Strategic Moves

“We must organize a merciless fight. The enemy must not lay hands on a
single loaf of bread, on a single liter of fuel. Collective farmers must drive their
livestock away and remove their grain. What cannot be removed must be
destroyed. Bridges and roads must be dynamited. Forests and depots must be
burned down. Intolerable conditions must be created for the enemy.”—Joseph
Stalin, proclaiming the Soviets’ “scorched earth” defense against the Nazis, July
3, 1941.

Today Stalin’s campaign lives on in the battlefields of corporate control.

When Western Pacific attempted to “annex” the publishing company Houghton
Mifflin, the publishing house responded by threatening to empty its stable of
authors. John Kenneth Galbraith, Archibald MacLeish, Arthur Schlesinger Jr.,
and many profitable textbook authors threatened to find new publishers if
Houghton Mifflin were acquired. “When Western Pacific Chairman Howard
(Mickey) Newman got the first few letters from authors, he thought it was a big
laugh, and called it a ‘put-up job.’ When he began getting more letters, he began
to realize, ‘I’m going to buy this company and I ain’t going to have nothing.’”1
Western Pacific withdrew its bid, and Houghton Mifflin remained independent.
This strategy doesn’t always work. When Rupert Murdoch was interested in
acquiring New York magazine, the incumbent management attempted to fight
him off. Many of the magazine’s best-known writers threatened to quit if
Murdoch attained control. Murdoch was not deterred. He acquired New York
magazine. The writers quit. But the advertisers stayed on. And Murdoch got
what he was looking for. The writers burned the wrong fields. For the scorched
earth strategy to be effective, you must destroy what the invader wants, which
may not coincide with what the present occupants value.
We do not mean to imply any moral approval of such tactics or their
outcomes—successful or not. We can easily imagine circumstances where
society would wish to prevent the wasteful destruction. Our purpose is to explain
the nature of these strategies so that you may better use them or prevent them.
The scorched earth defense is but one example of devices game theorists call
strategic moves.2 A strategic move is designed to alter the beliefs and actions of
others in a direction favorable to yourself. The distinguishing feature is that the
move purposefully limits your freedom of action. This can be done in an
unconditional way; a presidential candidate pledges he will not raise taxes,
period. Or, freedom can be limited because the strategic move specifies a rule for
how to respond under different circumstances. For example, many states have
mandatory sentencing laws for crimes with handguns; these statutes purposefully
limit judicial discretion.
You might have thought that leaving options open is always preferable. But
in the realm of game theory that is no longer true. Your lack of freedom has
strategic value. It changes other players’ expectations about your future
responses, and you can turn this to your advantage. Others know that when you
have the freedom to act, you also have the freedom to capitulate. To quote Oscar
Wilde, “I can resist anything except temptation.”3

1. UNCONDITIONAL MOVES
Picture a rivalry between the United States and Japan to develop high-definition
TV. Although the United States has a technological edge, it also has more limited
resources owing to accumulated budget deficits. The Japanese play off of this
handicap and once again beat the United States. But a strategic move that at first
glance appears to handicap the United States further can change all that.
In the absence of any unconditional moves, Washington and Tokyo
simultaneously choose their strategies. Each country decides between a low or
high level of research and development effort; a high-effort level shortens
development time, incurring much greater costs. We depict this as a game, and
set up the payoff table. Each side has two strategies, so there are four possible
outcomes.
We suppose both sides regard a high-effort race as the worst scenario—the
Japanese because the United States is more likely to win an all-out race, and the
United States because of the greater cost. Call this payoff 1 for each side. Each
side’s second worst outcome (payoff 2) is pursuing low effort while the other
goes all out: this is spending money with little chance of success.
 Payoffs for High-Definition TV Race (U.S., Japan)

The Japanese like best (labeled as payoff 4) the situation in which they
pursue high effort and the United States follows low effort; their chances of
winning are high, and resource costs matter less for them. For the United States,
the best situation is when both sides make low effort; they are likely to win at
low cost.
Low effort is the dominant strategy for the United States. The problem for
the United States is that the Japanese can anticipate this. The Japanese best
response is to follow high effort. The equilibrium of the game is the top right
cell, where the United States gets its second worst payoff. To improve its
position calls for a strategic move.
Suppose the United States preempts. It announces its unconditional effort
level before the Japanese reach their decision. This turns the simultaneous-move
game into a sequential-move game, one in which the United States goes first.
The table turns into a tree.*

Tree and Payoffs in Sequential-Move Game

 Payoffs to (U.S., Japan)

This game is solved by looking forward and reasoning back. If the United
States pursues low effort, the Japanese respond with high, and the U.S. payoff is
2. If the United States pursues high effort, the Japanese respond with low, and
the U.S. payoff is 3. Therefore the United States should announce high, and
expect the Japanese to respond low. This is the equilibrium of the sequential-
move game. It gives the United States a payoff of 3, more than the 2 it got in the
simultaneous-move game.
The strategic move that brings the United States this advantage is a unilateral
and unconditional declaration of its choice. The choice is not what the United
States would have made in simultaneous play. This is where the strategic
thinking enters. The United States has nothing to gain by declaring the choice of
low effort; the Japanese expect that anyway in the absence of any declaration.
To behave strategically, you must commit not to follow your equilibrium
strategy of the simultaneous-move game. The strategic move changes Japanese
expectations, and therefore their response. Once they believe that the United
States is committed to high effort, the Japanese will choose low effort. Of
course, after the Japanese choose their path, the United States would do better to
change its mind and switch to low effort, too.
This raises several questions: Why should the Japanese believe the U.S.
declaration? Would they not anticipate a change of mind? And if they anticipate
such a reversal, would they not choose high effort?
In other words, the credibility of the U.S. unconditional first move is
suspect. Without credibility, the move has no effect. Most strategic moves must
confront this problem of credibility. Recall the examples at the opening of the
chapter. Although the politician’s pledge not to raise taxes is unconditional, it is
not irreversible. Once elected, excuses are often found to raise taxes. Conditional
rules are also subject to exceptions when the time comes; the mandatory
sentence is waived when a neurologist uses an illegal handgun in self-defense
against a deranged patient.
To give a strategic move credibility, you have to take some other supporting
action that makes reversing the move too costly or even impossible. Credibility
requires a commitment to the strategic move. In the case of Stalin’s threat to
starve the enemy, burning the fields made his threat credible. In other situations,
credibility is a matter of degree. Precedent in the legal system gives credibility to
the mandatory sentencing rule (in most cases); for politicians’ promises,
exceptions are more the rule. In the race for high-definition TV, the United States
might commit funds to which interested companies can lay claim in order to
make a high R&D effort credible.
Strategic moves thus contain two elements: the planned course of action and
the commitment that makes this course credible. In this chapter we focus
attention on the actions. We classify and explain different types of strategic
behavior, leaving aside for the moment the problem of how to make them
credible. To make an analogy with cooking, the next chapter offers recipes for
commitment. We continue here with a menu of moves.

2. THREATS AND PROMISES

An unconditional move gives a strategic advantage to a player able to seize the
initiative and move first. Even when you don’t actually move first, you can
achieve a similar strategic advantage through a commitment to a response rule.
The response rule prescribes your action as a response to the others’ moves.
Although you act as a follower, the commitment to the response rule must be in
place before others make their moves. A parent telling a child “No dessert unless
you eat your spinach” is establishing such a response rule. Of course this rule
must be in place and clearly communicated before the child feeds its spinach to
the dog.
Response rules fall under two broad categories: threats and promises. A
threat is a response rule that punishes others who fail to cooperate with you.
There are compellent threats, as when a terrorist hijacks a plane and establishes a
response rule that the passengers will be killed if his demands are rejected, and
there are deterrent threats, as when the United States threatens that it will
respond with nuclear weapons if the Soviet Union attacks any NATO country. A
compellent threat is designed to induce someone to action, while a deterrent
threat is designed to prevent someone from taking an action. The two threats
share a common feature: both sides will suffer if the threat has to be carried out.
The second category of response rules is promises. This is an offer to reward
someone who cooperates with you. In search of a witness, a prosecutor promises
one defendant a more lenient sentence if he turns state’s evidence against his
codefendants. Again there can be compellent and deterrent promises. A
compellent promise is designed to induce someone to take a favorable action,
such as turning state’s evidence. A deterrent promise is designed to prevent
someone from taking an unfavorable action, such as when the mobsters promise
the witness they will take care of him if he keeps his mouth shut. The two
promises also share a common feature: once the action is taken (or not taken),
there is an incentive to go back on one’s word.
Sometimes the distinctions between threats and promises are blurred. A
friend was mugged in New York City with the following promise: If you “lend”
me twenty dollars, I promise I won’t hurt you. More relevant was the mugger’s
implicit threat that if our friend didn’t lend him the money, he would be hurt.
As this story suggests, the distinction between a threat and a promise
depends only on what you call the status quo. The traditional mugger threatens
to hurt you if you don’t give him some money. If you don’t, he starts hurting
you, making that the new status quo, and promises to stop once you give him
money. A compellent threat is just like a deterrent promise with a change of
status quo; likewise, a deterrent threat and a compellent promise differ only in
their status quo.

3. WARNINGS AND ASSURANCES

The common feature to all threats and promises is this: the response rule
commits you to actions that you would not take in its absence. If the rule merely
says you will do what is best at the time, this is as if there is no rule. There is no
change in others’ expectations about your future actions and hence no influence
of the rule. Still, there is an informational role for stating what will happen
without a rule; these statements are called warnings and assurances.
When it is in your interest to carry out a “threat,” we call this a warning. For
example, if the president warns he will veto a bill not to his liking, this is simply
an indication of his intentions. It would be a threat if he were willing to sign the
bill, but strategically committed to veto it in order to induce Congress to offer
something even better.
 A warning is used to inform others of the effect of their actions. A parent
who warns a child that a stove-top is hot, makes a statement of fact, not strategy.
When it is in your interest to carry out a “promise,” we call this an
assurance. A child who ignores the warning that the stove-top is hot and gets
burned assures the parent that he won’t do this again.
We emphasize this distinction for a reason. Threats and promises are truly
strategic moves, whereas warnings and assurances play more of an informational
role. Warnings or assurances do not change your response rule in order to
influence another party. Instead, you are simply informing them of how you will
want to respond based on their actions. In stark contrast, the sole purpose of a
threat or promise is to change your response rule away from what will be best
when the time comes. This is done not to inform but to manipulate. Because
threats and promises indicate that you will act against your own interest, there is
an issue of credibility. After others have moved, you have an incentive to break
your threat or promise. A commitment is needed to ensure credibility.
We summarize the options for strategic moves in a chart below. An
unconditional move is a response rule in which you move first and your action is
fixed. Threats and promises arise when you move second. They are conditional
moves because the response dictated by the rule depends on what the other side
does.

A strategic move is always a preemptive action. The response rule must be in

place before the other side moves. That means that whatever strategic move is
made, the game should be analyzed as one with sequential moves. When you are
intransigent, others respond to your unconditional action. With threats and
promises, you first lay down a response rule, then others move and you respond
according to your response rule.
As a result, commitment to an action or response rule transforms an
otherwise simultaneous-move game into a sequential-move game. Although the
payoffs remain unchanged, a game played with simultaneous moves in one case
and sequential moves in another can have dramatically different outcomes. The
different outcomes are due to the different rules of play. We illustrated this effect
with an unconditional move in the story of U.S.-Japanese rivalry; let us now
look at threats and promises arising in a confrontation between the United States
and the Soviets and then the Democrats and the Republicans.

4. NUCLEAR DETERRENCE
For over forty years, the North Atlantic Treaty Organization (NATO) sought a
credible deterrence to any Soviet attempt to invade Western Europe. A
conventional defense by NATO forces was not likely to succeed. A primary
component of the NATO deterrence was based on the U.S. nuclear forces. Yet, a
nuclear response would be devastating for the whole world. How could this
work?
Let us show the game in a tree. The Soviets have the first move. If they do
not attack, we have the status quo; score this 0 for each side. If they attack and
NATO attempts a conventional defense, suppose the Soviets have the payoff 1
and the United States has -1. A nuclear response gives -100 to each side.

Tree and Payoffs in Sequential-Move Game

In this game, the Soviets look ahead and forecast that their aggression will
not bring forth a nuclear response. It is not in the U.S. interests after the fact.
Thus attacking will give them the payoff 1; not attacking, 0. Therefore they will
attack.
If you think this an unlikely scenario, the European members of NATO
thought it all too likely that the United States would desert them in their time of
need in just this way. They wanted the United States to commit credibly to a
nuclear response.
Let us leave aside the issue of credibility for now, and examine the
mechanics of how such a threat could work. Now the United States has the first
move, namely the response rule it puts in place. The pertinent rule is the threat:
“If the Soviets attack Western Europe, our response will be nuclear.” If the
United States does not make the threat, the rest of the game unfolds as before.
With the threat in place, the choice of a conventional defense no longer exists.
The full game tree is as follows.

Payoffs in Sequential-Move Game with Threat in

Place

Once the U.S. threat is in place, the Soviets look ahead and recognize that
aggression will meet a nuclear response and result in a Soviet payoff of -100.
They prefer the status quo, and so do not invade. Now the United States in its
first move looks ahead to all this and sees that its payoff is 0 with the threat and
1 without. Therefore U.S. interests dictate making the threat.
Once again, observe that the U.S. response rule requires doing something
that is not the best response after the fact. Therein lies the strategic purpose: by
credibly altering the Soviets’ perception of the U.S. response after the fact, the
United States can change “the fact”—namely, the Soviet decision whether or not
to invade Western Europe.
 The rule must be in place before the other party has already taken the action
you want to influence. After the fact, neither an unconditional move nor threats
and promises have any relevance.
This first move must be either observed or inferred by the rival, or else you
cannot use it for strategic effect. In the film Dr. Strangelove, the Soviets install
their sure deterrent, the doomsday device, on a Friday, but delay telling the
Americans until Monday. Over the weekend, U.S. Air Force General Jack D.
Ripper orders his squadron of planes to launch a nuclear attack. The deterrent
fails by being unobservable.
Observability is not as straightforward as it seems. One need not actually
observe the other person’s actions if the action can be inferred from the
consequence. If I am allergic to shellfish, I can tell that you cooked with shrimp
even if I did not actually observe you in the kitchen.*
Just as your unconditional move must be observable if it is to influence your
rival, his actions must be observable if you are to influence them by threats or
promises. Otherwise you cannot check his compliance, and he knows this.
Now that you have seen how credible unconditional moves and threats have
their effects, you will be able to analyze most simple situations of this kind
without drawing a game tree in all its detail. A verbal argument will usually
suffice. If ever it does not, and you doubt if the prose has covered all the cases
correctly, you can always check the reasoning by drawing the tree.

5. STRATEGIES OF THE TIMES

In 1981, Ronald Reagan was a newly elected president with tremendous popular
appeal. But, could he carry his vision for tax reform through Congress? The
battle lines were drawn in the fight over his first budget proposal. The
Democrats wanted Reagan to compromise, sacrificing part of the tax cut for the
sake of a smaller deficit. The Republicans wanted the full dose of supply-side
economics. The outcome would depend on how the two parties played the game.
In the Senate, the Democrats went along with Reagan’s budget, hoping to
induce some Republican compromise in return for the bipartisan support. But the
Republicans held firm to the original plan. Thus the scene turned to the House of
Representatives. Was there some better strategy for the Democrats?
A pair of New York Times columns by Leonard Silk neatly laid out the
strategic possibilities.4 As he described the negotiations, each party had two
choices and there were four possible outcomes. We reproduce Silk’s table of the
game.
 Ranking of Outcomes for [Democrats, Republicans]

The Democrats regard as best the outcome where they attack Reagan and the
Republicans compromise, because the Democrats can claim the credit for fiscal
responsibility while implementing their favored budget. For the Republicans, the
best outcome occurs in the top left, where Reagan’s budget gets bipartisan
support. When the Democrats attack while the Republicans hold firm, the result
is a stalemate and both parties lose. The Democrats would be willing to
moderate their attack if the Republicans would compromise; both parties would
get their second-best outcome.
The Democrats’ main problem is that the Republicans have a dominant
strategy: support Reagan completely. If the Democrats mainly support Reagan,
the Republicans should support Reagan completely to attain their top outcome. If
the Democrats attack Reagan, the Republicans should support Reagan to avoid
their worst outcome. Whatever the Democrats do, it is always better for the
Republicans to support Reagan completely.*
Thus the Republican strategy seems easy to predict. The Democrats should
expect the Republicans to support Reagan completely, and then the Democrats
do best by following suit and mainly supporting Reagan. This is exactly what
happened in the Senate.
So far, the outcome greatly favors the Republicans. To improve their
position, the Democrats need to make some type of strategic move. They must
turn the situation into a sequential-move game, moving first and then letting the
Republicans respond to their strategy.† Thus we consider what type of threats,
promises, or other moves shift the outcome in favor of the Democrats.
None of the basic strategies seem to work for the Democrats. Unconditional
moves, promises, even threats all fail. Only the combined use of a threat and
promise can induce Republican compromise.
The problem with unconditionality is that it doesn’t influence the Republican
position. The Democrats are currently expected to support Reagan. Committing
themselves to this action does not alter the Republicans’ perception and thus
leads to the same outcome. The only strategic possibility is for the Democrats to
attack Reagan unconditionally. In this case, they can look forward and reason
that the Republicans will still respond by supporting Reagan completely. (The
Republicans always prefer to support Reagan completely—it is their dominant
strategy.) But the combination of Democrats attacking with the Republicans
giving complete support is worse for the Democrats than the alternative of both
parties supporting Reagan.
The Democrats want to induce the Republicans to move from completely
supporting Reagan to compromise. Therefore, they might promise to support
*
Reagan if the Republicans agree to compromise. But this promise will not help
them. The Republicans know that if they ignore the promise and choose to
support Reagan completely, the Democrats’ best response is to support Reagan.
The effect of the Democrats’ promise is that they end up unconditionally
supporting Reagan. The Republicans appreciate this gesture and proceed to
support Reagan completely, maintaining their best outcome. The promise is
pointless. The Republicans can safely ignore it.
The Democrats have only one threat that they can use to stop the Republican
support of Reagan. They can threaten to attack Reagan if the Republicans
support him completely. But the threat is not enough. The effect of the threat is
that the Democrats have unconditionally committed to attack Reagan. If the
Republicans support Reagan, the Democrats carry out their threat and attack
Reagan; if the Republicans compromise, it is in the Democrats’ best interest to
attack Reagan. Since the Democrats attack Reagan whatever the Republicans do,
the Republicans support Reagan completely, making the best of the two
possibilities.
A promise ends up being equivalent to unconditional Democrat support for
Reagan, while a threat is equivalent to an unconditional Democrat attack on
Reagan. Neither is effective in changing the Republicans’ actions.
If the Democrats combine a promise with a threat, they can achieve a better
result for themselves. They should promise to support Reagan if the Republicans
compromise and threaten to attack Reagan if the Republicans support Reagan
completely. This strategy achieves the Democrats’ goals. With this threat and
promise in place, the Republicans must choose between compromising and
getting the Democrats to mainly support Reagan, or supporting Reagan
completely and thereby provoking the Democrats to attack Reagan. Between
these two alternatives, they prefer the compromise.
What actually happened was that Republicans supported Reagan completely
in both the Senate and in the House. The Senate Democrats went along with the
Republicans. In the House, the Democrats’s initial resistance quickly gave way
to a third strategy: they out-Reaganed Reagan in the tax-cutting game. The result
was a bipartisan “Christmas-tree” tax cut. The economic bills for that are just
coming due, and the negotiations to get out of the difficulty are developing into
new strategic games.

6. MORE STRATEGIC MOVES

In addition to the three basic strategic moves, there are more complicated
options. Instead of establishing a response rule directly, you can purposefully
allow someone else to take advantage of one of these strategies. Three options
are

You may allow someone to make an unconditional move before you

respond.
You may wait for a threat before taking any action.
You may wait for a promise before taking any action.

We have already seen examples in which someone who could move first
does even better by relinquishing this option, allowing the other side to make an
unconditional move. This is true whenever it is better to follow than to lead, as
in the tales of the America’s Cup race and gambling at the Cambridge May Ball.
While it can be advantageous to give up the initiative, this is not a general rule.
Sometimes your goal will be to prevent your opponent from making an
unconditional commitment. Chinese military strategist Sun Tzu wrote: “When
you surround an enemy, leave an outlet free.”5 One leaves an outlet free so that
the enemy may believe there is a road to safety. If the enemy does not see an
escape outlet, he will fight with the courage of desperation. Sun Tzu aimed to
deny the enemy an opportunity to make his own very credible commitment of
fighting to the death.
It is never advantageous to allow others to threaten you. You could always
do what they wanted you to do without the threat. The fact that they can make
you worse off if you do not cooperate cannot help, because it limits your
available options. But this maxim applies only to allowing threats alone. If the
other side can make both promises and threats, then you can both be better off.

7. A SLEDGEHAMMER TO CRACK A NUT?

It is clear that when making a promise, you should not promise more than you
have to. If the promise is successful in influencing the other party’s behavior,
you expect to carry out your word. This should be done as cheaply as possible,
and that means promising the minimum amount necessary.
It is less apparent that moderation applies equally well to threats. You
shouldn’t threaten someone any more than necessary. The reason is more subtle.
Why doesn’t the United States threaten a military attack against the Japanese
if they don’t agree to import more American rice, beef, and oranges?* The idea
may have some appeal to some American farmers and politicians. But there are
several good reasons against it.

1. Nobody would believe the threat, and thus it wouldn’t work.

2. Even if the threat did work, the Japanese might wisely want to
reconsider whether the Americans are really their allies.
3. If the Japanese didn’t import more oranges and the U.S. actually
carried out its threat, the rest of the world and especially the Japanese
would sanction the U.S. for selecting an inappropriate method of
punishment. But if the U.S. didn’t carry out its threat, that hurts its
reputation in the future. Either way the United States loses.
4. The threat dilutes the clarity of the original problem by introducing the
otherwise extraneous issue of military force.

The essence of all these points is that the threat is excessively large—too big
to be credible, too big to carry out, and too serious to stake a reputation over.
The first concern of a player making a threat would be just the opposite—a
threat must be large enough to achieve the desired deterrence or compellence.
The next thing that matters is credibility—the other side’s belief that if it defies
the threat, it will suffer the stated consequences. Under ideal circumstances,
nothing else should matter. If the threatened player knows and fears the
consequences of defiance, he will comply. The threatened action will never have
to be carried out. Then why does it matter how terrible it would have been if it
were carried out?
The point is that circumstances are never ideal in this sense. If we examine
the reasons for our not threatening to use military power in this case, we see
more clearly how reality differs from the ideal.
First, the very act of making a threat may be costly. Nations, businesses, and
even people are engaged in many games, and what they did in one game has an
impact on all the other games. In our dealings with Japan in the future, and with
other countries now and in the future, our use of an excessive threat will be
remembered. They will be reluctant to deal with us at all, and we will forgo the
benefits of many other trades and alliances.
Second, an excessive threat may be counterproductive even in the game in
which it is used. The Japanese will throw up their hands in horror, appeal to
world opinion and the decency of the American people, and more generally
delay the negotiation to the point where our timetable for compelling them to
open their markets is slowed rather than speeded.
Third, the theory that a successful threat need never be carried out is fine so
long as we are absolutely sure no unforeseen errors will occur. Suppose we have
misjudged the Japanese farmers’ power, and they are willing to let their nation
go to war rather than see their protected market disappear. Or suppose that the
Japanese agree to our terms, but some U.S. military commander down the line
who remembers his experience as a P.O.W. and is itching for revenge takes the
opportunity to launch an attack all the same. The possibility of such errors
should give us pause before we commit ourselves to a very large threat.
Finally, in view of this, a threat starts to lose credibility just for being too
large. If the Japanese do not believe we are truly committed to carrying out the
threat, it will not deter them either.
The conclusion is that one should strive for the smallest and the most
appropriate threat that will do the job—make the punishment fit the crime. When
the United States wants to stimulate the Japanese to import more oranges, it uses
a more reciprocal threat, one that more closely fits the crime. The United States
might retaliate in kind by limiting the quotas on imports of Japanese cars or
electronic goods.
Sometimes fitting threats are readily available. At other times, there are only
excessive threats, which must somehow be scaled down before they can be used.
Brinkmanship is perhaps the best scaling device of this kind, and we shall
explain it in Chapter 9.

8. CASE STUDY #5: BOEING, BOEING, GONE?

Developing a new commercial airplane is a gigantic gamble. The cost of

designing a new engine alone can reach two billion dollars. It is no exaggeration
to say that building a new and better plane requires “betting the company”.6 No
wonder governments get involved, each trying to make a larger market for its
domestic firm.
Here we look at the market for 150-passenger medium-range jets: the
Boeing 727 and the Airbus 320. Boeing developed the 727 first. Did it make
sense for Airbus to enter the market?
The primary market for these aircraft was in the United States and in the
European Economic Community (E.E.C.) countries. We assume each of these
markets is worth $900 million to a monopoly firm. Were the two firms to
compete head-on, total profits fall from $900 to $600 million, divided evenly
between the two firms. Although profits fall, competition results in cheaper
planes and lower airfares, so consumers benefit. These benefits to consumers are
worth $700 million in each market.
Airbus Industries estimates that it will cost $1 billion to develop the Airbus
320. If they go ahead without any government assistance, they can expect to
make a profit of $300 million in each of the markets, American and E.E.C. The
total of $600 million is not enough to cover the development costs.
The E.E.C. governments cannot offer direct assistance in the form of
subsidies because their budget is already committed to subsidizing farmers. In
the traditional trade-off between guns and butter, the E.E.C. has gone for butter
and has little left for either guns or Airbuses.
You are called to Brussels and asked for advice on whether the E.E.C.
should assist Airbus by giving it a protected market, that is, requiring European
airlines to buy the Airbus 320 over the Boeing 727. What do you suggest? How
do you expect the United States government to respond?
 Case Discussion
If the E.E.C. protects its home market and the American market stays open,
Airbus will earn $900 million as a monopolist in Europe and $300 million as a
duopolist in the United States. This is enough to cover the development costs of
$1 billion.
Is this policy in the interests of the E.E.C. as a whole? We have to consider
the gain to Airbus versus the loss to European consumers. Without a protected
market, Airbus would not enter. Boeing would have a monopoly in Europe.
Consumers would be no better off. Therefore there is no loss to consumers. The
economic gains to the E.E.C. as a whole coincide with the profits of Airbus. It
seems that the E.E.C. should support the venture by promising a protected
market.
It is important that the E.E.C. commit itself to protectionist policy. Suppose it
keeps its options open, and Airbus enters the market. At this point it does not
have an incentive to protect Airbus. Keeping the markets open will reduce
Airbus’s expected profit by $600 million (from $200 million to negative $400
million), but the competition from Boeing will raise the E.E.C. consumers’
benefits by $700 million. Knowing this, Airbus will not enter, because it does
not have a credible commitment that the E.E.C. governments will maintain a
protected market.
What about the American response? If the Americans act quickly, they too
can commit to protecting their domestic market before Airbus begins production.
Let us look ahead and reason backward. If the American market is kept open, the
picture unfolds as before. Boeing is shut out of Europe and makes $300 million
in competition with Airbus in the American market. The American consumer
gets an extra $700 million of benefits from the competition. The total gain to the
U.S. economy if it maintains an open market is $1,000 million.
Say the United States reciprocates and requires American airlines to
purchase the Boeing 727 over the Airbus 320. Then even the monopoly profit of
$900 million in Europe falls short of the Airbus development costs. So the
Airbus 320 will never be built. Boeing will enjoy a monopoly in both markets,
making profits of $1,800 million. This total economic gain to the United States
is considerably higher than when its market is open.7
The United States can defeat the E.E.C. support for Airbus by reciprocating
protectionism. It is in its interest to do so.