Business Economics (A)
Researcher training course
9th week
Yuji Honjo
Faculty of Commerce
Chuo University
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Contents

Theme


Keyword


Entry and exit
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-andrun 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
1982
1.
Entry and exit will be pervasive.

2.
Entrants and exiters tend to be smaller than
established firms.

3.
A typical entrant will be only one-third the size of
typical incumbent.
Most entrants do not survive 10 years, but those
that do grow precipitously.

4.
30 and 40 new entrants during 5 years per 100 firms
Roughly 60% will exit during 10 years.
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.
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 entrydeterring 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 upfront 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
Under what conditions does it pay for
incumbent firms to raise the barriers to entry
into their market?
 Two conditions for entry-deterring strategies



The incumbent earns higher profits as a
monopolist than it does as a duopolist.
Monopolistic profits > Duopolistic profits
The strategy changes entrants’ expectations about
the nature of post-entry competition.
( If the entrant ignores any strategy, the
strategy is useless.)
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cf. Contestable market

Who introduces a contestable market
(contestability theory)?


Baumal, Panzar, and Willing.
What does “contestable” indicates?



No sunk costs
In a contestable market, a hit-and-run entrant
rapidly enters the market.
So, the incumbent has to charge a price that yields
zero profits, even when it is an apparent
monopolist.
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(Continued)

Which industry is a contestable market?


Traditionally, airline markets (perhaps, US) have
often been regarded as a contestable market, since
the sunk costs are very low.
Borenstein’s (1989) paper


Monopoly routes have higher fares than duopoly
routes of comparable lengths.
He concluded that airline markets are not
perfectly contestable.
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Entry-deterring strategies

Assuming that the incumbent monopolist’s
market is not perfectly contestable
 The incumbent monopolist expect to reap
additional profits if it can keep out entrants.

Three ways for entry-deterring



Limit pricing
Predatory pricing
Capacity expansion
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Limit pricing

Limit pricing


An incumbent firm discourages entry by charging a low
price before entry occurs.
Example (see Table 9.1)



Nonrecoverable fixed costs for Firm E (entrant): $800
If the price remains at $30, Firm E does not enter the
market.
 Limit pricing
For Firm N (incumbent)
Monopolistic profits > Duopolistic profits
 Limit pricing seems rational.
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(Continued)

Is limit pricing rational? (See Figure 9.3.)


Firm N should not choose the limit pricing
strategy.
Limit pricing fails because the incumbent’s
preentry pricing does not influence the entrant's
expectations about postentry competition.
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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.

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(Continued)

Is predatory pricing rational?


Chain-store paradox
What is the chain-store paradox? (example)


A firm operates in 12 markets and faces entry in
each, In January, it faces entry in market 1; in
February, it faces entry in market 2; and so on.
Question: Should the incumbent slash prices in
January so as to deter enter later in the year?
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(Continued)

What is the chain-store paradox? (example)





Answer by working backward from December to see how
earlier pricing decisions after later entry.
The incumbent will not benefit from predatory pricing in
December because there is no further entry deter. And the
entrant will enter the market.
Backing up to November, the forward-looking incumbent
knows that it cannot deter entry in December.
The incumbent cannot benefit from slashing prices
(predatory pricing)
As a result, the incumbent realizes that it has noting to gain
from predatory pricing in January! (Predatory pricing is
irrational.)
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Rescuing limit pricing and predation: the
importance of uncertainty and reputation

Are limit pricing and predatory pricing
irrational strategies?


In the real world, many firms commonly perceived
as slashing prices to deter entry.
The explanation is that the analysis far fails
to capture important elements of their
strategies.


Uncertainty
(see also 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 (see Chapter 7.)
 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


Price war
Evidence on entry-deterring behavior

Survey data on entry deterrence by Smiley (1988)


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Learning curve
Advertising
R&D, Patents
Reputation
Limit pricing
Excess capacity
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