Credible Threat
What is Credible Threat?
A credible threat is one the threatening player would actually want to carry out when the time comes, which is why a rival believes it.
In a sequential game, work out what the threatening player would do at the node where the threat is supposed to be carried out. If following through pays less than backing down, the rival can ignore the announcement, and the threat is empty no matter how loudly it is made. Threats become credible when a player changes their own future payoffs in advance, by sinking money into extra capacity, signing a contract with penalties, or handing the decision to a rule that removes their discretion. That is the counterintuitive part: reducing your own options can strengthen your position, because the rival now knows what you will do. A promise works the same way and has to be self-enforcing to be believed.
Credible Threat: a worked example
A supermarket, Nest, warns a rival, Dot, that it will start a price war if Dot opens nearby. Payoffs are (Dot, Nest): Dot staying out gives (2, 12), Dot opening with Nest keeping prices high gives (5, 7), and Dot opening with Nest cutting prices gives (0, 4). Backward induction says Nest will not fight, since keeping prices high pays 7 against 4, so Dot opens and takes 5. Now let Nest publish a price guarantee that automatically refunds customers whenever a rival is cheaper, costing it 5 and pulling its keep-prices payoff down to 2. Cutting now pays 4 against 2, the threat is credible, and Dot stays out.
The mistake students make with credible threat
Students judge credibility by how much damage the threat would do to the rival, or by whether it was announced publicly. Neither matters. The only test is whether carrying out the threat is the best move for the threatener at the moment of truth, which you check by looking at that player's payoffs at the final node. A threat that costs the threatener more than backing down is ignored, however public the announcement was.
Credible Threat questions
What makes a threat credible?
A threat is credible when carrying it out is the threatener's own best move once the moment arrives. Sunk investments, contracts with penalty clauses, and public policies that remove discretion all work by changing those payoffs ahead of time. Words alone change nothing, because they leave the payoffs exactly where they were.
Why would a firm deliberately limit its own choices?
Limiting your own choices removes the option to back down, which is exactly what makes a threat believable. If a firm has already built capacity it can only use by producing heavily, rivals know a price war is coming and may stay away. The commitment has to be visible and hard to reverse, or it does nothing.
What is an example of a non-credible threat?
An incumbent threatening a price war that would lose it more money than sharing the market is the standard example of a non-credible threat. The entrant works out that fighting is the worse option for the incumbent and enters anyway. Firms face this problem whenever they warn newcomers away from a route or a neighborhood.
Related terms
Common comparisons
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