Entry and Exit
Introduction
 Incumbent firms formulate strategy taking into
account the possibility of entry by new firms
 Entry has two effects
 reduced market share
 intensified market competition
 Can take two forms
 entry by a new firm
 entry by an existing firm diversifying into a new market
 Exit is the reverse process
 Acquisition is not entry: merely change of identity
Some Stylized Facts
Entry and exit is pervasive
over a five year period in most industries
30-40% new firms enter
30-40% of existing firms exit
entrants are generally small if they are new
most entrants do not survive 10 years
if they survive they grow rapidly: 60% fail, the
remainder at least double in size
patterns vary across industries
Strategic Implications
Firms should
plan for entry by unknown firms
realize that diversifying entrants can threaten
incumbents
expect most new ventures to fail quickly
but survivors will grow quickly
in planning entry focus on how to manage rapid
growth
know the industry
Strategic implications (cont.)
Entrants should consider
costs of entry and exit: are there sunk costs?
likely reaction of incumbents: aggressive or
passive
what has been the history of the market?
barriers to entry of various types
Barriers to Entry
Barriers can take two forms
Structural
incumbents have natural cost advantages
cost
location
regulatory environment
Strategic
through deliberate actions of incumbents
A Taxonomy
Entry conditions can be classified into
three types
blockaded entry
structural conditions preclude entry without strategic
actions
accommodated entry
structural barriers are low and there are no effective
strategic barriers to entry
deterred entry
incumbents use specific strategies to deter entry
Structural Entry Barriers
control of strategic resources
patents
if not deliberately anti-competitive
economies of scale and scope
cost advantage of incumbency
ability to sustain a price war
leave no “holes” in the market
requires that some part of entry costs is sunk
Structural entry barriers (cont.)
marketing advantages of incumbency
exploit reputation and brand name
risky if a new product does not meet expectations
access to distribution based on reputation
Barriers to Exit
Exit if cannot make an acceptable return
on assets
Do not enter unlessassets
but consider only recoverable
$
PENTRY
expected price is at
An illustration of the
least PENTRY
Do notMC
exit if priceExit
barriers
entry/exit
decisions
is greater than
PEXIT
ATC
exist
AVC
PEXIT
Quantity
when there are
fixed costs
when there are
relationshipspecific assets
Strategic Entry Deterrence
An incumbent will adopt entry deterring
strategies
if monopoly is preferred to accommodated entry
if the strategies affect expectations of potential
entrants about post-entry competition
First condition is obvious
unless the market is perfectly contestable
Second condition requires that strategies
are credible
Entry deterrence
There are several potential strategies that
have been suggested
limit pricing
predatory pricing
capacity expansion
Limit pricing
Charge a low price before entry
entrant is put off by the low price
An illustration
suppose demand is P = 100 - Q
marginal cost is $10 per unit
fixed costs are $800 per annum
incumbent has monopoly in year one; faces potential entry in year 2
market closes at the end of year 2
The Example
$
100
55
An incumbent monopolist produces
Q = 45 units; price = $55
Profit p.a. = (55 - 10)x45 - 800 = $1,225
Monopoly profit per
Suppose an entrant in period 2 with the
Demandperiod ignoring
fixed costs same costs
Assume that the incumbent and entrant
are Cournot (quantity) competitors
MC
10
MR
45
100
Quantity
The Example
Each firm produces 30 units in
period 2; price = $40
Profit to each firm = (40 - 10)x30 - 800
= $100
$
100
Demand
Given this expectation entry will occur
The incumbent’s profit in period 2 is
sharply down
40
10
MC
MR
60
100
Quantity
The example (cont.)
Can the incumbent deter entry?
use the reasoning
price low in period 1
the entrant will then expect an even lower price in
period 2
entry will not happen
I can then charge the monopoly price in period 2
suppose the incumbent charges $30 in period 1
the incumbent then expects a price no higher
than $30 in period 2
suppose that the price is actually $30
The example (cont.)
aggregate demand is 70 units
suppose that this is split equally
the entrant expects profits of (30 - 10)x35 - 800
= -$100
Limit pricing would appear
Monopoly
with a lower price
are
even
greater
to be
successful
in
Profitlosses
in theprofit
inincreasing
the
profits
periodsecond
so the potentialfirst
entrant
should
periodnot enter
the incumbent then has profits
(30 - 10)x70 - 800 + $1,225 = $1,825
The Example (cont.)
 But this outcome is wrong: the logic is flawed
why only two years?
 if more periods then the limit price might have to be
sustained over a very long time
 for this to be acceptable the incumbent needs a strong cost
advantage over potential entrants
the supposed equilibrium is not credible
 technically, it is not subgame perfect
 the entrant’s supposed expectations regarding the
incumbent’s post-entry actions are unreasonable
consider the full game in extensive form
The Entry Game
IncumbentEntrant
sets thedecides
whether to enter
limit price
Incumbent chooses
Out
its pricing strategy
pI = $1,825; pE = 0
PL
PL
pI = $500; pE = -$100
Entrant
In
Incumbent
Incumbent
PC
Incumbent sets the
monopoly price
Out
Entrant
PM
In
pI = $700; pE = $100
pI = $2,450; pE = 0
PL
pI = $1,125; pE = -$100
Incumbent
PC
pI = $1,325; pE = $100
The Entry Game
If the Incumbent sets the
limit price the Entrant
If the Entrant enters the
will enter
Incumbent will choose
The Incumbent
Out
Cournot
will set the
pI = $1,825; pE = 0
monopoly price P
PL
L
pI = $500; pE = -$100
Entrant
In
Incumbent
If the Incumbent sets the
Incumbent
If the Entrant enters
the
ppII == $700;
$700; ppEE == $100
$100
monopoly price the
PC
Incumbent will choose
Entrant will enter
Out
Cournot
Limit pricing is not
pI = $2,450; pE = 0
Entrant
a credible strategy
PL
pI = $1,125; pE = -$100
PM
In
Incumbent
PPCC
pI = $1,325; pE = $100
Limit Pricing Rescued
 Can limit pricing be rational?
what if the entrant is uncertain of the incumbent’s
costs
 high-cost incumbent - enter
 low-cost incumbent - stay out
then the low-cost incumbent can signal a price
that induces the entrant to stay out
but a high-cost incumbent might send the same
signal
 for this to work the price signal by a low-cost incumbent
must be impossible for a high-cost incumbent
 or there is additional uncertainty e.g. about demand
Predatory Pricing
Pricing intended to eliminate rivals
more aggressive than limit pricing
charge low price to drive out rivals
then subsequently raise price
Has similar credibility problems
chain store paradox
incumbent will not fight in a “last” market
so will not fight in all previous markets
Predatory pricing (cont.)
 Paradox can be resolved if there is uncertainty about
the incumbent’s “type”
 if “easy” then entry is profitable
 if “tough” then entry is unprofitable
 incumbent wants to develop a tough reputation
 Wal-Mart
 American Airlines
 develop routines that make managers tough
 reward on market share not profits
Excess Capacity
Firms carry excess capacity
capacity use generally around 80%
economic reasons
to cope with unexpected fluctuations in demand
as a result of competition from new firms
strategic reasons
to deter entry
• convince potential entrants of toughness of incumbents
• potential entrants know that incumbents can expand
output at low cost
Entry at limited scale
Potential entrants may be able to enter at
low scale
deterrence is costly
incumbent may be inclined to ignore a small
entrant
so entrant needs credible mechanism to
convince incumbents of small-scale entry
“puppy-dog ploy”
modern manufacturing techniques may help
micro-breweries
War of attrition
Firms have been accused of charging low
prices to eliminate competition
Standard Oil
Toyota
Wal-Mart
but price wars are costly and uncertain
firm with “deep pockets” will win
but at the expense of considerable profits
create exit barriers to influence rivals