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Business Economics (A)Researcher training course 9-10th 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. Diversifying entrants tend to be three times the size

of other entrants.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.

e.g.) Microsoft X-box -> Sony playstation 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 Two conditions for entry-deterring

strategies The incumbent earns higher profits as a

monopolist than it does as a duopolist. The strategy changes entrants’

expectations about the nature of post-entry competition.

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(Continued) Three ways for entry-deterring

Limit pricing Predatory pricing Capacity expansion<= Assuming that the incumbent

monopolist’s market is not perfectly contestable.

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Cf. Contestability theory Baumol et al. (1982)

A monopolist cannot raise price above long-run average cost. => The market is perfectly contestable.

Cf.) hit-and-run entry The theory was applied to the airline

industry.=> See Borenstein (1989).

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Limit pricing Limit pricing

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

ExampleDemand function P = 100 – QCost function MC = 10, F = 800

Case: Monopoly MR = MC⇒ P = 55, Q = 45⇒ Profit = (55 – 10)*45 – 800

= 1225

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Limit pricingCase: Cournot duopoly (reaction functions)

⇒ P = 40, Q1 = Q2 = 30 (Q = 60)

⇒ Profit = (40 – 10)*30 – 800 = 100

Market Structure Price Annual Profit per Firm

Monopoly $55 $1225

Cournot duopoly $40 $100

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(Continued) Two-periods game

Incumbent => P = 30 (Q = 70) Incumbent’s profit (1st period)

(30 – 10)*70 – 800 = 600 Entrant’s profit (if entry occurs)

(30 – 10)*35 – 800 = – 100

Is limit pricing rational?

(See Figure 9.3.)

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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. Chain-store paradox

An incumbent can slash prices to drive out rivals. => Irrational

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

Are limit pricing and predatory pricing irrational strategies? The explanation is that the analysis far

fails to capture important elements of their strategies.

=> UncertaintyCf.) Milgrom and Roberts (1982) Reputation for toughness

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Limit pricing Limit pricing

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

(See Table 9.1.)

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(Continued) Is limit pricing rational?

(See Figure 9.3.)

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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. Chain-store paradox

An incumbent can slash prices to drive out rivals. => Irrational

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

Are limit pricing and predatory pricing irrational strategies? The explanation is that the analysis far

fails to capture important elements of their strategies.

=> UncertaintyCf.) 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 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

Evidence on entry-deterring behavior Survey data on entry deterrence by Smiley (1988)