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Business Economics (A)Researcher training course 9th week

Yuji Honjo

Faculty of Commerce

Chuo University

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Contents Theme

Entry and exit Keyword

Barriers to entry, Limit pricing, Predatory pricing Discussions

Do you think economies of scale are considered barriers to entry?

Do economies of scale protect incumbents from hit-and-run entry unless the associated fixed costs are sunk?

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Some facts about entry and exit Entry forms

New firm A firm did not exist before it entered a market.

Diversified firm A firm already exists but had not previously been

in that market. A firm sells the same product in other geographic

markets.e.g. Amazon.com (which sells books over the

Internet), Microsoft (which introduced the Microsoft X-Box gaming system)

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(Continued) Exit forms

Withdrawal of a product from a market A firm shuts down completely. A firm continues to operate in other markets.

e.g. Renault and Peugeot (which exited the U.S. automobile market), Sega (which exited the video game hardware market)

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Dunne et al.’s (1988) findings U.S. manufacturing firms between 1963

and 19821. Entry and exit will be pervasive.

30 and 40 new entrants during 5 years per 100 firms

2. Entrants and exiters tend to be smaller than established firms.

A typical entrant will be only one-third the size of typical incumbent.

3. Most entrants do not survive 10 years, but those that do grow precipitously.

Roughly 60% will exit during 10 years.

4. Entry and exit rates vary by industry.

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(Continued) Implications for strategy

The manager must account for an unknown competitor (entrant).

Not many diversifying competitors will build new plants, but the size of their plants can make them a threat to incumbents.

Managers should expect most new ventures to fail quickly.

Managers should know the entry and exit conditions of their industry.

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Entry and exit decisions: basic concepts A profit-maximizing, risk-neutral firm

should enter a market Net present value of expected post-entry

profits > Sunk costs of entry Post-entry profits demand and cost

conditions, and the nature of post-entry competition

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(Continued) Barriers to entry

Definition by Bain (1956) Factors that allow incumbent firms to earn positive

economic profits, while making it unprofitable for new comers to enter the industry.

Structural or strategic entry barriers The incumbent has natural cost or marketing

advantages. Structural entry barriers The incumbent aggressively deters entry.

Strategic entry barriers

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Bain’s typology of entry conditions Three entry conditions

Blockaded entry Structural entry barriers are so high that the

incumbent need do nothing to deter entry. Fixed investments, Product differentiation

Accommodated entry Structural entry barriers are low. Growing demand, Rapid technological improvements

Deterred entry The incumbent can keep the entrant out by

employing an entry-deterring strategy, and employing the entry-deterring strategy boosts the incumbent’s profits.

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Structural entry barriers Three main types of structural entry

barriers Control of essential resources Economies of scale and scope Marketing advantages of incumbency

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(Continued) Control of essential resources

e.g. DeBeers in diamonds, Alcoa in aluminum, and Ocean Spray in cranberries

Incumbents can legally erect entry barriers. Patent

cf. A government patent office sometimes cannot distinguish between a new product and an imitation of a protected product. Invented around

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(Continued) Economies of scale and scope

Cost advantage Minimum efficient scale (MES)

The entrant cannot recover its up-front entry costs if it subsequently decides to exit. Only if the up-front entry costs are sunk costs.

Marketing advantages of incumbency Brand umbrella

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Barriers to exit

(See Figure 9.2.)

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Entry-deterring strategies Under what conditions does it pay for

incumbent firms to raise the barriers to entry into their market?

Two conditions for entry-deterring strategies

The incumbent earns higher profits as a monopolist than it does as a duopolist.Monopolistic profits > Duopolistic profits

The strategy changes entrants’ expectations about the nature of post-entry competition.( If the entrant ignores any strategy, the strategy is useless.)

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cf. Contestable market Who introduces a contestable market

(contestability theory)? Baumal, Panzar, and Willing.

What does “contestable” indicates? No sunk costs In a contestable market, a hit-and-run entrant

rapidly enters the market. So, the incumbent has to charge a price that

yields zero profits, even when it is an apparent monopolist.

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(Continued) Which industry is a contestable market?

Traditionally, airline markets (perhaps, US) have often been regarded as a contestable market, since the sunk costs are very low.

Borenstein’s (1989) paper Monopoly routes have higher fares than

duopoly routes of comparable lengths. He concluded that airline markets are not

perfectly contestable.

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Entry-deterring strategies Assuming that the incumbent monopolist’s

market is not perfectly contestable The incumbent monopolist expect to reap

additional profits if it can keep out entrants. Three ways for entry-deterring

Limit pricing Predatory pricing Capacity expansion

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Limit pricing Limit pricing

An incumbent firm discourages entry by charging a low price before entry occurs.

Example (see Table 9.1) Nonrecoverable fixed costs for Firm E (entrant): $800 If the price remains at $30, Firm E does not enter the

market. Limit pricing

For Firm N (incumbent)Monopolistic profits > Duopolistic profits Limit pricing seems rational.

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(Continued) Is limit pricing rational? (See Figure 9.3.)

Firm N should not choose the limit pricing strategy.

Limit pricing fails because the incumbent’s preentry pricing does not influence the entrant's expectations about postentry competition.

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Predatory pricing Predatory pricing

A firm sets a low price to drive rivals out of business.

Difference between limit pricing and predatory pricing

Limit pricing Rivals that have not yet entered the market. Predatory pricing Rivals that have already entered.

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(Continued) Is predatory pricing rational?

Chain-store paradox What is the chain-store paradox?

(example) A firm operates in 12 markets and faces entry

in each, In January, it faces entry in market 1; in February, it faces entry in market 2; and so on.

Question: Should the incumbent slash prices in January so as to deter enter later in the year?

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(Continued) What is the chain-store paradox? (example)

Answer by working backward from December to see how earlier pricing decisions after later entry.

The incumbent will not benefit from predatory pricing in December because there is no further entry deter. And the entrant will enter the market.

Backing up to November, the forward-looking incumbent knows that it cannot deter entry in December.

The incumbent cannot benefit from slashing prices (predatory pricing)

As a result, the incumbent realizes that it has noting to gain from predatory pricing in January! (Predatory pricing is irrational.)

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Rescuing limit pricing and predation: the importance of uncertainty and reputation

Are limit pricing and predatory pricing irrational strategies?

In the real world, many firms commonly perceived as slashing prices to deter entry.

The explanation is that the analysis far fails to capture important elements of their strategies.

Uncertainty(see also Milgrom and Roberts (1982).)

Reputation for toughness

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Excess capacity Excess capacity

Firms hold more capacity than they use.

By holding excess capacity, an incumbent affects how potential entrants view post-entry competition, and thereby blockade entry.

cf. Credible commitment (see Chapter 7.) Excess capacity deters entry even when the entrants

possesses complete information about the incumbent’s strategic intentions.

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(Continued) Conditions for entry deterrence (Lieberman, 1987)

The incumbent should have a sustainable cost advantage. Market demand growth is slow. The investment in excess capacity must be sunk prior to

entry. The potential entrant should not itself be attempting to

establish a reputation for toughness.

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Judo economics and puppy-dog ploy Judo economics proposed by Gelman and Salop

(1983) Smaller firms and potential entrants can use the

incumbent’s size to their own advantage.

Cf. Puppy-dog ploy

Case: On-line book retail market (Amazon vs. Barnes & Noble)

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Exit-promoting strategies Wars of attrition

Price war Evidence on entry-deterring behavior

Survey data on entry deterrence by Smiley (1988) Learning curve Advertising R&D, Patents Reputation Limit pricing Excess capacity