5. Entry
• How does entry or potential competition affect market power
of established firms?
• How can dominant firms try to limit opportunities for
competition: deter entry, increase costs, reduce revenue,
close mkts, etc?
• So far only actual competition between firms already on
market
• Look at potential competition: competitive pressure by firms
not yet on market that can enter if conditions are attractive
enough
• Basic micro: entry determined by structure of market: entry
costs, demand, MC, number of firms on market, …
• Entry barriers: structural characteristics of market that
protects incumbent by making entry unprofitable
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•
•
•
•
– High sunk costs: capacity,
marketing costs, technology,
5. Entry
know-how, scale or scope economies, …
– Patent, license,...
Concentrate here on entry deterrence: strategies incumbent
can use to keep potential rivals out or influence their costs
and/or revenues
Suppose an incumbent monopolist i on market already,
charges p > ac
An entrant e considers whether to enter or not
Decision rule:
– enter if EV = ttte > f, sunk cost of entry
– otherwise stay out
• For small enough f and large enough V, entry yields positive
NPV
• If monopolist keeps p>ac, firms enter mkt until EV = f
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• Monopoly, but no mkt power!
(in LR)
5. Entry
• Contestable market: threat of entry or potential competition
enough to curb monopoly power, to keep price close to LRAC
• Game-theoretic structure of contestable market:
– 1) Firms choose prices
– 2) Given prices, firms choose quantities [0, qM]
– Flavor of model: output/capacity more flexible and easier
to change than price
– Not realistic?
• Not all mkts are contestable
– Threat of hit-and-run entry not credible
• General lesson: mere threat of entry important to curb
market power
• Could dominant incumbent try to prevent entry and remove
threat?
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5.2 Limit Pricing
•
•
•
•
•
•
•
•
•
•
Motta Ch 7
Limit price pL: price low enough to make entry unprofitable
pL depends on sunk entry costs f
Limit quantity qiL: corresponding output by incumbent
firm(s)
Idea: incumbent discourages entry by lowering price
High (low) price now signal of (low) high profits in future
Potential entrant supposed to conclude from low prices that
entry is not attractive and stay out
Incumbent raises price once threat of entry disappears and
earns high profits
Problem 1: Potential entrant can alter her decision and enter
if price does not stay low
Problem 2: Does limit pricing satisfy backward induction?
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• Stylized 2-stage entry game:
5. Entry
st
– 1 stage: e chooses to enter or stay out
– 2nd stage: i fights or accommodates
– e enters if net profits from post-entry game are positive
• Use backward induction to analyze entry decision
– Two alternartives
• i accommodates, eg. Stackelberg duopoly:
• i fights, eg. price war:
iF, eF
iA, eA
eA, so that e wants to enter
Fighting deters entry if eF < f
But iF < iA
– Assume f <
–
–
– No incentive for i to fight as post-entry fighting leaves
less profit than accommodation
– Fighting entry never rational to i
– e always enters, as threat of fighting is not credible
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• Only credible equilibrium:
deterrence is not possible
5. entry
Entry
• “Chain-Store Paradox:” Even a strong monopolist unable to
keep entrants out
• More general 3-stage game:
– 1st stage: i takes aggressive or passive stance
• Aggressive: eg. “irrationally” fights entry to gain
reputation for toughness
– 2nd stage: e chooses to enter or stay out
– 3rd stage: i fights or accommodates, and profits are
realized
– e enters if profits from post-entry game expected to be
positive
– e does not know whether i is irrational aggresive or
rational profit-maximizing firm
– e can use info, including i’s previous actions, to try to
predict i’s future behavior
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• Now entry deterrence can
credible
5. be
Entry
• Need Bayesian game theory to analyze, as there is
incomplete info: e does not know i’s objectives, hence
cannot plug in i’s RF in her decision problem
• Basic idea:
– 2 types of i: Tough (T) or Soft (S)
• S maximizes present value of profits
• T likes to fight, eg. gets some non-monetary utility
from aggressive behavior
– e has prior probability assesment 0 < P(iT) < 1
– e updates probability assesment by Bayes rule, using all
relevant info including i’s past behavior, P(iT|info)
• Early fighting increases P() for later entry decisions
• Milk reputation: P(iT|accomodation) = 0
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• e enters if expected profits
exceed sunk costs:
5. Entry
P(iT|info)eF + (1–P(iT|info))eA > f
• Early fighting now rational: gain reputation for toughness to
deter future entry
• Not maximizing profits yields higher profits than profit
maximizing!
– Incomplete info and possibility of “irrational” tough type
yield positive externality to i
– Similar results with other incomplete info
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5.3 Capacity
• Can excess or large capacity deter entry?
– i builds excess capacity to use it for price war if e enters?
• Excess capacity intended to signal price war after
entry
• Has i incentives to lower price and increase output
after entry? No
– i builds “too much” capacity to lower MC?
• Commit to high output
• Not necessarily free pre-entry capacity as i might
have incentives to produce at full capacity
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• 2-stage game
5. Entry
– 1st stage: i invests in capacity k
– 2nd stage: knowing k, e chooses to enter or stay out
– Cournot competition: qi, qe
– e enters if net profits from post-entry game positive
– e wants to install capacity ke = qe* = equilibrium output,
so we can ignore e’s capacity choice
– Cost of capacity r and cost of labor w
– Unit cost of production r+w
• Note that firms are symmetric, other than
– i on mkt already with sunk capacity k
– e must also consider entry costs f
– MCi = w for qi ≤ k
– e has marginal costs r+w for entire production
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• Can i credibly threaten to
entry by installing enough
5.fight
Entry
capacity to produce limit output?
• Backward induction:
Marginal costs at 2nd stage quantity subgame
• In equilibrium each produces at MR=MC, given (correct)
expectations of rival’s production
• MCe = w+r
• MCi:
– qi < k: MCi = w as cost of capital is sunk
– qi > k: MCi = w+r
– MC jumps up at k
Example
• Demand p=68–(qi+qe), cost of capital r=38, w=2, f=4
• Can i deter e from entering?
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–
–
–
–
–
–
–
–
–
Limit output = 24 (plug
in numbers from homework)
5. Entry
e’s RF is qe(qi) = (68 – qi – (w+r))/2
If qi = 24, qe* = 2
MRi (24) = 18
40 = MC(25) > MRi(24) > MC(24) = 2
Hence i wants to produce at full capacity
Anticipating qi = 24, e will not enter
Incumbent can deter entry
We do not yet know whether entry deterrence is
profitable
Reaction functions in 2nd stage quantity sugbame
• To find Nash equilibrium we need to find 2nd stage RF's for
both firms
• e's RF qe*(qi) is implicitely defined by MRe = MCe = w+r
• i's RF qi*(qe) is bit harder:
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1) Suppose k = , no capacity
constraint on 2nd stage
5. Entry
– Then 2nd stage MCi = w
– RF now defined by MRi(qi,qe) = w
– Denote RFi(,qe) by qi(qe)
2) Suppose other extreme: k = 0
– 2nd stage MCi = w+r
– Now RF defined by MRi(qi,qe) = w+r
– Denote RFi(0,qe) by qi0(qe)
3) For all other cases 0 < k < , MCi vertical at k
– MRi depends on qe
– For small (large) qe, i's MRi and profit maximizing output
is relatively high (low)
– i's RF defined by intersection of MRi and MCi
– If qe is low enough, i will want to increase capacity
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• Summary:
5. Entry
– If MRi(k,qe) < w, then qi = qi(qi)
– If MRi(k,qe) > w+r, then qi = qi0(qi)
– If w < MRi(k,qe) < w+r, then qi = k
• Translate MC picture into RF picture
– Kink in RF at k
– Different values of k shift the kink in i's RF
Nash equilibrium in quantity subgame
• Outputs of two firms are equal at one-stage Cournot
equilibrium outcome with MCi=w+r; denote with C
• Another one-stage equil outcome with MCi=w; denote with D
• i's RF is presented by linking these two one-stage RFs with
kink at k
• Nash equilibrium = intersection of RFs: both firms are producing profit maximizing quantities and neither has incentive
to deviate
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1)
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2)
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Capacity expansion: qiC 5.
> kEntry
Kink in RF left of C
Kink is also above qi0(qe)
i will want to increase output beyond k as MRi exceeds w+r
and i is not on its RF at (k, qe(k))
Excess capacity: k > qiD
Kink in RF right of D
i will not want to use all its capacity
To right of D, both qi0(qe) and qi(qi) lie below RFe qe(k,qi)
Kink will also be below qe(k,qi)
Producing at capacity means MR < MC
Threat of producing at capacity is not credible as e knows
that i will not want to produce qi = k
Thus e will want to expand her production above candidate
equilibrium outcome (k, qe’)
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3) Full capacity utilization: 5.
qiC Entry
> k > qiD
• Equilibrium on RF of e where qi = k and qe = qe*(k)
• To right of C and left of D, qi(qi) is above and qi0(qe) and
below RFe
• Kink will cross RFe at k
• i will want to produce at capacity and not to expand capacity,
as MRi < w+r
• In both 2) and 3), Nash equilibrium quantity subgame is
asymmetric and favors i
Optimal 1st stage capacity decision
3 cases:
1) Blocked entry: e's profits are negative at C
• Profits of e are negative even in best post-entry equilibrium
• Limit output less than monopoly profit maximizing level
• i need not worry about entry
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2)
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3)
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Stackelberg: e's profits are
positive at D
5. Entry
Profits of e are positive even in worst post-entry equilibrium
i can credibly commit only to qiD < qL, and e enters
Two subcases:
– i can commit to Stackelberg outcome qS by strategic
overinvestment if qS lies between C and D
– If cost advantage of sunk capital is small, excess capacity
at Stackelberg outcome  get close to Stackelberg
outcome and qi = k
Strategic entry deterrence or accommodation
Profits of e are positive at C and negative at D
i can deter entry since qL lies between C and D
Two sub-cases:
– Always profitable for i to strategically deter entry as
qL < qM
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•
•
•
•
S or strategically
– Accomodate entry by5.installing
k
=
q
EntryL
deter entry by installing k = q
i can choose to commit to either by choosing k
Optimal choice depends on relative profits:
– Benefits of entry deterrence: monopoly
– Costs of entry deterrence: expand capital and output
beyond monopoly level
– If entry on small scale, accomodation likely to be optimal
– If qS > qL, always deter entry
Entry deterrence is possible because capacity is sunk
investment, commitment
Incumbent strategically invests in capacity beyond monopoly
profit maximizing level to commit to output level guaranteed
to drive potential entrant's profits to zero
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• Two requirements for profitable
strategic entry deterrence:
5. Entry
– Incumbent able to reduce MC by sunk investments
– Economies of scale
• Other ways to limit entry:
– Tie customers with long-term contracts
– Discounting schemes
• May look aggressive competition but can be tool to
reduce entry
– Advertisement and brand loyalty
– Customer switching costs
– Manipulation of installed base of customers
– Homework: How would these show up in RF picture?
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Final Exam 23.05.2005
• 2+2 questions
– One applied, one technical
– Two straight forward explanations
– 1+1 answers
Requirements
• Lecture Notes
• US Merger Guidelines
• Airtours, Volvo/Scania, UPM/Haindl, Deutsche Post cases
– Economics behind
• Market definition
• Competitive assesment
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