Aggressive leaders.(strategic investments)

I characterize the incentives to undertake strategic investments in markets with Nash competition and endogenous entry. Contrary to the case with an exogenous number of firms, when the investment increases marginal profitability, only a "top dog" strategy is optimal. For instance, under both quantity and price competition, a market leader overinvests in cost reductions and overproduces complement products. The purpose of the strategic investment is to allow the firm to be more aggressive in the market and to reduce its price below those of other firms. Contrary to the post-Chicago approach, this shows that aggressive pricing strategies are not necessarily associated with exclusionary purposes.

1. Introduction

* In many market settings, a firm can have an incentive to undertake preliminary investments to gain advantage over its competitors. For instance, when Cournot competition takes place between two firms, one of them will usually gain by overinvesting to reduce costs, which allows it to be aggressive in the market, expanding production and inducing its rivals to produce less. Under Bertrand competition, however, the same firm would prefer to underinvest in cost reductions so as to be accommodating, increasing its price so as to induce its rivals to raise their price. More generally, Fudenberg and Tirole (1984) and Bulow, Geanakoplos, and Klemperer (1985), building on a pathbreaking contribution by Dixit (1980), have shown that when a preliminary investment increases marginal profitability, a firm would like to overinvest under strategic substitutability and underinvest under strategic complementarity: the first top dog strategy leads to aggressive behavior in the market (higher production or lower price), while the second "puppy dog" strategy induces accommodating behavior (lower production or higher price).

In this article I show that when entry is endogenous, a firm would always like to undertake investments to be aggressive in the market, that is, to expand production under Cournot competition and decrease prices under Bertrand competition. For instance, a leader will always find it optimal to overinvest in cost reductions (or adopt a similar top dog strategy) to be able to produce more and to reduce its price below the price of its competitors. This outcome emerges in many other contexts with surprising results about investments in quality improvements, production of complementary goods, dumping to exploit a learning curve or create network externalities, strategic vertical restraints, bundling of goods, and so on.

The intuition for the generalized aggressive behavior of leaders in competitive markets is simple. With a fixed number of firms, the leader is mainly concerned about the reactions of the other firms to its own investments, but these reactions are different under quantity competition or price competition (more precisely, according to whether strategic substitutability or complementarity holds). But when entry is endogenous, the leader is mainly concerned about the effect of its own investment on entry. An investment that induces the leader to be accommodating will attract entry, which makes such a strategy unprofitable. An investment that induces the leader to be aggressive will limit entry and allow the leader to achieve a larger market share and gain from a reduction in the average costs of production. This implies that a dominant position obtained through strategic investments can be the consequence of a competitive market environment and not the result of barriers to entry. (1) The practical implication is that competition policy should focus on promoting endogenous entry rather than fighting against market leaders, their dominant market shares, their aggressive pricing or bundling strategies, and their innovative investments.

The article is organized as follows. In Section 2, I develop a simple example where leadership is associated with a simple first-mover advantage rather than a proper strategic investment; it serves to show, in a simple way, the source of the aggressive behavior of leaders. In Section 3, I present the general model of strategic investment and Nash competition, and in Section 4, I solve it with and without barriers to entry. In Section 5, I study some applications under quantity and price competition with alternative forms of strategic commitments. Section 6 concludes.

2. A simple example