Economics of Strategy

Slide show prepared by

Richard PonArulCalifornia State University, Chico

© John Wiley & Sons, Inc.

Chapter 9

Entry and Exit

Besanko, Dranove, Shanley and Schaefer, 3rd Edition

Introduction

Incumbent firms formulate strategy taking into account the possibility of entry by new firmsEntry has two effects

– reduced market share– intensified market competition

Can take two forms– entry by a new firm (ex. Dreamworks SKG)– entry by an existing firm diversifying into a new market (ex.

Microsoft entering gaming systems market)

Acquisition is not entry: merely change of identity

Introduction

Exit is the reverse processExit could also take different forms– A firm may simply fold up (Example: PanAm)– A firm may discontinue a particular product or

product group or leave a particular market (Peugeot leaves the U.S. market)

Evidence on Entry and Exit

Dunne, Roberts and Samuelson (DRS): entry and exit in different industries in the U.S. (1963-1980) found that:Entry and exit is pervasive– over a five year period in most industries

30-40% new firms enter30-40% of existing firms exit

– entrants are generally small if they are new– most entrants do not survive 10 years– if they survive they grow rapidly: 60% fail, the

remainder at least double in size– patterns vary across industries

Implication of DRS Findings for Strategy

As part of planning for the future, managers should account for the unknown future competitorsDiversifying firms pose a greater threat to the incumbents since they tend to build bigger plants than other entrants

Implication of DRS Findings for Strategy

Managers of new firms need to find capital for growth since survival and growth go hand in handManagers should be aware of the entry and exit conditions of the industry and how these conditions change over time due to technological changes, regulation and other factors

Cost Benefit Analysis for Entry

A potential entrant compares the sunk cost of entry with the present value of the post-entry profit streamSunk costs of entry range from investment in specialized assets to government licensesPost-entry profits will depend on demand and cost conditions as well as the nature of post-entry competition

Barriers to Entry

Barriers to entry are factors that allow the incumbents to earn economic profit while it is unprofitable for the new firms to enter the industryBarriers to entry can be classified into– Structural barriers to entry and– Strategic barriers to entry

Barriers to Exit

Barriers to exit are factors that make the firm continue producing under such conditions which would not have encouraged the firm to enterExamples of such barriers are specialized assets labor agreements, commitment to suppliers and governmental regulations

Structural Barriers to Entry

Structural barriers to entry exist when– The incumbent has cost advantages or marketing

advantages over the entrants– Incumbents are protected by favorable

government policy and regulations

Strategic Barriers to Entry

Strategic entry barriers are barriers created and maintained by the incumbentsIncumbents can erect strategic barriers by expanding capacity and/or resorting to limit pricing and predatory pricing

Typology of Entry Conditions

Markets can be characterized by whether the existing barriers to entry are structural or strategicThree entry conditions according to Joe Bain are– Blockaded entry– Accommodated entry– Deterred entry

Blockaded Entry

Entry is considered to be blockaded when the incumbent does not need to take any action to deter entryExisting structural barriers are effective in deterring entry

Accommodated Entry

When the condition accommodated entry, the incumbents should not bother to deter entryThis condition is typical of markets with growing demand or rapid technological changeStructural barriers may be low and strategic barriers may be ineffective in deterring entry or simply not cost effective

Deterred Entry

Entry is not blockadedEntry deterring strategies are effective in discouraging potential rivals and are cost effectiveDeterred entry is the only condition under which the incumbents should engage in predatory acts

Types of Structural Barriers

The three main types of structural barriers to entry are– Control of essential resources by the incumbent– Economies of scale and scope– Marketing advantage of incumbency

Control of Essential Resources

Nature may limit the sources of certain inputs and the incumbents may be in control of these limited sourcesPatents can prevent rivals from imitating a firms productsSpecial know how that is hard for the rivals to replicate may be zealously guarded by the incumbents

Economies of Scale and Scope

If economies of scale are significant, incumbent may face a high threshold of market share to be profitableIncumbent’s strategic reaction to entry may further lower price and cut into entrant’s profitsIf entrant succeeds, intense price competition may ensue

Economies of Scale and Scope

Economies of scope in production may exists when multiple products that share inputs and production technology are produced in the same plantEconomies of scope in marketing are due to the bulky up front expenditure an entrant has to incur to achieve comparable brand awareness as the incumbent’s brand

Hit and Run Entry

Economies of scale and scope deter entry only if the entrant cannot recoup the up front entry costs If up front costs are nor sunk costs, entrant can come in on a large scale and exit if incumbents retaliate - hit and run strategyHowever, economies of scale and scope may often require up front sunk costs

Marketing Advantage of Incumbency

Incumbent can exploit the brand umbrella (different products sold under the same brand name) to introduce new products more easily than new entrants canThe brand umbrella can make it easy for the incumbent to negotiate the vertical channel (Example: It is easier to get shelf space with an established brand)

Marketing Advantage of Incumbency

Exploitation of the brand name and reputation is not risk-freeIf the new product is unsatisfactory, customer dissatisfaction may harm the image of the rest of the brands

Barriers to Exit

Exit if cannot make an acceptable return on assets

$

Quantity

ATC

AVC

MC

PENTRY

PEXIT

Exit barriers exist– when there are

fixed costs– when there are

relationship-specific assets

Entry Deterring Strategies

Some examples of entry deterring strategies are limit pricing, predatory pricing and capacity expansionFor these strategies to work– Incumbent must earn higher profits as a

monopolist than as a duopolist and– The strategy should change the entrants’

expectations regarding post-entry competition(incumbent’s strategies should be credible)

Contestable Markets and Entry Deterrence

In a perfectly contestable market, a monopolist sets the price at competitive levelsIf there is a possibility of a hit and run entry(zero sunk cost) the market is contestableIf the market is contestable, it is not worth the monopolist’s while to adopt entry deterring strategies

Limit Pricing

An incumbent using the limit pricing strategy will set the price sufficiently low to discourage entrantsThe entrant observes the low price and concludes that the post entry price will be low as well and decides not to enter

Limit pricing

Charge a low price before entry– entrant is put off by the low price

An illustrationsuppose demand is P = 100 - Qmarginal cost is $10 per unit

fixed costs are $800 per annum

incumbent has monopoly in year one; faces potential entry in year 2

market closes at the end of year 2

The Example

$

Quantity

Demand100

100

10MC

An incumbent monopolist produces Q = 45 units;

MR45

price = $55

55

Profit p.a. = (55 - 10)x45 - 800 = $1,225Suppose an entrant in period 2 with the same costsAssume that the incumbent and entrant are Cournot (quantity) competitors

The Example

$

Quantity

Demand100

100

10MC

Each firm produces 30 units in period 2;

MR

price = $40

Profit to each firm = (40 - 10)x30 - 800= $100

Given this expectation entry will occur

60

40

The incumbent’s profit in period 2 is sharply down

The example (cont.)

Can the incumbent deter entry?– use the reasoning

price low in period 1the entrant will then expect an even lower price in period 2entry will not happenI can then charge the monopoly price in period 2

– suppose the incumbent charges $30 in period 1– the incumbent then expects a price no higher than

$30 in period 2– suppose that the price is actually $30

The example (cont.)

– aggregate demand is 70 units– suppose that this is split equally– the entrant expects profits of (30 - 10)x35 - 800 =

-$100– with a lower price losses are even greater– so the potential entrant should not enter– the incumbent then has profits

(30 - 10)x70 - 800 + $1,225 = $1,825

The Example (cont.)

But this outcome is wrong: the logic is flawed– why only two years?

if more periods then the limit price might have to be sustained over a very long timefor this to be acceptable the incumbent needs a strong cost advantage over potential entrants

– the supposed equilibrium is not credibletechnically, it is not subgame perfectthe entrant’s supposed expectations regarding the incumbent’s post-entry actions are unreasonable

– consider the full game in extensive form

The Entry Game

Incumbent

PL

PM

Out

EntrantIn

πI = $1,825; πE = 0

EntrantOut

πI = $2,450; πE = 0

Incumbent

PL πI = $500; πE = -$100

PC

πI = $700; πE = $100

InIncumbent

PL πI = $1,125; πE = -$100

PC

πI = $1,325; πE = $100

The Entry Game

Incumbent

PL

PM

Out

EntrantIn

πI = $1,825; πE = 0

EntrantOut

πI = $2,450; πE = 0

Incumbent

PL πI = $500; πE = -$100

PC

πI = $700; πE = $100

InIncumbent

PL πI = $1,125; πE = -$100

PC

πI = $1,325; πE = $100

PC

πI = $700; πE = $100In

PCπI = $1,325; πE = $100

In

PM

Is Limit Pricing Rational?

When multiple periods are considered, the incumbent has to set the price low in each period to deter entry in the next periodThus, the incumbent never gets to raise the price and does not reap the benefits of entry deterrence

Is Limit Pricing Rational?

Even in a two period setting, limit pricing equilibrium is not subgame perfectPotential entrants can rationally anticipate that the post-entry price will not be less than the Cournot equilibrium price

Predatory Pricing

A firm using the predatory pricing strategy sets the price below short run marginal cost with the expectation of recouping the losses when the rival exitsLimit pricing is directed at potential entrants while predatory pricing is directed at entrants who have already entered

Is Predatory Pricing Rational?

If all the entrants can perfectly foresee the future course of incumbent’s pricing, predatory pricing will not deter entryIn experimental settings with complete information, predation did not occurChain store paradox: Many firms commonly perceived to engage in predatory pricing

Situations When Limit Pricing Works

Limit pricing will work if the incumbent has a cost advantage over the entrantWith a cost advantage, the incumbent can set the price slightly below entrant’s minimum average cost, ensuring that entrant can not make profits

Situations When Limit Pricing Works

Limit pricing will work if the entering firm in uncertain regarding the market demand or some determinant of post-entry pricing such as incumbent’s marginal costIf entrant can predict post-entry price, its decision to enter or not will be independent of the incumbent’s strategy

Limit Pricing and Uncertainty about Cost

In a model developed by Milgrom and Roberts, entrant is assumed be uncertain regarding incumbent’s marginal costIncumbent can be either a high cost producer or a low cost producerIf the incumbent is a low cost producer, it can pick a low price to signal its low cost and deter entry

Limit Pricing and Uncertainty about Cost

The price picked by the low cost incumbent will be too low to be rational had the incumbent been a high cost producerHence the low price becomes a credible signal of low marginal costIf the incumbent is a high cost producer, it cannot deter entry

Limit Pricing and Dual Uncertainty

In Garth Saloner's model, the entrant is uncertain about the incumbent’s cost as well as the level of demandIncumbent prices below the monopoly price regardless of cost which signals that either the demand is low or the incumbent is a low cost producerIn either case entry is deterred

Situations When Predatory Pricing Will Work

With uncertainty, predatory pricing can deter entryIf the incumbent does not slash prices, other challengers may consider him ‘easy’ rather than ‘tough’An incumbent can be ‘tough’ either due to low costs or due to an irrational desire for market shareTo deter entry, incumbent has to establish a reputation for toughness

Excess Capacity and Entry Deterrence

By holding excess capacity, the incumbent can credibly threaten to lower the price if entry occursSince an incumbent with excess capacity can expand output at a low cost, entry deterrence will occur even when the entrant is completely informed about the incumbent’s intentions

Excess Capacity is Not Always Strategic

When capacity addition has to be lumpy, firms may often have excess capacity in anticipation of future growthA temporary down turn in demand may leave the firms in an industry with excess capacity with no strategic overtones

Situations When Excess Capacity Works to Deter Entry

Incumbent has a sustainable cost advantageMarket demand growth is slowIncumbent cannot back-off from the investment in excess capacityEntrant is not the type trying to establish a reputation for toughness

> See entry deterrence game

Entrant’s Strategy: “Judo Economics”

If the entrant can convince the incumbent that it does not pose a long term threat, incumbent may be reluctant to adopt costly entry deterring strategies (using the opponent’s strength to one’s advantage)Netscape’s open source strategy may be Judo move against Microsoft whose strength is in standardized rather than customized software

War of Attrition

In a price war, larger players may have better staying power (larger cash reserves, better access to credit)Larger players also incur a greater cost (especially if they do not have a cost advantage)

Winning the War of Attrition

The more a firm believes it can outlast its rivals, the more willing it will be to begin and continue with a price warA firm that faces exit barriers is well positioned to engage in a price warA firm can also try to convince its rivals that it can outlast them (For example, by claiming that they are making money even during the price war

Evidence on the Use of Entry Deterring Strategies

Reported Use of Entry Deterring Strategies– Aggressive price reductions to move down the

learning curve– Intensive advertising to create brand loyalty– Acquiring patents– Enhancing reputation for predation using

announcements and other means– Limit pricing– Holding excess capacity