Do Buzz Words like First Mover Advantage or Winner Take All Work?

Do Buzz Words like First Mover Advantage or Winner Take All Work?

 

In strategy, we always use the above buzz words like First Mover Advantage or Winner Take All to emphasize the importance of growth. However, in reality, it works rarely. I analyzed how credible are these buzz words after news of a potential merger between Uber and Ola. Though both the firms denied these reports, Uber has exited China and Singapore, making similar deals with Didi Global and Grab Holdings.

 

Uber disrupted the taxi cabs industry with its ride-sharing model. First, Uber invested in capturing the entire taxi cab market by subsidizing customer fares. Then, it retained a minor component of the overall fees as commission as the fees that customers/driver has to pay to access its ecosystem. The rationale was that charging customers low and luring drivers to the Uber platform by paying them more would create a network effect. Thus, this network effect creates a high entry barrier and would deter entrants from entering the ride-sharing businesses. Once Uber implements this strategy, it will slowly increase the customer fee and reduce the payment to drivers, thus becoming a monopoly in the industry.

 

Though intuitively, the above strategy looks convincing, i decided to apply this strategy in the framework of Game theory.

 

I assumed that demand in the ride-sharing market is a function of price and given by

P= 100 – Q

 

P= Price 

Q=Quantity

 

Uber incurs significant investments initially in the form of R&D expenses/advertising/Customer acquisition costs to scale the market. I treat these investments as sunk costs because they do not guarantee Uber’s future profits. In addition, Uber incurs a marginal cost for each trip.

 

For simplicity, i assume

Sunk Costs = 800

Marginal Cost = 10

 

Suppose Uber does not see any potential entry threat. In that case, it sets prices below the fees that the conventional taxi players charge. 

 

Assuming that average fee/trip for Uber = 50, Uber’s annual profits = (50*50)-(50*10)-800 = 1,200

 

However, Lyft or Ola enters this business because it thinks that Uber charges high, so if it reduces its price, it can seize 50% of the overall market.

 

When Ola enters at a 40 price and captures 50% of the demand,

 

Uber’s profit reduces from $1200 to $100

Price = 40

Quantity = 100 – 40= 60 

Uber’s demand = 50% = 30

 

Solving the demand curve equation, Uber’s profit = (40*30)-(10*30)-800 

Uber’s profit = $100

 

Uber’s approach to counter Ola’s entry is to reduce the price from 50 to 30 before Ola enters the market. 

 

At the price of 30, Uber’s profit = is 600, whereas Ola’s profit = -100

 

Ola thinks it is not a profitable business. Thus, it exits.

 

After Ola exited, Uber increased the price from 30 to 50 in the next year.

 

Overall profits for Uber = 1800, better than 1300 if it sets the price at 40 in the second year.

 

This limit pricing approach deters Ola from entry. Here we think Ola is rational and will not enter an industry with a high entry barrier and low post-entry profits.

 

However, Ola enters the ride-sharing business and decides to hang around and face losses. It has support from VCs like SoftBank, which has deep pockets.

 

Let us take this Uber/Ola interaction from a Game theory perspective:

 

Uber limits price at 30

 

Both Uber and Ola suffer losses of -100 every year. However, they are taking these losses because they think one of them will exit the market, and once that happens, it will increase the price from 30 to 50. Thus, Ola and Uber are playing a war of attrition.

 

Both Ola and Uber are not in a stable state or Nash equilibrium.

 

What is the Nash equilibrium for this game?

 

If Ola continues to burn cash by hanging on, then at some point, Uber has to increase the price from 30 to 40. Once Uber raises the price, Ola will set the price at 40 and hope to capture 50% of the market.

 

Ola and Uber earn a profit here, with Ola making 100 and Uber earning 700.

 

Before Ola’s entry, Uber sets the price at 50, capturing 100% of the market, earning profits of 1200

 

Uber Profits prior to Ola entry = (50*50)-(10*50)-800 = 1200

 

After Ola’s entry, Uber reduced its price to 40 and retained 50% of the market.

 

Uber profits = (40*30)-(10*30)-800 = 100

Uber’s total profits = 1300

Ola profits = (40*30)-(10*30)-800 = 100

 

Thus, if Ola stays, the Nash equilibrium is at 40

 

However, in reality, Uber and Ola continued the war of attrition, expending resources battling each other. At one point, the survivor claims their reward and the loser regrets participating in the game. The paradox is that if the game lasts longer, the winner is worse than when it began because the resources it spent to win the game exceed its reward. The irony is that Softbank – the investor for Ola and Uber, didn’t realize this war of attrition and encouraged them to play price wars.

 

My Insights

  1. Gaining First mover advantage/winner take all by price wars is a lose-lose proposition.
  2. This strategy can only work when the marginal cost is zero. The other strategy is when the incumbent deters entry using strategic bundling. Here the incumbent sells a combination of goods/services at a price less than the cost to buy the same items separately, using its power to deter entry. Microsoft employed this strategy by bundling MS Windows with Microsoft Office, where the marginal cost for Microsoft is zero.
  3. The other way to deter entry is intense advertising to create brand loyalty (Apple) or acquire patents (Biotech/Drug) companies.

Finally, the winner takes all must have unique assets if it hopes to earn positive profits. The pricing game is a zero-sum game.



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