chapter 6 - entry and exit

8/10/2019 Chapter 6 - Entry and Exit

1/53

Economics of Strategy

Fifth Edition

Slides by: Richard Ponarul, California State University, Chico

Copyright2010 John WileySons, Inc.

Chapter 11

Entry and Exit

Besanko, Dranove, Shanley, and Schaefer


2/53

Entry

Entrants are firms that produce and sell innew markets

Entry threaten incumbents in two ways.

The market share of the incumbents is reduced

Price competition is intensified


3/53

Forms of Entry

Entry could take place in different forms

An entrant may be a brand new firm

An entrant may also be an established firm that is

diversifying into a new product/market

The form of entry is important for analyzingthe costs of entry and the strategic response

by incumbents


4/53

Forms of Exit

A firm may simply fold up (PanAm)

A firm may discontinue a particular productor product group (Sega leaves the videogame hardware market

A firm may leave a particular geographicmarket segment (Peugeot leaves the U. S.

market)


5/53

Evidence on Entry and Exit

Dunne, Roberts and Samuelson (DRS) studiedentry and exit in U. S. industries. They find that:

Entry and exit are pervasive in the U.S.

Entrants (exiters) are smaller than incumbents(survivors.)

Most entrants fail quickly and the ones that dont growprecipitously

The rates of entry and exit vary from industry to industry.


6/53

DRS Findings on Entry and Exit

Over a five year horizon, a typical industryexperienced 30 to 40 percent turnover

About half the entrants were diversified firms andthe rest were greenfieldentrants (new firms).

About 40% of the exiters were diversified firmsthat continued to operate in other markets.

Conditions in an industry that encouraged entry

also fostered exit


7/53


8/53


9/53

Implication of DRS Findings for Strategy

Managers of new firms need to find capitalfor growth since survival and growth gohand in hand

Managers should be aware of the entry andexit conditions of the industry and howthese conditions change over time.


10/53

Cost Benefit Analysis for Entry

A potential entrant compares the sunk cost of entrywith the present value of the post-entry profitstream

Sunk costs of entry range from investment inspecialized assets to obtaining government licenses

Post-entry profits will depend on demand and costconditions as well as post-entry competition


11/53

Barriers to Entry

Barriers to entry are factors that allow the incumbents to earn economic profit while

making it unprofitable for the new firms to enter the

industry. Barriers to entry can be classified into structural barriers (natural advantages) and

strategic barriers (incumbents actions to deter entry).


12/53

Structural Barriers to Entry

Structural barriers to entry exist when:

incumbents have cost advantages

incumbent have marketing advantages

incumbents are protected by favorablegovernment policy and regulations


13/53

Strategic Barriers to Entry

Incumbents can erect strategic barriers by

expanding capacity

resorting to limit pricing and

resorting to predatory pricing


14/53


15/53

Blockaded Entry

Entry is considered blockaded when the incumbentdoes not need to take any action to deter entry

Existing structural barriers are effective in

deterring entry


16/53

Accommodated Entry

With accommodated entry, the incumbentsshould not bother to deter entry

This condition is typical of markets with growing

demand or rapid technological change

Structural barriers may be low and strategicbarriers may be ineffective or not cost effective


17/53

Deterred Entry

Entry is not blockaded

Entry deterring strategies are effective indiscouraging potential rivals and are cost

effective

Deterred entry is the only condition underwhich the incumbents should engage in

predatory acts


18/53

Asymmetry between Incumbents and Entrants

What is sunk cost for incumbents isincremental cost for the entrants

Established relationships with customers

and suppliers are not easy to replicate

Learning curve effects

Switching costs for the customers


19/53

Types of Structural Barriers

The three main types of structural barriers toentry are:

control of essential resources by the incumbent

economies of scale and scope

marketing advantage of incumbency


20/53

Control of Essential Resources

Nature may limit the sources of certaininputs and the incumbents may be in controlof these limited sources

Patents can prevent rivals from imitating afirms products

Special know-how that is hard for the rivals

to replicate may be zealously guarded by theincumbents


21/53

Economies of Scale and Scope

If economies of scale are significant,potential may face cost disadvantages.

Incumbents strategic reaction to entry may

be to further lower price and cut intoentrants profits.

If entrant succeeds, intense price

competition may ensue.


22/53

Economies of Scale and Scope

Entrants can face cost disadvantages due toeconomies of scope.

Economies of scope in production exist when

multiple product lines are produced in the sameplant.

Economies of scope in marketing are due to theupfront cost of achieving brand awareness by

entrants.


23/53

Economies of Scale may be a Barrier to Entry


24/53


25/53

Marketing Advantage of Incumbency

Exploitation of the brand name andreputation is not risk-free.

If the new product is unsatisfactory,

customer dissatisfaction may harm theimage of the existing products.


26/53

Barriers to Exit

PEntry = the minimum price that will induce afirm to enter an industry

PExit = the minimum price that will induce an

incumbent firm to stay in an industry

PEntry > PExit Exit barriers drive a wedge between PEntry

and PExit .


27/53


28/53

Prices that Induce Entry and Exit may Differ


29/53

Entry Deterring Strategies

Some examples of entry deterring strategies arelimit pricing, predatory pricing and capacityexpansion.

For 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


30/53

Contestable Markets & Entry Deterrence

If there is a possibility of a hit and run entry(zerosunk cost) the market is contestable.

In a perfectly contestable market, a monopolist

sets the price at competitive levels If the market is contestable, it is not worth the

monopolists while to adopt entry deterringstrategies


31/53

Limit Pricing

An incumbent using the limit pricingstrategy will set the price sufficiently low todiscourage entrants

Two forms of limit pricingContestable limit pricing

Strategic limit pricing


32/53

Contestable Limit Pricing

Incumbent has excess capacity and can set pricesbelow entrants marginal cost

Incumbent can meet the market demand at the low

prices


33/53

Strategic Limit Pricing

Entrant has limited capacity or rising marginal costs

Limit pricing may mean sacrifice of profits orinability to meet market demand

Low price can be an entry deterrent if entrant infersthat post entry price will be low.


34/53

Price & Profits under Different Competitive Conditions


35/53

Is Limit Pricing Rational?

When multiple periods are considered, theincumbent has to set the price low in each periodto deter entry in the following period.

The incumbent may be better off being a Cournotduopolist than limit pricing forever as amonopolist.


36/53

Is Limit Pricing Rational?

Even in a two period setting, limit pricingequilibrium is not subgame perfect.

Potential entrants can rationally anticipate

that the post-entry price will not be less thanthe Cournot equilibrium price.


37/53

Limit Pricing: Extensive Form Game


38/53

Predatory Pricing

Predatory pricinginvolves setting the pricebelow short run marginal cost with theexpectation of recouping the losses via

monopoly profits once the rival exits Predatory pricing is directed at entrants who

have already entered while limit pricing is

directed at potential entrants.


39/53

Is Predatory Pricing Rational?

If all the entrants can perfectly foresee the futurecourse of incumbents pricing, predatory pricingwill not work.

The chain store paradox: Many firms arecommonly perceived to engage in predatorypricing even when it is irrational to expectpredatory pricing to deter entry.


40/53

Situations Where Limit Pricing & Predation are


41/53

Situations Where Limit Pricing & Predation areRational

Incumbent wants the entrant to lower itsexpectations for post entry price

Entrant lacks information about incumbents

costs.

Incumbents pricing strategy can alterentrants expectation when there is

asymmetric information.


42/53

Limit Pricing and Dual Uncertainty

In Garth Saloner's model, entrant is uncertain aboutincumbents cost as well as the level of demand.

Incumbent prices below the monopoly price

regardless of cost. Entrant infers that either the demand is low or the

incumbents cost is low.

In either case entry is deterred


43/53


44/53

Predatory Pricing and Reputation

An incumbent can be tougheither due to low costs

or due to an irrational desire for market share

or because there is other competition entrant isunaware of.

By slashing prices entrant is made to believe

that the incumbent is tough.


45/53

Predatory Pricing and Reputation

Some well known firms enjoy a reputationfor toughness after their rivals disappear.

Some aggressive strategies to seek market

share:Announce market share goals

Reward for managers based on market share

rather than profits


46/53

Excess Capacity

For U. S. manufacturers average capacityuse is about 80%.

When capacity addition has to be lumpy,

firms may often have excess capacity inanticipation of future growth

A temporary down turn in demand may

leave the firms in an industry with excesscapacity with no strategic overtones


47/53

Excess Capacity and Entry Deterrence

By holding excess capacity, the incumbentcan credibly threaten to lower the price ifentry occurs.

An incumbent with excess capacity canexpand output at a low cost.

Entry deterrence will occur even when the

entrant as informed as the incumbent.


48/53

Excess Capacity and Entry Deterrence

Excess capacity works to deter entry when incumbent has a sustainable cost advantage,

market demand growth is slow,

incumbent cannot back-off from the investmentin excess capacity and

entrant is not the type trying to establish a

reputation for toughness.


49/53

Entrants Strategy: Judo Economics

Use opponents strength to ones advantage.

Entrant discourages the incumbent fromentry deterrence strategies by appearing to

be a non-threat in the long term

Incurring large losses may not appearworthwhile to the incumbent.


50/53

War of Attrition

Predatory pricing strategy can degenerateinto a war of attrition.

If no one leaves in the early stages, a

prolonged price war can be bad for all thefirms in the industry.

Even the winner may be worse off compared

to not having had the price war at all.


51/53

Winning the War of Attrition

The more a firm believes it can outlast itsrivals, the more willing it to stay in the pricewar

A firm that faces exit barriers is wellpositioned to engage in a price war.

A firm can also try to convince its rivals that

it can outlast them (For example, byclaiming to be money even during the pricewar)


52/53

Entry Deterring Strategies

Aggressive price reductions to move downthe learning curve

Intensive advertising to create brand loyalty

Acquiring patents

Enhancing reputation for predation

Limit pricing

Holding excess capacity


53/53

Copyright 2010 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of this work beyond

that permitted in section 117 of the1976 United States Copyright Act

without express permission from the copyright owner is unlawful.

Requests for further information should be addressed to the

Permissions Department, John Wiley & Sons, Inc. The purchaser maymake back-up copies for his/her own use only and not for distribution

or resale. The Publisher assumes no responsibility for errors,

omissions, or damages caused by the use of these programs or from

the use of the information herein.

chapter 6 - entry and exit

Documents