How do the ideas of economic theory help us to understand the operation of interfirm collaboration such as joint ventures and alliances

Seminar Paper 2004 24 Pages

Economy - Theory of Competition, Competition Policy




1. Reasons for interfirm collaboration
1.1 Risk and uncertainty
1.2 Poor profitability
1.3 Market variables

2 Game theory
2.1 The prisoner's dilemma
2.2 Translation into a business situation
2.3 The iterated game

3 Forms of interfirm collaboration
3.1 Trade associations
3.2 Joint ventures
3.3 Strategic alliance
3.4 Cartels
3.5 Price leadership

4 Interfirm collaboration's mode of operation
4.1 An economic model
4.2 Collusive contracts

5 Stability of collusive agreements


Appendix: The kinked demand curve



Since the 1980s joint ventures and strategic alliances have enjoyed great popularity with firms, mainly in new and technology-intensive industries (Grabher p.12). Where two competitive firms work together to achieve a common purpose, this cooperation is named interfirm collaboration. Such collaborations are famous for their aim to avoid negative effects of competition or to benefit from the transfer of information and skills. The fact that competitors decide to establish a quasi-contractual relationship rather than to compete is discussed by various economic theories. The following implementations deal with these economic approaches. At first circumstances that lead firms to collusive behavior are analyzed, followed by specifying game theory as a suitable model to explain why firms decide to collaborate. The third part of this paper analyses various kinds of contractual relationships between collaborating firms, leading to a brief outline on stability of collaboration and problems appearing in such relationships.

1 Reasons for interfirm collaboration

1.1 Risk and uncertainty

Every firm is part of a rich network of relationships and interdependencies (Kay, p.9). Mutual interdependency can be described by Sweezy's kinked demand curve in an oligopoly (Sweezy (1939), cited in Lipczynski, p.29, see appendix). The competitive situation in an oligopoly is characterized by action-reaction: One firm's actions affect the ones of its rivals and vice versa (Lipczynski, p.15). Competitors determine their price and output on the basis of their rival's likely reactions. Since firms do not know which action their rivals will take next, they decide on conjectural variation. (Lipczynski, p.17). Trying to reduce the uncertainty that results from following rumors and guessing likely reactions, firms often move towards various forms of collusion (Lipczynski, p.17). As Asch mentions, collusive decrease competition, make near-monopoly power possible and are therefore a simple solution to a complex problem (Asch (1969), cited in Lipczynski, p.51). Besides, vertical collaboration may contribute to reduce transaction costs (Lundvall, p.56).

The risks to which a firm is exposed are of two kinds: The variability of the customer's demand and the risk resulting from competition (Lipczynski, p.52). Firms may enjoy independence in free markets as long as they are stronger than their competitors, but those that are aware of losing market shares intend to collaborate with their competitors (Lipczynski, p.50), They try for example to receive market information on which they can base their decisions.

Scherer and Ross (Scherer and Ross (1990), cited in Lipczynski, p.74) mention, that firms which are exposed to the risk of infrequent orders, tend to collaboration. As price competition does not solve their problem of excess capacity, these fix prices to ensure a reasonable return. Another risk stated by Scherer and Ross is a high ratio of fixed to variable costs, especially where competitive firms have discriminative fixed cost ratios (Lipczynski, p.76).

1.2 Poor profitability

Various studies, for example those of Asch and Seneca, found a negative relation between profitability and collusion (Asch and Seneca (1976), cited in Lipczynski, p.73). If firms suffer from low profits, which may be caused by frequent price-cutting or a general depression in the industry, they tend to collaborate. By fixing a certain price, firms avoid a further price warfare and guarantee a certain level of profit for each of them.

1.3 Market variables

Market variables are rather a conducive circumstance than a reason for collaboration. Industrial concentration is one of them. The higher the concentration in an industry, the easier it is for the firms to establish a collusive agreement. This is a result of different reasons: Firstly a small number of firms brings about low transaction costs. It will be easier for firms to find a common purpose, to communicate and to monitor the others. Furthermore, in a small group firms are more interdependent, they consider their rival's likely reactions in every action they take (Lipczynski, p.78).

Besides concentration, asymmetry of market shares is mentioned by Phillips (Phillips (1962), cited in Lipczynski, p.80) to be conducive to collaboration. In an industry of few big and several small firms, the big ones could act as leaders, the small ones as followers. On the other hand some economists state that symmetry of market shares may lead to collaboration, for example Mac Gregor (MacGregor (1906), cited in Lipczynski, p.80).

A further conducive circumstance is a lack of product differentiation (Lipczynski, p.80). Where firms offer homogeneous products, like for example in aviation, it will be easy for them to determine fixed prices for their comparable products. Inelastic demand is also known to be leading to collaboration. Where demand does not react on higher prices, firms tend to fix a higher price to ensure higher profits (Lipczynski, p.82).

2 Game Theory

2.1 The prisoner's dilemma

The above mentioned reasons for collusion are mostly outcomes of studies on actual collaborations. A more theoretical approach can be achieved by dint of game theory. In collaboration firms try to reduce risks by establishing a balanced situation in which both of them may win (Kay, p.9). The aim of such agreements can be of three kinds: Firstly firms may cooperate, which means to act on behalf of a common purpose. Secondly they could coordinate their actions for consistent reactions to a certain problem. Thirdly the aim could be differentiation, thus to avoid actions that are not compatible (Kay, p.33). The following statement concentrates on cooperation.

For game theorists firms in an oligopoly behave like in a strategic game. The most popular game is the prisoner's dilemma, named so as first demonstrated by example of two prisoners in an interrogation situation, faced with the decision to confess or not. They are not allowed to communicate, so each prisoner does not know whether the other confessed or not. Both get informed about the consequences, how many years they will have to spend in prison, if neither or both or only one of them confesses (Moschandreas, p. 171). The interdependency in the prisoner's dilemma is usually shown in a pay-off-matrix, like in the following figure:

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The pay-off to each strategy of one depends on what the other would do. For both the worst outcome appears in case of no-confessing. Therefore both of them will, selecting the best of the worst, decide to confess, ending up seven years in prison. They find themselves in the so-called Nash-equilibrium, where the strategy of each player is best, whatever the other does. They both are playing a dominant strategy (Douma, p.77). The result is only suboptimal, Kay calls it a "perverse result (...) an outcome that everyone recognizes as inferior" (Kay, p.48).



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Title: How do the ideas of economic theory help us to understand the operation of interfirm collaboration such as joint ventures and alliances