Actions a firm takes in one market may affect its
profitability in other markets, beyond any joint economies or
diseconomies in production. The reason is that an action in one
market, by changing marginal costs in a second market, may change
competitors' strategies in that second market. We show how to
calculate the strategic consequences in market 2, of a change in
conditions in market 1 or of a firm's action in market 1.
Qualitatively, the same results hold for both simultaneous markets and
sequential markets: whether a more aggressive (i.e., lower price or
higher quantity) strategy in the first market provides strategic costs
or benefits depends on (a) whether competitors' products are
strategic substitutes or strategic complements. The latter distinction
is determined by whether more aggressive play by one firm in a market
raises or lowers competing firms' marginal profitabilities in that
market. We discuss applications to how firms select "portfolios" of
businesses in which to compete, to rational retaliation as a barrier
to entry, to international trade, and to the learning curve.
Both strategic substitutes competition and strategic complements
competition are compatible with either quantity competition or price
competition. For example, strategic complements competition arises
from price competition with linear demand and from quantity
competition with constant elasticity demand.
The distinction between strategic substitutes and strategic
complements is also important in other areas of industrial
organization. For example, we show that with strategic complements
competition firms will strategically underinvest in fixed costs. This
contrasts with earlier studies which, focusing on the total profits of
potential entrants rather than the marginal profits of established
competitors, invariably emphasized the use of excess capacity.
