservation wage. There is no asymmetric information between the
owner and the manager. Contracts are signed and become public knowledge before
quantity competition takes place. These assumptions are restrictive but fairly standard
in the literature on strategic delegation .2
Given the incentive scheme described above, the behaviour of firm i's manager in the
Cournot game is captured by the first order condition on Oq ii () . Straightforward
computations yield equation (1):
       
∂
∂
∂
∂
β
O
q
pq
p
q
Q
qQ
i
i
i
i
i
ii
=+ +
+
=
−
−
(.)
(.)
()
2 0                                (1)
Note that the second order conditions are satisfied for any demand function satisfying
them in a standard Cournot game. The following comments are in order. First, equation
2In particular , these assumptions are those made in Fersthman and Judd (87), and Basu (95). See
Fershtman, Judd and Kalai (1991) on the importance of contracts' observability.                                                                         4
(1) implicitely defines the best reply of firm i  against the quantity of the opponents Q i − .
Let us denote by φii Q () − the explicit solution of equation (1). Since the last term in the
expression is positive, it is obvious that the best reply of firm i  must involve a larger
quantity under market share delegation than in the standard Cournot game. Second,
note also that the best reply against Q i − = 0 is the monopoly output. This is in sharp
contrast with the approach of Fershtman and Judd (87) where strategic delegation
implies larger output even in the monopoly case. Finally, and more interestingly, it is
easy to see that the sign of ∂φ ∂ i i Q (.) − is indeterminate. Using the implicit function
theorem, it is straightforward to show that the best reply's slope is positive whenever
equation (2) is satisfied.
∂φ
∂
∂
∂
∂
∂∂
β
i
ii
i
ii
ii ii q
p
Q
q
p
qQ
qQ qQ >⇔ + + + − >
−−
−− 0 0
2 (
(.) (.)
)( ) ( )               (2)
Thus, the assumptions made on the demand function in order to ensure that quantities
are strategic substitutes in a standard Cournot game, i.e. the first term in inequality (2)
is negative are not sufficient in the present setting. It is indeed obvious that if
qQ ii −> − 0, a sufficiently large β will result into a positive slope for firm i 's best
reply.  This result is summarized in the following proposition.
Proposition 1: In an industry where quantities are strategic substitutes under
standard Cournot competition,  the best reply of a delegating firm using Oq ii () is
not monotone: quantites are strategic complements when the firm is largely
dominant and strategic substitutes otherwise.
Thus, under the incentive scheme Oq ii () , the manager of a largely dominant firm is
likely to adopt an agressive behaviour and thus likely to fight for market shares against
small competitors. This result is quite intuitive. Moreover, it suggests that such a
delegation scheme could be used by the owner of an incumbent firm as a strategic
device to deter entry. Indeed, since the incumbent is by definition dominant before
entry takes place, the manager is less likely to accomodate entry given Oq ii () . This
issue is studied in the next section by mean of an example.
3/ The Entry Deterrence Game
In this section, we  consider a variant of the standard Dixit (79) entry deterrence game.
Our model follows closely the presentation by Tirole (88). In this latter model, a
sequential game is considered. The incumbent firm has the possibility to precommit to a
particular level of capacity k1 in the first stage. Entry may take place in the second
stage. The entrant has to install a capacity level k2 and has to bear a sunk cost  F only if                                                                         5
k2 0 > , i.e. if he enters. Capacity precommitment in the first stage together with the
sunk cost in the second stage makes it possible for the incumbent to deter entry while
preserving some market power. Entry is deterred provided the incumbent installs a
capacity which is large enough to induce negative profits for the entrant at her best
reply in case of entry.
We consider a slightly modified version of this game. In the first stage, the incumbent
has to possibility to hire a manager under the contract specified in the preceeding
section. Thus, there is delegation if β > 0. We assume that this contract cannot be
renegotiated in second period. In the second stage of the game, the contract is public
knowledge and the entrant decides whether to enter, bearing the sunk cost F and
possibly hiring a manager under contractOq EE () , or to stay out of the market. In case of
entry, a simultaneous Cournot game takes place between the two firms. We assume that
it is not possible to precommit in quantities in the first stage. We consider the case of a
linear inverse demand function. It is then easy to see that our delegation scheme makes
it possible to deter entry. The argument is easily captured by referring to figure 1.
qI
qE
φΙ
qM
qB
qB
E
I
Figure 1: Entry  deterrence through delegation
Firm E is the entrant. Her best reply in a standard Cournot game is discontinuous.
Indeed, below some quantity level,qE
B, profits become negative in case of entry,
because of the sunk cost. In this last case,  no entry is the best strategy since it secures
zero profits.  In order to deter entry,  the owner must  choose  a value for β such that
the incumbent's best reply is to the right of the discontinuity point. This is sufficient if
we do not allow the entrant to use our delegation scheme. If we allow him to delegate
under Oq EE ()  then the necessary condition is that the incumbent's best reply must lie
strictlyto the right of the isoprofit curve of the entrant at point ( , ) qq
IE
BB  for qq E
B
E > . In
this case indeed,  the entrant cannot gain by hiring a manager. Necessary and sufficient
conditions for entry deterrence are given in Proposition 2.                                                                         6
Proposition 2: Assume that  p =1−Q and entry involves a sunk cost F, then
there exists an optimal β
*such that the incumbent deters entry with the
delegation scheme Oq ii () .The owner of the incumbent firm obtains in this case
the monopoly profits less the reservation wage of the manager.
Proof: The game is solved as follows. Under the assumption that demand is given by
p =1−Q, the best reply of the entrant, if he does not delegate, is given by
q =1 - q 2
EI () . Recall that from equation (1), our delegation scheme involves larger
quantities then under standard Cournot competition. We then identify the critical level
of  qI to which the best reply in case of entry yields zero profits. This level , denoted
byqI
B , is the solution of the following equation:
1 0 −
⎛
⎝ ⎜
⎞
⎠ ⎟
⎛
⎝ ⎜
⎞
⎠ ⎟ −= qF I
B -
1-q
2
1-q
2
I
B
I
B
                                 (3)
We obtain qI
B
= − 12F. The best reply in case of entry is qE
B
= F . It then remains to
choose a value for β such that the best reply of the incumbent against  qE
B
= F  is
precisely qI
B
= − 12F.
In the present case, the best reply of a firm under delegation scheme Oq ii ()  is
implicitely defined by  equation (4).
q1 + q2 ()
2 1− 2q1− q2 () + bq2 = 0                                    (4)
Solving this equation in β for  q q I
B
E
B , () , we obtain the entry deterrent level for β :
β
* =
− () − () 11 3
2
FF
F
                                                 (5)
Tedious computations show that for relatively large values of F the corresponding
incumbent's best reply lies everywhere above the isoprofit curve π2 q, q I
B
E
B () − F,
therefore entry is deterred for all possible delegation scheme that the entrant could use.
When this condition holds, entry is deterred under any possible delegation scheme.
Indeed,  there exist no possibility for the entrant to acheive larger profits along the
incumbent's best reply, i.e. in any possible equilibrium of the quantity game. For
smaller values of the sunk cost,  it remains true that the incumbent's best reply lies
strictly above the isoprofit curve of the entrant passing at point ( , ) qq
IE
BB  for qq E
B
E > .
Therefore, the entrant cannot profitably enter by using contractOq ii () . Recall indeed
that the incentive scheme Oq ii ()  generates best reply functions involving larger
quantities than in the standard Cournot game.
Finally, it is clear from equation (1), the manager chooses the monopoly output when
entry is deterred. QED                                                                         7
In our setting,  the profitability of entry deterrence depends only on the level of the
wage required for the manager's participation. Thus, as in Dixit's model entry
deterrence is not necessarily profitable. However it seems reasonable to argue that the
cost of entry deterrence in the present model, which is in fact the reservation wage level
of the manager is smaller than the cost of extra-capacities involved in Dixit's one.
Moreover, when entry is deterred, the incumbent implements the monopoly solution, so
that gross profits are the monopoly ones.
4/ Final Remarks
In this note, we have assumed that the owners of firms could assign to their managers
an objective which puts a positive weight on market shares, even though market shares
as such have no economic value. The main feature of such a delegation scheme is that
quantities are viewed as strategic substitutes for the manager of a dominant firm
whereas they are complements for a small firm. This result has been derived under very
general conditions on demand functions. We have then shown by mean of an example
that such a delegation scheme could be perfectly rational for a profit maximizing
incumbent. This is so because, once publicly known, this contract has a strong
commitment value.
Note that our model differs from the received literature on strategic delegation which
tends to assume a delegation scheme based on sales incentives. However, the idea that
delegation has a strategic value is common to both approaches. In a two-stage duopoly
game where owners choose first an optimal contract based on sales incentives, and
managers compete in the second stage, it has been shown that  both owners are likely to
delegate in a Subgame Perfect Equilibrium, even though this results into lower profits
ex-post. Clearly, this result would also obtain in our setting. However, our approach
exhibits an important qualitative difference: sales incentives lead to a more agressive
behaviour in the quantity game, as compared to the standard Cournot competition,
however, a firm is always "accomodating", since quantities are strategic substitutes. In
our setting, the willingness to accomodate depends on the firm's size relative to the
industry. Typically, a dominant firm will not accomodate.
In our example an incumbent can acheive entry deterrence with a delegation scheme
based on market shares. A similar result would be harder to obtain with a delegation
scheme based on sales. It is indeed obvious that the non-monotone best replies are very
helpful in order to deter entry when the entrant is also allowed to delegate. Moreover,                                                                         8
monopoly profits would not be preserved in this last case and entry deterrence becomes
more costly when the sunk cost  becomes smaller.                                                                         9
References
Basu K. (1995), Stackelberg equilibrium in oligopoly: an explanation based on
managerial incentives, Economic Letters, 49: 459-464.
Bulow J., J. Geanakoplos and P. Klemperer (1985), Multimarket oligopoly: Strategic
substitutes and complements, Journal of Political Economy, 93:488-511.
Caminal R. and X. Vives (1996), Why market shares matter: an information-based
theory,  Rand Journal of Economics, 27:221-239.
Dixit A. (1979),  A model of duopoly suggesting a theory of entry barriers, Bell Journal
of Economics,  10:20-32
Fershtman C. and K.L. Judd (1987), Equilibrium incentives in oligopoly, American
Economic Review, 77:927-940.
Fershtman C., K.L. Judd and E. Kalai (1991), Observable contracts: strategic delegation
and cooperation, Internatioanl Economic Review, 32:551-559.
Katz M.L. and C. Shapiro (1986), Technology adoption in the presence of network
externalities, Journal of Political Economy, 94:822-841.
Klemperer P. (1995),  Competition when consumers have switching costs: An overview
with applications to industrial organization, macroeconomics and international trade.
Review of Economic Studies, 62:515-539.
Sklivas S. D. (1987), The strategic choice of management incentives,  Rand Journal of
Economics, 18:452-458.
Tirole J. (1988), The trheory of Industrial Organization, MIT Press,  Cambridge
Massachusetts.

Entry Deterrence and Strategic Delegation

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics