Empty Threats
Suppose Firm1 produces personal computers that can be used both as word processors and to do other tasks. Firm2 produces only dedicated word processors. As the payoff matrix in Table 13.11 shows, as long as Firm1 charge a high price for its computers, both firms can make a good deal of money. Even if Firm 2 charge a low price for its word processors, many people will still buy Firm1’s computers (because they can do so many other things), although some buyers will be induced by the price differential to buy the dedicated word processors instead. However, if Firm1 charge a low price. Firm2 will also have to charge a low price (or else make zero profit), and the profit two both firm will be significantly reduced.
Firm1 would prefer the outcome in the upper left-hand of the matrix. For Firm 2, however, charging a low price is clearly a dominant strategy. Thus the outcome in the upper right-hand corner will prevail (no matter which firm set its price first).
Firm1 would probably be viewed as the “dominant” firm in this industry because its pricing actions will have greatest impact on overall industry profits. Can Firm1 induce Firm2 to charge a high price by threatening to charge a low price if Firm2 charges a low price? No, as the payoff matrix in Table 13.11 make clear: Whatever Firm2 does, Firm1 will be much worse off if it charges a low price. As a result, its threat is not credible.