18.22 : Reputation

In game theory, a firm's reputation for aggressive behavior can serve as a powerful strategy to deter potential competitors from entering a market. This strategy hinges on convincing competitors that market entry will result in significant financial losses due to the firm's reputation for taking strong, retaliatory measures.

Consider a large online bookstore that dominates the market and a small independent bookstore contemplating market entry. If the larger bookstore allows the smaller one to enter without resistance, it signals a lack of aggression. Such a signal may embolden not only this competitor, but also other potential entrants. Over time, market entry would cause the larger bookstore's profits to erode as more competitors divide the market.

To prevent this, the larger bookstore might adopt an aggressive strategy, such as cutting prices on popular titles or offering extensive discounts that the smaller competitor cannot afford to match. While this approach would reduce the larger bookstore's short-term profits, it reinforces its reputation as a tough competitor. For example, if the smaller bookstore enters, both firms may experience losses: the smaller bookstore due to its limited resources and the larger one due to reduced profit margins. However, the long-term benefit lies in discouraging future competitors who perceive the larger bookstore as unwilling to share the market.

If the smaller bookstore views the larger bookstore's aggressive response as credible, it might choose not to enter the market at all. This outcome allows the larger bookstore to retain its dominance and profitability. By strategically leveraging its reputation, the firm demonstrates how short-term sacrifices can be used to secure long-term competitive advantages. This illustrates a core concept of game theory: how signaling and credibility shape decision-making and outcomes in competitive markets.