exit and entry

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ENTRY AND EXIT ENTRY AND EXIT



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Entry Entry

Entry is pervasive in many industries and

may take many forms

1. An entrant may be a new firm, that is, one

did not exist before it entered a market.2. An entrant may be a firm diversifying its

product line; that is, the firm already exists

but had not previously been in that market.

3. An entrant may be a firm diversifyinggeographically, that is, the firm sells the same

product in other geographic markets.



3

Entry Entry

The distinction between new anddiversifying firms is important, such as

when we assess the costs of entry and

when we consider strategic responses to it.



4

Exit Exit

Exit is the reverse of entry

the withdrawal of a product from a

market, either by a firm that shuts down

completely, or by a firm that continues to

operate in other markets.



5

The Study by Dunne, Roberts and The Study by Dunne, Roberts and

Samuelson Samuelson

The DRS findings have four important implicationsfor strategy:

1. When planning for the future, the manager mustaccount for an unknown competitor-the entrant.Fully one-third of a typical incumbent firm¶scompetition five years hence are not competitorstoday.

2. Not many diversifying competitors will build newplants, but the size of their plants can make them athreat to incumbents.



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The Study by Dunne, Roberts and The Study by Dunne, Roberts and Samuelson Samuelson

3. Managers should expect most venturesto fail quickly. However, survival and

growth usually go hand in hand, so

managers of new firms will have to find

the capital to support expansion.

4. Managers should know the entry and

exit conditions of their industry.



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H yundai¶s entry into the steel H yundai¶s entry into the steel

industryindustry

In December 1997, Hyundai announced that it

would enter the steel business.

It would have a production capacity of 6million tons per year.

The government had opposed the plan.

The dominant firm, POSCO, was once owned

by the government.

The government still owns a major portion of

the shares of POSCO.



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industryindustry

POSCO had a production capacity of 26

million tons.

No other company has a mill

approaching 6 million tons, the minimum

efficient scale.

POSCO priced below the competition,

and did not have enough capacity to meet

industry demand.



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industryindustry

Without POSCO, its customers wouldhave to turn to imports.

Hyundai felt that demand for steel would

continue to grow. Without a new plant,

Korea would have to import steel.



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industryindustry

Hyundai had many good reasons to enterthe steel market:

With demand forecast to grow, themarket was ripe to enter.

Hyundai felt it could be more efficient

than POSCO.Hyundai consumes so much steel itself that it can achieve minimum efficientscale without selling to the market.



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industryindustry

The Korean government discouraged

Hyundai from building the plant,

claiming that demand was likely to

slacken.

The Korean government¶s forecast

turned out to be correct after all.



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Entry and Exit Decisions Entry and Exit Decisions

A profit-maximizing, risk-neutral firm

should enter a market if the sunk costs of

entry are less than the net present value of expected post-entry profits.

There are many potential sunk costs to

enter a market, ranging from the costs of

specialized capital equipment to

government licenses.



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Post-entry profits will vary according to

demand and cost conditions, as well as

the nature of post-entry competition.

The potential entrant may use many

different types of information about

incumbents, including historical pricingpractices, costs, and capacity, to assess

what post-entry competition may be like.



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If the potential entrant expects post-entry

competition to be fierce, then it is morelikely to stay out. Even when the potential

entrant believes that post-entry

competition will be relatively mild, it may

not enter if there are significant barriers

to entry.



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Barriers to Entry Barriers to Entry

Barriers to entry are those factors thatallow incumbents to earn positiveeconomic profits, while making itunprofitable for newcomers to enter theindustry.

Barriers to entry may be structural orstrategic.



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Barriers to Entry Barriers to Entry

Structural entry barriers result when theincumbent has natural cost or marketingadvantages, or benefits from favorableregulations.

Strategic entry barriers result when theincumbent aggressively deters entry.

Entry-deterring strategies may includelimit pricing, predatory pricing, andcapacity expansion.



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Bain¶s Typology of Entry Conditions Bain¶s Typology of Entry Conditions

1.B

lockaded Entry: Entry is blockaded if structural barriers are so high that the

incumbent need do nothing to deter

entry.



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2. Accommodated Entry: Entry is

accommodated if structural entry barriers

are low, and either (a) entry-deterringstrategies will be ineffective, or (b) the cost to

the incumbent of trying to deter entry

exceeds the benefits it could gain from

keeping the entrant out. Accommodatedentry is typical in markets with growing

demand or rapid technological improvements.



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3. Deterred Entry: Entry is deterred if (a)

the incumbent can keep the entrant out

by employing an entry-deterring

strategy, and (b) employing the entry-

deterring strategy boosts theincumbent¶s profits.



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Entry Conditions Entry Conditions

Bain argued that an incumbent firm

should analyze the entry conditions in its

market and choose an entry-deterring

strategy based on these conditions.If entry is blockaded or accommodated,

the firm need do nothing more to deter

entry.If entry is deterred, the firm should

engaged in a predatory act.



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Entry Conditions Entry Conditions

To assess entry conditions, the firm mustunderstand the magnitude of structural

entry barriers and consider the likely

consequences of strategic entry barriers.



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Structural Entry Barriers Structural Entry Barriers

There are three main types of structural

entry barriers:

1. Control of essential resources

2. Economies of scale and scope

3. Marketing advantages of incumbency



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Control of Essential ResourcesControl of Essential Resources

An incumbent is protected from entry if it controls a resource necessary forproduction.

DeBeers in diamonds, Alcoa inaluminum, and Ocean Spray incranberries all maintained monopoliesor cartels by controlling essential inputs.

This suggests that firms should acquirekey inputs to gain monopoly status.

However, there are several risks to thisapproach.



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Control of Essential ResourcesControl of Essential ResourcesJust When the firm thinks that it has tied upexisting supplies, new input sources mayemerge.

Owners of scarce resources may hold out forhigh prices before selling to the would-bemonopolies.

There is a regulatory risk associated with

attaining monopoly status throughacquisition. Antitrust laws in many countriesforbid incumbents with dominant marketshare from preventing competitors fromobtaining key inputs.



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Incumbents can legally erect entry

barriers by obtaining a patent to a novel

and nonobvious product or productionprocess.

In Europe and Japan, the patent rights

go to the first person to apply for the

patent. In the United States the first

person to invent the idea gets the patent.



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Patents are not always effective entry

barriers because they can often be³invent around.´

Incumbents may not need patents to

protect specialized know-how. Coca-Colahas zealously guarded its cola syrup

formula for a century.



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Economies of Scale and Scope Economies of Scale and Scope

When economies of scale are

significant, established firmsoperating at or beyond the

minimum efficient scale (MES)

will have a substantial costadvantage over smaller entrants.



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Economies of Scale and Scope Economies of Scale and ScopeThe entrant might try to overcome the

incumbent¶s cost advantage by spending to

boost its market share. For example, it couldadvertise heavily or form a large sales force.

However, it involves two important costs.

1. The direct cost of advertising and creating the

sale force.

2. The indirect cost associated with a strategic

reaction by the incumbent.



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If the incumbent responds to a decline in its

market share by reducing its price, this willcut into the entrant¶s profits.

The entrant faces a dilemma: To overcome its

cost disadvantage, it must increase its market

share. But if its share increases, pricecompetition may intensify.



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Fierce price competition frequently

results from large-scale entry into

capital-intensive industries.

Incumbents may also derive a cost

advantage from economies of scope. The

ready-to-eat breakfast cereal industryprovides a good example.



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Economies of scale and scope create barriers to

entry because they force potential entrants to

enter on a large scale or with many products toachieve unit cost parity with incumbent firms.

Entering at a large scale or scope is

disadvantageous only to the extent that the

entrant cannot recover its up-front entry costsif it subsequently decides to exit (i.e., only if the

up-front entry costs are sunk costs).



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An entrant whose up-front entry costswere not sunk could come in at a largescale, undercut incumbent firms¶ prices,

and exit the market and recover its entrycosts if the incumbent firms retaliate.This strategy is known as hit-and-runentry.

Sunk costs, not economies of scale orscope per se, represent the underlyingstructural barrier to entry.



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The readyThe ready--toto--eat breakfast cereal eat breakfast cereal

industryindustry

For several decades, the industry has

been dominated by a few firms, includingKellogg, General Mills, General Foods,and Quaker Oats, and there has beenvirtually no new entry since World WarII.

There are significant economies of scopein producing and marketing cereal.



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industryindustry

Economies of scope in production stemfrom the flexibility in materials handlingand scheduling that arises from havingmultiple production lines within the same

plant.



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industryindustry

Economies of scope in marketing are dueto substantial up-front expenditures onadvertising that are needed for a newentrant to establish a minimum

acceptable level of brand awareness.



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industryindustry

If has been estimated that for entry to be

worthwhile, a newcomer would need tointroduce 6 to 12 successful brands.Thus,

capital requirements for entry are

substantial, making entry a risky

proposition.



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industryindustryAn incumbent launching a new cerealwould not face the same up-front costs as

a new entrant. The incumbent hasalready established brand nameawareness and may be able to usefacilities to manufacture its new cereal.

This explains why new products areprofitable for incumbents butunprofitable for new entrants.



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industryindustry

Despite the near total absence of entry by

outsiders, incumbents increased the number of

cereals offered for sale from 88 in 1980 to over200 in 1995.

High profit margins eventually invited limited

entry by private-label manufacturers.

Most of the successful newcomers have chosen

niche markets in which they may try to offset

their cost disadvantage by charging premium

prices.



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M arketing Advantages of M arketing Advantages of

Incumbency Incumbency

Umbrella branding (a firm sells differentproducts under the same brand name) is

a special case of economies of scope, butit is an extremely important one in manyconsumer product markets.

An incumbent can exploit the umbrella

effect to offset uncertainty about thequality of a new product that it isintroducing.



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The brand umbrella makes the

incumbent¶s sunk cost of introducing a

new product less than that of a newentrant, because the entrant must spend

additional amounts of money on

advertising and product promotion todevelop credibility in the eyes of

consumers, retailers, and distributors.



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Although the brand umbrella can giveincumbents an advantage over entrants,

the exploitation of brand namecredibility or reputation is not risk free.

The incumbent may suffer more thannewcomers if consumers¶ dissatisfaction

with the new product leads them todoubt the quality of the rest of theincumbent¶s product line.



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Incumbency IncumbencyThe umbrella effect may also help theincumbent negotiate the vertical chain. If

an incumbent¶s other products have soldwell in the past, distributors and retailersare more likely to devote scarcewarehousing and shelf space to its newproducts. Suppliers and distributors may

be more willing to make relationship-specific investments.



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Barriers to Exit Barriers to Exit

To exit a market, a firm stops productionand either redeploys or sells off its assets.

A risk-neutral, profit-maximizing firm will

exit if the value of its assets in their bestalternative use exceeds the present valuefrom remaining in the market.

Exit barriers commonly arise when firmshave obligations that they must meetwhether or not they cease operations.



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Barriers to Exit Barriers to Exit

Examples of such obligations include:

1. Labor agreements and commitments topurchase raw materials.

2. The low resale value of the relationship-specific productive assets.

3. Government restrictions.



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Entry Entry--Deterring Strategies Deterring Strategies

Entry-deterring strategies areworthwhile only if the following two

conditions are met:1. The incumbent earns higher profits as

a monopolist than it does as aduopolist.

2. The strategy changes entrants¶expectations about the nature of post-entry competition.



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ContestabilityContestability

If a monopolist cannot raise price above long-run average cost, the market is said to beperfectly contestable.

The key requirement for contestability is hit-

and-run entry.When a monopolist raises price in a contestablemarket, a hit-and-run entrant rapidly entersthe market, undercuts the price, reaps short-

term profits, and exits the market just asrapidly if the incumbent retaliates.

The hit-and-run entrant prospers as long as itcan set a price high enough, and for a longenough time, to recover its sunk entry costs.



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If the sunk entry costs are zero, then hit-and-run entry will always be profitable.I

n that case, the market price can neverbe higher than average cost, even if onlyone firm is currently producing. If theincumbent raised price above averagecost, there would be immediately entry,

and price would fall. The incumbent hasto charge a price that yields zero profit,even when it is an apparent monopolist.



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Contestability theory shows how the

mere threat of entry can keep

monopolists from raising prices.

However, finding contestable markets

has proven difficult.



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Entry Entry--Deterring Strategies Deterring Strategies

Assuming that the incumbentmonopolist¶s market is not perfectlycontestable, it may expect to reapadditional profits if it can keep outentrants. We discuss three ways inwhich it might do so:

1. Limit pricing2. Predatory pricing

3. Capacity expansion



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Limit Pricing Limit Pricing

Limit pricing refers to the practicewhereby an incumbent firmdiscourages entry by charging a low

price before entry occurs.The entrant, observing the low priceset by the incumbent, infers that thepost-entry price would be as low oreven lower, and that entry into themarket would be unprofitable.



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The logic of limit pricing is highlyappealing. Yet economists have identifieda number of problems with the limitpricing strategy.

As the incumbent might have to limitprice every year to constantly deter entry.

It would never get to raise price to reapthe monopoly profits that it forsook whenit initially set the limit price.



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Limit pricing fails because potential

entrants recognize that any pricereductions before entry are artificial,

and do not commit the incumbent to

maintain low prices subsequent to

entry.



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Once entry occurs, it would make nosense for the incumbent to continue tosuppress price. The lost profit

opportunities from having previously setthe limit price are sunk. Now that theentrant is already in the market, theincumbent will acquiesce and maximize

future profits.

Many firms do occasionally limit price(i.e., Xerox).



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Predatory Pricing Predatory Pricing

Predatory pricing refers to the practice

of setting a low price in order to drive

other firms out of business.The predatory firm expects that

whatever losses it incurs while driving

competitors from the market can bemade up later through the exercise of

market power.



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Predatory Pricing Predatory Pricing

The difference between predatory pricing

and limit pricing is that limit pricing isdirected at firms that have not yet

entered the market, whereas predatory

pricing is aimed at firms that have

already entered.



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The ChainThe Chain--Store Paradox Store Paradox

The idea that an incumbent can slash

prices to drive out rivals and deter entryis highly intuitive.

Yet it is possible to construct an example

in which the intuition fails.



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Regardless of the course of action before thelast entrant, the incumbent will find it optimalnot to engage in predatory pricing in the lastmarket. The reason is that there is no further

entry to deter.

The last entrant knows this, and counting onthe rationality of the incumbent, will enterregardless of previous price cuts. Knowing

that it cannot deter entry in the last market,the incumbent has no reason to slash prices inthe previous market.



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In a world in which all entrants could

accurately predict the future course of pricing, predatory pricing would not

deter entry, and therefore would be

irrational.



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The Importance of Uncertainty and The Importance of Uncertainty and

Reputation Reputation

Game theorists have identified keyconditions under which predatoryactions may be profitable.

Entering firms must be uncertain aboutsome characteristic of the incumbentfirm or the level of market demand.

The incumbent wants the entrant tobelieve that post-entry prices will be low.



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If the entrant is certain about whatdetermines post-entry pricing, the

entrant can analyze all possible post-entry pricing scenarios and correctlyforecast the post-entry price.

If the incumbent is best off selecting a

high post-entry price, the entrant willknow this, and will not be deterred fromentering.

Th I t f U t i t dTh I t f U t i t d



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If the entrant is uncertain about thepost-entry price, then the incumbent¶spricing strategy could affect the

entrant¶s expectations.An entrant is likely to know less aboutthe incumbent¶s costs than theincumbent itself does. If so, by engaging

in limit pricing the incumbent mayinfluence the entrant¶s estimate of itscost, and thus shape its expectations of post-entry profitability.



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Reputation ReputationGarth Saloner has pointed out that for limitpricing to deter entry, the entrant must beunable to perfectly infer the incumbent¶s cost

from its limit price.Saloner showed that this could occur if theentrant was uncertain about the level of demand as well as the incumbent¶s cost.

The low price signals to the entrant that theincumbent¶s costs may be low and/or market

demand may be low. Either signal may deterentry.

Th I f U i dTh I f U i d



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Similar arguments explain why firms wouldwant to set predatory prices, despite theconclusions of the chain-store paradox.

Predatory pricing in the chain-store paradoxappears to be irrational because potentialentrants can perfectly predict incumbentbehavior in every market and are certain thatpredatory pricing in the ³last´ market is

irrational, no matter what has happened up tothat point.



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Reputation ReputationWith a little bit of uncertainty, predation canmake sense. In any event, if a firm believes thatthe incumbent is easy (not slash prices), then it

may follow the logic of the chain-store paradoxand decide to enter. If the incumbent does notslash price in the first market, then otherpotential entrants may also think that it is easy.This is reinforced each time the incumbent

accommodates entry.If the incumbent wants to deter entry, it mustestablish and maintain a reputation fortoughness.



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Some well-known firms, including Wal-Martand American Airlines, enjoy a reputation fortoughness earned after fierce price competition

led to the demise of rivals.Some firms announce a mission to achievedominant market shares, such as Black andDecker. These announcements may effectively

signal to rivals that these firms will dowhatever is necessary, even sustain price wars,to secure their share of the market.



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Firms may promote toughness by rewarding

workers for aggressiveness in the market. A

firm might want to reward managers based onmarker share rather than profits. This will

encourage them to price aggressively, thereby

enhancing the firm¶s reputation for toughness,

and could ultimately lead to higher profits thanif managers were focusing on the bottom line.



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Coffee WarsCoffee Wars

In 1970, General Foods¶ Maxwell Housewas the best selling brand of coffee east

of the Mississippi. Procter andGamble¶s Golger¶s brand was the bestseller to the west.

In 1971, P&G started selling Folger¶s in

parts of the Midwest and east.



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Coffee WarsCoffee Wars

To promote Folger¶s, P&G used a combinationof television advertising, retailer¶s promotions,coupons, in-pack gifts, and free samples in the

mail. General Foods responded with mailedand in-pack coupons, promotional incentivesfor retailers to sell Maxwell House, and heavyprice discounts.

It appears that General Foods was signaling toP&G that it intended to fight aggressively todefend its dominant position in eastern markets.



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Excess Capacity Excess Capacity

Many firms carry excess capacity. The

capacity use is typically about 80 percent.

Firms hold more capacity than they use for

several reasons.

1. In some industries, it is economical to add

capacity only in large increments. If firms

build capacity ahead of demand, then such

industries may be characterized by periods

in which firms carry excess capacity.



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2. Excess capacity results from market forces.

Downturns in the general economic business

cycle, or a decline in demand for a single firmcan create excess capacity. Firms may be

profitable when operating at capacity, but

other firms may then enter seeking a share of

those profits, creating excess capacity.3. Firms may hold excess capacity for strategic

purposes.



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By holding excess capacity, an incumbentmay affect how potential entrants view

post-entry competition, and therebyblockade entry.

Excess capacity may deter entry evenwhen the entrant possesses complete

information about the incumbent¶sstrategic intentions.



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The reason is that when an incumbentbuilds excess capacity, it can expand

output at a relatively low cost.Facing competition, the incumbent mayfind it desirable to expand its outputconsiderably, regardless of the impact on

the entrant¶s profits. This will have theeffect of reducing the entrant¶s post-entryprofits.



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If the post-entry profits are less than the sunk

costs of entry, the entrant will stay out. Theincumbent may even decide not to utilize all of

its capacity, with the idle capacity serving as a

credible commitment that the incumbent will

expand output should entry occur.



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An incumbent firm can successfullydeter entry by holding excess capacityunder the following conditions:

1. The incumbent should have asustainable cost advantage. This gives itan advantage in the event of entry and asubsequent price war.

2. Market demand growth is slow.Otherwise, demand will quicklyoutstrip capacity.



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3. The investment in excess capacity must

be sunk prior to entry. Otherwise, theentrant might force the incumbent toback off in the event of a price war.

4. The potential entrant should not be

attempting to establish a reputation fortoughness.



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DuPont¶s Use of Excess Capacity to Control the DuPont¶s Use of Excess Capacity to Control the

M arket for Titanium Dioxide M arket for Titanium Dioxide

Titanium dioxide is a whitener used inpaints, papers, and plastics.

DuPont expected that the industrywould need 537,000 tons of additionalcapacity.

I

n 1972, DuPont elected to ³preempt´the market by adding 500,000 tons of capacity.



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DuPont¶s Use of Excess Capacity to Control DuPont¶s Use of Excess Capacity to Control

the M arket for Titanium Dioxidethe M arket for Titanium Dioxide

DuPont felt that it could expand fasterthan its competitors because (a) its

competitors had to spend money oncleanup that DuPont did not; and (b) ithad lower costs of using its raw materials,due to scale and learning economies.

DuPont believes that its costs were about22 percent lower than its competitors, sothat they would be reluctant to competehead to head.



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M arket for Titanium Dioxide


There is a lag between planning to addcapacity and having capacity in place.

DuPont tried to forestall additionalentry. It let its competitors know themagnitude of its planned expansion of existing facilities, and falsely announced

that it had begun constructing a new130,000-ton facility.



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DuPont also used limit pricing by setting prices just under the average total costs of production

in the new plants. DuPont¶s competitors,holding out for higher prices, refused to match.

This two-tiered pricing structure persistedbecause DuPont lacked capacity to handle thewhole market. When demand slackened in

early 1975, DuPont¶s competitors lostsubstantial sales and were forced to meetDuPont¶s price.



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When demand remained soft through1975, DuPont reexamined its preemptionstrategy. When demand did not recoverin 1976, DuPont scaled back its capacityexpansion.



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J udo Economics J udo Economics

We have provided examples in which an

incumbent firm has used its size and

reputation to put smaller rivals at adisadvantage.

However, smaller firms and potential

entrants can use the incumbent¶s size totheir own advantage. This is known as

³judo economics.´



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When an incumbent slashes prices to drive an

entrant from the market, it sacrifices its own

short-run profits.T

he larger is the incumbent,the greater the loss.

If an entrant can convince the incumbent that

it does not pose a significant long-term threat

to the incumbent¶s profitability, the incumbentmight think twice about incurring large losses

to drive the entrant from the market.



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An example is provided by Amazon¶s

entry into the on-line book retail market.

Many observers wondered whyBarnes &

Noble did not immediately respond with

their own web site, potentially drivingAmazon from the market.



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J udo Economics

J udo Economics

Because of its dominant presence in the bricks-

and-mortar market, Barnes & Noble had much

to lose by entering the on-line segment.This would quickly legitimize online sales, and

probably trigger an online price war, thereby

cannibalizingBarnes & Noble¶s bricks-and-

mortar sales. As it turned out, Amazonsucceeded beyond the expectations of most

market analysts.



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Wars of AttritionWars of Attrition

An aggressive firm supposedly starts aprice war to eliminate competition and

ultimately reap monopoly profits. Thispresumes that the rival would exit beforethe aggressor abandoned its strategy.

A price war harms all firms in the

market regardless of who started it.



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A larger firm is said to have deep pockets

from which it can finance the price warand have the ability to sustain lossesbetter than its smaller rivals.

However, a large firm may also suffer

greater losses during the price war.



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Price wars are examples of wars of attrition.

Firms may try to convince their rivalsthat they are better positioned to survive

the price war. Firms may claim that theyare actually making money during theprice war, or that they care more aboutwinning the war than about making

money. Either message may cause a rivalto rethink its ability to outlast itsopposition, and encourage it to exit themarket early.



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Survey Data on Entry Deterrence Survey Data on Entry Deterrence

Robert Smiley asked major consumerproduct makers if they pursued avariety of entry-deterring strategies.Smiley surveyed product managers atnearly 300 firms. He asked themwhether they used several strategiesincluding:



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1. Aggressive price reductions to move down thelearning curve, giving the firm a cost

advantage2. Intensive advertising to create brand loyalty

3. Acquiring patents for all variants of a product

4. Enhancing firm¶s reputation for predation

through announcements or some other vehicle5. Limit pricing

6. Holding excess capacity



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The first three strategies create highentry costs. The last three change theentrant¶s expectations of post-entrycompetition.

Reported Use of Entry Reported Use of Entry--Deterring Deterring



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Strategies Strategies

LearningCurve

Advertising R&DPatents

Reputation LimitPricing

ExcessCapacity

New

Products

Frequently 26% 62% 56% 27% 8% 22%

Occasionally 29% 16% 15% 27% 19% 20%

Seldom 45% 22% 29% 47% 73% 48%

Existing

Products

Frequently 52% 31% 27% 21% 21%

Occasionally 26% 16% 22% 21% 17%

Seldom 21% 54% 52% 58% 62%



Reported Use of Entry Reported Use of Entry--Deterring Deterring

Strategies StrategiesNote that managers were asked aboutexploiting the learning curve for new productsonly.

More than half of all product managerssurveyed report frequent use of at least oneentry-deterring strategies.

Product managers report that they rely much

more extensively on strategies that increaseentry costs, rather than on strategies thataffect the entrant¶s perception about post-entry competition

exit and entry

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