Tuesday, February 15, 2011

Class # 7: Key Take Aways

In this class, we studied the game theoretic valuation of an asset. While the usual role for holding an asset in a company is for the cash flows it throws off, there can also be strategic reasons. The presence (or absence) of an asset can provoke certain types of strategic responses from rivals. In the case we studied, the presence of excess capacity created incentives for the rival to respond forcefully to a price cut.
The reason is that failing to respond resulted in sufficient lost market share that retaliation was cost effective. In contrast, holding smaller excess capacity weakens the threat of a price cut and changes the strategic response of the rival. Now a price cut leads to smaller market share loss. The cost of retaliating in that circumstance is lower than the benefit. This type of "weakness" strategy is sometimes called the "puppy dog ploy."

Puppy dog ploys appear in a number of practical contexts. One notable context is for startup airlines. Imagine a cut rate carrier decides to add a route already served by an incumbent. (Kiwi Airlines did exactly this against Continental in Newark some years ago). If the startup is small, then the lost share is such that it's not worth fighting a price war. If, however, the rival's capacity grows (or threatens to grow), then a different and altogether more aggressive strategic response is provoked. Ultimately, it was the growth of Kiwi that doomed its business model.

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