(Basic) Game Theory in Action: HP and LAVA's Strategic Moves in India's Market
Academics Economics
* Addendum (March 10, 2023) A fun and gentle introduction to game theory. This year, I want to conduct more in-depth research and produce content with greater intention. Although my writing is no longer driven by tight deadlines and limited by academic requirements, I still recognize the value of using case studies as a means to solidify my understanding of concepts. Basically, this article could be improved in terms of writing, depth and analysis. But it's a fun snapshot of the things I loved pondering during my undergrad and squeezed into assignments.
Large multinationals like HP hold significant market power and can dictate the rules of their industry for long periods of time. This is particularly impactful for multiple stakeholders in developing nations, such as India, because efficiency, maximizing consumer surplus, and healthy competition can stagnate. New entrants, particularly in the tech sphere, face significant barriers to entry, some that are ‘natural’ to the industry and some that are imposed by the incumbent to protect its profits.
Stackelberg Competition
There is a clear imbalance in market power and market share between HP and newer players. However, this does not mean that there is no significant competition in place. Rather, the payoffs for each company will depend on different strategic and contextual factors. Importantly, the entry situation of the newcomer and the triggered strategy of the incumbent will shape the payoffs. The survival of both players, by maintaining sustainable levels of profit, will therefore inevitably be dependent on the other. Therefore, the matrix will be sequential.
The incumbent has significant advantages, which make its profits likely to be higher as well. These advantages will prove to be significant in the chosen strategies against new entrants.
Foremostly, HP has reached economies of scale, selling about $4 million worth of computers each hour (Rao, 2010). Combined with its substantial spending of 1.84 billion USD on research and development (10% increase in 2019 compared to 2018), it is able to produce and innovate extremely efficiently, resulting in overall lower production costs (Alsop, 2020), (United States Securities and Exchange Commission, 2019).
HP also dominates the PC market in India, holding the largest market share: 28.2% compared to the second biggest, such as Lenovo (Sharma, 2020). The top 5 (international) laptop brands hold 88.2% of the market, while the resulting 11.8% is shared by relative newcomers (Sharma, 2020). One of the relatively more significant ‘newcomers’ in the Indian local brand LAVA, which also invests significantly in R&D. Its almost 34 million USD investment in impressive but is still significantly smaller compared to HP (Bureau, 2018).
HP has a significant advantage as a result that goes beyond cheaper production: it is also better able to understand the needs of its customer segments and therefore has more space to innovate to different niche needs, beyond products and geographies. (Macmillan, 2014). It is also plausible to state that HP benefits from the first-mover advantage, resulting in strong brand recognition and loyalty among Indian consumers. One of the world’s largest patent portfolios is owned by HP (HP, 2020). This puts any newcomer at a disadvantage because products in the tech sphere, such as laptops, strongly rely on technological innovation to maintain acceptable costs.
This does not mean that HP is an untouchable force; there are some of its disadvantages that can be turned into advantages for the newcomer, such as LAVA.
Strategic mistakes by HP, such as the development of certain unsuccessful features like Snapfish, can be lessons and openings for newcomers to fill in the market (Bort, 2015). Especially with the introduction of relatively new products, such as gaming laptops, new entrants can be significant competition because they can focus on the niche market and develop brand recognition for that specific product. Particularly if late entrants are able to reverse-engineer this specific product and make it cheaper. (Corporate Finance Institute, 2020)
It is therefore important to acknowledge that even though HP dominates in absolute numbers, it is in a dynamic strive with competitive new entrants.
As explained, HP has multiple contextual factors that allow it to have the first advantage. It is likelier that HP will have a clearer strategy and can afford to set a quantity to sell, also because it has established itself for a long time in this market: it entered the computer market in India in 1989 (Fortune, 2011). HP has some price-setting power, while the newcomer will likelier adapt its quantity and adopt the same price. HP will rationally attempt to deter the entry of newcomers, taking into account two main consequences: the anticipated entry strategy of the newcomer and the outcomes of the chosen strategy for the incumbent itself (Gruca, 1995). Using reversed inductive reasoning, the matrix will likely look as follows:
If the incumbent anticipates that the newcomer will maintain the same price, then the incumbent will continue to dominate the market (as explained by its unique advantages and ability to move first and set its optimal quantity). The newcomer will still make some profits (it would not rationally enter the market if it did not predict some profits) but they are limited due to relatively high costs.
If the incumbent anticipates that the newcomer will increase its prices, then it would make profits by maintaining the status quo price because it would mean that consumers would rely on HP to provide the laptops, so it would maintain its dominant position in the market. It could also lower its prices and still make significant profits and it could be considered an aggressive deterrent strategy that could signal to the opposite entrant that it will outperform it. It also signals fewer profits, which could be a strategic move. However, this can backfire because if the opponent has significant knowledge, it could assume that there is a way to continue making costs lower and sell at lower prices.
If the incumbent anticipates a lowering price of the newcomer, it will still lower its price (and continue to do so) as a first move because it can afford price cuts and a potential price war. Lowering its prices will give it a higher quantity sold, even if it is a relatively modest lowering. The impact is higher for the newcomer, that has higher costs. Given the brand name of HP, it is plausible to assume that a small reduction in price will result in a higher quantity sold, proportionally more than the losses made due to lower prices. Laptops and electronic devices are relatively pricey products, and therefore selling more (so still making hundreds of dollars per sold item) is likely to be more beneficial than the ‘loss’ incurred from lowering the price by 50 dollars.
Payoff matrix of HP and a new entrant, such as LAVA. The starts indicate the best strategy of the incumbent given that the newcomer will either enter with higher, lower, or the same prices.
The dominant strategy for the incumbent is to lower its price. The newcomer does not have a dominant strategy. A nash-equilibrium occurs when both lower their prices, where they also both maximize profits and therefore are efficient.
Consumers as the clear ‘winning’ stakeholders
The dominant strategy for the incumbent is to lower its price because it would allow making significant profits by increasing a significant base of consumers. Given that it participates in economies of scale, the costs will be neglectable. The reason why the price was set higher was not necessarily to reflect costs but because it had monopoly tendencies in the market.
Based on the previous analysis, it is justified to assume that HP would lower its prices for laptops if a newcomer enters the regular laptop market, especially if it is offering laptops at a lower price as well.
HP laptops and newer, cheaper laptops are to some extent substitutes for one another. However, they are not perfectly substitutable for multiple reasons. For one, the lower price of the newcomer will not be extremely lower because it will have to maintain realistic revenue to keep operating. Given that HP is already largely efficient, it is doubtful whether the newcomer will lower the price too much. Secondly, the selling of laptops and technological brands relies on more than their absolute pragmatic utility. People also often purchase more known brands for the sake of owning slightly more luxurious versions. Furthermore, brand recognition makes HP perceived as better quality, worth the neglectable price difference.
Yet, a cheaper laptop that has similar functionalities will still be slightly favored. The following indifference curve shows, although modest, that a bigger drop in HP’s price will render it more preferred by consumers than the newcomer’s slightly more expensive and less known version. If the newcomer would have a bigger drop (figure 1), then it would be preferred over HP’s laptop. The ratio is smaller here though because HP still enjoys significant brand recognition.
Assuming that the average middle-class income is 500 USD and that there is expenditure on other products and that the lowered prices are in order, the budget line is given in the graph below. The indifference curve shows the marginal rate of substitution, which also makes sense in this scenario: an HP laptop is preferred over a LAVA laptop but the more HP laptops a person owns, the more indifferent they become as the additional utility of an extra HP laptop decreases.
The budget line and indifference curve. The purple graph represents the indifference curve and the black line is the budget line. Assuming that the average middle-income household spends its entire income of that month on laptops, the marginal rate of substitution can be derived from the indifference curve’s slope. The utility is maximized at the point of tangency.
Consumers will experience increased consumer surplus because their income did not change yet the competition drove the prices down, allowing them to buy more units. If the producers are able to sell more given the drop in price, then the surplus will not decrease. However, HP does have to share the market with LAVA, so its overall surplus did decrease. LAVA, in contrast, enjoys modest profits and therefore has an increasing effect on producer surplus. It could further compete with the incumbent by attempting to find a niche within the market that it could specialize in (and therefore cut costs), or find distributors with cheaper inputs before HP. Given that HP still has significant power, it is safe to assume that both groups are enjoying producer surplus and that it overall has a net increase.
Effects on the overall Indian Economy: AD/AS analysis
The competition between HP and new entrants to the market, such as LAVA, results in a drop in prices, which allows consumers to spend more (and therefore increase their utility).
If LAVA and HP form an advantageous dynamic - an upwards race to create cheaper and better products- then investment in the industry might increase as well. Foreign investors would want to be part of a fast-growing and profit-generating industry, which further causes aggregate demand to shift outwards in the short run. If LAVA gains significant market shares, it could globally expand and increase its exports to other developing countries, such as Nigeria: LAVA has already successfully established itself as a phone distributor in this market and therefore could launch its laptops as well. Although aggregate demand could have an inflationary pressure on price levels, it is also likely that productivity in the production of laptops and other products will increase, therefore causing an outward shift in the short-run aggregate supply. This will push the price levels down, as both companies will compete for market shares by decreasing prices.
Increased production also leads to more output, so it will likely cause an increase in GDP. Increased competition has an aggregated effect on long-run aggregate supply as well: through innovation - a necessary component to maintain levels of competition - aggregate demand increases but could also result in a shift outwards in the long-run aggregate supply: potential output increases due to structural changes, which occurs through innovation. Price fluctuations have little impact on long-run aggregate supply, but technological development does. Technological innovation as a result of competition also diffuses to other sectors beyond the laptop industry, which therefore has a national and secondary effect on many other tangent industries: from security to the pharmaceutical industries, changes in computer power and features have far-reaching effects. This could increase demand in these industries as well. According to McKinsey, India could generate $285 billion in economic value in 2030, which could be propelled by modernizing its IT services and technologies (McKinsey, 2020)
Increased productivity and efficiency have an overall positive effect on GDP in India, so long the investment and employment are indeed local and do not flee the country.
The AD/AS model shows predicted fluctuations, both in the long run and in the short run. The theory indicates the overall impact seems to be positive: an increase in output (more potential output), at lower price levels.
