Nuclear Deterrence and Profit Maximisation

In October 1962, the world watched on anxiously as the US and the USSR became precariously poised on the verge of mutually assured destruction during a confrontation known as the Cuban Missile Crisis. This tense 13-day period is considered by many as the point during the Cold War in which the two superpowers came closest to full scale nuclear warfare.

So why didn’t they?

And how is this relevant to economics?

In economic terms a Nash equilibrium materialised between the US and the USSR. Put simply, a Nash equilibrium occurs whereby each side is doing the ‘best’ they possibly can given what their opponent is doing. Neither side has an incentive to deviate from their current position taking into account the actions of their opponent.

Given the US had attempted to overthrow the communist government of Cuba on two occasions (the Bay of Pigs and Operation Mongoose) the USSR began to look for ways to deter further US invasions. The solution? The then USSR leader Nikita Khrushchev covertly arranged for the positioning of Soviet nuclear missiles in Cuba in order to prevent a US invasion into Cuba. Previously, the US faced no deterrents from the USSR in terms of entering Cuba. They possessed a larger nuclear arsenal, greater military resources, and faced a relatively smaller threat from Soviet nuclear missiles – which were purportedly inaccurate at best.

Once the US realised that missiles had been placed in Cuba, the threat of nuclear warfare and mutually assured destruction conditional on a US led invasion into Cuba become chillingly clear. The US faced a strong deterrent to invading Cuba. Aside from cooperation, the US had two courses of action. Firstly it could enter Cuba and risk full scale nuclear warfare which would have involved mutually assured destruction. Secondly the US could stay out of Cuba and avoid a nuclear catastrophe. The solution was simple. Acting rationally, the US refrained from invading Cuba. In turn, the US was doing the best it possibly could given what the USSR was doing. Given the USSR had deployed nuclear missiles in close proximity to US boundaries, the US’s most practical course of action was to stay out of Cuba to avoid antagonising the USSR and triggering nuclear warfare. Similarly, the USSR, by maintaining the nuclear missiles in Cuba and deterring the US invasion was doing the best they possibly could given the US’s desire to overthrow the Cuban government and stifle the spread of communism.

It is important to note that for the Nash equilibrium to occur at a point where the US was deterred from invading Cuba, the USSR needed to cultivate a credible threat. Thus, for the USSR to merely assert that they would respond with nuclear weapons would be insufficient to invoke sufficient fear of nuclear warfare to deter the US from invading Cuba. In the ‘Strategy of Conflict,’ Thomas Schelling highlights the importance of taking actual ‘moves’ in order to convey credible threats. According to Schelling, ‘moves’ convey ‘manifest costs, risks, or a reduced range of subsequent choice,’ and possess an ‘evidence content’ of a ‘different character’ from mere speech alone.^[1] Accordingly, the USSR’s placement of nuclear missiles in Cuba was sufficient to demonstrate that any subsequent threats made by the USSR were credible – and not merely empty.

With the US unwilling to initiate nuclear conflict, the Kennedy administration ultimately refrained from invading Cuba. Thus, through the placement of nuclear missiles in Cuba, the USSR was able to deter a US invasion into Cuba.

So how does nuclear deterrence relate to profit maximisation?

When an incumbent firm (i.e. firm already in the market) monopolises a particular market, it is in its best interest to sustain low levels of competition so as to enable it to charge a higher price and generate a higher profit. A reduction in the level of competition can be achieved by convincing any prospective entrant that entry into a market will be unprofitable. One means of achieving this – and a means directly analogous to the Cuban Missile Crisis – is by convincing a prospective entrant that entering the market will prompt the incumbent firm to instigate competitive warfare by lowering the price through an expansion of quantity produced.

The end result? Given the prospective entrant will face competitive warfare should it enter the market, the potential for incurring large losses upon entry operates as a strong deterrent to market entry.

In turn, the trick lies in convincing the prospective entrant that the threat to lower the price is a credible threat. Assuming the USSR is analogous to the incumbent firm, and the US analogous to a prospective market entrant (i.e. invading Cuba = entering market), the incumbent firm will have to make a definitive ‘move’ to deter market entry. Merely threatening or asserting to lower the price will lack a credible basis if it is against the incumbent firm’s best interests.

For example, if a prospective entrant ‘B’ faced the following payoff matrix, it could rationally infer that even if it did enter the market, the incumbent firm ‘A’ would still be better off maintaining a high price and accommodating firm B. If firm A lowered the price following B’s entry into the market, A would lose $150 million in profit (500-350). Accordingly, A’s threat to lower the price is not credible. B’s rational move is to enter the market, wherein a Nash equilibrium occurs at (500, 100).

Table 1^[2]

So how does firm A create a credible threat to lower the price?

Firm A must make an ‘irrevocable commitment’ that alters its incentives in favour of competitive warfare should entry occur.^[3] By making an ‘irrevocable commitment’ in the form of investing in the production of excess capacity, firm A now has the extra capacity to increase output and therein fare better in competitive warfare.^[4] Subsequent threats to lower price now appear completely credible. Firm A can now engage in competitive warfare should entry occur. By analogy, when the USSR made extensive investments in nuclear technology and deployed nuclear missiles in Cuba, the threat of nuclear warfare conditional on a US invasion to Cuba was completely credible. The USSR was well placed to engage in nuclear warfare given it had placed missiles in such close proximity to the USA. Similarly, firm A’s threat is no longer empty – as can be seen by the payoff matrix below, should B enter the market, ‘A’ now has the ability to lower the price i.e. initiate competitive warfare.

Table 2^[5]

Ultimately, an incumbent firm, by making a definitive commitment to invest in the production of excess capacity, will fare better in competitive warfare should B enter the market. Accordingly, as firm A has the ability to lower the price conditional on B’s entry into the market, and given the potential losses that will accrue to B should it enter, B would likely be deterred from market entry. In effect, the incumbent firm has engineered a new Nash equilibrium in which B’s best course of option is to stay out of the market. Should B enter, A’s threat to drop the price so that B incurs a loss is completely credible. Given A has invested in extra production capacity, it is now in a strong position to instigate competitive warfare. Thus, the Nash equilibrium has been manipulated favourably by the incumbent to reduce competition by deterring market entry. The incumbent can enjoy the corresponding rise in market share and therein profitability.