Economics of Strategy
Fifth Edition
Besanko, Dranove, Shanley, and Schaefer
Chapter 11
Entry and Exit
Slides by: Richard Ponarul, California State University, Chico
Copyright  2010 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 (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
 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.
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
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
Strategic Barriers to Entry
Incumbents can erect strategic barriers by



expanding capacity
resorting to limit pricing and
resorting to predatory pricing
Types of Structural Barriers
The three main types of structural barriers to
entry are:
 control
of essential resources by the incumbent
 economies of scale and scope
 marketing advantage of incumbency
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: Extensive Form Game
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.
Excess Capacity
 For U. S. manufacturers average capacity
use is about 80%.
 When capacity addition has to be lumpy,
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
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
DuPont Titanium Dioxide Ti-Pure®
DuPont
Monopoly
Capacity
Excess
Capacity
Rival
E
DuPont 2
Rival
1
NE
E
NE
4
1
3
0
-
0
E=Enter
NE=Do not enter
1
http://www.dupont.com/tipure/
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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.
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
ET and the Chocolate Wars
In the movie “E.T.” a trail of Reese's
Pieces, one of Hershey's chocolate
brands, is used to lure the little alien
into the house. As a result of the
publicity created by this scene, sales
of Reese's Pieces trebled, allowing
Hershey to catch up with rival Mars.
Page 25
ET and the Chocolate Wars
(Continued)

Universal Studio's original plan was to use a trail of Mars’
M&Ms.

However, Mars turned down the offer, presumably because it
thought $1m was a very high price to pay.

The producers of “E.T” then turned to Hershey, who accepted
the deal.
Page 26
ET and the Chocolate Wars
(Analysis)

Suppose that
 the publicity generated by having M&Ms included in the
movie would increase Mars' profits by $800,000.
 Hershey's increase in market share cost Mars a loss of
$500,000.
 the benefit for Hershey's from having its brand featured in
the movie is given by b.
 Hershey knows the exact value of b. Mars knows that
b=1200 or b=700 with equal probability.
Page 27
The Mars Problem
A: Decision-theory Approach
bu
y
[-200]
M
not buy
[0]
Page 28
The Mars Problem
B: Naïve Game-theory Approach
bu
y
[-200, 0]
M
not buy
0
H
bu
y
not buy
[-500, -50]
[0, 0]
Page 29
The Mars Problem
C: Game-theory Approach
[-200, 0]
buy
-500
M
b = 1200
(50%)
not buy
buy
[-500, 200]
H
not buy
[0, 0]
N
-250
b = 700
(50%)
buy
0
[-500, -300]
H
not buy
See also: Joël Glenn Brenner, The Emperors of Chocolate.
New York: Random House, 1999 http://www.JoelGlennBrenner.com/
http://luiscabral.org/iio/ch04/ET/
[0, 0]
Page 30
Dominant and Dominated
Strategies

Dominant strategy: payoff is greater than any other strategy
regardless of rival’s choice.
 Rule 1: if there is one, choose it and that’s the end of it.

Dominated strategy: payoff is lower than some other strategy
regardless of rival’s choice.
 Rule 2: do not choose dominated strategies.

Check whether there are dominant and/or dominated strategies
in the example above. What can we say based on this?
Page 31