Economics of Strategy

Sixth Edition
Besanko, Dranove, Shanley, and Schaefer

Chapter 6

Entry and Exit

Copyright  2013 John Wiley  Sons, Inc.

 Entry

 Entrants are firms that produce and sell in

new markets
 Entry threaten incumbents in two ways.
 The market share of the incumbents is reduced
 Price competition is intensified
 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 analyzing
the costs of entry and the strategic response
by incumbents
 Forms of Exit

 A firm may simply fold up / collapse

(PanAm)
 A firm may discontinue a particular product
or product group (Sega leaves the video
game hardware market)
 A firm may leave a particular geographic
market segment (Peugeot leaves the U. S.
market)
 Evidence on Entry and Exit

 Dunne, Roberts and Samuelson (DRS) studied

entry 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 don’t grow
precipitously (quickly)
 The rates of entry and exit vary from industry to industry.
 DRS Findings on Entry and Exit

 Over a five year horizon, a typical industry

experienced 30 to 40 percent turnover
 About half the entrants were diversified firms and
the rest were greenfield entrants (new firms).
 About 40% of the exiters were diversified firms
that continued to operate in other markets.
 Conditions in an industry that encouraged entry
also fostered exit
 DRS Findings on Entry and Exit

 Unlike new entrants, diversifying firms built plants

on the same scale as incumbents.
 The size of the exiters is about one third of the
average firms’.
 Within 10 years of entry 60% of the entrants leave
the industry. The survivors double in size over the
same horizon.
Implication of DRS Findings for Strategy

 As part of planning for the future, managers

should account for the unknown future
competitors
 Diversifying 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 hand
 Managers should be aware of the entry and
exit conditions of the industry and how
these conditions change over time.
 Cost Benefit Analysis for Entry

 A potential entrant compares the sunk cost of entry

with the present value of the post-entry profit
stream
 Sunk costs of entry range from investment in
specialized assets to obtaining government licenses
 Post-entry profits will depend on demand and cost
conditions as well as post-entry competition
 Question

 Under what conditions do

economies of scale serve as an
entry barrier? Do the same
conditions apply to learning
curves?
 Question

 Economies of scale can serve as an entry barrier when the

investment made by the incumbent is a sunk cost.
Incumbent is unlikely to quit when competition intensifies.
If the investment is not a sunk cost (reversible investments,
general purpose assets) then there will be no entry barriers
even if there are economies of scale.

 Learning curve effects are similar to sunk cost effects. The

high cost of production during the learning period can
serve as an entry barrier, the same way sunk cost
investments do.
 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).
 Structural Barriers to Entry

Structural barriers to entry exist when:

 incumbents have cost advantages
 incumbent have marketing advantages

 incumbents are protected by favorable

government policy and regulations
The structural entry barriers result from exogenous market forces. These are the barriers
that cannot be influenced by incumbents firms. Low-demand, high-capital requirements
and limited access to resources are all examples of structural entry barriers. Exit barriers
arise when firms have obligations that they must keep whether they produce or not.
Examples of such obligations include labor agreements and commitments to purchase
raw materials, obligations to input suppliers and relationship-specific investments.
 Strategic Barriers to Entry

Incumbents can erect strategic barriers by:

 expanding capacity
 resorting to limit pricing and
 resorting to predatory pricing
Limit pricing refers to the practice whereby an incumbent firm can
discourage entry by its ability to sustain a low price upon facing entry, while
setting a higher price when entry is not imminent. Predatory pricing is the
practice of setting a price with the objective of driving new entrants or
incumbent firms out of the industry. Limit pricing and predatory pricing
strategies can succeed only if the entrant is uncertain about the nature of post-
entry competition.
 Expanding Capacity

 Excess Capacity: Unlike predatory pricing and limit

pricing, excess capacity can deter entry even when
the entrant possesses full information about the
incumbent’s costs and strategic direction. If the
incumbent is holding an entry-deterring level of
capacity it is actually in the incumbent’s interest to
convey this information to would be entrants. If,
however, the incumbent is unable to hold an entry-
deterring level of investment, then the incumbent
might hope the entrant is uncertain about the level
of capacity the incumbent actually holds.
 Typology of Entry Conditions (Bain)

 Markets can be characterized by whether

 the existing barriers to entry are structural or strategic
and (structural: incumbent has natural cost or marketing advantages, or when the incumbent
benefits from favorable regulation; strategic: incumbent takes aggressive actions to deter entry)
 entry deterring strategies are feasible)

 Three possible entry conditions of a market

are
 Blockaded entry: structural barriers are so high
 Accommodated entry: structural entry barriers are low

 Deterred entry: predatory acts (increase entry costs or

reduce postentry profits)
 Blockaded Entry

 Entry is considered blockaded when the incumbent

does not need to take any action to deter entry
 Existing structural barriers are effective in
deterring entry
 Accommodated Entry

 With accommodated entry, the incumbents

should not bother to deter entry
 This condition is typical of markets with growing
demand or rapid technological change
 Structural barriers may be low and strategic
barriers may be ineffective or not cost effective
 Deterred Entry

 Entry is not blockaded

 Entry deterring strategies are effective in
discouraging potential rivals and are cost
effective
 Deterred entry is the only condition under
which the incumbents should engage in
predatory acts
Asymmetry between Incumbents and Entrants

 What is sunk cost for incumbents is

incremental cost for the entrants
 Established relationships with customers
and suppliers are not easy to replicate
 Learning curve effects
 Switching costs for the customers
 Types of Structural Barriers

The three main types of structural barriers to

entry are:
 controlof 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 sources
 Patents can prevent rivals from imitating a
firms products
 Special 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,

potential may face cost disadvantages.
 Incumbent’s strategic reaction to entry may
be to further lower price and cut into
entrant’s profits.
 If entrant succeeds, intense price
competition may ensue (follow).
 Economies of Scale and Scope

 Entrants can face cost disadvantages due to

economies of scope.
 Economies of scope in production exist when
multiple product lines are produced in the same
plant.
 Economies of scope in marketing are due to the
upfront cost of achieving brand awareness by
entrants.
Marketing Advantage of Incumbency

 Incumbent can exploit the brand umbrella to

introduce new products more easily than
new entrants can.
 The 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-free.
 If the new product is unsatisfactory,
customer dissatisfaction may harm the
image of the existing products.
 Barriers to Exit

 PEntry = the minimum price that will

induce a firm to enter an industry (the price at
which the firm is indifferent between entering and exit)

 PExit = the minimum price that will induce

an incumbent firm to stay in an industry
 PEntry > PExit ( firms may remain in the market even though
price is below long-run average cost)

 Exit barriers drive a wedge between PEntry

and PExit .
 Barriers to Exit

 Sunk costs make the marginal cost of staying

low.
 Obligations and commitments to suppliers
and employees are sunk costs as well.
 Relationship specific assets may have low
resale value.
 Government regulations can also be a
barrier to exit.
Prices that Induce Entry and Exit may Differ
 Entry Deterring Strategies

 Some examples of entry deterring strategies are

limit pricing, predatory pricing and capacity
expansion.
 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
Contestable Markets & Entry Deterrence

 If there is a possibility of a hit and run entry (zero

sunk 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
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 entrants
 Two forms of limit pricing
 Contestable limit pricing
 Strategic limit pricing
 Contestable Limit Pricing

 Incumbent has excess capacity and can

set prices below entrant’s marginal cost
 Incumbent can meet the market demand at
the low prices
 Strategic Limit Pricing

 Entrant has limited capacity or rising marginal costs

 Limit pricing may mean sacrifice of profits or
inability to meet market demand
 Low price can be an entry deterrent (prevent) if
entrant infers that post entry price will be low.
Price & Profits under Different Competitive Conditions
 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 following period.
 The incumbent may be better off being a Cournot
duopolist than limit pricing forever as a
monopolist.
 Is Limit Pricing Rational?

 Even in a two period setting, limit pricing

equilibrium is not subgame perfect.
 Potential entrants can rationally anticipate
that the post-entry price will not be less than
the Cournot equilibrium price.
 Predatory Pricing

 Predatory pricing involves setting the price

below short run marginal cost with the
expectation 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.
 Is Predatory Pricing Rational?

 If all the entrants can perfectly foresee the future

course of incumbent’s pricing, predatory pricing
will not work.
 The chain store paradox: Many firms are
commonly perceived to engage in predatory
pricing even when it is irrational to expect
predatory pricing to deter entry.
 Is Predatory Pricing Rational?

 Simple economic models indicate that

predatory pricing is irrational
 Either the firms’ pricing strategies are
irrational or the models are incomplete.
 Game theoretic models that include
uncertainty and information asymmetry
show that predation can be a rational
strategy.
Situations Where Limit Pricing & Predation are
Rational

 Incumbent wants the entrant to lower its

expectations for post entry price
 Entrant lacks information about incumbents
costs.
 Incumbent’s pricing strategy can alter
entrant’s expectation when there is
asymmetric information.
 Limit Pricing and Dual Uncertainty

 In Garth Saloner's model, entrant is uncertain about

incumbent’s 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
incumbent’s cost is low.
 In either case entry is deterred
 Predatory Pricing and Reputation

 Predatory pricing can deter entry when the

incumbent seeks a reputation for
toughness.
 If the incumbent does not slash prices,
other challengers may consider him ‘easy’
rather than ‘tough’
 Predatory Pricing and Reputation

 An incumbent can be ‘tough’

 eitherdue to low costs
 or due to an irrational desire for market share

 or because there is other competition entrant is

unaware of.
 By slashing prices entrant is made to believe
that the incumbent is tough.
 Predatory Pricing and Reputation

 Some well known firms enjoy a reputation

for 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
 War of Attrition

 Predatory pricing strategy can degenerate

into a war of attrition.
 If no one leaves in the early stages, a
prolonged price war can be bad for all the
firms in the industry.
 Even the winner may be worse off compared
to not having had the price war at all.
 Winning the War of Attrition

 The more a firm believes it can outlast its

rivals, the more willing it to stay in the price
war
 A firm that faces exit barriers is well
positioned to engage in a price war.
 A firm can also try to convince its rivals that
it can outlast them (For example, by
claiming to be money even during the price
war)
 Excess Capacity

 For U. S. manufacturers average capacity

use is about 80%.
 When capacity addition has to be lumpy (full
of), firms may often have excess capacity in
anticipation of future growth
 A temporary down turn in demand may
leave the firms in an industry with excess
capacity with no strategic overtones
(implication)
 Excess Capacity and Entry Deterrence

 By holding excess capacity, the incumbent

can credibly threaten to lower the price if
entry occurs.
 An incumbent with excess capacity can
expand output at a low cost.
 Entry deterrence will occur even when the
entrant as informed as the incumbent.
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 investment

in excess capacity and
 entrant is not the type trying to establish a
reputation for toughness.
 Entrant’s Strategy: “Judo Economics”

 Use opponent’s strength to one’s

advantage.
 Entrant discourages the incumbent from
entry deterrence strategies by appearing to
be a non-threat in the long term
 Incurring large losses may not appear
worthwhile to the incumbent.
Smaller firms and potential entrants can use the incumbent’s size to their own
advantage
 Entry Deterring Strategies

 Aggressive price reductions to move down

the learning curve
 Intensive advertising to create brand loyalty
 Acquiring patents
 Enhancing reputation for predation
 Limit pricing
 Holding excess capacity
 Entry before competitors to discourage
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 Question

 Consider a firm selling two products, A and

B, that substitute for each other. Suppose
that an entrant introduces a product that is
identical to product A. What factors do you
think will affect (1) whether a price war is
initiated, and (2) who wins the price war?


 Given that the incumbent is producing two substitute goods, the
incumbent has more to lose if a price war erupts. The reason is, if the
incumbent lowers the price of good A to match the price of the entrant’s
identical offering, the incumbent loses revenues on good B as well as on
good A because customers who used to purchase good B will substitute
toward good A. If exit barriers are minimal, the incumbent might
prefer to exit the market for good A rather than endure a price war.
The incumbent is more likely to stay and fight if exit barriers are high
and/or good A and B are weak substitutes. Clearly the probability of a
price war decreases if the level of demand for these goods is high
relative to the combined capacities of the firms.
 Question

 “Judo economics suggests that economies of

scale are useless at best.” Do you agree or
disagree?
 AGREE: Firms that have economies of scale over smaller or newer market
entrants typically have large sunk costs. These costs can become a
disadvantage when other smaller firms attack the market with a different
substitute product priced below the larger firm. This “judo” tactic results in the
revenue destruction effect where the larger firm in cutting its price to match the
substitute product’s price losses more revenue than the smaller firm due to its
large sunk costs. Economies of scale in this case are useless, and actually act as
a negative force on the larger firm.

 DISAGEE: Economies of scale can prevent newer entrants or drive smaller

firms from markets in certain circumstances. For example, the value of scale
economies would be to have such significant volume that vital resources and
vertical processes are effectively closed off to other market participants.
Economies of scale – a grand scale – are useful as a deterrent to market
entrance by effectively monopolizing the vertical production chain and
prohibiting others from participating in the market