First Follower’s Real Option to revert to the Competitive Strategy Low & High Price Point Collusion Capacities

Drawing from ideas of collusion in option games model with Cournot competition and price competition in a differentiated duopoly, we model, in a binomial framework, the latent collusion opportunity open to a first-follower. The first-follower is faced with investment decision in production capacity under market uncertainty as well as competitive uncertainty. The firstfollower has an opportunity to collude with the incumbent in the Bertrand pricing game which will ensue with the first-follower’s entry; on the basis of a non-binding agreement. The investment decision is faced by only one firm – the first follower; unlike other papers where both firms are faced with the same decision albeit with asymmetry in information or cost structure. Focus on collusion in Bertrand game in a differentiated duopoly leads to the insight that for a given degree of collusion (the extent by which Nash Equilibrium payoffs are improved for each of the players), there are two price pairs; which we call the high price point and the low price point. The capacity required to follow the high price point strategy is even lesser than that required to play the low price point strategy. The strategy to go in for low capacity in the initial period and scale up subsequently if need be has costs – variable costs are lower at higher capacity levels, scaling up requires installing appropriate technology and there is a possibility of the firstfollower’s capacity constraint becoming binding. We find that under different market demand volatility, elasticity and high/ low price point scenarios, the value of the option to revert to the competitive strategy (the option to scale up capacity) is significant. This insight can aid capacity creation decision of first-follower firms. Existence of low and high price points for collusion follows from an interesting Quartic equation in the price of either of the players.