ECON 312: Strategic Behavior in Entry & Exit
1
Industrial Organization
Strategic Behavior in Entry & Exit
In the previous analysis, we have ignored the possibility in deciding whether to
enter or otherwise, firms essentially performed a viability (or cost benefit analysis)
study without consideration to the possible strategic effects its choice might have on
entry or exit from a market. However, it is very unlikely that in industries where there
is high concentration, that incumbent firm or firms would sit passively by as new firms
enter to reduce their sales and market share.
What kind of strategies are available to incumbent firm(s) to deter entry (Entry
Deterrence)? We will consider the following:
1. Capacity Expansion
2. Product Proliferation
3. Long Term Contracting
Just as an incumbent firm or firms might deter entry, they might also induce exit,
and one possible strategy we will be considering is the strategy of selling at very low
prices, and possibly below cost, what is often called Predation.
Just as an incumbent firm has their tricks up their sleeves, so too are there strategies
that entering firms could exercise for entry, and one of which we will consider is entry
through Mergers and Acquisition.
1
Entry Deterrence through Capacity Expansion
Consider the following model:
1. Firm 1 is the incumbent firm (a monopoly), and firm 2 is the possible new entrant.
2. There is no difference between capacity levels and output levels considerations.
3. There is complete information.
ECON 312: Strategic Behavior in Entry & Exit
2
4. First mover is the incumbent firm which chooses first the capacity. Given the
capacity choice of firm 1, firm 2 then decides whether to enter, and when it enters
how much to produce, given a none zero level of entry cost.
We have to ask the question now of what the most prudent strategy that firm 1
should engage in. The equilibrium quantity or capacity choice of firm 1 when it is the
sole producer, i.e. the monopoly is q1M , and this produces the equilibrium profit of
π1M (q1M ). However, it were to exist as part of a duopoly, the equilibrium quantity and
profit would become q1S and π1S (q1S ), where from figure 1, it is clear that the monopoly’s
profit is far higher. The question is what should the incumbent monopoly do?
Figure 1: Quantity Precommitment & Entry Deterrence
π1 , π2
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π1M (q1M ) ...........
π1M (q1D )
π1S (q1S )
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π1M
π1S
q1S q1M
q1D
q1
π2
-
q1
What the incumbent would immediately notice based on the above is that as long
as it produced at the monopoly level, the profit that firm 2 can capture upon entry,
net of entry cost is none zero, that is π2 > 0. The only way firm 1 can induce firm 2 to
choose no to enter is to produce at a quantity greater than q1D , where below which firm
2 would always choose to enter, and above which, it would not. From the diagram, it
ECON 312: Strategic Behavior in Entry & Exit
3
is clear that firm one can choose any quantity or capacity that satisfies the following
boundary considerations, q1D ≥ q1 ≥ q 1 , where q 1 is the upper bound on capacity,
since if the incumbent firm produced more, its profit would be less that if it choose
to accommodate the entry by firm 2. Let q1∗ be the deterrence choice of output, then
by producing at a higher capacity, the incumbent loses π1M (q1M ) − π1M (q1∗ ). However, it
gains as long as π1M (q1∗ ) − π1S (q1S ) ≥ 0.
1.1
Entry Accomodation & Blockaded Entry
Of course this strategy is a figment of the manner in which figure 1 had been set
up. If the cost of entry is low, it is likely that it is a better policy for firm 1 to just
accommodate the entry. This can be easily depicted by shifting the profit function for
firm 2.
Figure 2: Entry Accommodation
π1 , π2
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π1M (q1M ) ..........
π1S (q1S )
π1M (q1D )
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π1M
π1S
π2
q1S
q1M
q1D
-
q1
It is easy to discern that because the entry cost in figure 2 is lower than it was in
figure 1, π1M (q1D ) < π1S (q1S ), which means it is now instead viable to accommodate than
ECON 312: Strategic Behavior in Entry & Exit
4
deter entry.
Just as entry cost can be low, it can just as well be extremely high, so high that
it becomes never a credible threat for the incumbent firm to preempt and deter entry.
In which case, the optimal strategy would in fact be to set production and capacity at
q1M . See figure 15.3 of your text.
1.2
Commitment, Ex-Ante Optimality, & Ex-Post Optimality
The analysis till now is in truth a gross simplification since capacity involves physical
capital and costly can and are typically costly. In which case, when they are costly, we
have to ask ourselves whether the stated strategy is indeed credible. Credible in the
sense that once stated, and if the event occurs, the player would actually go through
with it. There are two cases we will consider:
1. Suppose now that capacity is not equivalent to quantity, and that capacity adjustment is not costly, i.e. is not a sunk cost. Then the stated strategy of deterrence
through raising capacity amounts to just a declaration. Is the strategy stated for
deterrence really credible?
Consider then the following arguments:
(a) Firm 1 announces that it will raise capacity upon entry by firm 2.
(b) Firm 2 ignores the declaration, and upon entry produces the Cournot competitive level of quantity.
(c) Given the above point, the best move by firm 1 is to likewise produce at the
Cournot output level since upon entry, firm 1’s profit function is π1S , and
producing at the declared level through raising capacity is just not credible
(Examine figure 1.). You have to ask yourself, once entry has taken place,
does the firm have the incentive to actually increase capacity, and thereby
lower its profits?
(d) Since we assume complete information, firm 2 is aware that the threat of
deterrence is not credible will always choose to enter.
ECON 312: Strategic Behavior in Entry & Exit
5
2. Suppose instead that it is very costly to raise capacity, so as to produce a larger
output, and that the capacity once raised, cannot be sold, that is the cost once
made is sunk. In this scenario, we cannot use the declaration argument, and so
firm 1 will make the investment. Suppose that there are no additional cost, to
keep our analysis simple. What we happen, or be the equilibrium outcome under
the previously argued strategy?
Once the investment is made, it is costless for firm 1 to produce at any level
including the Cournot level. However, the previously mentioned strategy of producing at q1D or higher is now credible since the cost is sunk. If firm 2 chooses
to enter, it would make a loss. Note here that the key assumption is that the
cost has to be sunk, and that firm 1 can commit to the strategy even if firm 2
really enters. Note that in figure 1, even if firm 2 enters, and firm 1 keeps to
its strategy, it still earns positive profits. The punishment to firm 2 is negative
profits net of entry cost. It is easier for commitment here since when the cost is
sunk, whether it produces the said level or otherwise, firm 1 has already paid the
cost.
2
Alternative Preemption Strategies
The considerations thus far relate more to one shot or short run scenarios. However,
if you think about it, is it really possible for firms to deter entry forever. After all,
forever is a long time. Read your text, pages 264 to 265 for some concerns
regarding the approach.
We will now consider two alternative approaches by which firms could deter entry.
2.1
Product Proliferation
One possible strategy available to firms is to fill available product space with more
products through product differentiation so as to reduce the potential expected profit
for a potential entrant. To see this, we revert back to the Hotelling model discussed
previously. Let us adopt the following setup:
ECON 312: Strategic Behavior in Entry & Exit
6
1. Suppose now there is one incumbent firm (firm 1), and one potential entrant
(firm 2).
2. Assume for simplicity that firms do not compete on prices so that at the end of
the day, p1 = p2 = p∗ .
3. Suppose all consumers are distributed uniformly along a unit line.
4. Let the marginal cost of production be zero.
Suppose first that the single incumbent is constrained to only producing one product
in a full product spectrum (which without loss of generality, you can assume is between
0 and 1). The best strategy for firm 1 is to locate right in the middle of the spectrum.
This way, should the new entrant enters, it can do best only by locating right on the
same location, so that both firms enjoy 50% of the total market share.
Suppose instead now that firm 1 can choose to produce more variation of their
product, i.e. fill up more of the spectrum before firm 2 enters. Let F be the cost of
creating a new variety of the differentiated product, where F <
p∗
.
2
If firm 1 only has
one product, then there is an incentive for firm 2 to enter since there are positive gains.
However, since firm 1 would know this, and suppose it chooses to produce two types
of goods, then firm 1 would earn extraordinary profits. In this instance, the best that
firm 1 can do is to locate its two differentiated product on 14 , and 34 . This would then
mean that should firm 2 enter, the best it can do is to locate in the middle and obtain
25% of the market share. This would imply that it would enter if and only if F <
p∗
.
4
Is this strategy necessarily better for firm 1, i.e. is the threat credible, or can it
commit to it. If firm 2 does not enter, it obtains p∗ −2F > 0 since
p∗
4
<F <
p∗
2
and firm
2 stays out. If instead it produced only one variety, which would mean firm 2 enters,
its profit would instead be
p∗
2
− F , which is lower. This does explains why in some
industries, you would notice substantial differentiation by one firm, with concentration
rather stable. The example thus justifies product proliferation. However, note that
this strategy is optimal in the face of entry threat. Finally, you can always interpret
location choice literally, which explains why you see so many bank branches within
close proximity to each other, but with little new entry.
ECON 312: Strategic Behavior in Entry & Exit
2.2
7
Contracts as Barriers to Entry
It also not uncommon to see both upstream and downstream firms enter into long term
contracts to deter entry into their supplier’s market. It would seem rather curious that
downstream firms might willingly enter into such contracts when superficially, it would
seem they should have a preference towards free entry into the upstream firm’s market.
The rationale is that when both upstream and downstream firms enter into agreement, they are acting as a monopolist incumbent over the potential entrant. This
would ensure that the entrant is in fact efficient in production, and consequently have
a lower cost of production than the incumbent upstream firm. Only when it is substantially lower, thereby raising the gains to the incumbent buyers, would it then be
worth the while of the incumbent downstream firms to renege on their contracts. You
can think of the efficiency necessary for entry as a kind of entry price for the potential
entrant.
3
Predation
Even if an incumbent cannot prevent entry, it can always induce exit, a practice known
as Predation, and the practice of pricing below marginal cost to induce exit is known
as Predatory Pricing.
However, it should be noted that in practice, the culprit of predatory pricing is not
easily incriminated. Consider the following, we have one incumbent firm and one new
firm. By Bertrand Model, given products are homogenous, we should observe prices
falling upon entry, then how do we discern between prices falling due to competition
and that due to predation? You might be thinking intent is the key, but intent is not
verifiable in courts. At the end of the day, it would seem the only way one party might
be vindicated and the other incriminated would have to depend on circumstantial
evidence and subjective judgment.
Given that it seems that this sort of punishment is levied on both the incumbent
and entrant, is it really true and possible that it exists? We will now examine several
theories in brief:
ECON 312: Strategic Behavior in Entry & Exit
8
1. The Chicago School & the Long Purse Theories of Predatory Pricing:
The Chicago School of thought believes that rational players should never exit
when preyed upon and rational predators should never engage in predation.
The idea behind this argument is as follows, consider a two period model, where
the entrant has already entered. Suppose predatory pricing has taken place where
each firm now suffers a loss of L each. Now at the end of the first period, the
new entrant must decide whether it is in its interest to remain in the second
period. If it remained, it would obtain a profit of π D if the incumbent does not
remain aggressive. On the other hand, should the entrant exit, the incumbent
firm obtained a monopoly profit of π M . Since it is a two period model however,
there is no reason to expect the incumbent to be aggressive since otherwise it
would have made two periods of losses L, assuming that the discount factor is 1.
Therefore both firms would make duopoly profits of π D . Even if the losses suffered
in the first period has eroded the funding of the entrant, as long as π D > L, it
would always make sense for the entrant to borrow the money to sustain itself
into the second period, obtain π D , and still earn net positive profits. Given
complete information, the banks should also be willing to lend the money. Given
this scenario, it would imply that the first period strategy is likewise inconsistent
since the incumbent could always gain more by accommodation.
The arguments seem logical, however they are based on two essential assumptions,
(a) Players or firms are rational.
(b) Complete information by the bank.
which may not stand up to scrutiny. Here is the critique by the counter theoretical
argument known as Long Purse Theory. The only reason why the incumbent
might find predation worth while is that banks needn’t have full and complete
information of the market. Given this, we can think of the likelihood a bank
would lend to the entrant in the second period with probability ρ. Then the
entrant would remain if and only if the expected gains in the second period is
ρπ D > L. Now under what circumstances would it be rational for the incumbent
to be aggressive? With probability (1 − ρ), the banks will not lend the money to
ECON 312: Strategic Behavior in Entry & Exit
9
the entrant, and the incumbent would in turn obtain a profit of π M . So that it
would be rational to exercise predation if:
(1 − ρ)π M + ρπ D > L
(1 − ρ)π M > L − ρπ D
If this inequality is satisfied, then and only then would we observe predatory
pricing, and that it is rational. Note that the key point here is that one firm, the
entrant, suffers from financial constraint.
2. Low Cost Signalling: Of course there are other interpretations, one of which
is that the low prices set, are truly revealing the fact that the incumbent has a
lower marginal cost of operation. If this signal is accepted, the entrant would
deem resistance as futile, and choose to exit.
3. Reputation for Toughness: If those above signals are sent sequentially, it
is possible that the incumbent builds a reputation for itself as being tough on
competition, or a tough and strong competitor. It is the history that is reinforcing
the beliefs, hence deterring potential entrants.
4. Growing Markets: In markets that are growing, it may be vital to obtain
a critical market mass. If true, it would justify predatory pricing so as to rid
itself of any competition so as to allow for future growth. An example being the
operating systems market. Read your text, pages 272 to 273.
Besides predation through pricing, the following are other venues that predation
might come about:
1. Predation could occur through contracting for exclusive dealings.
2. Bundling or Tying is the practice of designing components and parts that
reduce demand for competitor’s products.
Read your text, page 273, for a short discussion.
ECON 312: Strategic Behavior in Entry & Exit
4
10
Mergers & Acquisition
An alternative to eliminating competition or entry is through mergers and acquisition.
In general, when mergers take place, prices rise and output falls. You can
see this using a n firm Cournot model, reducing the number of firms from n to n − 1
firms, assuming both fixed cost, and marginal cost remains the same in the new merged
entity. However, such a model would not rationalize a merger since the profit gain from
merger of two firms is marginal is n is large. However, based on anecdotal evidence
that suggests that firms in mergers enjoy cost reductions due to synergies achieved,
mergers would make sense.
Of course, it is often believed that mergers would also increase the market share of
the merging firms. If you maintain the Cournot framework assumption when marginal
cost and fixed cost remain the same, the reduction in number of firms through mergers
in fact raises the profit of the non-merging firms. The intuition to be gleaned here
is that when output falls by a unit, a firm faces two opposing forces, there is first a
positive effect through the increase in price since per unit, margin rises.
Secondly, the fall in quantity sold means a reduction in revenue, which is
a negative point. At equilibrium, this forces cancels out. However, upon merger,
the quantity reduction is induced by the merged entity at no cost to the non-merger
firms, but the gains from the point of view of price-cost margin is strictly positive, thus
non-merging firms will strictly prefer to raise output, which is diametrically opposed
to the choice of the merged entity which is to reduce output.
However, if the cost efficiencies achieved through merger by the merged entities are
large, then the true beneficiaries of the merger is the merged entity, who would then see
an increase in market share, and obviating the loss for non-merging firms. Using the
same arguments prior, with the cost reduction, the first effect due to margin increase
is strictly positive, so that if the cost reduction is very large, the merged entity has a
strict advantage over its competition. Further, as quantity increases the second effect
due to revenue increase further reinforces the first.
This prior analysis presumes that upon merger, the mode of competition stays the
same. However, based on anecdotal evidence that mergers do typically take place
in waves, either endogenously or exogenously induced, the reduction in the number
ECON 312: Strategic Behavior in Entry & Exit
11
of firms, if substantial, does increase the ease in tacit coordination should thereby
changing competitive behavior to collusive.
4.1
Public Policy toward Mergers
Given the analysis of mergers, we know that of the three parties involved, merging
firms, non-merging firms, and consumers, the last definitively will suffer a fall in consumer surplus. Whether the second suffers or otherwise is unclear. Consequently when
social planners examine these cases, they are faced with the problem of verifying and
determining whether it is in society’s interest to permit the merger.
In general, mergers between large entities are hard to justify in favour of, or fight
against. Read your text pages 283 to 285. However, most authorities have used the
following rules:
1. Since the authorities typically protect consumers’ rights, if a merger would imply
substantial price increases, it would not be allowed. This requires the estimation
of the price effect of a merger. The principal reason for the focus on high prices
is the idea that high prices are due to increased collusion from the merged entity.
2. Another general rule is that mergers between smaller firms are more readily
permitted than if they were between larger firms. The rationale is that since
mergers between smaller firms also has smaller market effects, the revealed reason
for merger is typically deemed to be due to cost efficiencies that could be achieved.
Of course the size of the firms are based on market share.
3. Mergers are more readily permitted if the entry and exit into the industry is free
or almost so.
Of course all this rules still suffer from the usual problems of market definition, since
it will determine the market share, and the effects above.