Nash Equilibrium , price leadership and prisoners dilemma/Case Study 32: Lesser Antilles Lines

Description
Read attached documents to go over the case study and the format needed for the case study analysis paper.
Case Study 32: Lesser Antilles Lines

Description
This case describes two shipping firms in the midst of a price war over the market for containerized shipping to and from a small Caribbean island. The situation is a classic duopoly. The case presents a table of contributions to both firms as a function of their prices. This table serves as a basis by which the class can explore the concepts of Nash equilibrium, price leadership, and prisoners’ dilemma. See also ”Lesser Antilles Lines (B)” and ”Lesser Antilles Lines (C).”
Learning objective:
The case and the subsequent class discussion are designed to review the conditions under which predatory pricing does and does not make sense; explore in detail pricing considerations in a duopoly; and introduce the concepts of equilibrium pricing, price leadership, and the prisoners’ dilemma.
Subjects Covered:
Competition; Diversity; Game theory; International business; Pricing; Quantitative analysis
Setting:
? Geographic: Caribbean
? Industry: Shipping
? Company Revenue: $5 million to 99.9 million

This session introduces students to the basic ideas of the game theory and their application to managerial decision-making. The case considers a game between two shipping lines and emphasizes identifying the important strategic characteristic for decision-making.

Does Predatory Pricing Make Sense or Not? Price Considerations in a Duopoly. Equilibrium Pricing. Price Leadership. Prisoner?s Dilemma. Does Market Share Play into the Pricing?

Format for Case Studies

Your case study should include but not be limited to the following format.

Executive Summary of the case ? This is a paragraph or two about the facts in the case. Be brief, but be thorough. This should be in summary format.

Decision Problem ? This should be a statement of the decision or decisions the case is asking you to make.

IMPORTANT: Your case analysis has to be completely the work of your team. If you seek help or information from any other source, published or unpublished, you MUST cite your sources, neglecting to do so, constitutes academic dishonesty. The paper will be given a grade of ?F? if any of the paper is plagiarized. Only American Psychological Association (APA) style documentation is acceptable.

UV0351 Rev. Apr. 27, 2016
This case was prepared by James V. Gelly under the supervision of Professor Phillip E. Pfeifer. Names, places, and figures have been disguised. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright ? 2010 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means?electronic, mechanical, photocopying, recording, or otherwise?without the permission of the Darden School Foundation.
Lesser Antilles Lines: The Island of San Huberto (A)
James Vaughan looked over the balcony railing to the sea beyond. As he settled comfortably into the rattan chair, he watched the sweat roll down the side of his water glass. He sniffled repeatedly. After three months in the Caribbean, Vaughan had become somewhat acclimatized, but the effects of a summer cold lingered. With a sigh, he thought of his imminent return to the United States for the second year of his MBA program. San Huberto was his last assignment for the summer. The evening?s sea breeze blew across the balcony of the Gran Hotel San Huberto, and Vaughan thought about the recommendations he would make about pricing strategy to his summer employer, Lesser Antilles Lines (LAL). LAL was a very successful containerized shipping firm moving cargo between Fort Lauderdale, Florida, and about 15 Caribbean islands. Vaughan was hired to investigate eight potential new markets in the Caribbean and Central America. On his way back to Fort Lauderdale, he received a call asking him to stop in San Huberto. Because LAL was embroiled in a particularly vicious price war, San Huberto was the only market in which LAL was not producing impressive earnings. Vaughan was asked to survey the scene and evaluate LAL?s pricing strategy for the island.
Lesser Antilles Lines
LAL was born in the early 1960s when a Florida construction firm successfully bid on a contract to build sidewalks on a Caribbean island. Much to the manager?s disgust, transporting equipment and materials to that particular location was virtually impossible. Although the occasional vessel might call at the port, voyages were infrequent and unreliable. In true West Indian style, vessel operators? attitudes toward scheduling were relaxed and unhurried. The construction firm was unwilling to tolerate the vagaries of local shipping, so it purchased an old barge and began regular travel between Fort Lauderdale and the island. In a short time, grocery wholesalers, hardware stores, and other businesses on the island began requesting that their goods be transported on the barge for a fee. They claimed that such a service was better than any other available at that time. LAL ?came of age? when revenues from the shipping service began to approach those from the construction end of the business. In 20 years, LAL?s service network grew from one island to fifteen. Revenues in 1985 were almost $50 million. LAL specialized in serving the small islands that historically received little attention from the established shipping lines. By offering reliable and frequent transportation in previously neglected regions, LAL garnered impressive market shares, and by providing the highest levels of service to even the smallest customers, the firm defended its market share in spite of intense competition. LAL became something of a legend in the region for its punctuality; it was said that you could set your watch by its vessels.
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Maritime Trade
Ocean shipping always played a central role in the world economy; virtually all internationally traded goods were transported by sea. Maritime trade was divided into two categories, bulk and general cargo. The bulk category accounted for roughly 75% of total world tonnage shipped in 1985 and was principally made up of petroleum, mineral ores, coal, and grain. General cargo, which comprised the remaining 25% of total world tonnage shipped, referred to manufactured goods and consumer products. Because general cargo represented relatively high-value goods, fast and efficient transportation was required to move them. LAL competed in that higher-value general cargo industry, commonly known as the liner trade.
Containerized transportation
Before the 1950s, general cargo had been moved by the ?break-bulk? method. Individual boxes, drums, crates, and sacks were loaded on and off ship by crane and by hand; stevedores and longshoremen supplied labor at the ports of origination and destination. This system was not an efficient one, however. Ocean transportation was a labor-intensive industry. In the early 1960s, a modern liner spent approximately half the year in port being loaded and unloaded. Although a simple concept, containerization did not begin until the mid-1950s, when Malcolm McLean, the owner of a Virginia-based trucking firm, began shipping entire trailer loads of goods. After removing the wheels from the 35-foot trailers commonly seen on U.S. highways, McLean shipped full, sealed trailers rather than the individual parcels that were formerly the unit of transportation. Containerization quickly transformed the liner industry. By the mid-1980s, the industry was almost completely standardized with the twenty-foot equivalent unit (TEU)?the unit of measure. A TEU could be moved intermodally (by road, rail, and sea) with a minimum of labor and without disturbing the contents (Exhibit 1).
Competitive environment in the mid-1980s
The liner industry traditionally operated within conferences, which were international groups of private liner companies that collectively agreed on routes, schedules, and rates. Some have observed that conferences resembled institutionalized price-fixing. The conference shipping system became increasingly unstable in the late 1970s and early 1980s. Having once controlled 80% to 90% of traffic volume in certain trades, the conferences? control dropped to less than 50% by the mid-1980s. As containerization spread, productivity increased and prices adjusted downward. Furthermore, adaptable firms withdrew from the conferences to take advantage of new trade patterns. By 1985, the world shipping industry was in a severe slump. Subsidized shipyards in most industrialized countries caused new-vessel prices to drop, and the supply of vessels outstripped demand. A contraction in world petroleum consumption caused tremendous underutilization of bulk vessels, and tanker ships were laid up and/or scrapped at unprecedented rates. Overcapacity also struck the liner industry as the growth in vessel capacity outpaced the growth in demand. Because the industry was one of high fixed costs, freight rates were cut to keep cargoes, and revenues?in real terms?dropped well below 1970 levels. The market value of all types of vessels fell to a fraction of their replacement cost. Shipyards began offering liberal financing for new construction contracts. As both market value and replacement costs fell, the liner industry became easy to enter. Even as large shipping firms filed for bankruptcy, new firms announced their entry into the already overcrowded routes.
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The Caribbean Environment
The small island states in the Caribbean were among the last to convert to containerization. Because they were developing countries with near subsistence economies, they could not afford the cost of modernizing their port infrastructures, and many were forced to borrow heavily from developmental agencies to support the shift to containerization. LAL successfully anticipated the move toward containerization in the Caribbean and was one of the first firms there to convert completely to containerized operations. LAL was also the first to introduce a regular, reliable container service in many markets, and the firm dredged harbors and installed cranes in ports where such improvements were not forthcoming.
Demand characteristics
Imports of Caribbean islands reflected the structure and development of the underlying economies. Because many countries were underdeveloped, imports consisted mainly of corrugated tin roofing, lumber, foodstuffs, tools, clothing, and vehicles. The small islands were almost totally dependent on imports for manufactured goods. Countries with tourist industries imported the goods to which American and European vacationers were accustomed. In this region, the local importer of goods bore the entire cost of transportation, which was often included on invoices as a surcharge. Exports consisted of agricultural products, such as copra and tropical fruit, as well as handcrafted items. Balance-of-payments constraints were chronic. Because many Caribbean economies claimed tourism as their only industry, increased demand for shipping depended on natural population growth and the size of the tourism sector. Demand could not drop below a critical level of importation, however, because those less-developed economies had no alternative but to import essential commodities. One of the most important aspects of the Caribbean liner industry was the almost-perfect price inelasticity of demand?the price of shipping services could change dramatically in either direction and had almost no effect on the amount of services demanded. Transportation costs played such a small part in the retail price of most imported goods that even a 50% reduction or rise in freight charges had little impact on demand. For example, assume a grocery wholesaler paid $2,000 per TEU in freight charges to import frozen chicken parts. A TEU could hold as much as 40,000 pounds of chicken, so the transportation cost per pound was $0.05. Assume a cut in freight rates per TEU of $l,000; the $0.025 savings per pound would have little effect on sales of frozen chicken. Also, Caribbean importers were notorious for absorbing any such savings. Thus, necessity, as well as pricing practices, caused Caribbean demand for shipping services to be almost perfectly price inelastic.
San Huberto
Discovered in the 16th century, San Huberto (see Exhibit 2 for a map of the Caribbean) was colonized by the English in the 1630s. In 1788, St. Hubert?s, as it was then called, was ceded to Spain. After a century of neglect, the island was claimed by a Latin American country and its name changed to its Spanish form, San Huberto. Since World War II, Spanish had been the official language of San Huberto, although Caribbean English was the language, or patois, for more than three centuries. In 1985, the majority of San Huberto?s 34,000 inhabitants were English-speaking blacks, the descendants of plantation slaves brought from Jamaica. Unemployment among them was over 35%. By the mid-1980s, a
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substantial tourism industry evolved in response to the island?s duty-free status. San Huberto had two industries?subsistence farming and modern, international resort-class tourism. An estimated 100,000 tourists visited the island each year, and the volume of consumer durables moving in and out of San Huberto was considerable. Catering to wealthy Colombians, Salvadorans, Costa Ricans, Guatemalans, and Hondurans in search of duty-free bargains and white-sand beaches, San Huberto offered numerous hotels, restaurants, and stores selling luxuries such as perfume, appliances, and jewelry. Virtually all goods imported to San Huberto originated in the United States. Dominant users of the container service between the United States and San Huberto were the local importers of food, pharmaceuticals, consumer durables, clothes, alcohol, and hotel supplies. Importers wishing to arrange transportation typically contacted the shipping agent representing a given liner firm. The shipping agent was knowledgeable about sailing schedules, prices, and capacity, and, in a small market such as San Huberto, he or she might also serve as the salesperson, marketing manager, and even the dockside supervisor. The most important facet of the San Huberto market was the island?s shallow-draft port. (Draft referred to the depth to which a ship extended under water.) Given that the maximum draft of San Huberto?s port was only 16 feet, the number and size of vessels able to call there was quite limited. Of firms operating in those waters, only LAL and Kronos Lines (KL) were equipped with the shallow-draft class of vessel required to call on San Huberto. In effect, the San Huberto shipping market was an oligopoly simply because of its remote location and physical limitations. LAL entered the San Huberto market in 1980, at which time KL had a monopoly on service to the United States. LAL chose Stanley Montagu, one of the island?s best-known agents, to help it gain a share of the market serving the United States. Montagu operated a small agency begun by his grandfather in the 1880s and had historically acted as agent for the yachters who called at San Huberto. Although he was a first-rate agent, Montagu had to work hard to gain share for LAL. As a member of the island?s black community, he was only slowly gaining the business of the predominantly Spanish-speaking hoteliers, retailers, and restaurateurs. Although they were the only two firms offering a U.S.?San Huberto connection, LAL and KL became bitter rivals. Begun in the 1960s, KL was owned and operated by Anatoly Rapport, a vibrant southern European with a reputation for being cheap, tough, and ruthless. KL operated four vessels (versus LAL?s eleven) and competed in several of the same markets as LAL. KL was a good example of the tough niche player that offered service to only a few markets, but was renowned for the tenacity with which it clung to those markets. KL met with some bad luck when one of its vessels was seized by the Venezuelan government for alleged smuggling operations and two others were detained by the Colombian government. These problems did not limit KL?s ability to service the islands, however. TransCaribe, which had strong ties with many of the major importers, was the agent used by KL in San Huberto for the past 15 years.
San Huberto Market Data
Vaughan?s first initiative after arriving in San Huberto was to determine the exact size of the market. This task entailed eight hours of studying shipping manifests (the records of each vessel?s cargo), which he found in a cardboard box in a disarranged file room. After poring over the last three months? shipping manifests in the hot, airless room, Vaughan estimated a total of 3,900 TEUs per year imported into San Huberto. While his total ignorance of Spanish worried him a little, he believed the number to be accurate. On the basis of those same manifests, Vaughan was able to calculate that LAL had a 40% unit share of the market.
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He then began the extensive series of interviews that served as market research. His custom during the summer was to identify himself as a consultant for an unidentified shipping firm and attempt to interview importers, exporters, and shipping agents in order to get a feel for the more subjective dimensions of the market. The task in San Huberto was difficult, because he could not communicate with many of the businesspeople to whom he spoke, and he was forced to hire, at considerable expense, an employee at his hotel to translate for him. Vaughan learned first that LAL?s choice of Montagu, based on Montagu?s abilities, was a wise one, but that the racial and language barrier on San Huberto might work against the agent. Many of the importers stated that they preferred to work with KL?s agent, TransCaribe, but could not offer any economic reason for the preference. Montagu, however, was respected by the entire San Huberto market and had made real inroads during the six years that LAL served San Huberto. Based on his interviews, Vaughan believed that KL had built up a certain loyalty among the major importers during its long period of monopoly in San Huberto. He learned, however, that the usual practice in San Huberto was for importers to divide their orders between both shipping lines in varying proportions. This double sourcing was considered a legacy from the not too distant past of infrequent and unreliable transportation. Vaughan wanted to know which shipping firm importers would prefer if LAL?s and KL?s rates were identical, so in his interviews he collected subjective estimates of LAL?s market share on that basis. He was surprised to learn that, at equal freight rates, KL was likely to retain a 60% market share. The more- experienced shipping agents seemed to feel that each difference of $100 per TEU in freight rates would equal about a 10% loss of share for the more-expensive firm. Exhibit 3 shows a graph of the relationship between LAL market share and the difference in price that those assumptions implied. Vaughan was surprised at those results, but the pattern recurred throughout his interviews. LAL, at equal freight rates, would still enjoy only a 40% market share. In order to gain share, LAL would have to set its price below KL?s. This conclusion apparently explained LAL?s poor profit performance in San Huberto. In trying to gain share, Montagu seemed to touch off the vicious price war of the last year. Because lower freight rates would not stimulate more volume (due to the severe price inelasticity of demand), cutting prices led to shrinking contributions for both firms. Vaughan wondered if Montagu?s strategy was either appropriate or wise. His stated objective was to dominate KL and to ?run them out of the market,? but KL could not be pushed around. Indeed, KL had met every one of LAL?s price changes shortly after Montagu announced them. After some work with LAL?s controller, Vaughan worked out the various costs associated with shipping one TEU. The costs were for rental on containers, handling expenses in Fort Lauderdale, vessel costs, and handling costs at LAL?s hub port of San Juan, Puerto Rico. The firm?s TEUs originated in Fort Lauderdale, were shipped to Puerto Rico on LAL?s large line haul vessels, offloaded in San Juan, and then reloaded onto smaller feeder vessels that sailed to small islands throughout the Caribbean (Table 1). Table 1. Costs associated with shipping one TEU. LAL?s variable cost per TEU in 1986 was: Cost per TEU Trailer rental $246 Fort Lauderdale variable handling 308 San Juan variable handling 287 Total $841
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The firm?s marketing managers in San Juan believed that KL?s cost per TEU was about 5% greater than LAL?s ($883) because of inefficiencies and KL?s smaller-scale operation. The two firms called at the port of San Huberto with the same frequency (i.e., bi-monthly). Vaughan constructed a matrix showing both LAL?s and KL?s contribution, given the different pricing combinations covered in his market share analysis. His assumptions for the matrix (Exhibit 4) were as follows in Table 2. Table 2. Assumptions for the matrix. Market size = 3,900 TEU per year Market shareLAL = 0.40 + (PKL – PLAL)(1/1000) Market shareKL = 0.60 + (PLAL – PKL)(1/1000) ContributionLAL = (P LAL – $841)(3900)(Market shareLAL) ContributionKL = (P KL – $883)(3900)(Market shareKL) After completing the matrix, Vaughan learned that KL had just announced that it would match LAL?s most recently posted freight rate to San Huberto of $800 per TEU. Studying his findings, he wondered what strategy recommendations he could make to Montagu regarding future LAL prices.
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Exhibit 1 Lesser Antilles Lines: The Island of San Huberto (A) A Liner Loaded with Containers
Source: Photo courtesy of Emre Dogan via Wikimedia Commons, http://upload.wikimedia.org/wikipedia /en/8/83/Resim_057.jpg (accessed Dec. 16, 2010).
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Exhibit 2 Lesser Antilles Lines: The Island of San Huberto (A) Map of the Caribbean
Source: Created by author.
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Exhibit 3 Lesser Antilles Lines: The Island of San Huberto (A) LAL Share as a Function of Price Differential
Source: Created by author.
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Exhibit 4 Lesser Antilles Lines: The Island of San Huberto (A) Contribution Matrix (all numbers are in U.S. dollars)
Note: The top number in each cell is the KL payoff, and the bottom number in each cell is the LAL payoff. If LAL picks $800 and KL picks $800, KL gets -$194 and LAL gets -$64. Source: Created by author.
KL PRICE 1,9000000003977931,1901,5871,9832,380 -1602306201,0101,4001,7901,9622,0562,0722,0101,8701,652
1,800000003587151,0731,4311,7882,1462,503 -1602306201,0101,4001,6111,7441,7991,7761,6751,4961,239
1,70000003196379561,2751,5931,9122,2302,549 -1602306201,0101,2601,4321,5261,5421,4801,3401,122826
1,6000002805598391,1191,3981,6781,9572,2372,517 -1602306209091,1201,2531,3081,2851,1841,005748413
1,500002414817229631,2031,4441,6841,9252,1662,406 -1602305588089801,0741,0901,0288886703740
1,40002024036058071,0081,2101,4111,6131,8152,0162,016 -16020749670784089587277159233500
1,3001633254886518139761,1381,3011,4641,6261,6261,626 -144184434606700716654514296000
1,2002473714956187428659891,1131,2361,2361,2361,236 -1281613725055605374362570000
1,100254339423508592677762846846846846846 -11213831040442035821800000
1,000183228274319365411456456456456456456 -96115248303280179000000
900334046536066666666666666 -80921862021400000000
800-194-227-259-291-324-324-324-324-324-324-324-324 -646912410100000000
8009001,0001,1001,2001,3001,4001,5001,6001,7001,8001,900
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